Chapter Three: Producer Decision Making Academic Year: 2021

Chapter Three: Producer Decision Making

3.1. Introduction
 This chapter introduces some basic concepts fundamental to the study of production
economics and provides a brief review of fundamental terms used in economics.
 These terms are usually presented as part of an introductory economics or agricultural
economics course, and provide a starting point for the further study of agricultural
production economics.
 In production theory the main choices center upon what to produce (which product or
combination of products), how much to produce (the level of output) and how to produce (the
combination of inputs to use). The decision making unit is the firm which is defined as a
'distinct agent specialized in the conversion of inputs into desired goods as outputs'
 We now turn to one of the main elements of Neoclassical theory - the producer's decision.
 A "producer" is any entity which transforms factors of production into finished goods.
 Economics is defined as the study of how limited resources can best be used to fulfill unlimited
human wants.
 Whereas the wants or desires of human beings are unlimited, the means or resources
available for meeting these wants or desires are not unlimited (limited).
 Economics thus deals with making the best use of available resources in order to fulfill
these unlimited wants.
 An entire society, an entire country, or for that matter, the world, faces constraints and
limitations in the availability of resources.
 When the word resource is used, people usually think of basic natural resources, such as
oil and gas, and iron ore. However, the term has a much broader economic meaning, and
economists include not only basic natural resources, but a broad array of other items that
would not occur to those who have not studied economics.
 An important resource is the amount of labor that is available within a society.
 The money that is invested in industrial plants used to produce items consumers want is
another basic resource within a society.
 A resource can be defined still more broadly.
 Human beings vary in their skill at doing jobs. A society consisting primarily of highly
educated and well-trained individuals will be a much more productive society than one in
which most people have few skills. Thus the education and skills of jobholders within an
economy must be viewed as a limiting resource.
 Students may attend college because they hope to obtain skills that will allow them to
earn higher incomes. They view the lack of a college degree to be a constraint or limitation
on their ability to earn income.
 Underlying this is the basic driving force of unlimited human wants. Because human wants
and desires are unlimited, whereas the resources useful in fulfilling these wants are limited,
the basic problem that must be faced, both by individuals and by societies, is how best to go
about utilizing scarce resources in attempting to fulfill these unlimited wants.
 Economics involves choices. This chapter deals with set of choices faced by producers.
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 The set of choices faced by the producer of goods and services desired by the
consumer.
 The producer also attempts to maximize utility.
 To maximize utility, the producer is motivated by a desire to make money, again in
order better to fulfill unlimited wants.
 Although the producer may have other goals, the producer frequently attempts to
maximize profit as a means of achieving utility or satisfaction.
 Profit is the difference between the revenues obtained from what is sold and the costs
incurred in producing the goods.
 However, producers face constraints, too. If producers did not face constraints, the
solution to the profit-maximization problem for the producer would be to produce as
much as possible of anything that could be sold for more than the cost of production.
 Producers may attempt to maximize something other than profit as a means for achieving the
greatest utility or satisfaction.
 Some farmers might indeed have the objective of maximizing profits on their farms
given resources such as land, labor, and farm machinery.
 The underlying motivation for maximizing profits on the farm is that some of these
profits will be used as income to purchase goods and services for which the farmer
(and his or her family) obtains satisfaction or utility.
 Such a farmer behaves no differently from any other consumer.
 Other farmers might attempt to maximize something else, such as the amount of land
owned, as a means to achieve satisfaction.
 The producer faces an allocation problem analogous to that faced by the consumer.
 The consumer frequently is interested in allocating income such that utility or
satisfaction is maximized. The producer frequently is interested in allocating
resources such that profits are maximized.
 Economics is concerned with the basic choices that must be made to achieve these
objectives.
 Consumption economics deals primarily with the utility maximization problem,
whereas production economics is concerned primarily with the profit maximization
problem. However, profits are used by the owner of the firm to purchase goods and
services that provide utility or satisfaction.

3.2. Agricultural Production Economics

 Until now, little has been said about agricultural economics and its relationship to economics.
 There has been a reason for this. An agricultural economist is, first, an economist, in
that an agricultural economist knows economic theory intimately. However, an
agricultural economist is also an economist with a specialization in agriculture.
 The primary interest is in applying economic logic to problems that occur in
agriculture.

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 An agricultural economist needs to know economics, but a knowledge of agriculture is

also important. If an agricultural economist is to portray relationships accurately using
a model of some component of an agricultural sector, the agricultural economist must
know these relationships. Otherwise, the salient or important elements of the theory
would be missed.
 Agricultural production Economics is concerned primarily with economic theory as it relates
to the producer of agricultural commodities.
 Some major concerns in agricultural production economics include the following.
 Goals and objectives of the farm manager.
 Agricultural economists often assume that the objective of any farm manager is
that of maximizing profits, a measurement of which is the difference between
returns from the sale of crops and livestock less the costs of producing these
commodities.
 However, individual farmers have unique goals. One farmer might be more
interested in obtaining ownership of the largest farm in the county. Another
might have as his or her goal that of owning the best set of farm machinery.
Still another might be interested in minimizing his or her debt load.
 The goals and objectives of a farm manager are closely intertwined with a
person's psychological makeup, and the goals selected by a particular person
may have very little to do with profit maximization. Nonetheless, most
economic models used for representing the behavior of farm managers assume
that the manager is interested in maximizing profits, or at minimum is interested
in maximizing revenue subject to constraints imposed by the availability of
resources.
 Choice of outputs to be produced.
 A farm manager faces an array of options with regard to what to produce given
available land, labor, machinery, and equipment.
 The manager must not only decide how much of each particular commodity to
be produced, but also how available resources are to be allocated among
alternative commodities.
 The farmer might be interested in maximizing profits but may have other goals
as well. Often other constraints enter.
 For example, the government may permit the farmer to grow only a certain
number of acres of a particular commodity.
 The farmer may have a particular knowledge of, or preference for, a certain
commodity.
 The farmland may be better suited for certain types of crops or livestock than
for other types.
 Allocation of resources among outputs.
 Once decisions have been made with regard to what commodity or commodities
are to be produced, the farmer must decide how his or her available resources
are to be allocated among outputs.

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 A simple question to be answered is which field is to be used for the production

of each crop, but the questions quickly become far more complex. The amount
of farm labor and machinery on each farm is limited. Labor and machinery time
must be allocated to each crop and livestock activity, consistent with the
farmer's overall objective.
 The greatest share of this text is devoted to dealing with issues underlying the
problems faced by farm managers in the allocation of resources or inputs
across alternative outputs or enterprises.
 Assumption of risk and uncertainty.
 Models in production economics frequently assume that the manager knows
with certainty the applicable production function (for example, the yield that
would result for a crop if a particular amount of fertilizer were applied) and the
prices both for inputs to be purchased and outputs to be sold.
 However, in agriculture, the assumption of knowledge with respect to the
production function is almost never met.
 Weather is, of course, the key variable, but nature presents other challenges.
 Cattle develop diseases and die, and crops are affected by insects and disease.
 Most farmers would scoff at economic theory that assumes that a production
function is known with certainty.
 Although farmers may be fully aware of the prices they must pay for inputs
such as fuel, fertilizer, and seed at the time each input is purchased, they are
almost never aware at the beginning of the production season of prices that will
prevail when outputs are sold. Price uncertainty is a result of the biological lag
facing the producer of nearly any agricultural commodity, and production in
agriculture takes time.
 The competitive economic environment in which the farm firm operates.
 Economists often cite farming as the closest real. World example of the traditional
model of pure competition. But the competitive environment under which a farmer
operates depends heavily on the particular commodity being produced.

3.3. Physical relationships

o This section introduces the concept of a production function and uses the concept as a basis for
the development of the factor-product model. Algebraic examples of simple production
functions with one input and one output are developed.

3.3.1. What Is a Production Function?

 Production is the process of combining and coordinating inputs (resources or factors of
production) in the creation of a good or service. A production function describes the technical
relationship that transforms inputs (resources) into outputs (commodities).
 Producing a ton of wheat, for example, requires, in addition to suitable climatic
conditions, some amount of arable land, seed, and fertilizer, the services of equipment
such as ploughs and harvesters, and human labor.

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 It seems reasonable to assume that production will vary in a systematic way with the
levels of input usage and, as a shorthand device, economists often express this
relationship between inputs and outputs in mathematical symbols.
 It shows functional relationship between the changes in output due to change in inputs.
 A mathematician defines a function as a rule for assigning to each value in one set of
variables (the domain of the function) a single value in another set of variables (the range
of the function).
o Suppose you want to start a farm to produce tomatoes. You need land, tomato seeds, water for
irrigation, workers to work on the farm, a tractor and possibly some other machinery.
 All those are inputs, or factors of production, that are going to be used to produce
tomatoes (output). Inputs include labor, machinery, buildings, raw materials and energy.
o The relationship between the quantity of inputs a firm uses and the output it produces is called
a production function.
 We restrict the analysis to the case where only two inputs are used to produce a good or
service. Those two inputs will be called capital (for example, machinery, buildings, and
so on) and labor (for example, number of workers or number of worked hours).
o An input (or factor of production) is a good or service used to produce output.
o The production function summarizes technically efficient ways to combine inputs to produce
output.
 A general way of writing a production function is
Q = f (x)…………………………………..……………………………………………………………………….. (1)
 Where Q is an output and x is an input. All values of x greater than or equal to zero
constitute the domain of this function. The range of the function consists of each output
level (Q) that results from each level of input (x) being used.
 Equation (1) is a very general form for a production function.
 The production function is a purely physical concept: it depicts the maximum output in
physical terms for each and every combination of specified inputs in physical terms. It relates
to a given state of technology.
 As should become clear, the production function is the core concept in the economic theory of
production.
 For ease of exposition, the technical aspects of production will be discussed
a) in terms of the factor-product relationship, where there is one variable input in a
production process creating a single output,
b) the factor-factor relationship, where there are two or more variable inputs.
c) the product-product relationship in which more than one product may be produced
from the available stock of inputs.

A. The factor-product relationship

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 If it is assumed that all inputs except one (say, fertiliser, denoted as 𝑋1) are held fixed at some
level, the relationship between output and the single variable factor can be derived.
 This factor-product relationship is denoted as

 where 𝑋2..., 𝑋𝑛 are the fixed factors; 𝑋1 is the variable factor. Graphically the relationship
is represented by the total product (TP) curve of Fig. 3.1 (a).
 In this case, as more fertiliser (𝑋1) is applied, output (Q) increases until a maximum,
associated with input usage 𝑋1 is reached.
 Further applications of fertilizer will only serve to reduce the total quantity produced.
 Note that the TP curve is drawn for a given level of the fixed factors and for a given state
of technology. For a numerical illustration of this relationship refer to Table 3.1.
 Two other aspects of the factor-product relationship will be of interest. These are
 Inputs are commonly classified as fixed inputs or variable inputs.
 Fixed inputs are those inputs whose quantity cannot readily be changed when market
conditions indicate that an immediate adjustment in output is required.
o Buildings, land, and machineries are examples of fixed inputs because their
quantity cannot be manipulated easily in a short period of time.
 Variable inputs are those inputs whose quantity can be altered almost instantaneously in
response to desired changes in output.
o The best example of variable input is unskilled labor, chemical fertilizer, etc..

a. The marginal product (MP) of the variable input

 This is defined as the change in output resulting from a small change in the variable input
expressed per unit of the input.
 The symbol ∆ is commonly used to denote a change.
 Thus the marginal product of a small change, ∆𝑋1 , in input 𝑋1 can be obtained from
the following expression:

𝜕𝑄
 For an infinitesimal change 𝜕𝑋1 in the factor, 𝑀𝑃𝑋1 = 𝜕𝑋 = the slope of the total product
1
curve at the relevant point.
 Thus in Fig. 3.1, MP is at a maximum (the slope of TP is greatest) at the point of
inflection of the curve (at input level 𝑋 ′ ), it is zero at the point of maximum total
product (at input level X") and it becomes negative at input levels beyond X".

b. The average product (AP) of the variable input

 This is defined as total product divided by the amount of variable input i.e.

 Diagrammatically, average product at a particular level of input use is given as the

slope of a line from the origin at point O to the relevant point on the total product curve.

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 Thus, for example, in Fig. 3.1 (a) the slope of line OA gives the average product of 𝑋1
at input level 𝑋 01 .
 It should be clear from these definitions why 𝐴𝑃𝑋1 =𝑀𝑃𝑋1 at 𝑋 01 in Fig. 3.1 (the slope
of the TP curve = the slope of a line from the origin at 𝑋 01), and why 𝐴𝑃𝑋1 is at a
maximum at this point (a line from the origin to the TP curve has greatest slope there).
 The product curves in Fig. 3.1 satisfy the almost universal law of diminishing marginal
returns.
 The law of diminishing marginal returns states that as more and more of a variable
input is used, with other inputs held constant, eventually the increases to total product
will become smaller and smaller i.e. after some point the marginal product of the
variable input will decline.
 In Fig. 3.1, the factor-product relationship is one of increasing returns up to 𝑋 ′1 , but
diminishing marginal returns set in beyond this level of input usage.
 As we have already noted, the total product is a purely physical relationship; economic
considerations involving prices of inputs and outputs are not part of the analysis. Yet it
is possible to determine, on technical grounds alone, a range of input usage in which
the rational producer will operate.
 This point may be illustrated with the aid of Fig. 3.1 where the TP, MP and AP curves
have been divided into stages of production.
Stage 1 is defined to be that in which the average product of 𝑋1 , 𝐴𝑃𝑋1 , is rising.
Stage 2 both marginal (𝑀𝑃𝑋1 ) and average product are falling but both are
positive.
Stage 3 is that in which marginal product, 𝑀𝑃𝑋1 , is actually negative.
 In the following discussion, it will be helpful to bear in mind that the producer is using at
least two inputs: a variable input, say fertilizer, and a second which represents a set of fixed
factors of production (land, labor, seed etc.).

Fig. 3.1. (a): The total product curve

Fig. 3.1. (b) The marginal product and average product curves
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 In Stage 3, additional units of fertilizer reduce total product i.e. the marginal product of
fertiliser is negative.
 The fixed inputs, notably land, are overloaded and the producer's interest would be
better served (output would increase) by using less fertilizer and in so doing, by
moving back, out of Stage 3.
 In other words it is irrational to choose a level of fertilizer in Stage 3. Whereas in
Stage 3 the producer uses too much fertilizer, by contrast in Stage 1 not enough of
the input is being applied, given the level of the fixed factors.
 In Stage 1, the average product of the variable input is rising and throughout this stage MP
lies above AP.
 With each additional unit of fertilizer, more is being added to total product than was
added on average by the previous units of fertilizer.
 Therefore if it is profitable to produce any output, the farmer can make more profit
by using more fertilizer at least up to the end of Stage 1.
 It would therefore be predicted that the optimum position in terms of variable input usage
will lie somewhere in Stage 2.
 The precise position can only be determined by incorporating the prices of inputs and of
the final product into the analysis.
 A numerical illustration of the factor-product relationships for a simple production function
are presented in Table 3.1.
 Three inputs, fertilizer, land, and labor are used to produce maize.
 Naturally if none of these inputs is employed total product is zero. With one unit of all three
inputs total product rises to 0.25 tones.
 Thereafter column 4 shows how total product of maize changes as successive units of
fertilizer are employed while land and labor are both fixed at one unit each.
 As an exercise readers might care to check that they can calculate the average and marginal
product values in columns 5 and 6. They might also usefully graph the data in Table 2.1 and
examine its relationship to Fig. 3.1.

Table 2.1. Hypothetical example: factor-product relationships

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B. The factor-factor relationship

 Typically in a given production period of say a year, there would be more than one variable
factor of production.
 For example, in the production of wheat, fertilizer, seed, and labor services may be
variable, while the land and machinery inputs remain fixed.
 In this case, we are interested both in the relationship between output and the set of
variable inputs and the extent to which one variable factor may be substituted for
another.
 Discussion of these factor-factor relationships is often confined to the two variable inputs case,
but the results can be generalized to the case of three or more variables. Assuming two variable
inputs, the production function is denoted as:

 Where the vertical line before 𝑋3 indicates that all inputs other than 𝑋1 and 𝑋2 are fixed.
 This relationship can be conveniently illustrated by an isoquant map such as the one in Fig.
3.2.
 An isoquant is a 'contour' line or locus of different combinations of the two inputs which
yield the same level of output.

Fig. 3.2. The isoquant map

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 Thus, for example, ten units of output can be produced by both the input combination at
point A and that at point B in Fig. 3.2.

 Where ∆ signifies a change, and 𝜕 the derivative for an infinitesimally small change.
 In general, MRS is negative since more usage of one input is associated with less of
another i.e. the isoquant is downward sloping.
 However the negative sign is often omitted and this will be the convention adopted here.
 Thus far, our discussion has concerned the production setting in which some factors of
production are variable, while other factors are fixed.
 In economic terminology, we have been dealing with the short run i.e. a period when the set
of inputs available to the producer is not wholly adjustable.
 In the long run changes in output can be achieved by varying all factors.
 Thus, in the long run, the farmer may vary all available resources including the size of the
farm, the number of farm buildings and the type of machinery.
 The long run factor-factor relationship which receives most attention is that known as the
returns to scale.
 In the long run output may be increased by changing all factors by the same proportion
i.e. by altering the scale of the operation.
 The response of output to scale changes in inputs will depend on the technical
characteristics of the production function.
 A classification of possible outcomes is useful:

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 If, when all inputs are increased by the same proportion (say, by 50%), output
increases by the same proportion (i.e. 50%), then we say there are constant returns
to scale.
 If output increases less than in proportion (say, by 25%) with the same (50 %)
increase in all factors, we have decreasing returns to scale.
 If output increases more than in proportion (say, by 75 %) when we increase all
factors by 50%, we have increasing returns to scale.

C. The product-product relationship

 In this section, the analysis is extended to the multiproduct firm, since most farmers have a
range of alternative crops they could grow on the same land and of livestock they could rear.
 To simplify the exposition, it is assumed that the producer can produce two products, wheat
and maize, each output being produced by a set of n inputs.
 Production functions for wheat and maize respectively can be specified:

The form of these production relationships, together with the level of the (limited)
resources available, will determine the production possibilities facing the producer.
 The production options which are technically feasible can be illustrated by a production-
possibility frontier (or transformation curve), Fig. 3.2.
 This curve is the locus of combinations of wheat and maize which can be produced with
a set of given inputs and assuming a particular state of technology.
 If all available resources were used in the production of wheat, 𝑤𝑜 units of wheat could
be grown; if all inputs were diverted to maize production, mo units of maize could be
produced. Alternative combinations of the two products are depicted by points along the
curve 𝑤𝑜 𝑚𝑜 .
 The slope of the production-possibility frontier represents the marginal rate of transformation
(MRT) of maize for wheat:

 This measures the opportunity cost of producing maize in terms of wheat i.e. how much
wheat must be sacrificed in order to obtain an additional unit of maize.
 In Fig. 3.2, the slope of the curve (or MRT) increases, in absolute terms, as more maize
is produced. This is an example of increasing opportunity costs i.e. increasing amounts
of wheat output must be sacrificed to produce additional units of maize.

Fig. 3.2. The production-possibility curve

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 Finally, it should be noted that an efficient farmer would choose to operate at

some point on the production-possibility frontier.
 A point such as c in Fig. 3.2 would be considered an inefficient use of resources,
since with the same level of inputs, more of at least one of the products could be
forthcoming.
 Specifically in the ab segment of the curve total output of either or both products
will be higher.
Opportunity costs: this is a key concept in economics which reflects the subject's
central concern with choices about the allocation of scarce resources.
 Choosing to allocate resources in one way rules out other choices.
 The opportunity cost of a decision is the value of the best alternative choice
which is foregone as a result of that decision.
 In the context of the production possibility frontier the decision to produce more
maize involves switching resources from wheat production and therefore
sacrificing wheat output.
 The value of the wheat output which could be produced with the resources
switched to maize is the opportunity cost of maize production. It only makes
economic sense to make the switch if the value of the extra maize exceeds
opportunity cost in terms of value of lost wheat output. In an entirely analogous
way, in analyzing consumers' choices about the allocation of income,
purchasing more of Y can only mean less income available for other uses.
 Thus, there is an opportunity, cost to the purchase of more Y in terms of less of
other products or services.

3.4. Economic relationships

 In the traditional approach to production economics, the goal of the entrepreneur is assumed
to be profit maximization.
o It must of course be recognized that in certain circumstances the producer may have a
different objective or indeed that multiple goals may be sought. For example one
suggestion, dating from the 1950s but which has had rather limited impact on economic

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analysis, is that producers adopt satisficing rather than maximizing behavior i.e. they
set minimum acceptable levels of profits and other targets and will be satisfied with
any outcome which meets them.
o An alternative approach is based on the premise that producers are indeed optimizers;
however, they do not merely maximize profits but rather their satisfaction from a range
of variables, of which profits may be just one.
o Profit maximization would seem to be a plausible objective for the producer operating
in a competitive market and it may not entirely preclude higher level goals reflecting,
for example, social and cultural desires.
o It is further assumed, for the purpose of this chapter, that the individual producer is a
price-taker. That is to say, in both product and input markets, the producer is unable
to influence prices in any way. Again this is a reasonable assumption when the analysis
is confined to competitive markets where there are many firms, none of which has
sufficient market power to manipulate price.

3.4.1. Economic optimum: the factor-product relationship

 In deciding what is the economic optimal usage of a single variable input, the producer
requires three pieces of information:
i. the marginal product of the input (𝑀𝑃𝑋1 ), which indicates the contribution to total
output which an additional unit of the input would make,
ii. the price per unit of the final product (P) and
iii. the price per unit of the variable input (𝑃𝑋 ).
 The value of an additional unit of the input to the producer is the extra revenue which will be
forthcoming as a result of greater input usage. This is measured by the value of the marginal
product (VMP) i.e. 𝑀𝑃𝑋1 x P.
o The economic optimum, yielding maximum profits, will be attained where the value of
the marginal product of the variable input is equated to its price:

o At the particular level of input usage associated with the optimal condition ( the above
equation), the producer is said to be in equilibrium.
o In equilibrium there is no incentive to alter the production plan.
o To demonstrate that the above equation does indeed indicate the optimum position,
suppose that 𝑉𝑀𝑃𝑋1 exceeds 𝑃𝑋 .
o An additional unit of the input would then yield more to the producer in terms pf extra
revenue than it would cost; thus more profit would be obtained if an extra unit were
employed.
o On the other hand, if 𝑉𝑀𝑃𝑋1 were less than 𝑃𝑋 , the last unit of the input employed
contributed less to revenue than it added to costs; hence less of the input should be
used. The producer will only be in (profit maximizing) equilibrium when the above
equation holds.

3.4.2. Economic optimum: the factor-factor relationship

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 To determine the appropriate level of input use when there are two variable factors of
production, a producer must know the rates at which inputs are exchanged in the market (their
relative prices) as well as the rates at which they can be exchanged in production (their
marginal rate of substitution).
 To illustrate the former, we introduce the iso-cost line.
o Iso-cost line is the locus of all combinations of the two inputs which the producer can
purchase with a given cost outlay. An iso-cost line is the locus points denoting all
combination of factors that a firm can purchase with a given monetary outlay, given
prices of factors
o Fig. 3.3 depicts an iso-cost line for an outlay 𝐶𝑜 , which is simply the sum of
expenditures on input 𝑋1 (i.e. 𝑃𝑋1 𝑋1) and an input 𝑋2 (i.e. 𝑃𝑋2 𝑋2).
Hence, 𝐶𝑜 = 𝑃𝑋1 𝑋1+ 𝑃𝑋2 𝑋2
𝑃
o The slope of the iso-cost line is the ratio of input prices, ( -) 𝑋1⁄𝑃 .
𝑋2
o The isocost line for a larger cost outlay would be represented by a parallel line located
further from the origin.

Fig. 3.3. The iso-cost line

o Since the producer would wish the cost outlay on variable inputs to be as small as
possible, we need a rule for determining the least cost combination of inputs.
 The least cost outlay on variable inputs to produce a given output level 𝑄̅ is shown in Fig. 3.4
to be at the point of tangency between iso-cost line 𝐶1 and the 𝑄̅ isoquant.
 Output Q could be generated by other combinations of the two inputs other than that at point
A but these would be associated with higher cost outlays (represented by iso-cost lines such as
𝐶2 to the right of 𝐶1 ).
 Lower cost outlays, such as 𝐶0 , would be insufficient to generate the required level of
production.
 Thus the optimum for any given output level is found at the point of tangency between
the lowest isocost line and the appropriate isoquant.
 Since at this point the slope of the isoquant is equal to the slope of the isocost line, and
since the slope of the isoquant is the marginal rate of substitution, the optimal condition
is
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 The foregoing analysis provides a rule for determining the level of (minimum) costs
and the combination of inputs uniquely associated with a particular level of output.
 This analytical process can be repeated for all possible levels of output to obtain a
schedule of the minimum cost of production associated with each level of production.
 This schedule of minimum costs of production is the Total Cost (TC) schedule.
 Given that we can now determine the least cost way of producing any stated amount of
production, we can proceed to consider the problem of choosing the optimum level of
production.
 In order to do this it is necessary to undertake a more detailed examination of the cost
structure of a firm employing several variable inputs and some fixed factors. That is,
the analysis which follows is presented in terms of the short-run.
 Total costs (TC) may be divided into:
i. Fixed costs (FC), which are associated with the fixed inputs e.g., rents or
mortgage payments, depreciation on farm buildings etc., and which are
independent of the level of output, and
ii. Variable costs (VC), which arise from employing the variable factors of
production such as feed, seed, fertilizer etc.

Fig. 3.4. The least cost combination of inputs

 Fig. 3.5 illustrates a typical set of cost curves. Fixed cost (FC) is by definition constant for all
levels of output. However variable costs are determined by the characteristics of the production
technology.
o It is assumed that as output increases from a certain low level there are increasing returns
so that fewer units of variable factors are required for each extra unit of output, and the
rate of increase in variable costs slows down.
o Once output passes a certain higher level, decreasing returns assert themselves, more units
of variable inputs are needed for successive increments of output, and variable costs begin
to accelerate.
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o Total cost (TC), as shown in Fig. 3.5, is the vertical summation of the FC and VC curves.
o From the total cost schedule it is possible to derive the marginal and average costs of
production. These are very important concepts in the theory of the firm.
o Marginal cost (MC) is the addition to total cost associated with the production of an
additional unit of output i.e.

 This is given by the slope of a line from the origin to the relevant point on the TC
curve.
 Fig. 3.6 illustrates the MC, AVC, and AC curves associated with the cost curves of
Fig. 3.5, and Table 3.2 provides a numerical illustration.
 The most important relationship in the Table is the one between the level of output
and total variable cost (VC); although VC rises continuously as output increases, it
increases by successively smaller increments up to the fourth unit of output, after
which it begins to rise more rapidly.
 This is revealed most clearly in the U-shape of the marginal cost (MC) schedule which
reaches its minimum at the fourth unit of output; the values of the marginal cost
schedule equal the changes in both the variable cost and total cost schedules. It can be
observed that the minimum average variable cost (AVC) is reached at a higher output
level than the minimum MC, and that minimum average total cost (AC) is reached at
an even higher level of production.
 This corresponds to the relationships shown in Fig. 3.6, which show that AVC and AC
are at their minima and rise upwards from the point where the marginal cost curve cuts
them on its upward path.

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Fig. 3.5. The fixed, variable, and total cost curves

Fig. 3.6. The marginal, average variable and average total cost curves

 Marginal revenue (MR) is defined as the addition to total revenue due to an extra unit of output
i.e.

Table 3.2. Costs of production - a hypothetical example

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 The firm will achieve its desired state or equilibrium when profits (𝜋), defined as the difference
between total cost and total revenue, are maximized.
o In Fig. 3.7 (a), losses would be made at output levels lower than 𝑄1 and higher than 𝑄2 , since
in these ranges the total cost curve lies above the total revenue curve. The optimum level of
production is given at Q* where TR exceeds TC by the largest amount.
o An equivalent way of presenting this solution is given in panel b of Fig. 3.7. In this figure
the horizontal line is the price line. Each unit is sold at the same price, so that marginal
revenue equals price, and average revenue equals price i.e. MR = P = AR.
o The marginal cost (MQ curve and average total cost (AC) curve, derived from the total cost
curve in the upper figure, take the usual U shape, with MC cutting AC at its minimum point.
For output to be profitable, price or average revenue (AR) must exceed average cost. In other
words, production must take place within the range 𝑄1 to 𝑄2 .
o The precise profit-maximizing level of output is easily found. Profits rise whenever the
production of an extra unit of output adds more to revenue than it adds to costs i.e.
MR > MC.
o On the other hand, profits fail when additional production adds more to costs than to revenue
i.e. MC>MR.
o Therefore, the profit-maximizing rule is to produce to the point where marginal cost and
marginal revenue are just equal.
o For maximum profits,

o In Fig. 3.6, this point is located at Q* where the slope of the total cost curve (or MC) equals
the slope of the total revenue curve (or MR).

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Fig. 3.7. The (short run) economic optimum

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o Note that in Fig. 3.7 (b), the condition that MC = MR is satisfied at two points - at output
𝑄0 , where MC is on its downward path when it cuts the AR line, and at output Q*, where
MC is on its upward path when it cuts the AR line. But at Qo, price ( = AR = MR) is less
than AC and so a loss is incurred. Hence in deriving the profit maximising level of output a
second condition must be added, namely the MC curve must cut the MR curve from below.
 At higher prices than that portrayed in Fig. 3.7(b) the MR would intersect the MC
curve to the right of point D and optimal output would exceed Q*.
 At lower prices the intersection would be to the left of D and the firm's optimal output
would be less than Q*.
 Note however that it would not be profitable for production to occur if the price were
so low that it intersected with MC at a point such as F. For in such a case average
revenue would be less than average total cost, and production would occur at a loss.
 At any price below minimum average total cost, at point C in Fig. 3.7(b), production
would incur losses. In the short run, however, it will still be worthwhile to continue
in production even if MR and AR are below average total costs, provided that they
exceed average variable costs.
 For in that way a surplus is earned over recurrent variable costs which contribute to
meeting the fixed costs which, by definition, cannot be avoided by ceasing
production.
 On the basis of these simple results it is possible to define the product supply curve
of the competitive firm as the portion of the firm's marginal cost curve above the level
of minimum average variable cost.
For a numerical illustration of the firm's supply curve it is possible to use the
hypothetical data in Table 3.2. For a small firm (farm) in competition price (P) is
constant for each unit of output and is therefore equal to both average and marginal
revenue (AR and MR). Whether any output is produced or not, a fixed cost of £20 is
incurred. If price were only £13 it would equal the marginal cost of producing the fourth
unit of output, but is less than the average variable cost. Indeed the total revenue of £52
(4x 13) falls appreciably short of total variable costs (£75). The overall loss is £43

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(£95 - £52). This exceeds the loss which would be made by not producing at all, since
by not producing at all the loss would only be £20 (the fixed cost). Hence the profit-
maximizing (or loss-minimizing) decision would be to cease production.
At a price of £20, the marginal cost of the sixth unit of production is met and MR
exceeds AVC; in fact total revenue is £120, which is higher than the total variable cost
of £110 but less than the total of all costs which is £130 (a loss of £10 is incurred). Thus
at a price of £20 it would be profitable in the short-run to produce six units of output.
At a price of £25 production, at seven units, becomes profitable with total revenue of
£175 against TC of £155. Note that this discussion applies strictly to the short run. In
the long-run, all factors are variable and all costs must be met if the firm is to remain
in production.

3.4.3. Economic optimum: the product-product relationship

 An evaluation of the product mix that will maximize profit in the multiproduct firm requires
information on
i. the marginal rate of transformation between products and
ii. product prices.
 Assuming that the quantity of inputs and their prices are given, then profit maximization is
achieved by maximizing total revenue. Given the prices of the products we can define an iso-
revenue line as the locus of points of various combinations of the products which yield the
same revenue to the firm. For the two product case, an iso-revenue line is depicted in Fig. 3.8.
𝑃
 The slope of the line is given by the ratio of product prices (− 𝑃 𝑀 ).
𝑊
 In Fig. 3.9, a set of iso-revenue lines is superimposed on the production possibility frontier and
the optimum point (maximum total revenue) is given at the point of tangency between the
production possibility frontier and the highest attainable iso-revenue curve; in this case the
point of tangency is associated with output levels Q* and Q*.
 The equilibrium condition is therefore that (MRT) the marginal rate of transformation of maize
∆𝑄
for wheat ∆𝑄𝑊 is equal to the negative value of the ratio of price of maize to the price of wheat.
𝑀
That is

Fig. 3.8. The iso-revenue line

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 The negative sign reflects the fact that the MRT of two products is generally negative, since
increasing output of one requires production of the other to be reduced.
 Application of the rule in the above equation to the production frontier in the two product case,
enables the profit-maximizing combination of products to be determined.

Fig. 3.9. Product-product equilibrium

3.4.4. Economic optimum: the general case

 The preceding sections have explained and developed the rules for profit-maximization by a
firm in stages.
 One has examined how to choose the right combination of two variable inputs to
minimize the cost of producing a given amount of output.
 Another has examined how to determine the optimal production level when the least cost
production method has been selected.
 A third has explained how, if there are two products and a fixed quantity of inputs
available for use, the optimal combination of outputs (and by implication, allocation of
inputs to each product) can be determined.
 In reality, on the typical farm there are far more than two possible products and more than two
factors of production.

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 It is possible using more advanced mathematical techniques to solve jointly for the
profit maximizing output and input levels, plus the allocation of inputs to outputs, for
such cases.
 The economic principles embodied within those mathematical techniques for profit
maximization are precisely those which have been presented in this chapter, and they
can be appropriately described as the foundation of production economics.

 Summary points
The physical relationships in production are often expressed by a production function for a
single product, or by a set of production functions when more than one product is produced.
 Three relationships are of particular interest:
 The total product curve, which describes the relationship between
output and a single input, all other inputs held fixed. Its slope denotes
the marginal product of the variable input.
 The isoquant, which depicts the combinations of two variable inputs
which yield a given level of output. Its slope denotes the marginal rate
of substitution of one input for the other.
 The production possibility frontier, which depicts the combinations of
two products which can be produced with a given set of inputs. Its slope
represents the marginal rate of transformation of one product for the
other.
Given these physical relationships and the prices of inputs and outputs, a set of economic
relationships can be established for the profit maximizing producer:
 An input would be employed to the point where the value of its marginal
product is just equal to its price.
 For a given level of output, the least cost combination of inputs is found where
the marginal rate of substitution is equal to the (inverse) ratio of the prices of
the inputs.
 For any pair of outputs, the optimal level of production in a multi-product firm
is given where the marginal rate of transformation is equal to the (inverse) ratio
of the prices of the products.
For the firm operating in a competitive environment, the profit maximizing level of output is
established where the (given) price of the product, which is equivalent to the competitive
firm's marginal revenue, is equated to the marginal cost of production.
“End of Chapter Three”

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