Agribusiness Library

1. Agribusiness Library Lesson 060103 Law of Diminishing Returns

2. Student Learning Objectives 1. Explain the production function, and define related terms. 2. Identify the three stages of the production function, and describe the Law of Diminishing Returns. 3. Analyze the cost of production, and define related terms. 4. Describe the Rule of Profit, and define related terms. 5. Define profit maximization, and determine how much input should be used to maximize profit.

3. average cost average fixed cost average product average revenue average variable cost diminishing marginal returns fixed cost marginal cost marginal product marginal revenue production function profit profit maximization revenues Terms

4. Stage 1 in a production function Stage 2 in a production function Stage 3 in a production function total cost total product value of marginal product variable cost Terms (cont’d)

5. How do producers know how much to produce? What are some related terms? The production function relates the inputs and outputs of a process that creates goods or services. A. Total product is the amount of product produced given a combination of inputs. For example, the total product on a 100-acre farm might be 20,000 bushels of corn (200 bu/acre × 100 acres).

6. How do producers know how much to produce? What are some related terms? B. The marginal product is the additional production from one additional unit of input. C. There are often diminishing marginal returns to additional inputs, which means the cost of the additional inputs may not be worth the end result. For example, when you are studying, you are likely to learn the most during the first hour. Each additional hour will add to your learning, but it will not help as much as the first hour. As you grow more tired, you may stop learning entirely.

7. How do producers know how much to produce? What are some related terms? D. To calculate the value of marginal product, it is necessary to multiply the marginal product by the price of the output. E. The average product is simply the total product divided by the number of inputs. For example, if a person uses 10 bags of seed to grow 4,600 bushels of corn, then the average bushels of corn per bag of seed is 46. F. When making production decisions, the value of marginal product is the most important.

8. How do you know when to stop adding additional inputs? What is the Law of Diminishing Returns? The production function for most outputs has three stages. A. Stage 1 in a production function exhibits increasing marginal returns. Each additional unit of input yields more output than the previous unit.

9. How do you know when to stop adding additional inputs? What is the Law of Diminishing Returns? B. Stage 2 in a production function exhibits diminishing—but positive—marginal returns. Therefore, total production increases with each additional unit of input, but total production does not increase as much as the last additional unit of input.

10. How do you know when to stop adding additional inputs? What is the Law of Diminishing Returns? C. Stage 3 in a production function exhibits negative marginal returns. As the variable input used exceeds the capacity of the fixed inputs, the output may actually begin to decline. For example, when a person waters plants too much, the plants drown. When this occurs, there are negative marginal returns to watering the plants.

12. How does a producer know how much it will cost to produce a unit of output? What are some of the common terms associated with the cost of production? When an individual is producing output, he or she will have to purchase inputs. The costs of these inputs can be measured and assigned to each unit of output.

13. How does a producer know how much it will cost to produce a unit of output? What are some of the common terms associated with the cost of production? A. A fixed cost is a cost that is constant, regardless of the number of units produced. For example, if a farmer invests in an acre of land, the cost of that land is the same whether the farmer grows 1 bushel or 200 bushels of corn. Total fixed cost is simply the fixed cost of the input.

14. How does a producer know how much it will cost to produce a unit of output? What are some of the common terms associated with the cost of production? B. A variable cost is a cost that is incurred with each unit of production. For example, the cost of feeding a dairy cow occurs only if additional cows are milked and additional milk is produced. Total variable cost is calculated by multiplying the variable cost per unit by the number of units produced.

15. How does a producer know how much it will cost to produce a unit of output? What are some of the common terms associated with the cost of production? C. Total cost is the sum of fixed costs and variable costs. Total costs measure the entire cost of producing a given level of output. D. Marginal cost is the cost of producing one additional unit of output. E. Average cost is calculated by dividing the total cost by the number of units produced.

16. How does a producer know how much it will cost to produce a unit of output? What are some of the common terms associated with the cost of production? F. Average fixed cost is calculated by dividing the total fixed cost by the number of units produced. G. Average variable cost is calculated by dividing the total variable cost by the number of units produced.

17. How does a producer know how much it will cost to produce a unit of output? What are some of the common terms associated with the cost of production? H. The stages of the production function impact the marginal, average, and total costs. Total costs will always rise. In the first stage of production, the marginal cost will start relatively high (due to fixed costs), but they will drop rapidly as the fixed costs are spread out among more units. As production moves into Stage two, the marginal cost curve will start to increase with each additional unit. In Stage 3 of production, marginal costs will rise exponentially.

18. How does a producer know how much it will cost to produce a unit of output? What are some of the common terms associated with the cost of production? • Total Cost = Total Fixed Costs + (Quantity Produced × Variable Cost) • Average Cost = Total Costs/Number of Units Produced • Average Fixed Cost = Total Fixed Costs/Number of Units Produced • Average Variable Cost = Total Variable Costs/Number of Produced

19. How does a producer measure the revenues earned from sales of output? What are some terms associated with the Rule of Profit? Revenues are earned by selling outputs. The quantity of output sold multiplied by the price per unit will equal total revenues. A. Marginal revenue is the price per unit earned on the last unit sold. B. Average revenue is the total revenue divided by the number of units sold. C. Profit is calculated by subtracting the total costs from the total revenues.

20. What is profit maximization? How should profit be maximized? Profit maximization occurs when marginal revenue is equal to marginal cost. A. If a firm cannot set its own price, then the market price will be marginal revenue. B. In this perfectly competitive market, producers should produce where the marginal cost of one unit of output is equal to the market price. C. Inputs should be used until their marginal cost is equal to their marginal product value.

21. Review • When is the value of marginal product is the most important? • Describe the three stages of the production function. • How is total cost calculated? How average cost calculated? • What is the quantity of output sold multiplied by the price per unit equal to? • How should profit be maximized?