AAEC 2305 Fundamentals of Ag Economics

1. AAEC 2305Fundamentals of Ag Economics CHAPTER 3 Production Functions and Product Curves

2. Production for profit • Production is the use of inputs to produce a good or service. • Basic assumption of producer behavior is that the objective of managing the business is to maximize economic profit. • Economic profit = total revenue – cash payments for inputs – opportunity costs of firm owned inputs.

3. Factors of Production • Inputs are generally designated as “X” • 1) Fixed Inputs - factors must be maintained (i.e. paid for, kept up, etc.) whether pdn occurs or not (ex. - land, buildings, heavy machinery, etc.) • 2) Variable inputs - factors that vary as the output level changes (ex. - labor, fertilizer, seed, etc.)

4. Short vs. Long Run • 1) Short-Run: Time span such that some factors are variable & some factors are fixed. • 2) Long-Run: Time span so long that no inputs are fixed.

5. Production Function (PF) • Defn: The technical relationship between inputs & output indicating the maximum amount of output that can be produced using alternative amounts of variable inputs in combination with one or more fixed inputs under a given state of technology. • Or, simply speaking, it is the technical relationship between inputs & output

6. Product Curves • Used to study PF • Total Physical Product (TPP) - illustrates relationship that exists between output and one variable input, ceterus paribus • Indicates total amount of output produced at each level of input use

7. Product Curves (Cont.) • Average Physical Product (APP) - shows how much pdn, on average, can be obtained per unit of the variable input with a fixed amount of other inputs • Indicates avg productivity of the inputs being used - how productive is each input level on average • APP = TPP / X

8. Product Curves (Cont.) • Marginal Physical Product (MPP) - represents the amount of additional (i.e., marginal) TPP obtained from using an additional unit of variable input (X). • The slope of the TPP curve • We use the MPP to identify the rate of change in output resulting from adding one more unit of input • MPP = ΔTPP / ΔX

9. Law of Diminishing Marginal Physical Product • Law of Diminishing Marginal Physical Product: As additional units of one input are combined with a fixed amount of other inputs, a point is always reached where the additional product received from the last unit of added input will decline

10. Relationships between Product Curves • MPP is slope of TPP • At Inflection Point (pt of diminishing mpp): • TPP changes from increasing at an increasing rate to increasing at a decreasing rate • Therefore, MPP reaches a maximum at inflection point

11. Relationships between Product Curves • MPP = 0 occurs when TPP is maximum • MPP is negative beyond TPP max

12. Relationships between Product Curves • APP measures the average productivity of each unit of variable input being used • Drawing a line from the origin which is tangent to the TPP curve gives APP max • At point where APP is max, MPP crosses APP (MPP=APP)

13. Summary of Relationships • When MPP > APP, APP is increasing • When MPP = APP, APP is at a max • When MPP < APP, APP is decreasing • The relationship between TPP, APP, & MPP is very specific. If we have COMPLETE information about one curve, the other two curves can be derived.

14. Stages of Production:Rational & Irrational • In stage I: • TPP is increasing • APP is increasing • MPP increases, reaches a maximum & decreases to APP • IRRATIONAL STAGE BECAUSE APP IS STILL INCREASING

15. Stages of Production:Rational & Irrational • In Stage II: • TPP is increasing • APP is decreasing • MPP is decreasing and less than APP, but still positive • RATIONAL STAGE BECAUSE TPP IS STILL INCREASING

16. Stages of Production:Rational & Irrational • In Stage III: • TPP is decreasing • APP is decreasing • MPP is decreasing and negative • IRRATIONAL STAGE BECAUSE TPP IS DECREASING

17. Stage II of Production • Note: For each additional unit of X that is being used within stage II, TPP is increasing but APP is decreasing, resulting in a trade-off between increased production & decreased productivity for each input. This trade-off is the core of economic decision making and requires the skills of the decision maker.

18. Effects of Technological Change • We know that the PF gives the max amount of output that can be produced by a firm using a given technology. • The PF can shift over time as a result of a technological change

19. Effects of Technological Change • Technological change refers to the introduction of new technology that increases output with the same amount of resources (i.e., the TPP curve would shift upward) • The technological change that shifts the TPP upward would result in a corresponding upward shift in the APP & MPP curves

20. Summary • Production function is a technical relationship between inputs and output. • Production functions cover 3 stages of production • Stage I – irrational production • Stage II - profits maximized somewhere within stage II depending on relationship between product curve and prices of output and inputs. • Stage III – irrational production