Agribusiness Unit 2 Starting and Running an Agribusiness

Agribusiness Unit 2. Starting and Running an Agribusiness Chapter 12. Production Economics 1

Objectives • Define economics and the role it plays in society • Explain how economics is characterized • Illustrate the interaction of the product and • • resource market sectors within the economy List the 6 basic concepts of economics and explain their significance Explain the production function relationship and give a working example of a production function 2

Introduction Economics in society • Study of economics gives us important insight into how capitalistic societies operate • How prices are actually determined in the market • • • for goods/services How price signals are communicated between buyers and sellers, or producers and consumers How institution should be organized to facilitate efficient operation and function of the markets for goods/services The appropriate role of government, in both the private and public sectors the economy 3

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Introduction Economics in society • Comprehensive view of the economy • Households • Individuals and families call home • They are the consumers of all goods • Own the economic resources of the country • Business firms • The companies that produce all goods and services (sole proprietorships, partnerships, corporation, or cooperatives) • Purchase or rent the economic resources available within the economy 5

Introduction Economics in society • Product market sector • The market for finished good • Illustrate the flow of finished goods from producer(business) to consumer(households) • The product market establishes the prices that regulate the quantity and quality of goods produced and consumed within the economy 6

Introduction Economics in society • Resource market sector • The movement of economic resources owned by consumers to business firms • Land, labor, capital and management • Within this sector, the producer pays the consumer for the desired resources • The resource market determines the prices(cost paid for resources used)that regulate the flow of resources from consumer to producer 7

Economics Basics Scarcity of resources • Resources are defined as inputs provided by • nature that are transformed by human labor and technology to produce goods and services Because resources are scarce, many goods and services are also scarce • Therefore, choices must be made among alternative uses of those scarce resources 8

Economics Basics Scarcity of resources • Alternative uses in production • Using land for soybean rather than oat production • Alternative uses in consumption • Using native grassland for conservation purposes rather than as pastureland • Alterative uses regarding time • Working more overtime rather than having additional leisure time • These alternatives allow managers to make appropriate decisions and choices to their operations 9

Economics Basics Basic economic concepts • Supply and Demand • The quantity of a good or services that buyers are willing to purchase • Supply • The quantity of a good or services that sellers are willing to offer • Equilibrium price • The point where quantity demanded equals quantity supplied 10

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Economics Basics Basic economic concepts • Supply and Demand • Elasticity • The price responsiveness of an item • When the supply of or demand for a good is very price responsive, it is considered to be elastic • Conversely, with regard to a good for which the relationship is considered to be inelastic, inelastic a large change in price will bring about a relatively small response in the quantity demanded or supplied. 14

Economics Basics Basic economic concepts • Opportunity cost • The value of what is given up when a resource is employed for one activity • Diminishing returns • As you add more and more of something while holding everything else constant, the added benefit in returns received from each additional unit will eventually begin to decline • The point at which the benefits begin to decrease is defined as the point of diminishing returns 15

Economics Basics Basic economic concepts • Marginality • In economics, the margin is an additional or incremental unit of something • A large part of economic theory is based on marginal revenues and marginal costs • Thus marginality provides a measurement to aid in effective decision-making 16

Economics Basics Basic economic concepts • Cost and Returns • Much of economics deals with the tradeoff between costs and returns • The bottom line of any economic situation requires investigation of the costs and returns of alternative possible decisions • Externalities • In most economic situations, the parties generally do not bear all of the costs or receive all of the returns involved in a transaction 17

The Production Function The production function • Relationship summarizing the process of the conversion of inputs into a particular output • This relationship is determined by the specific technology used in the production process Factors of production • Land, Labor, Capital, and Management • Each of these factors plays an important role in the production process of any agribusiness 18

The Production Function Inputs • Material or good used in creating a final • product Fixed input • It remains the same regardless of whether production takes place • Buildings, land, and machinery • Variable input • It changes according to the amount of production that takes place • Feed, fertilizer, seed, chemicals 19

The Production Function Outputs • Good or service produced • The amount of output is the result of varying • one(or sometimes more)of the input amounts used Output Cost • Fixed Costs + Variable Costs = Total Output Costs 20

The Production Function Production Equations • Total Product (TP) • The level of output produced within the production process corresponding to the amount of variable input added • Average Product (AP) • The amount of output produced by each individual unit of the variable input 21

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Production Equations • Marginal Product (MP) • The added production associated with each unit increase in variable input • Marginal Factor Cost (MFC) • The additional cost of adding one more unit of a variable input to the production process • Marginal Value Product (MVP) • Demonstrate the change in total returns received by adding one more unit of input 23

Law of Diminishing Returns • Tabular Example (1) Units of the Variable Resource (Labor) 0 1 2 3 4 5 6 7 8 (2) Total Product (TP) 0 10 25 45 60 70 75 75 70 ] ] ] ] (3) Marginal Product (MP), Change in (2)/ Change in (1) 10 15 20 15 10 5 0 -5 Increasing Marginal Product Diminishing Marginal Product Negative Marginal Product (3) Average Product (AP), (2)/(1) 10. 00 12. 50 15. 00 14. 00 12. 50 10. 71 8. 75

Law of Diminishing Returns Total Product, TP Graphical Portrayal 30 TP 20 10 0 Marginal Product, MP 20 1 2 3 Increasing Marginal Returns 4 5 6 7 8 9 Negative Marginal Returns Diminishing Marginal Returns 10 AP 1 2 3 4 5 6 7 8 MP 9

Relationship between TP, MP, and AP • TP and MP go through three phases. - First Phase: TP is rising at an increasing rate. MP is increasing. - Second Phase: TP is rising at a diminishing rate until reaching a max. MP is still positive but decreasing to zero. - Third Phase: After reaching a maximum, TP declines. MP becomes negative. • MP intersects AP where AP is at maximum. - Where MP exceeds AP, AP rises. - Where MP is less than AP, AP declines.

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The Production Function Principle of diminishing returns-input basis • At some point, as inputs are continually added, eventually adding one more input unit will not be useful and will actually be detrimental to the production process • Decision rule • Maximizing net returns above the cost of the input • MVP ≥ MFC (to maximize profitability) 28

The Production Function Returns to scale • Increasing returns to scale • As inputs are increased by a specific proportion, production(output) increases by a greater proportion • Decreasing returns to scale • As inputs are increased by a specific proportion, output increases by a lesser proportion • Constant return to scale • As inputs are increased by a given proportion, production increases by the same proportion 29

The Cost Function Short-Run Costs • Total Costs (TC) • The total costs of production in the short run • TFC+TVC • Total Fixed Costs (TFC) • Costs that do not change according to output • Total Variable Costs (TVC) • Costs that change according to the level of production 30

Short-Run Costs • Average Total Costs (ATC) • Average Fixed Costs (AFC) • Average Variable Costs (AVC) • Marginal Costs (MC) • The costs of producing each additional unit of output 31

Short-Run Production Costs Total Cost, Fixed and Variable Costs $1100 TC 1000 900 TVC 800 Costs 700 600 Fixed Cost 500 400 Total Cost 300 200 Variable Cost 100 TFC 0 1 2 3 4 5 6 7 8 9 10 Q

Law of Increasing Cost • Tabular Example (1) Total Product (TP) (2) Total Variable Cost (TVC) 0 10 25 45 60 70 75 75 70 0 10 20 30 40 50 60 70 80 ] ] ] ] (3) Marginal Cost (MC), Change in (2)/ Change in (1) 1. 0 0. 7 0. 5 0. 7 1. 0 2. 0 Inf. decreasing Marginal Cost Infinite Marginal Cost (3) Average Cost (AC), (2)/(1) 1. 00 0. 80 0. 67 0. 71 0. 80 0. 93 1. 14

Average Production Costs Total Cost Total Product (TP) Average Cost Total Fixed Cost Variable Cost (TFC) Cost (TVC) (TC) 0 $0 1 $80 80 2 Average Fixed Cost Variable Total Cost (AFC) Cost (AVC) (ATC) 50 $80 130 $80 $50 - 80 95 175 40 47. 50 87. 50 3 80 140 220 26. 66 46. 66 73. 33 4 80 190 270 20 47. 50 67. 50 5 245 6 80 80 305 325 385 16 13. 33 49 50. 83 65 61. 17 7 80 370 450 11. 42 52. 86 62. 28 8 80 440 520 10 55 65 $130

Marginal Production Costs Total Cost Total Product (TP) Total Fixed Cost (TFC) Total Variable Cost (TVC) Average Cost Average Fixed Cost (AFC) Total Cost (TC) Average Variable Cost (AVC) Average Total Cost (ATC) Marginal Cost (MC) 0 $80 $0 $80 - - - 1 80 50 130 $80 $50 $130 2 80 95 175 40 47. 50 87. 50 3 80 140 220 26. 66 46. 66 73. 33 4 80 190 270 20 47. 50 67. 50 5 80 245 325 16 49 65 6 80 305 385 13. 33 50. 83 61. 17 7 80 370 450 11. 42 52. 86 62. 28 8 80 440 520 10 55 65 $50 45 45 50 55 60 65 70

Short-Run Production Costs Average and Marginal Costs $200 MC 150 Costs AFC ATC AVC 100 50 AVC AFC 0 1 2 3 4 5 6 7 8 9 10 Q

The Relationship between Productivity Curves and Cost Curves Average Product and Marginal Production Curves Cost Curves AP MP Quantity of Labor Cost (Dollars) MC Quantity of Output AVC

The Cost Function Long-Run Costs • In the long run, all costs are considered variable, as the producer can adjust the level of inputs • Economies of scale • An expansion allows the agribusiness to produce at a lower long-run average cost • Increasing the size of the business makes it continuously more efficient, thus decreasing the minimum average cost 38

Long-Run ATC Curve Average Total Costs ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Output Any number of short-run optimum size cost curves can be constructed.

Long-Run ATC Curve Average Total Costs ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Long-Run ATC Output The long-run ATC curve just “envelopes” the short run ATCs.

Long-Run ATC Curve: Why U-Shape? Alternative Long-Run ATC Shapes Diseconomies Of Scale Constant Returns To Scale Average Total Costs Economies Of Scale Long-Run ATC q 1 q 2 Output Long-Run ATC Curve Where Economies Of Scale Exist

The Cost Function Long-Run Costs • Constant returns to scale • This occurs when long-run average costs remain constant, even as output is increased • Diseconomies of Scale • At a certain point, additional increases to output lead to an increases in average cost • At this point, the agribusiness starts to become less efficient 42

The Cost Function Long-Run Costs • Two factors of economies of scale • Improving the division of labor and specialization • Lower input costs • Buying in bulk • More efficient use of costly or specialized • inputs More effective use of organization and learning inputs 43

Resource Substitution Marginal Rate of Substitution • It is the amount of one input that is replaced by an additional unit of another input Isoquant Curve • It illustrates the set of all pairs of inputs(X 1, X 2)that can be used to produce the same level of output(Y) 44

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Resource Substitution Isoquant Curve • Types of substitution • Imperfect substitutes • Additional units of one input replace less and less of the other input(resulting in a negatively sloping graph • Perfect substitution • Isoquants are straight lines • Perfect complements • The curve is L-shaped 46

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Resource Substitution Isocost Line • It illustrates the different combinations of 2 inputs that can be purchased with the same amount of money • It also shows the amount of one input that would cost the same if another unit of the other input was purchased • The slope of isocost line 49

Resource Substitution Least-Cost Combination of Inputs • • • The producer should continue to add more of one input(X 1) to replace another input(X 2) as long as the cost of the input being replaced is greater than or equal to the cost of the input being added 50

Profit Maximization in the Short-Run In the short run, the purely competitive agribusiness firm maximizes profits or minimizes losses only by adjusting output (since it is a price taker) only through changes in the amount of variable resources (since it has a fixed input). Three questions must be answered: 1. Should the firm produce? 2. If so, in what amount? 3. What economic profit (or loss) will it realize? Two different approaches are used to examine a firm’s short-run maximum profit or minimum loss 1. Compare TR and TC (produce where TR-TC is greatest). 2. Compare MR and MC (produce where MR=MC).

TR-TC Approach Do You See Profit Maximization? Price = $131 (1) Total Product (Output) (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Profit (+) or Loss (-) 0 1 2 3 4 5 6 7 8 9 10 $100 100 100 $0 90 170 240 300 370 450 540 650 780 930 $100 190 270 340 400 470 550 640 750 880 1030 $0 131 262 393 524 655 786 917 1048 1179 1310 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280

Total Economic Profit Total Revenue and Total Cost TR-TC Approach $1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 $500 400 300 200 100 Break-Even Point (Normal Profit) Total Revenue, (TR) Maximum Economic Profit $299 Total Cost, (TC) P=$131 Break-Even Point (Normal Profit) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Quantity Demanded (Sold) Total Economic Profit $299 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Quantity Demanded (Sold)

MR-MC Approach The market price is $131. Do you see profit maximization now? Profit-Maximizing Case (1) Total Product (Output) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) 0 1 2 3 4 5 6 7 8 9 10 $100 100 100 $0 90 170 240 300 370 450 540 650 780 930 $100 190 270 340 400 470 550 640 750 880 1030 (5) Marginal Cost (MC) $90 80 70 60 70 80 90 110 130 150 (6) Marginal Revenue (MR) (7) Profit (+) or Loss (-) $131 131 131 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280

Daily Quiz Assume that in the short run a firm is producing 100 units of output. The firm has Average Total Costs of $200, and Average Variable Costs of $150. The firm's Total Fixed Costs are: A) B) C) D) $5, 000 $500 $. 50 $50 Please provide why it is the answer !!!