Economic Principles Choosing Input and Output Combinations Chapter

Economic Principles Choosing Input and Output Combinations (Chapter 8) 1

Objectives 1. Explain substitution in economics and decision making. 2. Learn how to compute a substitution ratio and a price ratio for two inputs. 3. Use the input substitution and price ratios to find the least-cost combination of two inputs. 4. Distinguish between competitive, supplementary, and complementary enterprises. 5. Use the output substitution and price ratios to find the profit-maximizing combination of two enterprises. 2

Input Substitution • Substitution that takes place in the production of goods and/or services (physical component): – Machinery, computers, and robots can substitute for labor. – Barley can be substituted for corn in a feed ration. – Urea can be substituted for anhydrous as fertilizer. • Prices influence whether and how much substitution should take place. • Substitution is a type of marginal analysis that considers changes in costs and/or income when making the substitution decision. 3

Input Combinations • The Basic Decision: How to produce? • The Problem: Determining whether more of an input can profitably be substituted for less of another: – Livestock ration: one grain for another or forage for grain. – Machinery for labor. – Herbicide for mechanical and/or hand cultivation. • The Goal: Find the least combination of inputs that will produce a given amount of output. • The Strategy: Always look for new input combinations that cost less. 4

Input Substitution Ratio • First step: Determine if it is physically possible to make a substitution and at what rate: Substitution ratio = amount of input replaced amount of input added 5

Possible Types of Substitution 6

The Price Ratio • Price ratio = Price of input being added Price of input being replaced • Inverse price ratio: The added input price divided by the replaced input price. • Substitution ratio: The amount of replaced input divided by the amount of added input. 7

The Decision Rule The least-cost combination of inputs is where the substitution ratio equals the price ratio. Substitution ratio = Price ratio • In most cases the two ratios won’t be exactly equal. • Usually choose the last combination where the substitution ratio is greater than the price ratio. 8

Selecting a Least-Cost Feed Ration 9

Why does this rule work? • Compares the additional cost of using more of one input versus the reduction in cost from using less of the other. • If the additional cost is less than the cost reduction – the total cost is lowered. • Make the substitution when the substitution ratio > price ratio. 10

What happens when prices change? • The price ratio will change. – Substitution ratio? – (Substitution ratio usually stays about the same – physical input output relationship) • A different input combination will become the new least-cost combination: – Less of the higher priced input. – More of the lower priced input. 11

Product Substitution (Consumption Issue) • When one product is purchased or used in place of another. • When income is spent on one class of product rather than another. • Substitutions or replacements may occur because of: – Increase or decrease in income. – Change in price or perceived quality differences. • Product substitution is a type of marginal analysis that considers changes in costs and/or income when making the substitution decision. 12

Enterprise Combinations • • The Basic Decision: What to produce? The Problem: Determining the physical relationship among enterprises. The Goal: Find the combination of enterprises that will maximize profit. Enterprise relationships: 1. Competitive Enterprises 2. Supplementary Enterprises 3. Complementary Enterprises 13

Competitive Enterprises • Most common type. • Competing for the use of the same limited input at the same time. • The production from one enterprise can often be increased only by decreasing the production from another enterprise. • Some of the limited input must be switched from one enterprise to another. 14

Production Possibilities Curves for Competitive Enterprises 15

Production Possibilities Curves for Competitive Enterprises • Straight line PPC – substitution ratio stays the same all along the curve. • Curved PPC – substitution ratio is different for different combinations of enterprises. • Over time a combination of crop enterprises may benefit each other: – Weed, disease, insect control, soil fertility, erosion control, timing of planting and harvesting. 16

Finding the Profit Maximizing Combination of two Competitive Enterprises Compare their substitution ratio and their price ratio: Substitution ratio = Quantity of output lost Quantity of output gained Price ratio = Price of output gained Price of output lost Decision Rule: Substitution ratio = Price ratio 17

Selecting a Profit-Maximizing Enterprise Combination 18

Supplementary Enterprises • Production from one can be increased without affecting the production level of the other. • Examples: – Stocker steers on winter wheat pasture. – Landowners leasing hunting rights. 19

Production Possibilities Curve for Supplementary Enterprises 20

Finding the profit maximizing combination of two supplementary enterprises • The profit maximizing combination will not be within the supplementary range. • It will be at least at the point where the relationship changes from supplementary to competitive. – It will likely be in the competitive portion of the PPC. • Solution then depends on the substitution ratio and price ratio for competitive enterprises. 21

Complementary Enterprises • Increasing the production from one enterprise increases the production of the other enterprise. • Example: – Non-irrigated wheat production with limited rainfall – leave some land fallow each year to store moisture. 22

Production Possibilities Curve for Complementary Enterprises 23

Finding the profit maximizing combination of two complementary enterprises • Increase the complimentary enterprise at least to the point where production from the primary enterprise is at a maximum. • The profit maximizing combination will not be within the complementary range: – It will be at least to the point where the relationship changes from complementary to competitive. – As long as both enterprises produce some revenue, it will be in the competitive range. • Solution then depends on the substitution ratio and price ratio for competitive enterprises. 24

Summary • Use substitution principles to help answer the questions of how and what to produce. • How to produce? – Find the least-cost combination of inputs to produce a given amount of output. – Decision rule: Substitution ratio = Price ratio 25

Summary • What to produce? – Find the profit-maximizing combination of enterprises. – Decision rule: Substitution ratio = Price ratio • Three combinations of enterprises – Competitive, supplementary, & complementary • Supplementary and complementary enterprises: – Eventually become competitive when they begin competing for some limited input. – The profit maximizing combination will usually be within their competitive range. 26