AECO 110

AGRICULTURAL PRODUCTION ECONOMICS

Lecture 1

INTRODUCTION

Nora DM. Carambas

ECONOMICS AND ITS
BRANCHES
ECONOMICS
– the science of allocating scarce resources
among the unlimited human wants.

1. MACROECONOMICS
– deals with big picture or issues
confronting the entire economy, e.g.
inflation, employment, taxation, etc.

2. MICROECONOMICS
– concerned with the behavior of individual
decision making units.
ECONOMICS AND ITS
BRANCHES
2.1 CONSUMPTION ECONOMICS
– concerned with the behavior of individual consumer as
income is allocated among consumption goods in
order to maximize satisfaction

– deals with the problem of organization of consumption.

2.2 PRODUCTION ECONOMICS

– concerned with the behavior of individual producer who
allocates his or her resources consistent with his or
her goals
– deals with the problem of organization of production.
AGRICULTURAL PRODUCTION
ECONOMICS
─ The oldest and the most widespread specialization in
agricultural economics.
─ Studies the basic principles upon which problems in
agricultural production and resource use can be
analyzed.
─ Emphases are on:
 fundamentals with respect to production and resource
relationships.
 the conditions under which efficiency is attained.
 the behavioral patterns of persons who serve as
managers and administrators of agricultural
resources.
1.3 IMPORTANCE OF AGRICULTURAL
PRODUCTION ECONOMICS
- can be deduced from its objectives

Overall Objectives
1. to help farmers and farm people
attain their stated objectives
2. to facilitate the most efficient use of
agricultural resources from the
standpoint of the consuming
economy
Specific Objectives
1. to outline the conditions which give the
optimum use of resources
2. to determine the extent to which the
existing use of resources deviates from
the optimum use
3. to analyze the forces which condition
production patterns and resource use
4. to explain means and methods in getting
from the existing to optimum use of
resources
 AECO 110
AGRICULTURAL PRODUCTION ECONOMICS

Lecture 2

Resource Allocation Under Perfect Knowledge:

Constrained and Unconstrained Optimization

Nora DM. Carambas

Producer Rationality
Assumption

Producers are profit maximizers.

Purely Competitive Market
Assumption
for explaining the behavior of firms in an
industry
The firm can sell as much output as it desires
at the going market price.

Market price does not vary.

It can purchase as much input as it needs at

the going market price
Market price does not vary.
 2.1
Factor-Product Relationship
Basic Concept
Production Function
─ refersto the technical or physical
relationship between inputs of
resources and output of goods per unit
of time.
─ gives
maximum output that can be
produced with a given input
combination.
Functional Structures
Production Function:

𝒚=𝒇 𝒙

where:
y = output
x = vector of inputs
Traditional PF
𝒚 = 𝒇(𝒍𝒂𝒏𝒅, 𝒍𝒂𝒃𝒐𝒓, 𝒄𝒂𝒑𝒊𝒕𝒂𝒍)

Fixed input: land

Variable inputs:
labor
capital (e.g., seeds, chemicals, fertilizers)
Modern PF
𝒚 = 𝒇(𝒍𝒂𝒏𝒅, 𝒍𝒂𝒃𝒐𝒓, 𝒄𝒂𝒑𝒊𝒕𝒂𝒍, 𝒎𝒈𝒕. , 𝒔𝒕𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒔𝒐𝒖𝒓𝒄𝒆𝒔)

Fixed input: land

Variable inputs:
labor
capital (e.g., seeds, chemicals, fertilizers)
Management inputs
State of resources (soil and water)
Functional Forms of
Production Functions
1) Linear:
y = A + b1x1 + b2x2
2) Quadratic :
y = A + b1x1 + b2x2 + 0.5(b11x12 + b12x1x2 + b22x22)

3) Cobb-Douglas:
y = Ax1b1x2b2
4) Transcendental:
y = Ax1a1x2a2eb1x1 + b2x2
5) Constant Elasticity of Substitution (CES):
y = A[bx1-g + (1-b)x2-g]-b/g
6) Transcendental Logarithm or Translog:
lny = lnA + b1lnx1 + b2lnx2 + 0.5(b11lnx12 + b12lnx1lnx2 +
b22lnx22)
Production Function
Graphical Presentation:
Neoclassical Production Function
Production Function
Mathematical Representation
Specific Example:
R = 5N0.2L0.5F0.3
where
R – quantity of rice output (ton)
N – quantity of land (ha)
L – quantity of labor (man day)
F – quantity of fertilizer (bag)
PRODUCTION QUANTITIES
TOTAL PHYSICAL PRODUCT (TPP)
– the amount of output that will be
produced from given level of inputs.

– mathematically given by the original

production function, e.g.,
TPP = y = f(x1, x2, x3,…, xn)
TPPx1 = y = f(x1x2, x3,…, xn)

Example: R = 5N0.2L0.5F0.3
PRODUCTION QUANTITIES Contd.

MARGINAL PHYSICAL PRODUCT (MPP)

– the change in output associated with an

incremental change in the use of an input
– or the rate of change in TPP at specific input
level.

– mathematically given by:

MPPx1  TPPx1 / x1  y / x1

Example: MPPL = R/L = 2.5N.2L-.5F.3

PRODUCTION QUANTITIES Contd.

AVERAGE PHYSICAL PRODUCT (APP)

– output per unit of input on the average.
– mathematically given by:

APPx1  TPPx1 / x1  y / x1

Example: APPL = R/L = 5N.2L.5F.3/L = 5N.2L-.5F.3

Stages of Production
S
t
a
g
e
s

o
f
Extensive Margin
Intensive Margin
P
r L|N,F
o
d
u
c
t
i
o
n
 Stage I
S
– begins at the zero input level and continues to the point where APP is
t maximum and is equal to MPP.
a
– MPP > APP > 0.
g
e – APP is increasing implying that each additional unit of input yields
relatively more output on average.
s
– Economically irrelevant because adding additional unit of input will
o increase the productivity of all previous inputs as measured by APP.
f
Stage II
P – begins where APP is maximum and ends where MPP is zero (or TPP is
r maximum).
o – APP > MPP  0.
d
– the economically relevant range.
u
c
Stage III
t
i – the range of input levels where MPP is negative or TPP is declining.
o
– economically irrelevant because additional input causes TPP to
n decrease.
S
t
a At the boundary of Stages I and II,
g
e
MPP = maximum APP.
s
At the boundary of Stages II and III,
o
f
MPP = 0.

P
INTENSIVE MARGIN – the point of zero MPP
r
o
of the variable input; land is cultivated
d
intensively.
u
c
EXTENSIVE MARGIN – the point of maximum
t
i
APP of the variable input; the cultivation of
o
land is extensive.
n
RELATIONSHIP BETWEEN APP AND MPP

If APP is increasing (has a positive slope),

MPP must be greater than APP.
If APP is decreasing (has negative slope),
MPP must be less than APP.
If APP has a zero slope (maximum), MPP
and APP must be equal.

Proof:
 y
y   x or TPP  APP  x`
x
dy y d ( y / x)
  x or MPP  APP  slope of APP  x
dx x dx
Law of Diminishing Marginal Returns

─ statesthat as units of a variable input

are added to units of one or more fixed
inputs, after a point, each incremental
unit of the variable input produces less
and less additional output.
─ based on the biological process found
in agricultural production.
inability of plants and animals to
provide the same response
indefinitely to successive increases in
nutrients or some other inputs.
Some Mathematical Notes
The first derivative of production
function (PF) represents the
corresponding MPP function.
The second derivative of PF is the first
derivative of MPP function or slope of
MPP function.
The third derivative of PF is the second
derivative of MPP function or
curvature of MPP function.
PRODUCTION ELASTICITY
- measures the responsiveness of output to changes
in an input.
- mathematically given by:

y
%y y y x dy x 1 MPP
 y,x      MPP 
%x  x x y dx y APP APP
x
Example:

y = 50 + 5.93x  y,x = 5.93x/(50 + 5.93x)

R = 5N0.2L0.5F0.3  R,N = 0.2
Elasticities of Production
with Neoclassical Production Function

MPP
 y, x 
APP
εy,x = 1

εy,x > 1 0<εy,x < 1 εy,x < 0

εy,x = 0
UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT
Recall:
PROFIT ()

– net revenue, net returns, net income

– the difference between total revenue

(TR) and total cost (TC).

 = TR – TC
UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT

 How much input to use? or

 What is the optimal input use to maximize
profit?
𝝅(𝒙) = 𝑻𝑽𝑷 − 𝑻𝑭𝑪
FOC:
𝒅𝝅 𝒅𝑻𝑽𝑷 𝒅𝑻𝑭𝑪
= − =𝟎
𝒅𝒙 𝒅𝒙 𝒅𝒙
𝒅𝑻𝑽𝑷 𝒅𝑻𝑭𝑪
= ↔ 𝑴𝑽𝑷 = 𝑴𝑭𝑪
𝒅𝒙 𝒅𝒙
where:
𝑴𝑭𝑪 = 𝑷𝒙 under competitive market.
Therefore, equivalently, 𝑴𝑽𝑷 = 𝑷𝒙 .
UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT

SOC:
𝒅𝟐 𝑻𝑽𝑷 𝒅𝑻𝑭𝑪
𝟐 − <𝟎
𝒅𝒙 𝒅𝒙
𝒅𝟐 𝑻𝑽𝑷 𝒅𝟐 𝑻𝑭𝑪
< ↔ 𝑴𝑽𝑷′ < 𝑴𝑭𝑪′
𝒅𝒙𝟐 𝒅𝒙𝟐

Since 𝑴𝑭𝑪′ = 𝟎, 𝑴𝑽𝑷′ must be less than

zero (downward sloping) at profit
maximum.
SOME NOTES AND DEFINITIONS

NECESSARY CONDITION OR FIRST ORDER CONDITION (FOC)

─ the condition that must hold for the event to occur, e.g., the slope
of the profit function must be equal to zero if the function is to be
maximized.

─ taken alone, it does not ensure that profits will be maximum, only
that profit could be maximum.

SUFFICIENT CONDITION OR SECOND ORDER CONDITION (SOC)

─ the condition that must be present to ensure that the event will
occur.

THE TWO taken together will ensure that the event will always occur
and that no other set of conditions will result in the occurrence of
the event.
SOME NOTES AND DEFINITIONS

TVP – total value product

𝐓𝐕𝐏 = 𝑷𝒚 ∗ 𝑻𝑷𝑷
Since output price is constant, the TVP function
has the same shape as the TPP function. Only
units of the vertical axis have changed.
TFC – total factor cost
𝑻𝑭𝑪 = 𝑷𝒙 𝑿

The TFC has a constant slope, 𝑷𝑿 . The slope is

called marginal factor cost (MFC). This is the
cost associated with the purchase of an
additional unit of the input.
 Profit Maximum
and Equilibrium Input Level

Breakeven
TVP = TFC

Maximum
(MVP = MFC)

Maximum loss
(MVP = MFC)
 Maximum

0
L*
Breakeven

Maximum Loss
 Profit Maximization
and Equilibrium Input Level

AVP

AFC
MFC
MVP

L*
MVP
Maximum

AVP
𝑴𝑭𝑪 = 𝑷𝑿 = 𝑨𝑭𝑪
UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT
By definition,
𝑴𝑽𝑷 = 𝑴𝑭𝑪
is equivalent to:
𝑷𝒚 ∗ 𝑴𝑷𝑷 = 𝑷𝒙
Rearranging the FOC, it becomes:
𝑷𝒙
𝑴𝑷𝑷 = .
𝑷𝒚

Dividing this equation by APP = y/x, we get:

𝑷𝒙
𝑴𝑷𝑷 𝑷𝒚 𝑷𝒙 𝑿 𝑻𝑪
= 𝒚 = ↔ 𝜺𝒚,𝒙 = .
𝑨𝑷𝑷 𝒙 𝑷𝒚 𝒀 𝑻𝑹

THEREFORE, we can say that at the point of maximum profit,

MPP is equal to the factor-product price ratio and the
elasticity of production for the input is exactly equal to the
ratio of TFC to TR.
Production Function Surface
UNCONSTRAINED PROFIT MAXIMIZATION

The production function surface can be likened to a

mountain.
The top of the mountain or the global point of
maximum would be the position where the farm
manager would prefer to operate a farm if inputs
were free and there were no other restrictions on
the use of the inputs.
If the inputs were not free, the profit-maximizing level
of input use will always be somewhat less than the
level of input use that maximizes the production
function.
The distinction between the point representing
maximum profit and the point representing
maximum revenue (or output) becomes more and
more important as input prices rise.
UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT

A. With One Variable Input

Suppose y = f(x), Py = po, Px = vo

Then (x) = pof(x) – vx
FOC:
d/dx = pofx – vo = 0 or VMP = MFC
 UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT

Examples: Find the profit-maximizing input levels

given:
1) y = 2x0.5, po = P4, vo = P3.
2) y = 0.75x + 0.0042x2 + 0.000023x3, po = P4, vo = P0.15.
 UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT

SHADOW PRICE OF INPUT

(also called imputed value or implicit worth of input)

─the value of the last peso spent on the input in

terms of its contribution to the revenue of the
farm.

SP = VMP/MFC

Q: What is the shadow price of input at the point

of profit maximum?
UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT

B. With Many Variable Inputs

Suppose y = f(x1, x2, x3, …, xn)

Then  = pof(x1, x2, …, xn) – (v1x1 + v2x2 +… + vnxn )

The necessary conditions (FOCs) are as follows:

/x1 = pof1 – v1 = 0 or VMP1 = MFC1 or VMP1/MFC1 = 1
/x2 = pof2 – v2 = 0 or VMP2 = MFC2 or VMP2/MFC2 = 1
………
/xn = pofn – vn = 0 or VMPn = MFCn or VMPn/MFCn = 1
UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT

And the Sufficient Conditions (SOCs) are as

follows:

11 < 0

1122 – 1221 > 0,

where assuming fixed input prices:

11 = pof11, 22 = pof22, 12 = pof12, 21 = pof21

UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT
With matrix notation, the SOCs require that the
principal minors must alternate in sign starting
with negative (or the determinant be NEGATIVE
DEFINITE), i.e.:

H1 < 0, H2 > 0, H3 < 0

e.g.,  11  12  13
H   21  22  23
 31  32  33
 11  12  13
 11  12
H1   11  0 H2  0 H 3   21  22  23  0
 21  22
 31  32  33
UNCONSTRAINED PROFIT MAXIMIZATION
WITH RESPECT TO INPUT

Sample Computation
Given: y = 2x11/2x21/3, p = 15, v1 = 10, v2 = 5,

find the profit-maximizing input combination, the

corresponding output level, profit.
Answers:
Optimal Input Combination: X1 = 20.25 X2= 27

SOCs:

H1 = |11| = -0.25 < 0

11 12  0.25 0.12
H2    0.0156  0
 21  22 0.12  0.12

Therefore, profit is indeed maximum at X1 = 20.25 X2= 27.