Chapter 1

AGRICULTURAL PRODUCTION ECONOMICS:

An Introduction
1.1 MEANING
 Agricultural Production Economics is a division of Agricultural Economics.
 It is concerned with the selection of production patterns and resource use
efficiency in order to maximize the objective function of a farmer or farming
community or the nation within a framework of limited resources.

1.2 DEFINITION
Agricultural Production Economics is an applied field of science wherein the
principles of choice are applied to the use of land, labour, capital and management resources
in the farming industry.
1.3 SUBJECT MATTER
Agricultural Production Economics involves:
 Analysis of production relationships
 Principles of rational decisions.
 Productivity of resources
 Resource use efficiency
 Resource combination
 Resource allocation
 Resource management
The subject matter of production economics involves topics like factor-product
relationship, factor-factor relationship, product-product relationship, size of the farm, returns
to scale, credit, risk and uncertainty, etc.
The agricultural production economics is therefore concerned with any phenomena,
which have a bearing on economic efficiency in the use of resources. Any Agricultural
problem that falls under the scope of resource allocation and marginal productivity
analysis is the subject matter of Agricultural Production Economics.
1.4 GOAL
 At an individual farm level: To provide guidance to individual farmers in using their
resources most efficiently.
 At national level: To rationalize the use of resources from the standpoint of economy.
1.5 OBJECTIVES OR IMPORTANCE
The main objectives of Agricultural Production Economics are:

 To determine the conditions which provide for optimum use of resources.

 To determine the extent to which the existing use of resources deviates from the
optimum use.

1
  To analyze the forces which are responsible for existing production pattern and
resource use.
 To find out means and methods for changing the existing use of resources to the
optimum level.

1.6 BASIC CONCEPTS AND TERMS

Farm It is a piece of land, where crop s and livestock enterprises are

taken up under a single management and has specific
boundaries.
Farm – firm It is an economic unit which is run under one management.
Land holding The total area of land owned by an individual or joint family
whether cultivated by the family or rented out.
Operational holding Total land area held under a single management for the purpose
of cultivation. It excludes any land leased-out to another person
but includes any land leased-in.
Economic holding It is defined as one which could provide a reasonable standard
of living to the cultivators and give full employment for a
family of normal size.
Marginal farmer Farmer owning up to 1 ha land is called marginal farmer.
Small farmer Farmer owning more than 1 ha to 2 ha land is called small
farmer.
Medium farmer Farmer owning more than 2 ha to 4 ha land is called medium
farmer.
Large farmer Farmer owning more than 4 ha land is called large farmer.
Resources Anything that aids in production is called resources. They
physically enter the production process to transform into
output. Examples: inputs such as seeds, fertilizers, water, etc.
Resources services The work done by person, machine or livestock is called
resource service. Here only services are available for
production. Examples: services of land, labour, machinery,
livestock etc.
Fixed resources / Resources which remain unchanged irrespective of the level of
Fixed cost production are called fixed resources. The costs which are
associated with fixed resources are called fixed costs.
Examples: land, building, permanent labour, implements etc.
Variable resource / Resources which changed with the level of production are
Variable cost called variable resources. The costs which are associated with
variable resources are called variable costs. Examples: seeds,
fertilizers, casual labour, etc.
Flow resources The resources which cannot be stored and should be used as
and when they are available. Examples: services of land,
labour, machinery etc.
Stock resources The resources which can be stored and should be used as and
when required. Examples: seed, fertilizers etc.

2
Mono-period It is the resource which is used only once in production.
resource Examples: seeds, fertilizers, petrol, diesel, electricity, etc.
Poly-period It is the resource which is used in the production process over
resource several periods. Examples: land, labour, machinery,
implements etc.

Variable Any input which can have different quantities/values in the

production process.
Independent It is a variable whose value does not depend on other variable.
variable Such variables influence the dependent variable. Ex: labour,
seed, fertilizer, land etc.
Dependent variable A variable that is governed by another variable. Example: Crop
output.
Product It is an outcome of the production process. Ex: Paddy, wheat,
sugarcane, milk etc.
Production The transformation of inputs into outputs is called production.
In economics, production means creation of utilities.
Production function A systematic and mathematical way of measuring the
relationship between input and input.
Short-run The planning period during which one or more resources are
production function fixed.
Long-run It is a planning period during which all resources are varied.
production function
Productivity Productivity denotes the efficiency with which various inputs
are converted in to products.
It is a measurement of output per unit of the factor used.
Total Output
Productivity = -------------------
Total Input
Technical coefficient The amount of input used per unit of output is called technical
coefficient.
Efficiency It means using resources most effectively to satisfy the
farmer’s needs and goals.
Technical efficiency It is the ratio of output to input. It can be achieved if the same
output can be produced using fewer inputs.
Technical Efficiency means output produced using the fewest
possible inputs.
Economic efficiency / It is the expression of technical efficiency in monetary value by
Productive efficiency attaching prices. In other words, the ratio of value of output to
value of input is called economic efficiency. It is also called
Productive efficiency. It can be achieved where the same
output could be produced at lower cost.
Productive Efficiency means output produced at the lowest
possible cost.

3
 Allocative efficiency It occurs where the goods and services being produced match
the demand by consumers.
Social efficiency It occurs where the private and social cost of production is
equal to the private and social benefits derived from their
consumption. It is a measure of social welfare.
Choice indicator It is a yardstick indicating which of the two or more
alternatives maximizes a given end. Choice indicator always
expressed in ratio. Ex: Price ratio, MRTS, MRPS, etc.
Cost of cultivation The expenditure incurred on all inputs and input services in
raising a crop on a unit area, is referred to as cost of
cultivation. Ex: costs in Rs/ha, Rs./acre, etc.
Cost of production The expenditure incurred in producing a unit quantity of output
is called cost of production. Ex: Cost in Rs/quintal, Rs/kg, etc.
Optimality It indicates a level of production where net profit is maximum
(output may be or may not be maximum).
Profit maximisation It is assumed to be the standard motive of firms in the private
sector. Profit maximisation occurs where Marginal Cost =
Marginal Revenue (MC = MR). The firm will continue to
increase output up to the point where the cost of producing one
extra unit of output is equals to the revenue received from
selling that last unit of output.
Marginal Cost (MC) It is the cost of producing one extra unit of production.
Marginal Revenue It is the addition to total revenue as a result of producing one
(MR) more unit of output. It is the price received from selling that
extra unit.
Farm entrepreneur He is the person who organizes and operates the farm business
and bears responsibility of the outcome of the business.
Farm manager He is a person appointed by the entrepreneur to manage or
supervise the farm business and paid for his services. He
carries the instruction of the entrepreneur.

2.4 BASIC TERMS

Total It is the sum of output which can be produced by using various

Product units of inputs. It is denoted as Y
(TP)
Marginal It is the additional quantity of output, added by an additional unit of
Product input i.e., the change in output as a result of change in the variable
(MP) input.
Change in Total Product ∆Y
MP = ------------------------------ = -------
Change in Input level ∆X

Average It refers to the average productivity of a resource. It is the ratio of

Product total product to the total input used in producing that amount of

4
 (AP) product.
Total Product (TP) Y
AP = --------------------------- = --------
Total Inputs (X) X

Elasticity of It is defined as percentage change in output as a result of percentage

Production change in input. It can also be defined as ratio of MP and AP.
(Ep)
% change in Output MP
Ep = --------------------------- or ---------
% change in Input AP
Solution:
∆Y/Y*100 ∆Y/Y ∆Y ∆X ∆Y X
Ep = -------------- = -------- = ---- ÷ ---- = ---- * -----
∆X/X*100 ∆X/X Y X Y ∆X

∆Y X ∆Y Y
= ---- * ---- = ----- ÷ ----
∆X Y ∆X X
We know that ∆Y/∆X = MP, and Y/X = AP
MP
Therefore, Ep = ------
AP

5
 Chapter- 2

LAWS OF RETURNS
3.1 INTRODUCTION
There are three laws of returns. (1) Law of increasing returns (2) Law of constant
returns and (3) Law of decreasing returns. “There is said to be increasing, decreasing or
constant returns according to the marginal returns rise, fall or remain constant” as the
quantity of a factor of production is increased.

3.1.1 LAW OF INCREASING RETURNS

Every additional or marginal unit of input adds more to total product than the
previous unit i.e., addition to the total product is at an increasing rate.

Input Output Marginal Input Marginal Output Marginal Rate of Return

(X) (Y) (∆X) (∆Y) (∆Y/∆X)
0 0 - - -
5 25 5 25 5
10 75 5 50 10
15 150 5 75 15
20 250 5 100 20
25 400 5 150 30
450
400
350
∆Y5
300
Output

250
200 ∆Y4
150
100 ∆Y3

50 ∆Y2
0
0 5 10 15 20 25 30
Input

Fig. 1: Law of increasing Returns

The slope of the curve will go steeper and steeper with the added unit. i.e., its shape
gets convex to the origin. This relationship can also be expressed as:
∆Y1 ∆Y2 ∆Y3 ∆Yn
------ < ------ < ------ < ------ < -------
∆X1 ∆X2 ∆X3 ∆Xn

 The law of increasing returns states that the ratio ∆Y/∆X will go on increasing as
more and more units of input are added.

6
  This law operates in the economies where non-human and non-animal power
resources (water and wind power, steam, electricity, atomic energy, etc.) are used or
where automatic self-adjusting mechanism is applied.
 In agriculture, this law is normally observed at an initial stage of production.
3.1.3 LAW OF CONSTANT RETURNS

Every additional or marginal unit of input adds an equal quantity to total product
i.e., addition to the total product is at a constant rate.

Input Output Marginal Input Marginal Marginal Rate of

(X) (Y) (∆X) Output Return
(∆Y) (∆Y/∆X)
0 0 - - -
1 5 1 5 5
2 10 1 5 5
3 15 1 5 5
4 20 1 5 5
5 25 1 5 5
6 30 1 5 5

35

30
∆Y6
25
∆Y5
20
Output

∆Y4
15
∆Y3
10
∆Y2
5
∆Y1
0
0 1 2 3 4 5 6 7

Input

Fig. 3: Law of Constant Returns

This production function is a straight line or linear relationship having the same slope
throughout its entire range. This relationship can also be expressed as:

∆Y1 ∆Y2 ∆Y3 ∆Yn

------ = ------ = ------ = ------ = -------
∆X1 ∆X2 ∆X3 ∆Xn

 The law of constant returns states that the ratio ∆Y/∆X will remain constant as more
and more units of input is added.

7
  This law operates in manufacturing industries where non-human like machineries
play greater role.

3.1.2 LAW OF DECREASING RETURN

Every additional or marginal unit of input adds less to total product than the previous
unit i.e., addition to the total product is at a decreasing rate.

Input Output Marginal Marginal Marginal Rate of

(X) (Y) Input Output Return
(∆X) (∆Y) (∆Y/∆X)
0 50 - - -
10 140 10 90 9
20 210 10 70 7
30 260 10 50 5
40 300 10 40 4
50 330 10 30 3
60 350 10 20 2

400

350
∆Y6
300 ∆Y5
∆Y4
250
∆Y3
Output

200
∆Y2
150

100
∆Y1
50

0
0 10 20 30 40 50 60 70

Input

Fig. 2: Law of Decreasing Returns

The slope of the curve will concave to the origin with the added unit. This
relationship can also be expressed as:
∆Y1 ∆Y2 ∆Y3 ∆Yn
------ > ------ > ------ > ------ > -------
∆X1 ∆X2 ∆X3 ∆Xn

8
  The law of decreasing returns states that the ratio ∆Y/∆X will go on decreasing as
more and more units of input is added.
 This law operates widely in agriculture, mining, fisheries, building industries, etc.
where human and animal power resources are widely used.

In actual, these three laws are only three aspects of one law, viz., Law of Variable
Proportion. It represents three different stages of the same law. It is also known as Law of
Diminishing Marginal Return.

3.2 THE COMPARISION OF THE LAWS OF RETURNS

Law of Increasing Law of Constant Returns Law of Decreasing

Returns Return
Marginal returns rise as the Marginal returns remains Marginal returns fall as the
quantity of an input is constant as the quantity of quantity of an input is
increased. an input is increased. increased.
Every additional or Every additional or Every additional or
marginal unit of input adds marginal unit of input adds marginal unit of input adds
more to total product than in total product equal to less to total product than the
the previous unit. the previous unit. previous unit.

∆Y1 ∆Y2 ∆Yn ∆Y1 ∆Y2 ∆Yn ∆Y1 ∆Y2 ∆Yn

------ < ------ < …. < ------ ------ = ------ = … = ------ ------ > ------ > … > ------
∆X1 ∆X2 ∆Xn ∆X1 ∆X2 ∆Xn ∆X1 ∆X2 ∆Xn
450
40 400
400
350
300
30 300
Output

250
20 200
Output
Output

200
150
100
10 100
50
0
0 5 10 15 20 25 30 0 0
Input
0 1 2 3 Input
4 5 6 7 0 10 20 30Input
40 50 60 70

The shape of the curve gets The shape of the curve gets The shape of the curve gets
convex to the origin. straight line. concave to the origin.
This law operates in the This law operates in This law operates widely
economies where non- manufacturing industries in agriculture, fisheries,
human and non-animal where non-human like mining, etc. where human
power resources are used or machineries play a greater and animal power
where automatic self- role. resources are widely used.
adjusting mechanism is
applied.
In agriculture, this law is In agriculture, this law is In agriculture, this law is
normally observed at the normally observed at the normally observed at a later
initial stage of production. middle stage of stage of production.
production.
In actual, these three laws are only three aspects of one law i.e., Law of
Variable Proportion. It represents three different stages of the same law. It is also
known as Law of Diminishing Marginal Return.

9
 Chapter-3
Seven cost concepts

Cost refers to the money value of effort expended or sacrifice made in producing a
commodity or rendering a service or achieving a specific objective.

Costs and revenues are the two major factors that a profit maximizing farm firm needs to
monitor continuously. It is the level of cost relative to revenue that determines the farms
overall profitability. In order to maximize profits, a farm tries to increase its revenue and
lower its cost. The firm’s output level is determined by its cost. The purpose of this exercise
is to explore cost and its relevance to decision-making.

Classification of costs :
The manner in which costs are classified or deferred is largely dependent on the purpose for
which the cost data are being outlined. There are many different types of costs relevant for
decision making under varying situations.
1. Fixed cost and Variable costs

Fixed Costs variable Costs

1. Fixed costs are those costs which do not 1. Variable costs are those costs which
vary with changes in output increase with the level of output
2. The costs associated with fixed 2. The costs associated with variable resources
resources are called fixed costs are called variable costs
3. Fixed costs are associated with the very 3. Variable costs are paid when there is some
existence of a production unit and output
therefore must be paid even if the output
is zero.
4. Ex.:Interest on borrowed capital, rental 4. Ex : Payments for raw materials, seed,
payments, portion of depreciation fertilizers, pesticides, charges on fuels and
charges on equipment and buildings, electricity, wages of casual labour and
salaries of permanent employees and salaries of temporary staff etc.
managers, taxes etc
5. The distinction is only for the short run 5. In long run all costs are variable

6. Fixed costs are not relevant for decision 6. Variable costs are relevant for decision
making purpose making purposes

2. Explicit and Implicit costs :

Explicit costs are those that are recorded in their books as representing an actual transfer of
money. These are explicit or nominal costs and often do not represent full economical costs,
that should be considered on a given decision. Actual outlay of cash relevant for managers to
exercise control over it. Out of pocket costs Economists use implicit costs or imputed cost in
evaluating a decision. Time cost in money terms can be referred as implicit cost. Do not
involve actual outlay of cash. Assumed costs or hypothetical costs. Do not affect business

10
funds and costs of operation of farm business. Ex : Interest on owned capital, contribution of
family labour and owners, rental charges on owned land.

3. Direct costs and indirect costs :

There are some costs which can be directly attributed to production of a given product. The
use of raw materials-seed, fertilizers, labour input and machine-time involved in the
production of each unit can easily be determined. There are certain costs like depreciation of
machinery and buildings, electricity charges, administrative expenses and stationery charges,
that cannot easily and accurately be separated and attributed to individual units of production,
except on arbitrary basis. While referring to the separable costs of first category accountants
call them direct or prime costs per unit. The joint costs of the second category are referred to
as indirect or over-head costs. Direct and indirect costs are not exactly synonymous to what
economists refer to as variable costs and fixed costs.

4. Private costs versus social costs : Private costs are those that accrue directly to the
individuals of firms engaged in relevant activity. External costs, on the other hand are passed
on to persons not involved in the activity in any direct way, they are passed on to society at
large.
5. Relevant costs and irrelevant costs : The relevant costs for decision-making purposes are
those costs which are incurred as a result of the decision under consideration. These costs are
also referred as incremental costs. There are three main categories of relevant or incremental
costs. 1. Present period explicit costs 2. Opportunity costs implicitly involved in the decision
3. Future cost implications that flow from the decision Costs that have been incurred already
and costs that will be incurred in future regardless of the present decision are irrelevant costs.

6. Separable and Common costs : Costs can also be classified on the basis of their
traceability. The costs that can be easily attribute to a product, a division or a process are
called separable costs and the rest are called non-separable or common costs. They are also
referred as direct and indirect costs. The distinction between direct and indirect costs is of
particular significance in a multi product firm for setting up economic prices for different
products.
7. Opportunity costs and Actual costs : Opportunity cost refers to the value of benefits of a
foregone alternative. The cost of using one resource in production of a product is the return
that would have been received from the same resources if used in its most profitable

11
alternative use. It is the cost, equivalent to the returns foregone from the next best alternative.
Actual costs are the costs actually increased by spending costs.

Seven production costs concepts

In short run a firm incurs some costs that are also associated with variable factors and others
that result from fixed factors. The seven production costs are ;
1. Total variable costs
2. Total fixed costs
3. Total costs
4. Average variable costs
5. Average fixed costs
6. Average total costs or average cost
7. Marginal cost
1)Total Costs (TC): Total costs are the sum of total variable costs and total fixed costs.

2.) Total Variable Costs (TVC): These are also called out of pocket costs. The total
variable cost represents the sum of expenditure on variable inputs for any level of output.
They are short-run costs. Because the farmer has control of all the variable inputs, TVC must
be covered in the short-run, or else the farmer will not incur expenditure on these variable
inputs.

12
3.)Total Fixed Costs (TFC): Sum of expenditures which will be incurred irrespective of
output level. These are relatively long-run costs.

4. Marginal Costs (MC): Marginal cost is the additional cost necessary to produce one
more unit of output. Marginal cost is comprised entirely of variable costs. No fixed costs are
part of marginal costs, because they are neither increased nor decreased by additional
production.

Change in total costs Δ TC or Δ TVC

Change in output ΔQ ΔQ

13
5. Average Variable Costs (AVC): Average variable cost is worked out by dividing total
variable costs by the amount of output. AVC varies with the level of production. AVC is
inversely related to average physical product, i.e. when APP (Average physical product) is
increasing, AVC is decreasing, when APP is maximum AVC is minimum.

7. Average Fixed Costs (AFC): It is worked out by dividing total fixed costs by the amount
of output. As output increases, AFC (Average fixed cost) decreases.

AFC = Total Fixed costs = TFC

Output Q

7. Average Total Cost (ATC): It can be computed by two ways (a) by dividing the total
costs by output or (b) by adding AFC and AVC. The shape ATC depends upon the shape of

14
the production function. ATC is often referred as the unit cost of production. ATC decrease
as the output increases.
AFC = Total Costs TC TFC + TVC
Output Q Q

1. Total Cost (TC) = TFC + TVC

2. Average Total Cost (ATC) OR Average Cost (AC) = TC/ OUTPUT
3. Total Fixed cost (TFC) = Sum of fixed costs
4. Average Fixed cost (AFC) = TFC/ OUTPUT
5. Total Variable cost (TVC) = TC – TFC, OR sum of all variable costs
6. Average Variable Cost (AVC) = TVC / OUTPUT
7. Marginal Cost (MC) = (Change in Total cost) / (Change in output)

Relationship Between Average Fixed Cost, Average Variable

Cost, Average Total Cost:

 As output increases, average fixed cost (AFC) decreases, as shown graphically in Fig.
1.1.
 When output is zero, AFC= TCF, AFC always slopes downwards regardless of
production function. As shown graphically in fig.1.1.

15
  Like AFC, AVC cannot be computed when output is zero.
 AVC is inversely related to the Average fixed product.
 AVC first falls due to economies of large scale production and then rises due to
diseconomies of scale in production.
 When AVC is decreasing, the efficiency of the variable input is increasing.
 The efficiency is at maximum when AVC is at minimum.
 ATC decreases as the output increases, attains a minimum and increases thereafter.
 Average fixed cost (AFC) curves will continue to decline and never show upward
moment because after maximum product is achieved, inputs beyond this become
irrational.
 As the production expands, the AVC keeps on declining. It reaches the lowest point
and then bends upwards. At this point APP (average physical product) is highest.
 ATC curve has the same shape as AVC. Difference is that the lowest point in case of
AVC reaches earlier as compared to ATC.

Relationship Between Marginal and Average Cost:

 Average variable cost continues to decline as long as the marginal cost is below it,
but is start rising at the point where MC crosses AVC.

 MC Cost always rises more sharply than the AVC. Similar relationship holds
between marginal cost and average cost. But increase in fixed cost will increase
average total cost not to the marginal cost.

 When the MC is less than AC (average cost), average cost is falling and when MC is
greater than AC, average cost is rising.
 At the point of intersection, where MC equals AC, average cost curve have just
caused to fall, and afterward start to rise. Thus it is the minimum point on the AC
curve.
Relationship of MC to AVC and ATC :
1. MC cuts both AVC and ATC at their minimum.
2. When both MC and AVC are falling, average cost will fall at a slower rate.
3. When MC and AVC are both rising, MC will rise at a faster rate. As a result MC will
attain its minimum before the AVC.

16
 4. MC is less than AVC (MC<AVC), AVC will fall. When MC exceeds AVC,
(MC>AVC) AVC will rise.
5. At the point of intersection whose MC = AVC, AVC is minimum. AVC has just used
to fall and attained its minimum but not yet begin to rise. MC = AVC at the lowest
point of AVC.
6. MC curve cuts the ATC at the latter’s minimum point. MC = AC at the lowest point of
AC.
7. AVC and AC curves fall as long as the MC curve is below them and vice versa.

Chapter 4

FACTOR - PRODUCT RELATIONSHIP

Classical Production Function

4.1 INTRODUCTION
 Factor-Product Relationship is also known as Classical Production Function.
 It examines the relationship between one variable factor and output, keeping the
quantities of other factors fixed.
 It is a short-run production function.
 It explains the Law of Variable Proportion or the Law of Diminishing Marginal
Return.

4.2 DEFINITION
The Law of Variable Proportion states that as the proportion of one factor in a
combination of factors is increased, after a point, first the marginal and then the
average product of that factor will diminish. It is, therefore, known as Law of Diminishing
Marginal Return.
4.3 PRODUCTION FUNCTION USED
Y = f (X1 | X2, X3,…, Xn).
Where, Y = output;
X1 = variable input;
X2, X3,…., Xn = fixed inputs.
4.4 OBJECTIVE
 The main objective of this relationship is to find out optimum level of resource use or
resource optimization.
 The management problem associated with this analysis is how much to produce?

4.5 EXAMPLE

17
Input Output Marginal Marginal AP MP Remarks
(X) (TP) Input Output (Y/X) (∆Y/∆X)
(Y) (∆X) (∆Y)
0 0 - - - - Increasing
1 2 1 2 2.00 2 at increasing
2 5 1 3 2.50 3 rate
3 9 1 4 3.00 4
4 14 1 5 3.50 5 Increasing
5 19 1 5 3.80 5 at constant
rate
6 23 1 4 3.83 4 Increasing
7 26 1 3 3.71 3 at
8 28 1 2 3.50 2 decreasing
rate
9 29 1 1 3.22 1
10 29 1 0 2.90 0

11 28 1 -1 2.54 -1 Decreasing
(negative
12 26 1 -2 2.16 -2
return)

18
 35

TP
AP
Ep=0
30
TP is max
MP Ep<1

Ep=1 TP Curve
25

Ep>1
20 Point of
Inflection
Output (q)

15
TP increased at TP increased at TP decreasing
increasing rate decreasing rate

Zone – I Zone – II Zone – III

10
Increasing Return Decreasing Return Negative Return
(Irrational Zone) (Rational Zone) (Irrational Zone)
MP is max AP is max
5

MP=AP AP Curve
0
1 2 3 4 5 6 7 8 9 10 11 12

Input (kg) MP=0 MP Curve

-5

Fig.1: Classical Production Function

Nature of TP Curve Nature of MP Curve Nature of AP Curve

 TP increasing at increasing rate  MP increasing  AP increasing
 TP increasing at decreasing rate  MP attains maximum  AP attains maximum
 TP riches at maximum and  MP remains constant  AP is decreasing
remains constant  MP decreasing
 TP decreasing
Relationship between TP and MP
 When TP increasing at increasing rate, MP also increasing.
 When TP increasing at decreasing rate, MP also decreasing.
 When TP is maximum or remain constant, MP=0
 When TP decreasing, MP becomes negative.
 When TP changes its curvature (from increasing rate to decreasing rate), MP
is maximum. This point is known as point of inflection.

Relationship between MP and TP Relationship between MP and AP

19
  MP > 0, TP increasing  When MP > AP, AP increasing; Ep >1
 MP = 0, TP maximum  When MP = AP, AP is maximum; Ep=1
 MP < 0, TP decreasing  When MP < AP, AP decreasing; Ep<1
4.6 THREE ZONES OF PRODUCTION FUNCTION

The classical production function can be divided into three zones.

Zone-I: Stage of increasing returns
 This region starts from the point of origin and ends where the average product reaches
its highest (maximum) or where MP=AP.
 During this stage, the TP, AP and MP are increasing.
 It is notable that the MP in this stage increases but in a later part it starts declining.
Though MP declining, it is greater than the AP.
 AP increases throughout this region indicating that the efficiency of all the variable
inputs keeps on increasing.
Zone-II: Stage of decreasing returns
 This region starts where 1st zone ends. i.e. MP=AP and extends to the point where
MP=0 or TP is maximum.
 In this zone, the TP continues to increase but at a diminishing rate.
 The MP and the AP are declining but are positive.
Zone-III: Stage of negative returns
 This region starts when MP crosses zero and becomes negative.
 In this zone the MP becomes negative.
 The TP and the AP are declining.

Rational / Irrational Zones

Zone-III
 This is a irrational zone because in this zone the TP is decreasing and MP becomes
negative which indicates that additional quantities of inputs reduces the total output.
 So, it is not advisable to operate in this region even if the additional quantities of
inputs are available free of cost.
 If a farmer operates in this zone, he will have double loss: i.) reduced production and
ii) unnecessarily additional cost of inputs.
 For example, many farmers in canal area operate in this zone. They use excess water
which ultimately reduces the profit.
Zone-I
 This is also irrational zone because, the AP increases throughout this zone indicating
that the efficiency of all the variable inputs keeps on increasing. So, farmer should not
stop in this zone and he must produce up to the level where AP is maximum.
 Input-use should be continued until zone-II. Hence, it is not reasonable to stop using
an input when its efficiency is increasing. If he stops in this region, some of his
resource will remain unused or underutilized.
 For example, most of the tribal farmers operate in this region because they don’t have
sufficient inputs.

20
 Zone-II
 This is a rational zone.
 In this zone, TP is increasing; MP is decreasing but remains positive.
 Within the boundaries of this region is the area of economic relevance.
 Optimum use of input is somewhere in this zone which, however, can be located only
when input and output prices are known.
 This zone represents the range of rational production decisions.
SUMMARY

Zone - I Zone - II Zone – III

From origin to AP=MP From AP=MP to MP=0 From MP=0 to onwards
TP, AP & MP all are TP is increasing but at a TP, AP & MP all are
increasing decreasing rate. MP & AP decreasing. MP becomes
decreasing but are positive. negative.
Ep > 1 Ep < 1 Ep < 0
Stage of increasing return Stage of decreasing return Stage of negative return
Irrational zone Rational zone Irrational zone
Zone of underutilization Zone of optimum level of Zone of overutilization of
of resources resources resources

4.7 OPTIMUM LEVEL OF INPUT USE

Optimum level of input use will be at the stage where the cost of additional input
(MC) and the value of additional product (MR) are equal i.e., MC=MR. To calculate
optimum level, data regarding price of input as well as output will be required.
Suppose, price of input is Rs.5/unit and price of output is Rs.4/unit.
Input (X) Output Total Total Marginal Marginal Net
(Y) Cost Return Cost Return Return
0 0 0 0 - - 0
1 2 5 8 5 8 3
2 5 10 20 5 12 10
3 9 15 36 5 16 21
4 14 20 56 5 20 36
5 19 25 76 5 20 51
6 23 30 92 5 16 62
7 26 35 104 5 12 69
8 28 40 112 5 8 72
9 29 45 116 5 4 71
10 29 50 116 5 0 66
11 28 55 112 5 -4 57
12 26 60 104 5 -8 44

In this example, the optimum use of resource is somewhere between 8 and 9 unit.

21
4.8 APPLICATION OF THE LAW
 The law is widely applicable to agriculture.
 Besides, agriculture, it also applies to mining, fisheries and also to building
industries where the nature has supremacy.
 It is therefore, often remarked that the part that the nature plays in production
corresponds to diminishing returns and the part which man plays conforms to the
law of increasing returns.
 Thus, we can say that agriculture, where nature is supreme, is subject to diminishing
returns, while industry, where man is supreme, is subject to increasing returns.

4.8.1 Reasons why agriculture is subject to the law of diminishing returns

1. Agricultural is related to nature. Man is not a complete master of nature. The
operations are likely to be interrupted frequently by rain and other climatic changes.
2. The agricultural operations are spread out over a wide area, and consequently
supervision cannot be very effective.
3. Scope for the use of specialized machinery is also very limited.
4. No scope for division of labour.

4.8.2 Reasons why industry is subject to the law of increasing returns

1. In case of manufacturing industries, man has the fullest scope to show his ability.
2. By the introduction of division of labour and the use of the most modern
technology, production can be greatly increased.
3. Concentration of workers under one roof renders supervision easy and effective.

But, if the industry is expanded too much, supervision will become difficult and the
costs will go up. In such situation, law of diminishing returns will set in. A prudent
industrialist may not allow that stage to come at all.
Hence, we can say that the law of diminishing returns has wide applications. In
agriculture it sets in earlier, while in industry, it sets in a later stage.

-:-:-:-:-:-

22
 Chapter 5

FACTOR - FACTOR RELATIONSHIP

Law of Factor Substitution

5.1 INTRODUCTION
 Any production activity requires different inputs to produce a given quantity of
output. There are many ways of combining these resources in production process.
 Farm production facilitates the substitution of resources. For example, a farmer
producing crop does make a choice between manures and chemical fertilizers,
human labour and machinery, etc. Similarly a dairy farmer has to decide upon the
quantity of fodder and concentrate to arrive at feed ration.
 The factor-factor relationship is explained by the law of factor substitution.
 In this relationship, two factors or inputs are varied and the output is kept constant.

5.2 PRODUCTION FUNCTION USED

Y = f (X1, X2 | X3, X4, … , Xn)
Where, Y = a fixed level of output;
X1, X2 = variable inputs.
X3, X4,…., Xn = inputs which remains constant.
5.3 OBJECTIVE
 The objective here is to find out the most appropriate combination of inputs that costs
the least amount in producing a given level of output or cost minimization.
 The management decision associated with this analysis is how to produce? i.e.
which combination of two factors to be used?

5.4 ISO-QUANT
 Iso means equal and quant means quantity.
 The curve representing all combinations of X1 and X2 that produce the equal
quantity of output is called an iso-quant (Fig.1).
 It is also termed as iso-product curve or product indifference curve.
Example: The output of paddy amounting to 1000 kg/acre can be produced using the
different combinations of two inputs viz., Manure (X1) and Urea (X2) as under.
Combination Manure (X1) Urea (X2)
(qty. in cart-load/acre) (qty. in kg/acre)
A 1 200
B 2 125
C 3 80
D 4 50
E 5 30

23
 F 6 17
G 7 10
From the above table, it is clear that all combinations with different quantities of X1
and X2 result in the same level of production. Iso-quant (Fig.1) represents all combinations
of X1 and X2 that produce 1000 kg of paddy per acre.
Iso-quant can be shown for any level of output. As such, several iso-quants can be
shown for various levels of output with different levels of inputs. If a number of iso-quants
are drawn in one graph, it is known as iso-quant map (Fig. 2).

250 250
Iso-quant Curve Iso-quant Map
200 200

Y=1000 kg/acre
150 150
X2 X2
100 100 Y=1200

Y=800
50 50 Y=1000

0 0
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
X1 X1
Fig. 1: Iso-quant Curve Fig. 2: Iso-quant Map
Characteristics or Properties of an iso-quant
 Iso-quant is downward sloping from left to right i.e. it is negatively sloped.
 Iso-quant is convex to the origin.
 Iso-quant placed above represent higher output and vice-versa.
 Iso-quants are non-intersecting.

5.5 MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS)

 It is the rate of exchange between two inputs which are equally preferred.
 It indicates the absolute amount by which one input is decreased or replaced to add
a unit of another input.
 Alternatively, the quantity of one input to be sacrificed or given up in order to
gain another input by one unit, in process of substitution.
Quantity of replaced input
MRTS = -----------------------------------
Quantity of added input
MRTS of X1 for X2 is written as : MRTSX1X2 = ∆X2 ÷ ∆X1 ; and
MRTS of X2 for X1 is written as : MRTSX2X1 = ∆X1 ÷ ∆X2
The computation of MRTS is presented in following table.
Combi- Manure (X1) Urea (X2) ∆X1 ∆X2 MRTSX1X2 MRTSX2X1
nation (cart-load/acre) (kg/acre) = ∆X2 ÷ X1 = ∆X1÷∆X2
A 1 200 - - - -

24
 B 2 125 1 75 75 0.013
C 3 80 1 45 45 0.022
D 4 50 1 30 30 0.033
E 5 30 1 20 20 0.050
F 6 17 1 13 13 0.077
G 7 10 1 7 7 0.143

5.6 ISO-COST LINE

 Iso-cost line represents various combinations of two inputs that can be purchased
with the given amount of money.
 It is known as price line or budget line.
 It can be drawn by locating the end points of X1 and X2 that can be purchased from
the given amount of money.
 It plays an important role in determining the combination of factors that the farmer
should choose for production.
Example:
Suppose, a farmer has a fund of Rs. 1000 and he has to spend on two inputs
viz., X1 (Manure) and X2 (Urea). Price of X1 is Rs. 200/cart-load and that of X2 is
Rs. 5/kg. Given the prices of X1 and X2, he can purchase a maximum 5 cart-load of
Manure or 200 kg of Urea.
To draw Iso-cost line we need two extreme points X1 and X2 which can be
obtained as under:

X1 (cart-load) X2 (kg)
5 0
0 200

When these two points X1 (5,0) and X2 (0,200) are joined, we get iso-cost
line (Fig.3). Similarly, iso-cost line for budget of Rs. 750 and Rs. 1250 can be drawn
as under. They will be parallel to each other.

250

200 Budget = Rs.1250

150
X2 Budget or total cost = Rs. 1000
(Urea)
100

50 Budget=Rs.750

0
0 2 4 6
X1 (Manure)

Fig. 3: Iso-Cost Lines

25
 Characteristics of Iso-cost line
 Iso-cost line is always a straight line.
 The slop of iso-cost line shows the inverse price ratio of two inputs.
 Change in input prices will change the slop of the iso-cost line.
 When the total outlay or budget is increased, the iso-cost line shifts upwards to the
right and it moves farther away from the origin and vice-versa.
 Iso-cost lines are parallel to one other, since relative price ratio remains constant.

5.7 LEAST COST COMBINATION

 Factor-factor analysis is mainly concerned with the determination of least cost
combination of resources.
 There will be many combinations of two resources that produce the same level of
output.
 The problem here is to find out particular combination of inputs, which produce a
given quantity of output with minimum cost.
There are three methods of finding out least cost combination viz., Tabular Method,
Algebraic Method and Graphic Method.
Example
A farmer wants to produce 1000 kg of paddy per acre of land. He has two types of
fertilizers viz., Manures and Urea that can be used to produce the crop. The following
different combinations of Manures and Urea produce the same quantity of output i.e., 1000
kg of paddy per acre.
Combination Manure (X1) Urea (X2)
(qty. in cart-load/acre) (qty. in kg/acre)
A 1 200
B 2 125
C 3 80
D 4 50
E 5 30
F 6 17
G 7 10
Price of Manure is Rs. 200/cart-load and price of Urea is Rs. 5/kg.
Find out least cost combination using all three methods and give your advice to the
farmer about how much quantity of Manure and Urea he should use to produce the required
output.
Solution
5.7.1 Tabular Method
Combin Manure (X1) Urea (X2) Cost of Cost of Total
ation (cart-load/acre) (kg/acre) X1 X2 Cost
(X1*PX1) (X2*PX2)
A 1 200 200 1000 1200

26
 B 2 125 400 625 1025
C 3 80 600 400 1000
D 4 50 800 250 1050
E 5 30 1000 150 1150
F 6 17 1200 85 1285
G 7 10 1400 50 1450

Conclusion:Total Cost of “C” combination is the minimum (least) among all.

Therefore, the farmer should use 3 cart-load of Manure and 80 kg of
Urea to produce the given output.
5.7.2 Algebraic Method
Step-I : Compute the Marginal Rate of Technical Substitution (MRTS)
∆ X2
MRTS X1X2 = ---------
∆ X1
Step-II : Compute the Price Ratio (inverse)
PX1
PR X2X1 = --------
PX2
Step-III : Find out least cost combination by equating MRTS with inverse PR

Calculation of MRTS and Price Ratio

Price of X1 = Rs. 200/cart-load, Price of X2 = Rs. 5/kg

Combi- X1 X2 ∆X1 ∆X2 MRTSX1X2 PR X2X1

nation (cart-load/ (kg/acre) ∆X2 PX1
acre) = ------ = ------
∆X1 PX2
A 1 200 - - - -
B 2 125 1 75 75 40
C 3 80 1 45 45 40
D 4 50 1 30 30 40
E 5 30 1 20 20 40
F 6 17 1 13 13 40
G 7 10 1 7 7 40

OR
Combi- X1 X2 ∆X1 ∆X2 MRTSX2X1 PR X1X2
nation (cart-load/ (kg/acre) ∆X1 PX2
acre) = ------ = ------
∆X2 PX1
A 1 200 - - - -

27
 B 2 125 1 75 0.013 0.025
C 3 80 1 45 0.022 0.025
D 4 50 1 30 0.033 0.025
E 5 30 1 20 0.050 0.025
F 6 17 1 13 0.077 0.025
G 7 10 1 7 0.143 0.025

Conclusion: At Combination “C”, MRTS=PR is observed. So, this combination is

the least cost combination. Therefore, the farmer should use 3 cart-load
of Manure and 80 kg of Urea to produce the given output.

5.7.3 Graphical Method

Step-I : Draw Iso-quant on a graph paper.
Plot X1 (added quantity) on X axis and X2 (replaced quantity) on Y
axis to get Iso-quant.
Step-II : Draw Iso-cost Line on the same graph paper.
To draw Iso-cost line we need two extreme points X1 and X2.
Suppose, we have a budget of Rs. 1000. The Maximum quantity of X1 and
X2 can be purchased as under:

X1 (cart-load) X2 (kg)
5 0
0 200

Plot these two extreme points of X1 (5,0) and X2 (0,200) on the same
graph. Join these two points X1X2. This line is called Iso-Cost Line.

Step-III : If required, move the Iso-cost line or draw the parallel line in such a way
that it intersects the Iso-quant at one point. This point indicates the least
cost combination of two inputs.

28
 250

A
200
Iso-quant Curve

150 B
X2

100 C

D
E
50 Iso-cost Line F
G

0
0 1 2 3 4 5 6 7 8
X1
Conclusion: Combination “C” is found to be least cost because at this level
Iso-quant curve and Iso-cost line intersects to each other. Therefore, the farmer
should use 3 cart-load of Manure and 80 kg of Urea to produce the given
output.

-:-:-:-:-:-
Chapter 6

PRODUCT - PRODUCT RELATIONSHIP

(Law of Product Substitution)

6.1 INTRODUCTION
The basic resources of farming viz., land, labour and capital are scare. However, these
scare resources have many alternative uses. These can be used in producing different crops
and livestock enterprise. Farmers have to decide whether to produce crops alone or livestock
alone or their combinations. The farmer should choose such a combination of crops and
livestock enterprise that maximizes profit.
 Product-product relationship deals with the allocation of resources among different
crop and livestock enterprise.
 It is explained by the law of product substitution.
 In this relationship, resources or inputs are kept constant and products are varied.

6.2 PRODUCTION FUNCTION USED

Y1 = f (Y2 | X1, X2, …, Xn).

29
 Where, Y1 and Y2 are variable output of two products;
X1, X2, ..., Xn are fixed inputs.
6.3 OBJECTIVE
 The objective of product-product relationship is profit maximization.
 The management problem associated with this analysis is what to produce.

6.4 PRODUCTION POSSIBILITY CURVE

 It represents all possible combinations of two products (Y1 and Y2) that could be
produced with given amount of resources.
 It is known as opportunity curve because it represents all the production
opportunities available with a given amount of resources.
 It is also called a Production Frontier because the limited resources cannot help to
produce anything beyond production possibility curve. It demarcates what is possible
at a given quantity of inputs.
Suppose a farmer has a limited input i.e., 5 acres of land. He has two alternatives i.e.,
the production of Maize (Y1) crop and/or Bajra (Y2) crop. Problem here is how to allocate
his 5 acres between Y1 and Y2. Here, farmer can allocate entire 5 acres to Y1 alone or Y2
alone. In between these two extreme possibilities, he may have different options like, 1 acre
to Y1 and 4 acres to Y2 or 2 acres to Y1 and 3 acres to Y2 and so on. For example, different
levels of land and the corresponding levels of output of Y1 and Y2 are as under.
Land Production (qtl)
(acre) Maize (Y1) Bajra (Y2)
1 9 8
2 15 14
3 20 20
4 23 24
5 25 27
Here, possible allocation of land among two crops Y1 and Y2 can be done as under.
Combin- Allocation of Land in acres Output (Production) in qtls
ation Maize (Y1) Bajra (Y2) Maize (Y1) Bajra (Y2)
A 0 5 0 27
B 1 4 9 24
C 2 3 15 20
D 3 2 20 14
E 4 1 23 8
F 5 0 25 0
The production possibility curve for the above situation can be prepared by
presenting the outputs of Y1 and Y2 in graphical form (Fig.1).
Qty in q

30
 30 A
B
25 ●N
C Production
20
Possibility Curve
15

Y2
D
●M
10
E
5
F
0
0 5 10 15 20 25 30 Qty in q
Y1
Fig 1. Production Possibility Curve
Characteristics of Production Possibility Curve
 It is concave to the origin.
 The slope of the curve indicates the marginal rate of product substitution.
 Any combination of Y1 and Y2 inside the curve (Point M) is possible but it reflects
inefficient use of resources.
 Any combination of Y1 and Y2 on the curve (Point A to F) is possible to produce and
it reflects efficient use of resources.
 Any combination of Y1 and Y2 outside the curve (Point N) is not possible to produce
at given amount of resources.
 Change in input levels, shifts the production possibility curve.

30 PPC at given
level of inputs
25
20
15 PPC at higher
Y2

level of inputs
10 PPC at lower
5 level of inputs
0
0 5 10 15 20 25 30 Qty in q
Y1
Fig. 2: Shifts in Production Possibility Curve
6.5 MARGINAL RATE OF PRODUCT SUBSTITUTION (MRPS)
 The absolute amount, by which one product is decreased, in order to gain another
product by a unit is called marginal rate of product substitution.
 It is the rate of exchange between two products which are equally preferred.

Number of units of replaced product

MRTS = ---------------------------------------------
Number of units of added product
∆Y2
MRPS of Y1 for Y2 (MRPSY1Y2 ) = --------
∆Y1
or

31
 ∆Y1
MRPS of Y2 for Y1 (MRPSY2Y1) = ------
∆Y2
6.6 ISO-REVENUE LINE
It is line, which represents all possible combinations of two products which
would yield equal revenue.
Suppose we wish to obtain a total revenue of Rs. 7000. If Price of Y1 is Rs.1000/q
and price of Y2 is Rs.700/q, the expected revenue of Rs.7000 can be earned by producing 7
quintals of Y1 or 10 quintals of Y2.

Y1 (q) Y2 (q)
7 0
0 10

Plot these two extreme points Y1 (7,0) and Y2 (0,10). Join these two points and the
line that we get is called iso-revenue line (Fig.3). Similarly, the iso-revenue line for Rs. 4000
and Rs. 9000 can be drawn as under. They will be parallel to each other.
Qty in q
11
Iso-Revenue Line
10
9
8 TR = Rs. 9000

7
6
Total Revenue
Y2 5 = Rs. 7000
4
3
2 TR = Rs. 4000
1
0
0 1 2 3 4 5 6 7 8 Qty in q
Y1
Fig. 3: Iso-revenue Line

32
 Characteristics or properties of Iso-revenue Line
 Iso-revenue line is a straight line.
 As the total revenue increases, the iso-revenue shifts upwards and moves away from
the origin and vice-versa.
 The iso-revenue lines are parallel to each other, since price ratio remains constant,
 The slope of the iso-revenue line indicates the inverse price ratio of the products. The
slop is affected by price change.

6.7 PROFIT MAXIMIZATION

The objective of product-product relationship is to determine which out of all possible
combinations is the most profitable. For this, we require the prices of Y1 and Y2 products.
Suppose, the price of Y1 is Rs.1000/q and price of Y2 is Rs.700/q, for the given example,
find out the combination of two crops which gives the maximum profit.
Solution
There are three methods to find out the best combination that gives maximum profit
viz., Tabular Method, Algebraic Method and Graphical Method.
6.7.1 Tabular Method
Combi- Allocation of Production Income Total
nation land (acre) (qtl/acre) Income
Y1 Y2 Y1 Y2 Y1*PY1 Y2*PY2
A 0 5 0 27 0 18900 18900
B 1 4 9 24 9000 16800 25800
C 2 3 15 20 15000 14000 29000
D 3 2 20 14 20000 9800 29800
E 4 1 23 8 23000 5600 28600
F 5 0 25 0 25000 0 25000

Conclusion : Combination “D” gives highest Income. Therefore, out of 5 acres, farmer
should grow Y1 crop in 3 acres and Y2 crop in 2 acres of land.

6.7.2 Algebraic Method

Step 1: Find out Marginal Rate of Product Substitution (MRPS)
Step 2: Find out inverse ‘Price Ratio’ for given prices of Y1 & Y2
Step 3: Compare both MRPS and PR ratio. MRPS=PR gives maximum returns.
Combi- Allocation of Production ∆ Y1 ∆ Y2 MRPSY PR MRPS PR
nation land (acre) (qtl/acre) 1Y2 Y2Y1 Y2Y1 Y1Y2

Y1 Y2 Y1 Y2
A 0 5 0 27 - - - - - -
B 1 4 9 24 9 3 0.33 1.43 3.00 0.70
C 2 3 15 20 6 4 0.66 1.43 1.50 0.70
D 3 2 20 14 5 6 1.20 1.43 0.83 0.70
E 4 1 23 8 3 6 3.00 1.43 0.50 0.70
F 5 0 25 0 2 8 4.00 1.43 0.25 0.70

33
Conclusion : Combination D represents MRPS=PR. Therefore, out of 5 acres, farmer should
grow Y1 crop in 3 acres and Y2 crop in 2 acres of land.
6.7.3 Graphical Method
Step 1: Prepare a Production Possibility Curve
Plot Y1 (added quantity) on X axis and Y2 (replaced quantity) on Y
axis to get production possibility curve.

Step 2 : Draw Iso-Revenue Line or Price Line using price data.

To draw iso-revenue line we need two extreme points of Y1 and Y2
which can be obtained as under:
Suppose, we want to have a total revenue of Rs. 21,000. It is possible
as under:
Y1 (q) Y2 (q)
21 0
0 30

Plot these two extreme points of Y1 (21,0) and Y2(0,30) on the same
graph. Join these two points Y1Y2. This line is called Iso-Revenue Line.

Step 3 : Move Iso-revenue line to intersect production possibility Curve at one

point.
At the point where Production possibility Curve and Iso-revenue
Line intersect is the point of maximum profit. At this point combination of
two products Y1 & Y2 gives maximum profit.

Qty in q Iso-revenue Line

30
A
B
25 Production Possibility Curve

C
20

15 D
Y2

10
E

Iso-revenue Line
5

F
0
0 5 10 15 20 25 30 Qty in q
Y1

Conclusion: The Production Possibility Curve and Iso-revenue Line intersect at D Point.
Thus, combination D represents MRPS=PR. Therefore, out of 5 acres, farmer

34
 should grow Y1 crop in 3 acres and Y2 crop in 2 acres of land.

6.8 SUMMARY OF THREE BASIC PRODUCTION RELATIONSHIPS

Factor – Product Factor – Factor Product – Product

Relationship Relationship Relationship
It is explained by It is explained by It is explained by
Law of Diminishing Return Law of Factor Substitution Law of Product Substitution
Management Problem: Management Problem: Management Problem:
How much to produce? How to produce? What to produce?
Objective : Objective : Objective :
Resource Optimization Cost Minimization Profit maximization
It is concerned with It is concerned with It is concerned with
Resource use efficiency Resource combination and Resource allocation
substitution
It is used for determination It is used for determination It is used for determination of
of optimum input use and of least cost combination optimum combination of
optimum output to produce of resources products to be produced
Functional relationship: Functional relationship: Functional relationship:
Y= f (X1 | X2, X3,…., Xn) Y= f (X1,X2,| X3,X4,., Xn) Y1= f (Y2,|X1,X2,…., Xn)
One input varied, others are Output is constant and Inputs are constant and
kept constant inputs are varied products are varied

Three Zones of Iso-quant Curve and Production Possibility Curve

Production Iso-cost Line and Iso-revenue Line
35

TP
AP
250 30 Iso-revenue
30
MP

200 25 Line
25
Iso-quant
150 20
Curve
20 X2 PPC
15
Y2

100
Output (q)

15
Zone 10
50 Iso-cost
10 I II III
5
0 Line
5

0 1 2 3 4 5 6 7 8 0
0
0 5 10 15 20 25 30
1 2 3 4 5 6 7 8 9 10 11 12 X1 Y1
Input (kg)
-5

Profit rule: MC=MR Profit rule: MRTS=PR Profit rule: MRPS=PR

-:-:-:-:-:-

35
 Chapter -7

RETURNS TO SCALE
8.1 INTRODUCTION
 Increasing successive units of a variable factor to a fixed factor will increase output
but eventually the addition to output will start to slow down and would eventually
become negative.
 To prevent diminishing returns setting in, all factors need to be increased. It is
called returns to scale.
 It is also called long-run production function. In the long run, all factors can be
changed.

8.2 DEFINITION
 Returns to scale studies the changes in output when all factors are changed.
 An increase in scale means that all inputs or factors are increased simultaneously in
the same proportion.
 In other words, in return to scale, we analyze the effect of doubling, tripling and so
on of all the inputs used in the production process.

8.3 THREE PHASES OF RETURNS TO SCALE

8.3.1 Phase-I: Increasing returns to scale
If the increase in all factors leads to a more than proportionate increase in output, it is
called increasing returns to scale. For example, if all the inputs are increased by 5%, the
output increases by more than 5%. In this case the marginal product will be rising.
8.3.2 Phase-II: Constant returns to scale
If we increase all the factors (i.e. scale) in a given proportion, the output will increase
in the same proportion i.e. a 5% increase in all the factors will result in an equal proportion of
5% increase in the output. Here the marginal product is constant.
8.3.3 Phase-III: Decreasing returns to scale
If the increase in all factors leads to a less than proportionate increase in output, it is
called decreasing returns to scale i.e. if all the factors are increased by 5%, the output will
increase by less than 5%. In this phase marginal product will be decreasing.
8.4 EXAMPLE
Sr. Scale of Production Total Output / Marginal Remarks
No. (Inputs) Returns (qtl) Return (qtl)
1 2W* + 1AL* 2 - -
2 4W + 2AL 5 3 Stage-I
3 6W + 3AL 9 4 Increasing Return
4 8W + 4AL 14 5
5 10W + 5AL 19 5 Stage-II Constant
6 12W + 6AL 24 5 Return
7 14W + 7AL 28 4 Stage-III
8 16W + 8AL 31 3 Decreasing

36
 9 18W + 9AL 33 2 Return
* W = Worker; AL = Acres of Land

6
B Constant
C
5

Marginal Returns
4 Increasing Decreasing

A D
2

1
0 2 4 6 8 10
Scale of Production (Inputs)

Fig. 4: Returns to Scale

In the table, we see that when we employ 2 worker on 1 acres of land, the total
product is 2 qtls. Now to increase output, we double the scale, but the total production
increases to more than double (to 5 instead of 4) and so on up to certain point. If the scale of
production is further increased, the marginal product remains constant to a certain point, and
beyond that, it (MP) starts diminishing. The same is explained by the figure where AB, BC
and CD indicate increasing, constant and decreasing returns to scale, respectively.

8.5 IMPORTANCE AND LIMITATIONS

However, it is very important to state that, in actual life, the scale of production
cannot be increased beyond a certain limit. To increase the scale of production means that all
the factors being used in production can be increased at will and indefinitely. But it is not so
in practice. While land, labour and capital can be increased at will, organization or
entrepreneur does not admit for being increased, since the entrepreneur or organizer
remains the same. In other words, there is at least one factor of production which cannot be
varied at will, and, hence when more output is desired, the proportion among the factors of
production used must change. Hence, returns to scale are more theoretical interest than
being relevant to actual life.

8.6 DIFFERENCE BETWEEN LAWS OF RETURNS AND RETURNS TO SCALE

Laws of Returns Returns to Scale

Short run Production function. Long run Production function.
Only one factor is varied and all The Scale changes i.e., all factors are
other factors are kept constant. changed simultaneously in the same ratio.
Law does not apply when the Law does apply when the
factors are used in fixed proportions. factors are used in fixed proportions.
Widely applicable. More of theoretical interest than being
relevant to actual life.

37
 Chapter-8
Farm cost concepts and Income measures

Cost concepts are widely used because of their relevance in the decision making
process. This means that these costs serve as a basis to expand the size of the farm, to
buy the requisite capital assets in the long run and the requisite input in the short run.
For example variable cost have the bearing on the level of production in the short
run, on the other hand the decisions like expanding the size of farm, buying the
durable assets, etc., are based on the total costs.

Farm cost concepts:

Dr Sen’s special expert committee for improving the cost of cultivation/production
estimates (1979) recommended the following classification of costs to be adopted and
later they were slightly modified. The different cost items that are to be included
under each cost concept are detailed below with their imputational procedures.

CATEGORIZATION OF FARM COST CONCEPTS

The Commission on Agricultural Costs and Prices (CACP), Govt. of India, had
categorized the farm costs concepts as follows.
1. Cost A1 : It includes all actual expenses in cash and kind incurred in production by
the farmer.
i) Value of hired human labour
ii) Value of bullock labour (both hired and owned)
iii) Value of machine power (both hired and owned)
iv) Value of seeds (both owned and purchased)
v) Value of insecticides and pesticides, weedicides
vi) Value of manures (both owned and purchased)
vii) Value of fertilizers
viii) Depreciation of implements and farm buildings
ix) Irrigation charges
x) Land revenue, cess and other taxes
xi) Miscellaneous expenses (electricity charges etc)

38
 xii) Interest on working capital
2. Cost A2 : Cost A1 + rent paid for leased in- land
3. Cost B1 : Cost A2 + interest on value of owned capital assets (excluding land)
4. Cost B2 : Cost B1 + rental value of owned land
5. Cost C1 : Cost B1 + imputed value of family labour
6. Cost C2 : Cost B2 + imputed value of family labour
7. Cost C3 : Cost C2 x 1.10, (10% of cost C2 is added to cost C2) : this is a recently added
concept to provide allowance for managerial functions undertaken by the
farmer. It is the Total Cost or comprehensive cost of cultivation.
8. Cost of production = (Cost C3-Value of byproduct) / Yield

Farm business income measures : Workout the following farm business income measures
or returns over different cost concepts.
1. Gross returns: Value of main product plus byproduct. The main products and
byproducts are to be imputed taking into account the actual marketed prices, or the
village level prices prevailed at the time of enquiry.
2. Farm business income = Gross return-Cost A1
3. Owned farm business income = Gross return-Cost A2
4. Family labour income = Gross return-Cost B2
5. Net income = Gross return-Cost C3
6. Intensive income = Net income + rental value of owned land+ interest of fixed capital
7. Farm investment income = Farm business income-Imputed value of family labour

Imputation procedure to be followed while estimating cost of cultivation of crops

1. Casual labour: Actual cash wages or kind wages and perquisites are to be imputed
considering the ruling price in the village at the time of operations.
2. Attached servants: The per day wage rate is to be arrived based on total wages (cash +
kind + perquisites) paid and the number of days.
3. Bullock labour: Hired – actual charges paid are considered. In case of owned bullock
labour the per work day or per work hour cost of maintenance is to be taken into
account.
4. Owned manures, seeds and other are to be imputed at the prices prevailed in the
village at the time of their use.

39
5. Interest on working capital – Interest on entire cash costs are to be charged @ 7 per
cent per annum, for half of the crop period only. Actual interest charges are to be
considered in respect of borrowed capital.
6. Depreciation on fixed assets (other than the value of land such as farm implements,
farm buildings, irrigation structures, work cattle, pump sheds, following the straight
line method. The total amount of depreciation/year is to appropriated to each crop
according to the proportion of usage of assets and equipment in each crop or in
proportion to the each crop acreage in the cropping pattern on the farm.
7. Rent on owned land: Local prevailing lease amount for land is to be considered or 30
per cent of the value of output (main product plus by product) is to be considered as
rental value of owned land.
8. Interested on owned fixed capital (other than the land value) : It is to be charged @
10 per cent per annum. The total amount is to be apportioned to each crop as per the
proportion of each crop in the cropping pattern on the farm.
9. Family labour: Men family labour is to be charged on par with the attached servants
(average wage value) of the village, while family women labour is to be imputed
considering the wages paid to the women labour for the similar operation.
10. The actual costs plus transport charges are to be considered in case of other purchased
inputs such as fertilizers, insecticides etc.
11. Machine labour: Actual hire charges are to be taken and in case of owned machine
prevailing hire charges are to be adopted.

**************************

40
 Chapter-9
Farm Management
Meaning of Farm Management: Farm Management comprises of two words i.e.
Farm and Management. Farm means a piece of land where crops and livestock enterprises are
taken up under common management and has specific boundaries. Farm is a socio economic
unit which not only provides income to a farmer but also a source of happiness to him and his
family.
It is also a decision making unit where the farmer has many alternatives for his resources in
the production of crops and livestock enterprises and their disposal. Hence, the farms are the
micro units of vital importance which represents centre of dynamic decision making in regard
to guiding the farm resources in the production process. The welfare of a nation depends
upon happenings in the organisation in each farm unit. It is clear that agricultural production
of a country is the sum of the contributions of the individual farm units and the development
of agriculture means the development of millions of individual farms.
Management is the art of getting work done out of others working in a group. Management is
the process of designing and maintaining an environment in which individuals working
together in groups accomplish selected aims. Management is the key ingredient. The manager
makes or breaks a business. Management takes on a new dimension and importance in
agriculture which is mechanised, uses many technological innovations, and operates with
large amounts of borrowed capital. The prosperity of any country depends upon the
prosperity of farmers, which in turn depends upon the rational allocation of resources among
various uses and adoption improved technology. Human race depends more on farm products
for their existence than anything else since food, clothing – the prime necessaries are
products of farming industry. Even for industrial prosperity, farming industry forms the basic
infrastructure.
Thus the study farm management has got prime importance in any economy
particularly on agrarian economy.

DEFINITIONS OF FARM MANAGEMENT.

1. The art of managing a Farm successfully, as measured by the test of profitableness is called
farm management. (L.C. Gray)
2. Farm management is defined as the science of organisation and management of farm
enterprises for the purpose of securing the maximum continuous profits. (G.F. Warren)

41
3. Farm management may be defined as the science that deals with the organisation and
operation of the farm in the context of efficiency and continuous profits. (Efferson)
4. Farm management is defined as the study of business phase of farming.
5. Farm management is a branch of agricultural economics which deals with wealth earning
and wealth spending activities of a farmer, in relation to the organisation and operation of the
individual farm unit for securing the maximum possible net income. (Bradford and Johnson)

NATURE OF FARM MANAGEMENT.

Farm management deals with the business principles of farming from the point of view of an
individual farm. Its field of study is limited to the individual farm as a unit and it is interested
in maximum possible returns to the individual farmer. It applies the local knowledge as well
as scientific finding to the individual farm business. Farm management in short be called as a
science of choice or decision making.
OBJECTIVES

1. To examine production pattern and resource use on the farm.

2. To identify the factors responsible for the present production pattern.
3. To determine the conditions of optimality in the resource use and production
pattern.
4. To analyze the extent of sub-optimality in the resource use.
5. To suggest ways and means in getting the present use of resources to optimality.

SCOPE OF FARM MANAGEMENT.

Farm Management is generally considered to be MICROECONOMIC in its scope. It deals
with the allocation of resources at the level of individual farm. The primary concern of the
farm management is the farm as a unit. Farm Management deals with decisions that affect
the profitability of farm business. Farm Management seeks to help the farmer in deciding the
problems like what to produce, buy or sell, how to produce, buy or sell and how much to
produce etc. It covers all aspects of farming which have bearing on the economic efficiency
of farm.

RELATIONSHIP OF FARM MANAGEMENT WITH OTHER SCIENCES.

The Farm Management integrates and synthesises diverse piece of information from
physical and biological sciences of agriculture. The physical and biological sciences like
42
Agronomy, animal husbandry, soil science, horticulture, plant breeding, agricultural
engineering provide input-output relationships in their respective areas in physical terms
i.e. they define production possibilities within which various choices can be made. Such
information is helpful to the farm management in dealing with the problems of production
efficiency.
Farm Management as a subject matter is the application of business principles n farming
from the point view of an individual farmer. It is a specialised branch of wider field of
economics. The tools and techniques for farm management are supplied by general
economic theory. The law of variable proportion, principle of factor substitution, principle
of product substitution are all instances of tools of economic theory used in farm
management analysis.
Statistics is another science that has been used extensively by the agricultural economist.
This science is helpful in providing methods and procedures by which data regarding
specific farm problems can be collected, analysed and evaluated. Psychology provides
information of human motivations and attitudes, attitude towards risks depends on the
psychological aspects of decision maker.
Sometimes philosophy and religion forbid the farmers to grow certain enterprises, though
they are highly profitable. For example, islam prohibits muslim farmer to take up piggery
while Hinduism prohibits beef production. The various pieces of legislation and actions of
government affect the production decisions of the farmer such as ceiling on land, support
prices, food zones etc.
The physical sciences specify what can be produced; economics specify how resources
should be used, while sociology, psychology, political sciences etc. specify the limitations
which are placed on choice, through laws, customs etc.

43
 Chapter -10
Farm Resource Management
Farm: It is a piece of land, where crop s and livestock enterprises are taken up under single
management and has specific boundaries.
Size of Farm: The size of farm generally understood in terms of physical area, volume of
production and value of production.
In general the size of farm refers to physical area, but in terms of economics this refers to
either the volume of production or value of production.
Types and system of farming refer to the nature and degree of products and their combination
and various methods followed in the production of the same.

1. SPECIALIZED FARMING
 When a farm business unit derives more than 50 per cent of its income from a single
enterprise it is called as a specialized farm.
 This means that among the possible crops or livestock enterprises taken up by a
farmer, one particular crop or livestock enterprise contributes more than 50 per cent
of the income.
 The reasons for specialized farming are; 1) assured income from the enterprise; 2) its
suitability to the area; 3) its relative profitability, etc.
 For example, paddy farming, sugarcane farming, tobacco farming, poultry, sheep
farming, fish farming, etc.

Advantages
1. Better Utilization of Land: Land can be put to most productive use, by opting the
enterprise that is best suited. A given type of land no doubt allows options for
alternative crops; still there is a possibility of a particular crop capable of rewarding
the farmer with better income.
2. Better Management: Specialization since is bestowing attention on a particular
enterprise, it reduces the pressure on the farmer to care for several enterprises.
Naturally it reduces the wastage of resources.
3. Less Requirement of Equipment: The farmer can carry on the business activity with
the equipment that is required for the chosen enterprise. There are no pressing
requirements to equip the farm with a variety of equipment.
4. Increase in Skill of the Farmer: The efficiency of the farmer increases as he can
concentrate on one enterprise. His experience in the enterprise sharpens his skills in
running the enterprise.
5. Allows Better Marketing: On marketing front, the farmer is better placed. He is
saved from the pressure of finding market if he were to sell diversified products. It
allows for better marketing functions i.e., assembling, transport, grading, etc.

44
 Disadvantages
1. Failure of crop: The farmer runs the risk of heavy loss in case of crop failure. There
is no possibility of compensation. This is the biggest drawback of specialized farming.
2. Non-utilization of Productive Resources: Since the farmer confines to one or few
enterprises, the various farm resources like land, water, labour, capital, etc., may not
be fully utilized. In view of the limited enterprises, some of the resources may remain
untapped or under-utilized.
3. Affect on Soil Health: Continuous raising of one crop or few crops may be exerting
greater pressure on soil health. This practice does not allow crop rotation, thereby
affecting the soil health.

2. DIVERSIFIED FARMING
 It is also known as general farming.
 It means a number of enterprises are taken up on the farm at the same time.
 There is no much significance for a single enterprise under this situation.
 No single enterprise contributes as high as 50 per cent of the total income.
Advantages

1. Better Utilization of Farm Resources: In view of the diversified cropping and crop
rotations, farm resources are better utilized compared to specialized farming.
2. Reduction of Farm Risks: As a variety of crops are found, failure of one or two
crops will not much affect the income from farming.
3. Flow of Income: The farmer enjoys the advantage of deriving regular income, as
different crops are grown.
Disadvantages
 Ineffective Supervision: The presence of a number of enterprises on the farm will
stand in the way of the farmer in bestowing effective supervision. Effectiveness can
be found when there is a limit to the number of enterprises. This is likely to affect the
farm economy.
 Less Possibility for Maintaining a Variety of Implements and Machinery: It
becomes expensive to purchase and maintain the required suitable implements and
machinery for the various enterprises taken up on the farm.
 Probable Marketing Insufficiencies: The growing of a variety of crops is likely to
bring in problems on marketing front. The farmers have to search for markets.

3. MIXED FARMING
 It represents a type of farming in which crop production and livestock production are
combined to sustain and satisfy as many needs of the farmer as possible.
 There are limits specified regarding contribution of livestock production, poultry,
fisheries, and bee keeping, etc., to the gross income on the farm. These enterprises are

45
 supposed to contribute at least 10 per cent of gross income. However, this
contribution should not exceed 49 per cent.
 It facilitates the application of organic manuring to soil, thus helping the maintenance
of soil health.
 It provides employment to the farmer and his family throughout the year.
 Agricultural byproducts are properly used in mixed farming.
 It further provides a sort of stability to the farm business.

4. DRY FARMING
 Growing of crops entirely under rainfed conditions is known as dry land agriculture.
 Depending on the amount of rainfall received, dry land agriculture is categorized into
dry farming, dry land farming and rainfed farming.
 Dry farming means cultivation of crops in areas where rainfall is less than 750 mm
per annum. Crop failure is the most common due to prolonged dry spells during the
crop period. Dry farming regions are equivalent to arid regions and moisture
conservation practices are important in this region.
 Dry land farming is the cultivation of crops in regions with an annual rainfall of
more than 750 mm. Dry spells during crop period occurs, but crop failures are
relatively less frequent. Moisture conservation practices are necessary for crop
production.
 Rainfed farming is crop production in regions with an annual rainfall of more than
1150 mm. It is practiced in humid regions where crop failures are rare and drainage is
the important problem.
 In dry farming and dry land farming, emphasis is on soil and water conservation,
sustainable crop yields and limited fertilizer use according to soil moisture
availability.
 In rainfed agriculture the emphasis is on disposal of excess water, maximum crop
yield, and high levels of inputs and control of water erosion.

5. RANCHING
Grazing of livestock on public pastures is called ranching. These lands are not fit for
cultivation.

FACTORS INFLUENCING TYPES AND SIZE OF FARM

1) Physical Factors
1. Climate: It includes sunshine, rainfall, wind, length of sunlight, etc. These factors
predominantly influence the choice of crops, thereby affecting the type of farming.
Crops like paddy and sugarcane requires substantial water while others like oilseeds;
millets and pulses can withstand low rainfall.
2. Soil: The type of soil, depth of soil and fertility status of the soil affects the selection
of crops. Deep soils facilitate production of a variety of crops bringing prosperity to

46
 agriculture. If soils are fertile, manurial costs can be reduced thereby the cost of
cultivation.
3. Topography: It means the general contour of the land, whether it is hilly or plain.
Temperatures are low and growing seasons are shorter at higher elevation and
therefore more suitable for establishment of plantation crops like tea, coffee, etc.
Contour also determines the type of machinery that can be used and the rate of soil
erosion, which in turn influences the choice of crop.

2) Economic Factors
1. Relative Profitability: Given the option of choosing among several crops in an area,
farmers first look into the relative profitability of a given enterprise. A particular
enterprise if found to be relatively profitable, farmers are inclined to go for it. In a
dynamic situation the options are bound to change with changes in the relative
profitability of crops. These changes occur in view of changes in yields, changes in
prices, risk factors, introduction of incentives, crop restrictions, technology, etc.
2. Availability of Funds: Different enterprises require different levels of funds. For
example, commercial enterprises like sugarcane, chillies, onion, prawn culture, etc.,
require large amount of funds over enterprises like oilseeds, millets, etc. Therefore
availability of funds determines the type of farming.
3. Availability of the Inputs: All the inputs like labour, seed, fertilizer, etc., should be
available as per the requirement. If labour shortages are common in an area during
peak periods, certainly the farmers do keep this in mind in the selection of the
enterprises. Timely availability of other inputs in required quantities also influences
their decision with regard to selection of enterprises.
4. Marketing Arrangements: The marketing facilities available for the products are
also given due weightage in the selection of enterprises. Mere assured output with
inadequate marketing arrangements will not influence the farmers to opt for a given
enterprise and
5. Personal Choices: Apart from aforesaid factors individual farmer's likes and dislikes
have a say, in the selection of enterprises.

47
 Chapter-11
Farm Management Decision

Farm management Decision: It is seen that farm management is called the science of decision
making or science of choice. It is a choice in the efficient utilization of available but limited
resources among competing ends. The principal farm management decisions made by most of
the farmers are:
1. Strategic Management Decisions
(a) Deciding the best size of farm: Type of farming area, typoe of business, land under
irrigation, mechanization, ability of the farmer to manage, etc.
(b) Decisions on farm labour and machinery programme.
(c) Decision on construction of building
(d) Decision regarding irrigation, conservation and reclamation programmes.
2. Operational management decision
In the day to day operations of the farm business, the frequency of these decision is more
as compared to strategic decision but the investment is relatively small and impact short
lived.
 These type of decisions involve less investment.
 These are made more frequently.
 The effect of these decisions is short lived.
 Can be reversed without incurring much cost.
 These are also known as tactical decisions.
The decisions are generally as follows:
1. What to produce? - aims at profit maximization (Selection of enterprises)
2. How to produce? - aims at cost minimization. (Selection of least cost efficientmethod)
3. How much to produce? - aims at resource optimization. (Enterprise mix)
4. When to produce? – aims at timimg of production

3. Administrative Management Decisions

Besides organizational management decisions, the farmer also makes several administrative
decisions according to Government policies.
(a) Financing the Farm Business
From whom to borrow

48
When to borrow and
How much to borrow.
(b) Supervision of work
(c)Accounting and book keeping
(d) Adjustment the government programme and policies
(e) Production for home consumption and market

4. Marketing Management Decisions

Marketing decisions are the most important under the changing environment of agriculture.
These decisions include buying and selling.
Buying: A farmer has to decide the agency, the timing, and the quantity to be purchased.
Selling: What to sell, where to sell, whom to sell, when to sell and how to sell are the
important selling decisions that are to be made by the farmer.

****************************

Chapter-12

ECONOMIC PRINCIPLES APPLIED TO FARM MANAGEMENT

INTRODUCTION

Basically farm management is the application of agricultural sciences and economic

principles to the organization and operation of a farm business. The economic principles
guide the manager in setting the goals and preparing plans on the basis of optimum resource
allocation, resource substitution and enterprise combination.
The various economic principles applied to farm management are discussed below:
1. Law of diminishing returns
2. Principle of factor substitution
3. Principle of product substitution
4. Principle of equi-marginal returns
5. Opportunity cost principle
6. Minimum loss principle
7. Principle of comparative advantage
8. Time comparison and uncertainty principle

LAW OF DIMINISHING RETURNS

49
  It explains the input-output or factor-product relationship.
 This law states that if the quantity of one input is increased, keeping other resources
constant, the total product may increase initially, but will decrease after a certain
point .
 This principle is associated with farmer’s decision about how much to produce?
 This law is also known as the law of variable proportions. It is a fundamental
economic law, applicable to any production activity.
 This principle guides the farmer/manager in choosing the optimum level of
production.

Why the law of diminishing returns sets in quickly in farming?

1. Excessive Dependence on Nature: A farmer, however good he is in managing; the

farm may not get the expected yields as he has little control over weather. A bad
weather is just enough to make his expectation go topsy-turvy.
2. Less Scope for Division of Labour: There is no possibility of division of labour in
farming as the farmer himself performs the role of labour, manager and capitalist,
therefore the advantage of division of labour is not a possibility.
3. Less Scope for Mechanization: Though mechanization of the farms enhances the
productivity, the small size of holdings stands against using the machines for various
farm operations. Thus, the farmer fails to derive the advantage of mechanization.
4. Continuous Cultivation: Continuous cultivation of land drains out the fertility
status of the soil, thereby leading to low productivity. It is a fact that no farmer can
afford to keep the land fallow for a long period, to allow the land build its fertility
status.

Profit Rule: The optimum production level can be obtained at point where MC=MR.

PRINCIPLE OF FACTOR SUBSTITUTION

 This involves factor-factor relationship.

 This principle is associated with farmer’s decision about how to produce?
 It implies the choice of methods of production or technology or the type of
combination of resources.
 This principle guides the farmer/manager in choosing the most appropriate
combination of inputs that produces a given quantity of output with least cost.
Profit Rule
Least cost combination is at the point where MRTS = PR or ∆ X2 = PX1
∆ X1 PX2
Where, MRTS = Marginal Rate of Product Substitution
PR = Price Ratio

10.4 PRINCIPLE OF PRODUCT SUBSTITUTION

 This principle involves product-product relationship

 This principle is associated with farmer’s decision about what to produce?

50
  The objective of this principle is profit maximization.
 This principle guides the farmer/manager in choosing the most appropriate
combination of enterprises that gives the maximum profit.

To apply this principle there is a need to understand the following product

relationships:

 Complementary Enterprise: Two products are complementary, when increase

output of one also results in an increase in the output of the other, with resources held
constant.
 Supplementary Enterprise: Two products are supplementary, when an increase or
decrease in the output of one product does not affect the output of the other.
 Competitive Enterprise: Two products are competitive, if output of one product can
be increased only through a sacrifice in the output of the other.

Profit Rule
Profit maximizing combination is at the point MRPS = PR or ∆ Y2 = PY1
∆ Y1 PY2
Where, MRPS = Marginal Rate of Product Substitution
PR = Price Ratio

10.5 PRINCIPLE OF EQUI-MARGINAL RETURNS

 This principle is associated with the appropriate use of inputs which are limited.
 This principle states that the limited resources should be allocated among
alternative uses in such a way that the marginal value product (MVP or additional
returns) of the last unit of resources is equal in all uses.
 This principle guides the farmer/manager that any limited input should be allocated in
that use where it brings in the greatest MVP, so that the profit can be maximized.
Example
A farmer is having only 5 units of liquid capital each of Rs. 1000. These 5
units must be allocated among the three crops viz., bajra, maize and jowar in the
follow manner based on MVPs.

Comparative Advantage (value in Rs/ha)

Amount of liquid marginal value product (MVP) per unit of 1000 Rs.
capital used
(1 unit=1000 Rs.) Bajra Maize Jowar
1 2000 (5) 3200 (1) 2200 (4)
2 1600 2700 (2) 1800
3 1300 2300 (3) 1400
4 1100 1900 1100
5 1000 1600 800

 Allocate the inputs where it brings in the greatest MVP.

51
 Thus, Rs. 3000 should be allocated to maize and Rs. 1000 each to jowar and bajra
to obtain maximum returns.

OPPORTUNITY COST PRINCIPLE

 The income of next best alternative that is sacrificed to produce any good is
known as opportunity cost.
 Whatever must be given up to obtain some item is called opportunity cost.
 The opportunity cost is referred to as the real cost or true cost of an input.
 This principle guides the farmer/manager that If the returns from the current use of
the input are less than its opportunity cost, then the decision is to be changed.

Example
(Value in Rs/ha)
Particulars Crops
Bajra Maize Jowar
Actual cost of production 10000 11000 10000
Gross Returns 20000 23000 18000
Net Returns 10000 12000 8000
Opportunity cost 12000 10000 12000
Comparison NR<OC NR>OC NR<OC
Decision x √ X

 Here, if the farmer is growing bajra, he sacrifices Rs. 12000 from maize which is
the next best alternative and is called its opportunity cost. So, the actual cost is
Rs. 10000, but the real or opportunity cost is Rs. 12000.
 Likewise, the opportunity cost of maize and jowar is Rs. 10000 and Rs. 12000,
respectively.
 If the Net Returns from the current use of the input are less than its
opportunity cost, then the decision is to be changed.

MINIMUM LOSS PRINCIPLE

 This principle is associated with the fixed and variable cost.

 Fixed costs are those costs, which do not vary with the level of output. Fixed costs
incurred even in the absence of production. It includes depreciation, rental value of
land, interest on fixed capital, land revenue, etc.
 Variable costs are those costs, which vary with the level of output. If there is no
production, there are no variable costs. It includes cost of inputs, customs hiring,
wages of casual labour, interest on working capital, etc.
 The farmers sometimes incur loss instead of profit when price of farm produce goes
down. Then they should continue the farming with an objective of minimizing
losses. Thus, this principle explains, as to how, the producer minimizes losses under

52
 adverse price environment
 The farmer should continue the farming till the loss is less than fixed costs. If loss is
more than fixed cost then the production should be stopped temporarily, to
minimize the loss. In the long run if selling price is less than ATC, continuous losses
are incurred. In this situation, the producer should stop the production
permanently.

Example
Costs and returns in groundnut cultivation

Price of groundnut (Rs./q) 3000 2000 1500

TFC (Rs/ha) 8000 8000 8000
TVC (Rs/ha) 16000 16000 16000
TC (Rs/ha) 24000 24000 24000
Production (q/ha) 10 10 10
Gross Income (Rs/ha) 30000 20000 15000
ATC (Rs./q) 2300 2300 2300
Net Profit (Rs/ha) 6000 -4000 -9000
Decision whether to cultivate groundnut or not?
(on the basis of Minimum Loss Principle)
Loss if cultivated No loss 4000 9000
Loss if don’t cultivate 8000 8000 8000
Should be Should be Should not be
Decision cultivated cultivated cultivated
Because there is Because loss is Because loss is
no loss less than TFC more than TFC
Price > ATC Should be permanently stopped if
Price < ATC over the years

PRINCIPLE OF COMPARATIVE ADVANTAGE

 This principle explains regional specialization in the production of crops and

livestock enterprises.
 For example, Wheat farming is predominant in UP, Punjab and Haryana, Rice
farming in AP, WB, TN, and Assam, Cotton farming in Gujarat and Maharashtra,
Sericulture in Karnataka, Apple cultivation in Himachal Pradesh, etc.
 The relative yields, costs and returns are to be considered as the criteria for
explaining the principle.

53
 Example
Comparative Advantage (value in Rs/ha)

Particulars Region A (Saurashtra) Region B (Panchmahals)

Groundnut Maize Groundnut Maize
Goss income 20000 15000 14000 18000

Total costs 10000 8000 8000 9000

Net Profit 10000 7000 6000 9000

 Region 'A' : The net profit from groundnut is Rs.10000 whereas it is Rs.6000 in
Region ‘B’. Thus, Region 'A' has a comparative advantage in groundnut.
Therefore, farmers of Region ‘A’ should allocate larger area under groundnut to
get benefits of comparative advantage.
 Region ‘B’ : The net profit from maize is Rs. 9000 whereas it is Rs. 7000 in
Region ‘A’. Thus, Region ‘B’ has comparative advantage in maize. Therefore,
the farmers of Region ‘B’ should allocate more area under maize crop.

TIME COMPARISON PRINCIPLE

 This principle is associated with the investment made on capital assets or fixed
assets viz., land, farm buildings, machinery etc.
 The costs and returns from investing in operating resources occur within a
production period of a year or less. There is no need to bring time element into
discussion, as both costs and returns were assumed to fall within the same
production cycle.
 The situation is different in the case of investment on capital assets, where the costs
and returns are in different time periods. To examine the profitability of these
investments it requires the recognition of time value of money.
 Since, capital expenditure involves cash and benefits over time, it is necessary to
adjust for the time value of money which is made through compounding and
discounting.

Money has time value for the following reasons:

1. Earning Power of Money : The money possesses earning power which is
represented by the opportunity cost of money (rate of interest).
2. Inflation: Purchasing power of money varies inversely with the price level. Thus,
the value of money changes with inflation and deflation. A rupee earned in future is
less valuable than a rupee earned today.

3. Uncertainty: Investment deals with future and future is uncertain. Investment is

concerned with the commitment of funds today with the expectation of receiving a
stream of benefits in the future. As an individual since he is not certain about future
cash receipts, he prefers receiving cash now. This may be either due to the urgency of
present wants or the risk of not being in a position to enjoy future consumption that

54
 may be caused by illness, death or inflation.

Compounding

 Compounding is the procedure to find the future value of a present sum, given the
earning power (interest rate) of money and the frequency of compounding.
 The future value of money is the value of an investment on a particular date in the
future. It includes the original investment, the interest it earns and the interest on the
accumulated interest.
 Compounding is the process used to determine costs and returns at the end of the
planning period.
Example
Calculate the future value of Rs. 100 invested in a savings account for 4 years
which earns 10 % interest compounded annually.
Future Value of Present Sum for Lumpsum Amount
Year Amt. the beginning Interest Interest Amt. at the end
of the year (Rs) rate (%) earned (Rs) of the year (Rs)
1 100.00 10 10.00 110.00
2 110.00 10 11.00 121.00
3 121.00 10 12.10 133.10
4 133.10 10 13.31 146.41

 Thus, the future value of present sum of Rs. 100 would be Rs. 146.41 after 4 years.
 It means Rs. 100 invested in the current year is equivalent to Rs. 146.41 after 4 years.

The calculations can be simplified by using the following equation:

FV = P (1+i)n
Where, FV = Future Value
P = Present Sum
i = Interest rate
n = Number of years

FV = 100 (1+0.1)4
= 100 (1.01)4 = 100 (1.4641) = 146.41

Discounting

 Discounting is the procedure to find the present value of future sum.

 The present value refers to the current value of a sum of money to be received in
the future.
 A future amount is discounted because sum of money to be received in future is
worth somewhat less now, because of time difference assuming positive rate of
interest.

55
  The current value of future amount depends up on the rate of interest and length of
time before payment is received.

The formula to calculate the present value of future sum :

P
PV = ------
(1+i)n

Where, PV = Present Value

P = Amount to be received in future
i = Interest rate
n = Number of years
Example
Calculate the present value of Rs. 5000 to be received after 3 years. The
interest rate is 10 per cent.

5000 5000
PV = ----------- = ------- = 3756.57
(1 + 0.01)3 1.331

It means:
• A payment of Rs. 5,000 to be received after 3 years has present value Rs. 3,756.57 at
10 per cent interest.
• In other words, Rs. 3,756.57 invested today for 3 years at 10 per cent compound
interest would have a future value of Rs. 5,000.
• It also implies that an investor should not pay more than Rs. 3,756.57 for an
investment which can return Rs. 5,000 in 3 years.

Chapter-13
Farm records and Accounts

Introduction
It is always said that Indian cultivator is good producer rather than good business
man. He knows how to produce but he does not know how to keep accounts of the farm.
Accurate and up-to-date records are essential to good management and successful farming. It
is therefore very necessary to have knowledge about farm accountancy in order to handle the
farm business efficiently.
Records are essential in any management operation. A good record keeping system
will allow managers to monitor and evaluate the performance of their production system. It
will help them identity problem area in the production plan, and to make the necessary
corrective measures.

56
FARM RECORDS
Records are statements of fact or data concerning a specific subject which may be
specified in physical, monetary, mathematical or statistical terms. Farm records pertain to
information recorded on the day-to-day operation of a particular farm.
Farm records can the defined as systematic documentation of all activities taking
place in a farm enterprise over a given period of time. It is an act of writing down every
activity engaged in on the farm in every production season and at different stages of the
production process up to the final disposal of the goods and services to the ultimate
consumer.

Benefits or importance of Farm Records

The benefits of maintaining farm records are as under:
1. Means to higher income
Farm records are the sources to know the present income and net returns of the
farm. They help to check the unproductive expenditure and identify profitable enterprise
to improve the returns on the farm.

2. Basis for diagnosis and planning

Farm records provides data for farm planning. Analysis of farm records helps in
diagnosing the omissions in current plan.

3. Way to improve managerial ability of the farmer

Systematic recording of farm business transactions helps the farmer in knowing the
strengths and weaknesses of the business. It leads to the improvement in the management of
farm. It helps to acquire business habits which can help in taking advantage of changes in the
economic environment. The farmer gets a better insight into the working of his business,
which helps in finding out the defects which can be set right by exercising bettor control and
effecting economies. Farmer can avoid mistakes and losses which would otherwise result to
dependence only on his memory for guidance.

4. Basic for credit acquisition

Properly kept records and accounts are authentic records with the help of which the
lending agencies can sanction the loans easily.

5. Basic for research in agricultural economics

Research requires precise and correct data which is possible only if proper records
and accounts are maintained on the farms included in the study.

6. Basic for government policies

The farmers need to continuously feed the facts for state and national farm policies
such as land policies price policies and crop insurance. Records and accounts are helpful in
obtaining the correct data for examining and developing such policies to be sounds.

57
 In general, farm records are essential to:
1. know financial status at a point of time.
2. know gains and losses over time.
3. know better source of income and items of costs.
4. keep a check on unproductive expenditure.
5. examine comparative profitability & costs involved in different enterprises
6. know weak points of farm organization.
7. develop rational short term and long-term production plans.

Limitations in the maintenance of farm records

1. Illiteracy
2. Small size of holding
3. Fear of taxation
4. Complicated nature of record keeping

Records maintained on an average farm as well as on commercial dairy farm

Records maintained on Records maintained on
an average farm commercial dairy farm
1. Land use records 1. Live stock register
2. Farm livestock records 2. Milk production register
3. Permanent dead stock register 3. Milk disposal register
4. Farm labour records 4. Calf feeding register
5. Input records 5. Feeding schedule register
6. Feed records 6. Insemination register
7. Crop production and disposal records 7. Calving register
8. Live stock production and disposal 8. Gynecological status register
records 9. Health and vaccination register
9. Input and feed stock register 10. Mortality register
10. Log book 11. History sheet
12. Cash book

1. Land Use Records

Sr. No. Particulars Area (ha)

1 Land-use pattern
a. Total land holding
b. Land leased-in
c. Land leased-out
d. Cultivated land
e. Irrigated land
f. Un-irrigated land
g. Permanent fallow

58
 h. Land under fruits/plantation crops/trees
i. Land under building
j. Problematic land
2 Cropping pattern
Season Name of crop Area (ha)
a.
b.
Kharif c.
d.
Sub-total
a.
b.
Rabi
c.
Sub-total
a.
Summer b.
Sub-total
Grand-total

2. Farm Livestock Records

Sr. Type Number Breed Age Year of Purchase Rem
No. Homebred Purchased purchase value (`)
1 Milch animals
cows
She-buffaloes
2 Draft animals
Bullocks
He-buffaloes
3 Young stock
Heifers
Calves
4 Other
Sheep
Goat
Poultry birds
Camel
Horse

3. Permanent Dead Stock Register

Sr. Particulars Year of No. Rate Contruction/ Amount Rem.
No. constructio or (`) purchase spent on
n/ purchase Size value repairs/
(`) maintenance
(`)
1 Buildings
Farm building
59
 Cattle shed
Wells / tube wells
Pump house
2 Irrigation equipments
Oil engines
Electric motors
Submersible pump
Drip irrigation set
Fountain set
3 Farm machinery / Equipments
Tractors
Trolley
Bullock cart
Threshers
Sprayers
Dusters
Seed drills
Iron ploughs
Wooden ploughs
Cultivates
Harrows
Crowbars
4 Small implements / Minor equipments
Spades
Sickles
Hand hoes
5 Other

4. Farm Labour-Use Records

Season: Crop: Variety: Area:
Date Farm Owned labour Hired labour Wages/rent paid (`)
Operation
TR BL Human TR BL Human TR BL Human
M F M F M F

TR=Tractor (hours), BL=Bullock (pair-days),

M=Human man-days (Male), F=Human man-days (Female)
5. Input-Use Records

Season: Crop: Variety: Area:

Date Input Quantity Rate Total
Farm Produced Purchased (`) Value
(`)

60
 FYM
Cake
Seeds
Urea
DAP
SSP

6. Feed-use Records
Type of feed : Amuldan
Date Milch animals Draft animals Young stock Total
Qty. Value (`) Qty. Value Qty. Value Qty. Value
(`) (`) (`)

7. Crop Production and Disposal Records

Season Crop Area Date of Main By Household Consumption
(ha) harvest Product Product Qty. Value
Qty. Qty. (`)
Kharif a.
b.
c.
Rabi d.
e.
Summer f.
g.
Used as Seeds Kind Payments Sold Balance
Qty. Value Qty. Value Qty. Value Qty. Value
(`) (`) (`) (`)
a.
b.
c.
d.
e.
f.
g.
8. Livestock Production and Disposal Records

Date/ Milk

61
 Month Production Household Conversion to Sold
(lit) Consumption Ghee
Qty. Value (`) Qty. Value Qty. Value
(lit) (lit) (`) (lit) (`)

Date/ FYM
Month Production Household Sold Balance
(cart-load) Consumption
Qty. Value (`) Qty. Value Qty. Value
(cart-load) (cart-load) (`) (cartload) (`)

Date/ Eggs
Month Production Household Sold Balance
Qty. Consumption
(no.) Qty. Value (`) Qty. Value Qty. Value
(no.) (no.) (`) (no.) (`)

9. Input and Feed Stock Register

Name Opening Receipt Usage Balance Source of Details Cost (`)

of Balance Date Qty. Date Qty. Qty. purchase of usage
Input Qty.
FYM
Cake
Seeds
Urea
DAP
SSP

62
10. Log Book

Name of Machinery: Date of purchased: Price `:

Date Work/operation Time Power/fuel Lubricants Repairs/

done (hrs) consumed maintenance
Qty ` Qty. `

FARM ACCOUNTANCY
Account, Accounting and Accountancy
Account is a summary of business transactions. It is vertically divided in to two parts
in ‘T’ shape. The benefits received by that account are recorded on the left hand side (Dr.)
and the benefits given are recorded on the right hand side (Cr.).
Accounting is the art of recording, classifying and summarizing the business
transactions. Recording refers to writing in journal. Classifying means writing in ledger and
summarizing relates to preparation of trading account, profit and loss account and balance
sheet. Farm accounting is an application of the accounting principles to the farm- business.
Accountancy means the art of keeping books of account in a regular and systematic
manner. The farm accountancy is also called “Farm book keeping”.

System of Book Keeping

1. Single Entry System
This is the system which ignores the double effect of transactions. Only personal
account of debtors and creditors are kept and the impersonal accounts are ignored completely.
Under this system, the trader does not get all the information which he generally likes to
have. This system is incomplete and inaccurate.

2. Double Entry System

It is a method of recording each transactions in the books of accounts in its two fold
i.e. two entries are made for each transaction in the same set of books, one being a debit entry
and other a credit entry. Every business transaction involves two parties one, for receiving the
goods or services and other for giving them. Every transaction, therefore, is entered at two
places, for credit and for debit. The fundamental rule here is debit the account which
receives the benefit, and credit the account, which gives the benefit. For example:

(a) Sale of Wheat for ` 25000/- on 25-3-11

63
 Two accounts involved here are cash account and sale account. The cash is coming in
(receiving), so cash account will be written on the debit side. The sale account will be giving
account as wheat is going out, and hence the amount will be written on credit side.

(b) Purchase of fertilizers by cash for ` 5000/- on 26-3-11

Here, two accounts involved will be cash account and purchase account. Here ` 5000/
have been paid by cash. The cash is going out, so cash account should be credited. The
purchases are coming in, so purchase account should be debited.

Advantages of Double Entry System

1. Both personal and impersonal accounts are opened in order to keep a complete record
of business transaction.
2. It provides a check on the arithmetical accuracy with the help of trial balance.
3. It reduces the chances of errors. Hence, it is accurate and more reliable.
4. It helps to prepare Balance Sheet which explains financial position of the firm.
5. It is useful to the tax and legal authorities.
Difference between Double & Single Entry System
Double Entry system Single Entry System
Record of both personal and impersonal Only personal accounts are kept.
accounts are kept.
Trial and balance account is possible. Trial and balance account is not possible.
It is perfect, accurate and more reliable It is imperfect, inaccurate, unscientific,
and unreliable.

Types of Accounts

1. Personal accounts
a. Natural person: e.g., Mahesh A/C, Vijay A/C, etc.
b. Artificial person: e.g., Agri College A/C, Firms’s name A/C, etc.
c. Representative person: e.g. Salary A/C, Rent A/C, etc.
2. Real Accounts
The accounts relating to assets are known as real account. E.g., Cash A/C, Machinery
A/C, Sales A/C, Purchase A/C, Building A/C, etc.

Journal
All business transactions are first recorded in a book called journal. It means a daily
record. The journal is also called as a “book of original entry”

Ledger
The ledger is the chief book of accounts. A ledger is a book which contains various
accounts to which the entries made in the journal are transferred. The act of transferring each
entry from the journal to their respective accounts in ledger is called posting.

64
 There are two sides in the ledger. The left side is called Debit (Dr.) side ant the entry
made in this side is called debit entry- the side of the value received. The right side of the
ledger is called the credit side and the entry made is credit entry-the side meant for value
given out. Every transaction entered into ledger affects two accounts in the ledger; one
receives and the other gives.

Rules of posting
1. Every debit entry must have a corresponding credit entry and vice versa.
2. Every debit entry is recorded by a word ‘To’ and credit entry by a word ‘By’.
3. Debit account receives and credit accounts gives.
4. Indexing in alphabetical order.
5. All debit items are posted first and then credit items to avoid mistakes.

Cash Book
Transactions relating to only cash are recorded in one book called cashbook. The
principle here is, cash coming in is placed on debit side and cash going out is entered on
credit side.
Ex: Journalize the following transactions, posting it to ledger and prepare trial balance.
(a) 25-3-11 Sale of Wheat for ` 25000/-

(b) 26-3-11 Purchase of fertilizers by cash for ` 5000/-

Journal
Date Particulars LF Debit (` ) Credit (` )
25-3-11 To Cash A/C Dr. 25000
By Sale A/C Cr. 25000
25-3-11 To Purchase A/C Dr. 5000
By Cash A/C Cr. 5000

Ledger
Cash A/C
`
Dr. Cr.
To sales A/C 25000 By Purchase A/C 5000
To ….. …… By ….. ……
Total 25000 Total 5000
By balance 20000
25000 25000

Sale A/C
`
Dr. Cr.
To ……. .…. By sales 25000
To ….. …… By ….. ……

65
 Total 0 Total 25000
To balance 25000
25000 25000

Purchase A/C
`
Dr. Cr.
To cash A/C 5000 By ….. ……
To ….. …… By ….. ……
Total 5000 Total 0
By balance 5000
5000 5000

Trial Balance
Particulars Debit (`) Credit (`)
Cash A/C 20000
Sales A/C 25000
Purchase A/C 5000
Total 25000 25000

==============================================================

Chapter-14
Farm Inventory

FARM INVENTORY ANALYSIS

Introduction
The list of all the physical property of a business along with their values at a specific
point of time is called farm inventory. It is the complete list of farmer's assets. It is the first
step in farm accounting as it forms the basis for the preparation of income statement, balance
sheet, measurers of income, etc.
Inventory for a business is taken at two point's of time in a year i.e., at the
beginning of the agricultural year and at the end of the year. It constitutes cash assets,
depreciable assets and non-depreciable assets. The difference in the inventory at the two
points of time indicates the changes in the inventory.
The closing inventory for a year is the opening inventory for the next year.

66
Importance or Purposes
1. The farm inventory is a necessary step in complete farm accounting.
2. It provides information about all the assets with their values.
3. It shows what amount of capital accumulation goes back into the business.
4. It reveals the changes in assets through comparison of two inventories.
5. It enables to determine the depreciation costs.
6. It forms the basis of income statement.

Time
Actually, the time, the inventory is taken, is not an important factor; it can be done in
any month of the year, but to be of the most value, it must be taken about the same time each
year. The best time to take a farm inventory is at the beginning of the agricultural year i.e.,
on 1st June, Usually, at this time, the crop season is finished and work for the next season has
not yet begun. Also, stored crops and feed supplies on hand are ordinarily low at this time,
which makes the inventory jobs of physical measurement of these items and estimates of
value relatively easy. Thus, Lesser need of price estimates and Conveniences are two
important considerations in deciding the date for the preparation of inventory.

Process of taking farm inventory

Taking an inventory involves two processes:
(i) Physical counting of assets, and
(ii) Valuation of physical assets.
The farmer, with a critical eye, should walk over his farm to make a general
inspection of the land, buildings, fences, equipment, livestock, and supplies. The physical
count is necessary to verify numbers, weights and measurements. Next the farmer should
place value on each item using an appropriate valuation method. Valuation of farm assets is a
little difficult one because an error in the valuation of an inventory may render the accounting
results misleading. Suppose, for example, a farmer has 200 q of wheat and he values ` 1350

instead of ` 1250 per quintal, resulting in an over valuation by ` 20000/-. If this is an end
year inventory, it will inflate the net worth by the amount of over valuation. The inflated
opening inventory may reduce the income in the next year by the same amount. If the
inventory is undervalued it will have the opposite effect.

Methods of valuation
There are many methods of valuation. Every method has its own merits and demerits.
The use of a particular method of valuation will depend upon the purpose of the valuation and
nature of the assets being valued. As far as possible valuation should be appropriate because
inappropriate valuation can lead to unsound business decisions. Following are the commonly
used valuation methods:
1. Cost minus depreciation.
2. Market price

67
 3. Production cost or market prices (whichever is lower).
4. Net selling price.
5. Replacement cost minus depreciation.
6. Income capitalization.

1. Cost minus depreciation method

This method is commonly used for working assets such as machinery and
breeding livestock. Since these assets depreciate with every passing year, the depredation
amount is estimated and deducted from the purchase price: E.g.: Machinery, buildings
constructed recently, dairy cattle, carts, etc.

2. Market Price Method

This is a Common method for valuing purchased farm supplies like seeds, ferti-
lizers, pesticides, fuel, feeds, veterinary medicines, etc.

3. Production Cost or Market Price (whichever is lower) Method

This method is used to estimate current value of the farm produced inputs like seed,
FYM, etc. The valuation is estimated at the production cost or the market price, whichever is
lower. Standing crop is also valued through this method. Regarding valuing standing crop,
expenses incurred in raising the crops, till the date on which inventory is taken are recorded.

4. Net selling price Method

Net selling price means the price which could probably be obtained for the asset if
marketed, minus the cost of marketing. This method provides a reasonably accurate measure
of the current value of the asset. This conforms most closely to the present worth. This
method is used for those items that are held primarily for sale.

5. Replacement cost minus depreciation Method

This method is confined to estimate the value of very old buildings where wide
changes in the price level occur. Replacement cost represents the cost of constructing the
same type of building with the present technology at-present prices. After arriving at the
replacement cost, deduct the depredation so as to arrive at the current value of the building.
Example: Actual cost of construction of very old building = ` 10,000
Useful life = 50 years
Current (Replacement) cost of construction = `.50,000
Present age of building = 10 years
Amount of depreciation = ` 10000

Current value of the building = ` 40,000

6. Income capitalization Method

Asset which yields income over an infinite period of time is evaluated using this
method. E.g.: Land. This method is appropriate for the farm assets whose contribution to the

68
income of the farm business can be measured and which have a long life.
R
The capitalization formula V = ------ can be used for this purpose.
r
Where, V = Income capitalized value
R = Constant net income from land per annum over infinite number of years
r = Rate of interest
Example: Land area = 5 acres
Constant net income from land (R) = ` 1,00,000
Rate of interest (r) = 10% (i.e. 0.10)
Value of land (V) = R/r = 1,00,000/0.1 = ` 10,00,000

In practice neither the annual income nor the interest rate in future is known with
accuracy. As a result, this method is generally used in combination with other methods such
as the market price.
Suggestions for valuation

Sr. Item of Asset Appropriate Method of Valuation

No.
1 Farm Land Income capitalization Method or Market price
2 Old Buildings Replacement cost minus depreciation Method
Newly constructed building Cost minus depreciation method
3 All working assets (depreciable): Cost minus depreciation method
Farm Machinery, Implements,
Equipments, Farm animals, etc.
4 Purchased inputs (non-depreciable): Market price method
Seeds, Fertilizers,
5 Owned inputs (farm produced): Production cost or the market price
Seeds, FYM, fodder, feeds, etc. (whichever is lower).
6 Farm products for sale: Net selling price Method
Crop produced, Dairy products, etc. (i.e. market price minus marketing cost)
7 Standing crop Production cost or the market price
(whichever is lower).

Farm Inventory of a Hypothetical Farm on 1st June 2009 and 31st May 2010
Sr. Item Beginning of the year End of the year
No. (1st June, 2009) (31st May, 2010)
Qty. Amt. `) Qty. Amt. (`)
I Cash Assets
i Cash on hand 5000 4000
ii Savings in bank 15000 30000

69
 iii Shares and bonds Ril-25 25000 Ril-25 20000
iv Other - - Receivable 10000
Sub-total
II Depreciable Assets
i Land (including well/orchard) 5 acres 1000000 5 acres 1100000
ii Farm buildings /cattle shed 1+1 kacha 80000 1+1 kacha 75000
iii Farm machinery/equipments
(a) Tractor with trolley 1+1 250000 1+1 225000
(b) Submersible pump/oil-engine 1 30000 1 27000
(c) Thresher 1 10000 1 9000
(d) Sprayers and Dusters 1+0 2000 1+1 4000
(e) Drip irrigation set 1 60000 1+1 110000
(f) Bullock cart 1 8000 1 7000
(g) Tillage implements 5 25000 7 20000
(h) Small farm-tools 20 5000 25 6000
iv Farm animals
(a) Bullocks 2 25000 2 30000
(b) Dairy cattle 2c+1b 60000 2c+2b 80000
(c) Sheep/goat/ Poultry - - - -
v Other - - - -
Sub-total
III Non-depreciable Assets
i Crop produce ready for sale
(a) Cotton - - 10 q@4000 39000
(b) Wheat 20 q@1300 25000 - -
(c) Other - - - -
ii Growing / standing crops 1 acre bajra 5000 1 acre veg. 10000
iii Livestock products for sale - 1000 - 1000
iv Seeds Cotton-2p 2000 - -
v Fertilizers
(a) FYM 5 trolley 5000 7 trolley 7000
(b) Urea 4 bags 1000 -
(c) DAP - - -
vi Plant Protection Chemicals - 1000 - 1000
vii Feeds and Fodder - 4000 - 5000
ix Other - - -
Sub-total
Grand Total
Change in Inventory Closing Total `
– Beginning Total `
Change in Inventory = `

70
 Chapter-15
Preparation and Analysis of Farm Financial Statements
(Networth, Test Ratios)

Objective: To prepare Balance sheet and Income statement and study about their
different financial test ratios.

Introduction
Various tools of financial analysis i.e. Net Worth Statement (Balance Sheet), Income
Statement, Cash Flow Statement, Break-even Analysis etc. are used to assess the
performance of the farm business.
Balance Sheet or Net worth Statement
It is a statement of the financial position of a farm business at a particular time,
showing its assets, liabilities and equity.
If the assets are more than the liabilities it is called net worth or equity and its
converse is known as net deficit.
The typical balance sheet shows assets on the left hand side and liabilities & equity
on the right hand side. Both sides are always in balance hence the name balance sheet.
Importance of Balance Sheet
 It explains financial position of the farm business at any point of time.
 It shows solvency (do assets exceed liabilities?)
 It measures liquidity (will firm meet financial obligations?)
 It helps to study the performance of farm business over the years. If the net worth
increases over the time indicates efficient performance of the farm business.
Important Terminology
Assets : Are those which are owned by the farmer. Types of assets are as under:

71
 1. Current Assets (Short term Assets): It can be converted into cash within a short
time i.e. usually one year. E.g. cash on hand, farm produce ready for disposal, etc.
2. Intermediate Assets (Working Assets): Less liquid than the current assets. E.g.
machinery, equipment, livestock, tractor, etc.
3. Long term Assets: (Fixed Assets): An asset that is permanent or will be used
continuously for several years. E.g. land, farm building, etc.
Liabilities: It refers to all things, which are owned to others by the farmer. Types of liabilities
are as under:
1. Current liabilities: It is debt that must be paid in the short term or in very near future.
E.g. crop loans, account payable, hand loan, cost of maintenance of cattle, etc.
2. Intermediate liabilities: These loans are due for the repayment within a period of
two to five years. E.g. livestock loans, machinery loans, etc.
3. Long term liabilities: The duration of loan payments more than five years. E.g.
tractor loans.
Net Worth (Equity): If total assets > total liabilities it is called net worth or equity
(Total assets - Total liabilities) and its converse is known as net deficit.
Liquidity: It is the capacity of the farmer to meet immediate financial obligations.
Solvency: It is the financial ability to pay debts when they become due. It represents the
possession of surplus assets over the liabilities.

EXAMPLE

Following is the details of Assets and Liabilities of a hypothetical Farm as on

31-1-2011. Do the following exercise.
1) Prepare Balance Sheet.
2) Calculate different test ratio to know the financial position/stability of farm business
and also give your interpretation in relation to test ratio.

Sr.No. Item Amount (Rs.)

Assets
1 Value of land (including bore-well and orchard) 10,00,000
2 Tractor 2,00,000
3 Machinery and Implements 1,00,000
4 Bullocks 30,000
5 Dairy cattle 50,000
6 Farm buildings 50,000
7 Cash on hand 10,000
8 Saving in bank 25,000
9 Value of farm produce ready for disposable 1,00,000

72
 10 Value of livestock products ready for sale 10,000
11 Fruits/vegetable ready for sale 10,000
12 Value of bonds/shares to be realized in the current year 50,000
Liabilities
1 Tractor Loan (outstanding amount) 1,20,000
2 Machinery Loan (outstanding amount) 50,000
3 Orchard Loan (outstanding amount) 75,000
4 Crop loans to be repaid to bank 40,000
5 Unsecured loan for bore-well (to be paid within 3 years) 50,000
6 Live stock loan (outstanding amount) 30,000
7 Hand loans 10,000
8 Account payable 10,000
9 Money owned to input suppliers 25,000
10 Annual installment of MT & LT loans 25,000

SOLUTION

(1) Balance Sheet:

Balance Sheet of a Hypothetical Farm As on 31-1-2011
Assets Amount Liabilities Amount
(A) Current Assets: (A) Current Liabilities:
Cash on hand 10,000 Crop loans to be repaid to bank 40,000
Saving in bank 25,000 Hand loans 10,000
Value of farm produce
100,000 Account payable 10,000
ready for disposable
Value of livestock products Money owned to input
10,000 25,000
ready for sale suppliers
Fruits/vegetable ready Annual installment of
10,000 25,000
for sale MT & LT loans
Value of bonds/ shares to be
50,000
realized in the current year
Sub-Total 2,05,000 Sub-Total 1,10,000
(B) Intermediate Assets: (B) Intermediate Liabilities:

73
 Machinery Loan
Tractor 2,00,000 50,000
(outstanding amount)
Live stock loan
Machinery and Implements 1,00,000 30,000
(outstanding amount)
Unsecured loan for bore-well
Bullocks 30,000 50,000
(to be paid within 3 years)
Dairy cattle 50,000
Sub-Total 3,80,000 Sub-Total 1,30,000

(C) Long term Assets: (C) Long term Liabilities:

Value of land (including Tractor Loan
10,00,000 1,20,000
bore-well and orchard) (outstanding amount)
Orchard Loan
Farm buildings 50,000 75,000
(outstanding amount)
Sub-Total 10,50,000 Sub-Total 1,95,000
Total Assets 16,35,000 Total Liabilities 4,35,000
Net Worth or Equity 12,00,000
Total Liabilities + Net Worth 16,35,000

(2) Test Ratio and their interpretation:

The balance sheet is analyzed with the help of ratio measures, so as to know the
financial position and stability of the farm business. They are as under:
1. Current Ratio
2. Intermediate Ratio or Working Ratio
3. Net Capital Ratio
4. Current Liability
5. Debt Equity Ratio
6. Equity Value Ratio

1. Current Ratio
Total Current Assets 2,05,000
Current Ratio = ------------------------------ = ----------- = 1.86
Total Current Liabilities 1,10,000
This ratio indicates the capacity of the farmer to meet immediate financial obligations
(liquidity). It reflects liquidity within one year's time. A ratio of more than one indicates a
favourable run of the farm business. If current assets are more than current liabilities and
even though the farmer fails to repay the loan (in spite of his position being solvent), it is a
case of willful-defaulter.
2. Intermediate Ratio (Working Ratio)

74
 Total Curr. Assets + Total Int. Assets
Intermediate (Working) Ratio = ------------------------------------------------
Total Curr. Lia. + Total Int. Lia.

2,05,000 + 3,80,000 5,85,000

= ---------------------------- = ------------- = 2.44
1,10,000 + 1,30,000 2,40,000
This ratio indicates the liquidity position of the farm business over an intermediate
period of time, ranging from 2 to 5 years. A ratio of more than one indicates sound running
of the farm business.

3. Net Capital Ratio

Total Assets 16,35,000
Net Capital Ratio = --------------------- = ------------ = 3.76
Total Liabilities 4,35,000
This ratio indicates the long-term liquidity position of the farmers. If the net capital
ratio is more than one, the funds of institutional agencies are safe. A consistently increasing
ratio over the years reveals the sound financial growth of farm business. The farmer with this
record should be a very prompt repayer of all types of credit obligations. This ratio is also
most important measure of overall solvency position of the farmer as a borrower.

4. Current Liability
Current Liabilities 1,10,000
Current Liability = ----------------------- = ------------- = 0.09
Owner’s Equity 12,00,000
This ratio indicates the farmer's immediate financial obligations against the net worth.
A ratio is less than one indicates a healthy performance of the farm business and over the
years the ratio should become smaller and smaller to reflect a consistently good performance.

5. Debt Equity Ratio (Leverage Ratio)

Total Debts (Liabilities) 4,35,000
Debt Equity Ratio = ----------------------------- = ------------- = 0.36
Owner’s Equity 12,00,000
This ratio represents the capacity of the farmer to meet the long term commitments. A
consistently falling ratio indicates a very healthy performance of farming and the ability of
the farmer to reduce dependence on borrowings.

6. Equity Value Ratio

Owner’s Equity 12,00,000
Equity value Ratio = ------------------------ = ---------------- = 0.73
Total Assets 16,35,000
This ratio highlights the productivity gained by the farmer in relation to the assets
he has. The improvement in the ratio over the years makes it clear regarding the increased
strength in the financial structure of the farm business.

SUMMARY

75
 RATIO Indicator Interpretation
Current Ratio Immediate liquidity > 1 indicates a favourable run of the
(within one year) farm business.
Intermediate RatioIn Intermediate liquidity In > 1 indicates sound running of the farm
or Working Ratio ( 2 to 5 years). business.
Net Capital Ratio Long-term liquidity > 1 indicates the funds of institutional
(more than 5 years) and agencies are safe. A consistently
overall solvency increasing ratio over the years reveals the
position. sound financial growth of farm business.
Current Liability Immediate financial < 1 indicates healthy performance of
obligations against the
the farm business. The decrease in the
net worth. ratio over the years reflects a consistently
good performance.
Debt Equity Ratio Capacity to meet the long < 1 indicates healthy performance of
or Leverage Ratio term commitments. the farm business. The decrease in the
ratio over the years reflects a consistently
good performance.
Equity Value Ratio Productivity gained in It is generally < 1. The increase in the
relation to the assets. ratio over the years indicates the increased
financial strength of the farm business.

PREPARATION OF PROFIT AND LOSS ACCOUNT

(INCOME STATEMENT)
Introduction
Income Statement is entirely different from balance sheet in the scenes that in a
balance sheet, we considered assets and liabilities and did not consider operational efficiency
in terms of receipts and expenses. An income statement is the list of all farm expenses on one
hand and all receipts on the other.
Income Statement can be defined as a summary of receipts (or gains) minus
expenses (or losses) during a specific period. Thus, basically it consists of three items, viz.,
receipts, expenses and net income. It is prepared for the entire farm for one agricultural
year. It is also called Profit and Loss Statement.

Receipts
1. It includes returns obtained from the sale of crop produce and other supplementary
products like milk, eggs, etc.
2. It includes income in form of wages and receipt in form of gifts.
3. Gain in the form of appreciation in the value of assets is also included in the receipts.
4. However, returns from the sale of capital assets, such as livestock, machinery, farm
buildings etc. are not included.
Expenses

76
 1. It includes operating costs as well as fixed costs.
2. Losses in the form of depreciation on the asset value fall under the expenditure item.
3. However, the amount incurred on the purchase of capital assets is not considered.
Crop loans are included in operating expenses.

Net Income
It constitutes net cash income, net operating income and net farm income.
a) Net Cash Income: It gives the position of cash receipts minus cash expenses only
during the period for which income statement is prepared.
b) Net Operating Income: It is arrived at by deducting operating expenses from the
gross income. Fixed costs are not given any consideration.
c) Net Farm Income: Net farm income equals net operating income less fixed costs. It
is relatively a better measure of assessing the performance of a farm. It is the return
accrued to own capital and family labour employed.

Importance or Advantages
1. It provides information on cost and returns of the farm.
2. It provides the basis for a study and analysis of farm business.
3. Performance of a farm can be gauged by preparing income statements over the years.
4. It provides farmer an opportunity to compare the results with his expectations.
5. It helps to make comparisons of his efficiency with the performance of other farmers
operating under similar situations.

Income Statement of a hypothetical Farm for the year 2009-10

Sr. No. Particulars Amounts

(Rs.)
I RECEIPTS
(a) Returns from the sale of crop output 2,00,000
(b) Returns from Supplementary enterprise
(i) Revenue from Milk and Milk Products 50,000
(ii) Revenue from poultry Products 25,000
(c) Gift 10,000
(d) Gross Cash Income (a+b+c) 2,85,000
(e) Appreciation on the value of Assets 50,000
Gross Income (d+e) 3,35,000
II EXPENSES
(a) Operating expenses or costs:
i. Hired human labour 10,000
ii. Bullock labour 5,000
iii. Machinery 25,000
iv. Seeds 10,000
v. Feeds 15,000
vi. Manures & Fertilizers 20,000

77
 vii. Plant Protection Measures 5,000
viii. Veterinary aid 2,000
ix. Miscellaneous 10,000
x. Interest on working capital (a) int. on borr.cap.= 9000 13,000
+(b) int. on own.cap.= 4000
Total operating costs 1,15,000

(b) Fixed Expenses or Costs

i. Depreciation 5,000
ii. Land revenue 500
iii. Interest on fixed capital (a) int. on farm bldg = 500 2500
+ (b) int. on term loan = 2000
iv. Rental value of owned land 30,000
Total Fixed cost 38,000
Total Expenses (a+b) 1,53,000
III Net Cash Income = (2,85,000 – 1,15,000) 1,70,000
IV Net Operating Income = (3,35,000 – 1,15,000) 2,20,000
V Net Farm Income = (3,35,000 – 1,53,000) 1,82,000

Financial Test Ratios or Income Ratios

The performance of farm business can be assess through the income analysis of the
data presented in Income Statement. Financial Test ratios help the farmer to know the
financial position of his farm and landing institutions to develop standard morns for landing.
There are two sets of income ratios :
A. Expense-Income ratios
B. Income-Investment ratios

A. Expense-Income Ratio
Total Operating Expenses 1,15,000
1. Operating ratio = ------------------------------ = ------------ = 0.34
Gross Income 3,35,000

The ratio explains the relationship of operating costs to gross income. This ratio
underlines the magnitude of working expenditure incurred for a rupee of gross income. This
is a direct ratio, since operating costs are direct costs. Low ratio indicates better
performance of investment.

Total Fixed Expenses 38,000

2. Fixed ratio = ---------------------------- = --------------- = 0.11
Gross Income 3,35,000

78
 This ratio indicates the relationship between fixed expenses and gross income. It
depicts the amount of fixed expenses incurred to realize a rupee of gross income. This is an
indirect ratio, since fixed costs are indirect costs.

Total Expenses 1,53,000

3. Gross ratio = --------------------- = --------------- = 0.46
Gross Income 3,35,000

This is the ratio which is obtained when both operating expenses and fixed expenses
are totaled up and compared with gross income. This can be called input-output ratio.

All these ratios should be less than one to indicate the profitable run of the farm
business. When these ratios are estimated over the years, if they are descending, reflects a
healthy trend of farm business.

B. Income-Investment Ratio
Gross Income 3,35,000
1. Capital turnover ratio = ------------------------- = ------------ = 0.21
Avg. Capital Investment 16,00,000

Here, Average Capital Investment is arrived by adding the value of assets at the
beginning of the agriculture year and at the end of the year than averaging the two values. It
indicates gross income obtained for each rupee capital invested over the year.

Net Return to Capital 1,92,000

2. Rate of Return on Investment = ---------------------------- = ------------- = 0.12
Avg. Capital Investment 16,00,000

Here, Net Return to Capital = Net Farm Income ….. 1,82,000

+ Interest on working capital ….. + 13,000
+ Interest on term loans ….. + 2,000
- unpaid family labour ….. - 5,000
----------------
Net Return to Capital = 1,92,000
This ratio gives the net return for every rupee of capital invested.
Above two ratios explain the income generated over investment and are called income
-investment ratios. If they increase over the years, reflect a healthy trend of farm business.

Management Ratios
These also measure the productivity of farm business. They can be derived using data
of income statement as well as from other related information. They are discussed as under:

1. Management Return = Net farm Income …... 1,82,000

- Unpaid family labour wage …... - 5,000

79
 - Interest on owned capital ….. - 4,000
---------------
Management Return = 1,73,000
2. Crop yield & value
Comparing the yields obtained by the farmers for different crops with those of
average yields of the area. So also value can be compared. These data overtimes can be used
for appraising the ability of the farm manager.

3. Livestock income
The efficiency of livestock can be measured by comparing the feed expenditure
against livestock income.

4. Gross Income per man (labour efficiency)

Gross income divided by no of labour employed gives the measure of labour
efficiency.
A progressively higher ratios (management ratios) over the years reflect a better run
of the business.

Chapter 16 and 17
FARM PLANNING AND FARM BUDGETING

FARM PLANNING

WHAT IS FARM PLANNING?

 Farm planning is the foundation of management.
 Farm planning precedes all other managerial functions.
 It is the determination of a course of action to achieve the desired results.
 It is deciding in advance, viz., what to produce?, how to produce?, when to
produce?; how to borrow?, how much to borrow?, when to borrow?, where to buy
and sell?, when to buy and sell?, how to buy and sell?, etc.
 Farm planning bridges the gap from where we are to where we want to go.
 It is characterized as the process of thinking before doing.
 It is an intellectual process.
 It governs the survival, progress and prosperity of farm organization in a
competitive and dynamic environment.
 It is a continuous and unending process.

12.1.2 INFORMAL AND FORMAL PLANNING

80
  Farm planning is not a new technique. It is as old as farming itself. All farmers
whether progressive or backward, literate or illiterate, plan their farm business at the
beginning of every crop season in their minds. This is known as informal planning.
 As the agriculture is becoming a more complex business, the farmers cannot
remember all the necessary information required in order to plan their farm business
in a systematic manner. To be more systematic in thinking, the farmers need formal or
written farm plans. If the production intentions of the farmers are committed on a
paper, then it is called a formal or written plan.

12.1.3 DEFINITION

 Farm Planning can be defined as the deliberate and conscious effort on the part of
the farmer to think about the farm programmes in advance and adjust them according
to new knowledge on the technological developments, changes in physical and
economic situations, price structures, etc.
 Farm planning is a process of making decisions regarding the organization and
operation of farm business, so that it results in continuous maximum net returns of
farm business.

12.1.4 WHY FARM PLANNING IS NECESSARY?

It has been observed on majority of farms that there is under or over

utilization of existing farm resources. Due to this, farmers fail to get maximum net
return. Thus, it is immediate necessity of a farm to reorganize its structure and for the
proper allocation of its resources. This requires proper farm planning.
12.1.5 IMPORTANCE OF FARM PLANNING

1. To choose different farm activities which are suited to the given farm conditions.
2. To look into the future and decide on suitable course of action.
3. To select appropriate enterprise combinations that results in the better resources.
4. To help the farmers in timing various jobs and operations for smooth conduct of operations without competition.
5. To avoid wastages that occurs in the resource use.
6. To provide guidance and flexibility to the farmers for ensuring better use and growth of the farm.
7. To provide appropriate allocation of resources for producing the requisite products for marketing and household consumption.

12.1.6 OBJECTIVES OF FARM PLANNING

1. Efficient use of scare resources.

2. Selection and combination of different farm enterprises or activities.
3. Utilization of advance technology.
4. Easy and efficient management of farm business.
5. Continuous and maximum net returns of farm business.

12.1.7 THE INFORMATION REQUIRED FOR FARM PLANNING

1. Financial returns of farm

2. Requirements of variable inputs
3. Requirements of fixed resources

81
12.1.8 TYPES OF FARM PLANNING

 Simple farm planning: It implies planning for minor changes or for a particular enterprise. It is
adopted either by a part of land for one enterprise or to substitute one resource by
another.
 Complete farm planning: It envisages farm planning for the whole farm, i.e. for all
enterprises on the farm, for a change in the farm structure and organization. Complete
farm planning aims for a change in the entire farm structure and organization. It is
adopted for the farm as a whole.

12.1.9 WHAT IS A FARM PLAN?

A farm plan is a programme of the total farm activity drawn up in advance.

12.1.10 CHARACTERISTICS OF GOOD FARM PLAN

1. It should provide for efficient use of farm resources such as land, labour and capital.
2. It should provide balanced combination of enterprises.
3. It should provide appropriate combination of different crops.
4. It should help to maintain and improve soil fertility.
5. It should help to raise and stabilize farm earnings.
6. It should avoid excessive risks.
7. It should provide flexibility.
8. It should utilize the farmer’s knowledge, training experience and take into account of
the farmer’s likes and dislikes.
9. It should provide for all of up-to-date modern agricultural methods and practices.
10. It should give considerations to efficient marketing facilities.
11. It should provide programme of obtaining, using and repaying the credit.

12.1.11 BASIC STEPS OF FARM PLANNING

1. Statement of objective.
2. Survey of actual conditions of the farm and availability of resources.
3. Analysis / diagnosis of the existing plan.
4. Identification of enterprises to be included.
5. Discussion with the farmers and other specialists to examine the possibilities for
improvement through alternative plan operations.
6. Preparation of alternative plans on the basis of existing co-efficient.
7. Identification of risk.
8. Selection of final plan for implementation.

12.1.12 FARM PLANNING TECHNIQUES

a) Production and organization planning tools

● Production function models, ● Linear programming,
● Operational research techniques, ● Dynamic programming,

82
 ● Integer programming, ● Recursive programming,
● Modified programming models, ● Game theory models, etc.

b) Administrative planning tools and aids

● Farm technical coefficients, ● Accounting & data processing,
● Management consulting agency, ● Contractual farming or operations, etc.

c) Marketing planning tools and aids

● Demand supply projection analysis, ● Future trading analysis,
● Marketing management research, ● Price policies, etc.

12.1.13 LIMITATIONS OF FARM PLANNING

1. It is time consuming and expensive device.

2. It encourages a false sense of security against risks.
3. Unavailability of adequate information.
4. Inaccurate or false information.
5. The information particularly in respect of climate, water supply, markets, etc., is not
found in the required form.
6. The sources of data for diagnosis and planning are lacking.

As a result of above limitations, farm planning is not effectively formulated and

implemented. Therefore, farm standards derived from research stations and efficient farms in
the locality should form the basis for scientific planning. Data from research stations should
be continuously used for this purpose.

12.2 FARM BUDGETING

12.2.1 WHAT IS FARM BUDGETING?

 The expression of a farm plan in monetary terms by estimation of returns, expenses
and net income is called farm budgeting.
 Farm planning and farm budgeting go side by side.
 It is essentially a presentation of costs and returns, accompanied by a statement
showing the physical quantities of inputs and output.

12.2.2 OBJECTIVES OF FARM BUDGETING

1. To estimate the profitability of a particular pattern of organization
2. To determine the change in profits which is likely to follow a particular change.
3. To compare different cropping patterns or changes in organization on a profit basis.

12.2.3 TYPES OF FARM BUDGETING

1. Enterprise budget
2. Partial budgeting
3. Complete budgeting

12.2.4 FARM ENTERPRISE BUDGET

83
  It is the estimation of expected income, costs and profit for an enterprise.
 It is prepared for a unit i.e., acre, hectare, for a crop, one head of livestock, etc.
 Farm budgets can be developed for each potential enterprise.
 This facilitates easy comparison between the enterprises

How to prepare an enterprise budget?

1. It consists of three elements viz., income, costs and profitability.
2. Income is computed by estimating the expected output and expected price.
3. The estimated output is the average yield under normal weather conditions.
4. Output price should be the average price expected in future.
5. Variable costs should be estimated on the quantity of inputs required and their prices.
6. Fixed costs to be included such as land revenue, depreciation, interest on fixed capital
and rental value of d land, etc.
7. Finally, net profit is to be estimated on bases of estimated income and expenditure.

12.2.5 PARTIAL BUDGETING

 Partial budgeting is a statement of anticipated changes in costs, returns and
profitability for a minor modification.
 When a farmer contemplates few modifications or minor changes in the existing
plan of the farm business, partial budgeting technique is employed.
 It is similar to that of marginal analysis, wherein the changes in costs and returns
resulting from proposed modifications are alone considered.
 It is prepared in the form of an account which consists of four important elements
viz., added costs, added returns, reduced returns and reduced costs.
 It is generally used to evaluate the profitability of input substitution, enterprise
substitution and scale of operation.
Elements of Partial Budgeting

Debit Credit
Added costs : Added returns :
Reduced returns : Reduced costs :
Total Debit : Total Credit :
Net Income from the change (Total Credit – Total Debit) :

12.2.6 COMPLETE BUDGETING

 This method is used to make a budget for the whole farm.

 It is used in situations involving extensive remodeling of the farm organizations.
 It includes all the individual cost and return items for the farm, so that the overall net
return can be estimated from the whole farm.
 It considers all aspects of farm organization simultaneously.

Main steps of complete farm budgeting

84
 1. Listing of available resources.
2. Estimating crop areas and livestock numbers.
3. Estimating physical inputs and outputs.
4. Estimating fixed costs.
5. Estimating factor and product prices.
6. Calculating costs and returns.

12.2.7 EXAMPLE 1 : PARTIAL BUDGETING

For a farmer growing groundnut, the expenditure on seeds and groundnut yield
in existing (local variety) and alternate situation (improved variety) are as under:

Existing situation Alternate situation

Local variety: Improved variety:
50 kg @ Rs. 30/kg = Rs. 1500 50 kg @ 50/kg = Rs. 2500
Yield= 600 kg @ Rs. 30/ kg. =Rs.18000 Yield=700 kg @ Rs. 30/kg.= Rs.21000

The partial budget for proposed modification

Items Debit Items Credit

Added costs: Rs. 1000 Added returns: Rs. 3000
Reduced returns: Nil Reduced cost: Nil
Total Debit Rs. 1000 Total Credit Rs. 3000
(added costs + reduced returns) (added returns + reduced cost)

Net income from the change = Total Credit – Total Debit

= Rs. 3000 – Rs. 1000 = Rs. 2000

12.2.8 EXAMPLE 2: ENTERPRISE BUDGET

Enterprise Budget for Cotton per Hectare

Sr. No. Particulars Physical Rate Amount Rs.

Unit
1 Income
Yield 25 q 5500/q 1,37,500
2 Expenditure
(a) Fixed Cost
Rental value of land 1 ha 30000 30,000
Interest of fixed capital - - 1,000
Depreciation - - 3,000
Land revenue - - 1,000
Sub-Total 35,000
(b) Variable cost
1. Labour 200 100 20,000
2. Seeds 1.2 kg 2500/kg 3,000

85
 3. Bullock labour 20 300 6,000
4. Tractor charges - - 5,000
5. Fertilizers - - 10,000
6. Irrigation - - 6,000
7. Plant Protection chemicals - - 5,000
8. Miscellaneous - - 5,000
Sub-total 60,000
Total expenditure 95,000
3 Net Profit 42,500

-:-:-:-:-:-

Chapter 19

RISK AND UNCERTAINTY

13.1 INTRODUCTION
Agricultural production is biological and seasonal in nature and therefore, it
confronted with risk and uncertainty conditions. It is a highly difficult to make right decisions
when the production environment is risky and uncertain. Due to this the farmers have to
consider various management strategies relevant to the risk and uncertainty conditions. If
everything in farming and livestock rearing goes with certainty then every farmer becomes a
better manager, but this is not the case with real farming situation. Only a few farmers can
become efficient, particularly those who could understand risk and uncertainty situations in
farming and follow the relevant risk management strategies.

13.2 RISK AND UNCERTAINTY: A CONTRAST

Risk Uncertainty
It is defined as a, situation when all Uncertainty situation prevails when all
possible outcomes are known for a the possible outcomes of events are
given management decision and unknown, then neither the probability nor
probability associated with each the outcomes are known.
possible outcome is also known.

It is measurable through probability It is not measurable.

concepts.

13.3 SOURCES OF RISK

1. Production risk or technical risk
2. Price risk or marketing risk

86
 3. Financial

13.3.1 PRODUCTION RISK OR TECHNICAL RISK

 In industrial businesses we have a technical input-output relationship with known
quantity of output for a given quantity of input i.e., the production practices are
standardized in industrial production. Such type of relationship does not exist in
agricultural production.
 Output of crops and livestock is subject to change due to weather, disease, insects,
weeds and inadequate technology. These factors cannot be predicted accurately and
hence results in the variability of the output.
 1n fact, the yield variations are due to many factors. Some are under control while
some others are not under the control of management.
 Thus, the production-risk is due to largely many factors rather than a single factor.
 Weather risk and technical risk are the most important components of production-
risk.

13.3.2 PRICE RISK OR MARKETING RISK

 Prices are determined due to interaction of demand and supply in the market.
 Production of crops and livestock is influenced by prices in the market which are
beyond the control of farmers.
 Prices of commodities vary from year to year; season to season and exhibit seasonal
variation.
 Trade policy i.e., export import (Exim) policy would have a great impact on price
stabilization of commodity.

13.3.3 FINANCIAL RISK

 This type of risk increases with increased amount of borrowed money in the farm
business.
 Financing the production processes and storing the commodities under scientific
management require large amounts of borrowed capital.
 Hence a careful analysis is to be-made considering all types of risks.

13.4 MEASURING THE EXPECTATION AND VARIATION

In the risky farm environments, the farmers make decisions using some kind of the
expectations regarding prices, costs and yields. Let us look into as to how the expectations
and variations are worked out and used in the decision-making process.

13.4.1 Working out expected value through weighted averages

Two types of averages are used to work out an expected value. We take the actual
past prices (time series data) and yield to find out the simple average over the specific time
period. Second type of average is called weighted average. This method considers larger
weights for the more recent data and smaller weights for the remot data.

87
 Working out weighted averages for the prices

Year Av. Annual price of Weight Price x Weight

commodity (Rs./q)
2005 1000 1 1000
2006 1200 2 2400
2007 1400 3 4200
2008 1100 4 4400
2009 1000 5 5000
2010 1300 6 7800
Total 7000 21 24800
Simple average 1166.67
Weighted average 1180.95

For the given data there is no price risk for the commodity, as expected value is more
than simple average. On the contrary, if there is price risk its expected value would be less
than the simple average.

13.4.2 Working out expected value through the concept of probabilities

Another way of finding expectations is to choose the probability value, which is the
most likely to occur for the given price or yield or cost. In this procedure, we have to elicit
probabilities associated with each possible outcome. The outcome with the highest
probability would be selected as the most likely one to occur. This is shown as under:
Working out Expectations through Probabilities
Crop yield (q/ha) Probability Probability x Yield
11 0.1 1.1
14 0.4 5.6
10 0.1 1.0
12 0.3 3.6
18 . 0.1 1.8
Mean : 13 Total : 1.0 13.1

It is clear that the most likely output based on the highest probability is 14 q/ha.
Mathematical expectation of 13.1 q/ha is less than the most likely yield of 14 q/ha, but it is
more than the average yield i.e., 13 q/ha.

13.4.3 Variability
Two factors viz., the variance and the expected value, in general should form the basis
for selecting the best enterprise among alternative risky enterprises. Range is a measure of
variability and it refers to the difference between the lowest and the highest possible
outcome. Alternative enterprises should be preferred which have got smallest range value,

88
provided their expected values are the same. Similarly alternative enterprises with lowest
variance should be selected.

13.5 MEASURES TO MANAGE FARM RISK

13.5.1 DIVERSIFICATION

 Selection of suitable crop and livestock enterprises is the first step in diversification.
 The farmer produces several products rather than single product with the hope that
when the return from one enterprise is low, it is compensated by the higher returns
from the other enterprise.
 Idle resources can be put to use.
 The enterprises having less income variability should be selected.
 Income variability for the enterprises would be lessened.
 Risk programming models and game theory models should be used to formulate
whole farm plans under different risky situations.
 Stable enterprises should be preferred rather than risky enterprises particularly in
situation of farm risks.

13.5.2 INSURANCE

 The farmers have many types of insurances to reduce production risk and financial
risk.
 Crop insurance scheme reduces production risk.
 Livestock insurance provides safety against the fatal diseases of cattle.
 Farm assets can be insured against theft, fire or any other damage.

13.5.3 AGRONOMIC PRACTICES

 To reduce production risk, crop rotations, suitable varieties, deep tillage, mulching,
etc., should be adopted.

13.5.4 MARKET RISK MANAGEMENT

 Selling the Farm Products at Different Points of Time

 Due to financial obligations, farmers sell their produce immediately after the
harvest. During the harvesting periods generally prices will be low due to large
arrivals. If the farmers avoid such selling practices, they can get remunerative
prices for their products.
 The knowledge regarding supply and demand for the farm products and prices
prevailing in different markets and other market information is essential.
 For perishable commodities, storage facilities, freezing facilities, processing
facilities, etc., are required to get remunerative prices.

89
  Hedging is another measure adopted by the farmers and the traders to safeguard
against price-risk. Hedging practice is devised and followed by studying the
future markets.
 Government Price Polices and Programmes
 Minimum support price, procurement price, levy price, issue price, etc., are set for
various agricultural commodities by the Government every year to bring about
price stabilization.
 Support price provides protection for the farmers against fall in the prices of farm
products.

13.5.5 FINANCIAL RISK MANAGEMENT

 For reducing the financial risk we require many strategies, which are aimed at
liquidity and solvency of the farm business. Solvency by definition refers to business
ability to meet the long-term financial requirements of the farm. Liquidity strategies
should aim at as to how to build up the farm business to meet the short-term cash
requirements.
 At macro level fiscal policies formulated by RBI are aimed at to provide different
measures to safeguard against the financial risk.

-:-:-:-:-:-

Chapter-18
Appraisal of Farm Resources

Farm Resources:
1. Land
2. Labour
3. Capital
4. Management

WHAT IS PRODUCTION?
 Production is generally understood as the transformation of inputs into outputs.
 It refers to the creation of those goods and services which have exchange value.
 In economics, production means creation of utilities.
For example, a carpenter makes a table. He has produced wealth. But he has not
produced wood; it was already there. What then, has he really done? He has changed the form
of wood and given it to utility which it did not possess before. Conversion of cotton into cloth
and sugarcane into sugar are some other examples.
In economics, we are not concerned with the technical process of production. We do
not learn the art of making it. For example, we do not study how cloth is actually woven. We
are concerned with economic aspect, i.e. cost, price, profit etc. and not the technical aspect.

90
 FACTORS OF PRODUCTION
 Productive resources required to produce a given products are called factors of
production.
 In process of production, inputs are converted into an output. These inputs like land,
labour, capital, etc. are collectively called factors of production.
 Factors of production refer to those goods and services which help in the production
process.
 The factors of production have been traditionally classified as Land, Labour,
Capital and Organizer or Entrepreneur.
Nowadays most of the things we need are produced in a field or factory. To make
them workers gives his labour, the landlord his land, the capitalist his capital, while the
businessmen organizes the work of all these. They all get a reward in money.
In a production process, the labour earns wages, the landlord gets rent, and the
reward to capital is interest, while the entrepreneur’s reward is profit.

Land
 Land as a factor of production refers to all those natural resources or gifts of
nature which are provided free to man.
 It includes within itself several things such as land surface, air, water, minerals,
forests, rivers, lakes, seas, mountains, climate and weather.
 Thus, ‘Land’ includes all things that are not made by man.
Characteristics or Peculiarities of land
 Land is a natural factor.
 Land is imperishable.
 Land is immobile.
 Land is a passive factor of production.
 Supply is inelastic

Land Appraisal: Appraisal is a technique to estimate the value for given extent of land or
real estate. The firms which are involved in the real estate business are well versed with the
estimation of values. Tow important methods are in vogue in estimating the value of land
viz., market data method and the income capitalization method.

1. Market data method: Sale price for the comparable lands which re sold very
recently are taken into consideration to estimate the value for a given piece of land. If
the characteristics of the land that is being appraised are more or less identical with
one that is sold recently, the estimates are quite realistic. If the characteristics are
dissimilar between the one that is sold and the piece of land for which value is
supposed to be upraised, the difference such as soil type, location, productivity, etc.
are duly adjusted before determining the value.
2. Income capitalization method: This method uses project appraisal techniques to
estimate the present value of the future income stream from the land supposed to be
valued. This technique involves the estimation of annual net income, the selection of
appropriate discount factor are working out the net present value.

The formula to estimate the value of land is.

91
 P
V = -----------
I
Where, V= estimated land value (Rs.)
P= average annual net income (Rs.)
I= Discount rate

Following steps are adopted to estimate land value

1. For the given land for which the value is supposed to be estimated, find out the
crop grown along with the yields and the unit prices over a period of time. Yields
as well as prices are based on long run averages. Using yields and prices, the gross
income is estimated.
2. Estimate the total costs (Working costs+ fixed cost) for the crops grown.
3. Find out the average annual net income by deducting total expenses from the
gross income.
4. Finally capitalization of income is done. To do so an appropriate discount rate is
selected and estimated land value is arrived at.

Labour
 Labour is the human input into the production process.
 Any work, whether manual or mental, which is undertaken for a monetary
consideration is called labour in economics.
 Marshall defines labour as ‘the use or exertion of body or mind, partly or wholly, with
a view to secure an income apart from the pleasure derived from the work’.
Characteristics of labour
 Labour is an active factor of production.
 Labour is a natural factor.
 Labour is perishable.
 Labour is mobile.
Division of Labour
Division of Labour means dividing the process of production into distinct and several
component processes and assigning each component in the hands of a labour or a set of
labourers, who are specialists in that particular process. For example, a tailor stitches a shirt
in full. But in the garment factory, cutting of cloth, stitching of hands, body, collars, holes for
buttons, stitching of buttons, etc., are done independently by different workers.

The labour can be skilled, semi skilled, and unskilled.

1. Skilled labour: when a person undergoes specialized training to perform a specific
job, he is called skilled laborer. Ex. MECHANIC, DRIVER, CARPENTERS.
2. Semi- skilled labour: He does not require any elaborate training, but needs to gain
experience to perform a particular task by working under an experienced worker.
Example: Rearing silkworm cocoons, etc.
3. Unskilled labour: unskilled labour are those, who engage in tending of cattle,
weeding, application of FYM, etc.

Merits of Division of Labour

92
  It improves efficiency of labour when labour repeats doing the same tasks.
 Facilitates the use of machinery in production, resulting in inventions.
 Time and materials are put to the best and most efficient use.
Demerits of Division of Labour
 Repetition of the same task makes labour to feel that the work is monotonous.
 Narrow specialization reduces the possibility of labour to find alternative avenues of
employment. It increases unemployment.
 Reduce the growth of handicrafts.

Measuring of Labor Efficiency

Gross income-Cost of all inputs excluding labour

The returns per labour per day = --------------------------------------------------------------------
Number of worker in days

Labour Efficiency Index: In most of the farming areas, labour efficiency standards are
being set on the basis of past experiences of labour use for various crops and livestock
enterprises.
The efficiency index is worked out as follows for a hypothetical farm raising crops. The
average labour cost in th locality is, say Rs. 5,000 but the actual labour cost incurred by the
given farm is Rs. 4,000. Then based on this cost, the lobar efficiency index is.

5000 500
--------------- X 100 = ----------- = 125%
4000 4

Here labourers are efficiently employed.

Requirement of labour on the farm

As per the performance standard X Wage rate
Labour efficiency Index= --------------------------------------------------------------------------X 100
Actual labour employed on the farm X Wage rate

Capital
 In the ordinary language, capital means money.
 In Economics, capital is the man made physical goods used to produce other
goods and services. Thus, it is a produced means of production.
 Money is regarded as capital because it can be used to buy raw materials, tools,
implements and machinery for production.
 The terms capital and wealth are not synonymous. Capital is that part of wealth
which is used for the further production of wealth. Thus, all wealth is not capital but
all capital is wealth.

93
 Forms of Capital
1. Physical Capital: All man-made physical assets like plant and machinery, buildings,
tools, roads, dams and communication, etc.,
2. Money Capital: The investment that is made in the form of money or monetary
instruments is called money capital.
3. Human Capital: Human capital refers to the quality of labour resources, which can
be improved through investments in education, training, and
health. Higher the investments in human capital, higher will be the
productivity.
Characteristics of capital
 Capital is a passive factor of production.
 Capital is man-made.
 Capital has the highest mobility.
 Capital lasts over time. Thus, it is perishable.

LAND LABOUR CAPITAL

It is a passive factor of It is an active factor of It is a passive factor of
production. production. production.
It is a natural factor. It is a natural factor. It is man-made.
It is imperishable. It is perishable. It is perishable.
It is immobile. It is mobile. It is highly mobile.
Its reward is rent. Its reward is wages. Its reward is interest.

1.8.4 Organizer or Entrepreneur

 An organizer or entrepreneur is a person who combines the different factors of
production i.e., land, labour and capital in the right proportion and initiates the
process of production and also bears the risk involved in it.
 It is managerial and organizational skills needed to produce goods and services in
order to gain a profit.
Functions of an Organizer or Entrepreneur
1. He identifies profitable investment opportunities.
2. He decides the location and size of production unit.
3. He identifies the optimum combination of factors of production.
4. He decides the reward payment.
5. He takes risks.
6. He makes innovations.

***************************************

Chapter 19

94
 RISK AND UNCERTAINTY IN AGRICULTURE

13.1 INTRODUCTION
Agricultural production is biological and seasonal in nature and therefore, it
confronted with risk and uncertainty conditions. It is a highly difficult to make right decisions
when the production environment is risky and uncertain. Due to this the farmers have to
consider various management strategies relevant to the risk and uncertainty conditions. If
everything in farming and livestock rearing goes with certainty then every farmer becomes a
better manager, but this is not the case with real farming situation. Only a few farmers can
become efficient, particularly those who could understand risk and uncertainty situations in
farming and follow the relevant risk management strategies.

13.2 RISK AND UNCERTAINTY: A CONTRAST

Risk Uncertainty
It is defined as a, situation when all Uncertainty situation prevails when all
possible outcomes are known for a the possible outcomes of events are
given management decision and unknown, then neither the probability nor
probability associated with each the outcomes are known.
possible outcome is also known.

It is measurable through probability It is not measurable.

concepts.

13.3 SOURCES OF RISK

4. Production risk or technical risk
5. Price risk or marketing risk
6. Financial

13.3.1 PRODUCTION RISK OR TECHNICAL RISK

 In industrial businesses we have a technical input-output relationship with known
quantity of output for a given quantity of input i.e., the production practices are
standardized in industrial production. Such type of relationship does not exist in
agricultural production.
 Output of crops and livestock is subject to change due to weather, disease, insects,
weeds and inadequate technology. These factors cannot be predicted accurately and
hence results in the variability of the output.
 1n fact, the yield variations are due to many factors. Some are under control while
some others are not under the control of management.
 Thus, the production-risk is due to largely many factors rather than a single factor.
 Weather risk and technical risk are the most important components of production-
risk.

95
13.3.2 PRICE RISK OR MARKETING RISK
 Prices are determined due to interaction of demand and supply in the market.
 Production of crops and livestock is influenced by prices in the market which are
beyond the control of farmers.
 Prices of commodities vary from year to year; season to season and exhibit seasonal
variation.
 Trade policy i.e., export import (Exim) policy would have a great impact on price
stabilization of commodity.

13.3.3 FINANCIAL RISK

 This type of risk increases with increased amount of borrowed money in the farm
business.
 Financing the production processes and storing the commodities under scientific
management require large amounts of borrowed capital.
 Hence a careful analysis is to be-made considering all types of risks.

13.4 MEASURING THE EXPECTATION AND VARIATION

In the risky farm environments, the farmers make decisions using some kind of the
expectations regarding prices, costs and yields. Let us look into as to how the expectations
and variations are worked out and used in the decision-making process.

13.4.1 Working out expected value through weighted averages

Two types of averages are used to work out an expected value. We take the actual
past prices (time series data) and yield to find out the simple average over the specific time
period. Second type of average is called weighted average. This method considers larger
weights for the more recent data and smaller weights for the remot data.
Working out weighted averages for the prices

Year Av. Annual price of Weight Price x Weight

commodity (Rs./q)
2005 1000 1 1000
2006 1200 2 2400
2007 1400 3 4200
2008 1100 4 4400
2009 1000 5 5000
2010 1300 6 7800
Total 7000 21 24800
Simple average 1166.67
Weighted average 1180.95

For the given data there is no price risk for the commodity, as expected value is more
than simple average. On the contrary, if there is price risk its expected value would be less
than the simple average.

96
13.4.2 Working out expected value through the concept of probabilities
Another way of finding expectations is to choose the probability value, which is the
most likely to occur for the given price or yield or cost. In this procedure, we have to elicit
probabilities associated with each possible outcome. The outcome with the highest
probability would be selected as the most likely one to occur. This is shown as under:
Working out Expectations through Probabilities
Crop yield (q/ha) Probability Probability x Yield
11 0.1 1.1
14 0.4 5.6
10 0.1 1.0
12 0.3 3.6
18 . 0.1 1.8
Mean : 13 Total : 1.0 13.1

It is clear that the most likely output based on the highest probability is 14 q/ha.
Mathematical expectation of 13.1 q/ha is less than the most likely yield of 14 q/ha, but it is
more than the average yield i.e., 13 q/ha.

13.4.3 Variability
Two factors viz., the variance and the expected value, in general should form the basis
for selecting the best enterprise among alternative risky enterprises. Range is a measure of
variability and it refers to the difference between the lowest and the highest possible
outcome. Alternative enterprises should be preferred which have got smallest range value,
provided their expected values are the same. Similarly alternative enterprises with lowest
variance should be selected.

13.5 MEASURES TO MANAGE FARM RISK

13.5.1 DIVERSIFICATION

 Selection of suitable crop and livestock enterprises is the first step in diversification.
 The farmer produces several products rather than single product with the hope that
when the return from one enterprise is low, it is compensated by the higher returns
from the other enterprise.
 Idle resources can be put to use.
 The enterprises having less income variability should be selected.
 Income variability for the enterprises would be lessened.
 Risk programming models and game theory models should be used to formulate
whole farm plans under different risky situations.
 Stable enterprises should be preferred rather than risky enterprises particularly in
situation of farm risks.

97
13.5.2 INSURANCE
 The farmers have many types of insurances to reduce production risk and financial
risk.
 Crop insurance scheme reduces production risk.
 Livestock insurance provides safety against the fatal diseases of cattle.
 Farm assets can be insured against theft, fire or any other damage.

13.5.3 AGRONOMIC PRACTICES

 To reduce production risk, crop rotations, suitable varieties, deep tillage, mulching,
etc., should be adopted.

13.5.4 MARKET RISK MANAGEMENT

 Selling the Farm Products at Different Points of Time
 Due to financial obligations, farmers sell their produce immediately after the
harvest. During the harvesting periods generally prices will be low due to large
arrivals. If the farmers avoid such selling practices, they can get remunerative
prices for their products.
 The knowledge regarding supply and demand for the farm products and prices
prevailing in different markets and other market information is essential.
 For perishable commodities, storage facilities, freezing facilities, processing
facilities, etc., are required to get remunerative prices.
 Hedging is another measure adopted by the farmers and the traders to safeguard
against price-risk. Hedging practice is devised and followed by studying the
future markets.
 Government Price Polices and Programmes
 Minimum support price, procurement price, levy price, issue price, etc., are set for
various agricultural commodities by the Government every year to bring about
price stabilization.
 Support price provides protection for the farmers against fall in the prices of farm
products.

13.5.5 FINANCIAL RISK MANAGEMENT

 For reducing the financial risk we require many strategies, which are aimed at
liquidity and solvency of the farm business. Solvency by definition refers to business
ability to meet the long-term financial requirements of the farm. Liquidity strategies
should aim at as to how to build up the farm business to meet the short-term cash
requirements.
 At macro level fiscal policies formulated by RBI are aimed at to provide different
measures to safeguard against the financial risk.

98
 -:-:-:-:-:-

Chapter-20
Crop Insurance, Livestock Insurance and Weather based Insurance
in India :- An Overview

* Indian Agriculture is highly sensitive to the vagaries of weather.

Crop insurance is the only mechanism available to safeguard
production risk.
* During 1950s and 1960s, two pilot schemes were drawn up by
the Government.
- In 1970, Expert Committee on Crop Insurance was
appointed.
- Since then, Various Crop insurance schemes have been
in operation in the country.

Summary of various Crop Insurance Schemes in India and their features

Insurance Year Approach Crop Covered Salient features

Scheme Started
Crop Insurance 1972-73 Individual H-4 cotton, Voluntary implemented in 6
groundnut, wheat, potato states

Pilot Crop 1979-80 Area Cereals, millets, Confined to loanee farmers,

Insurance oilseeds, cotton, potato voluntary, 50% subsidy on
Scheme and chick pea premium for small and
marginal farmers

99
Comprehensive 1985-86 Area Food grains and Oil Compulsory for loanee
Crop Insurance seeds farmers
Scheme

Experimental 1997-98 Area Cereals, Pulses and Oil For covering non-loanee
Crop Insurance seeds small and marginal farmers
scheme also in addition to loanee
farmers.
National 1999-2000 Area and Food grains, Oilseeds, Available to all farmers. 10
Agricultural Individual annual commercial & per cent Premium subsidy
Insurance horticulture crops for small and marginal
scheme farmers.
Farm Income 2003-04 Area Wheat and rice Insurance against production
Insurance and market risks.
Compulsory for loanee
farmers.
Whether / 2003-04 Individual Food grains, oil seeds, Available to all farmers.
Rainfall annual commercial and Based on rainfall received at
Insurance horticultural crops the Indian Meteorological
Department (IMD)/block rain
gauges.

PMFBY 2016-17 Village About 28 crops Loanee and Non-Lonee

/Taluka farmers

Pradhan Mantri Fasal Bima Yojana (PMFBY)

The Pradhan Mantri Fasal Bima Yojana (Prime Minister's Crop Insurance Scheme) was
launched on 13 February, 2016. The new Crop Insurance Scheme is in line with One Nation
One Scheme theme. It incorporates the best features of all previous schemes and at the same
time, all previous shortcomings / weaknesses have been removed.

* The PMFBY replaces the existing two schemes National Agricultural Insurance Scheme as
well as the Modified NAIS.

Pradhan Mantri Fasal Bima Yojana aims at supporting sustainable production in agriculture
sector by way of following –
• The primary motive of the scheme is to provide financial support to the farmers of
Gujarat suffering crop loss / damage arising out of unforeseen events such as
hailstorm, landslide etc.
• Ensuring ease and continuity in farming by enhancing the income of farmers.
• Encouraging Farmers to adopt innovative and modern agricultural practices for
efficient farming.
• Ensuring flow of credit to the agriculture sector which will contribute to food security,
crop diversification and enhancing growth and competitiveness of agriculture sector
besides protecting farmers from production risk.
• In a way by enhancing agriculture sector, enhancing the overall economy of state of
Gujarat as well as India.

100
Objectives:
• To provide insurance coverage and financial support to the farmers in the event of
failure of any of the notified crop as a result of natural calamities, pests & diseases.
• To stabilize the income of farmers to ensure their continuance in farming.
• To encourage farmers to adopt innovative and modern agricultural practices.
• To ensure flow of credit to the agriculture sector.

Unit of insurance: The Scheme shall be implemented on an ‘Area Approach basis’ i.e.,
Defined Areas for each notified crop for widespread calamities with the assumption that
all the insured farmers, in a Unit of Insurance, to be defined as ‘Notified Area’ for a crop,
face similar risk exposures, incur to a large extent, identical cost of production per
hectare, earn comparable farm income per hectare, and experience similar extent of crop
loss due to the operation of an insured peril, in the notified area.
Defined Area (i.e., unit area of insurance) is Village/Village Panchayat level by
whatsoever name these areas may be called for major crops and for other crops it may be a
unit of size above the level of Village/Village Panchayat.
GOVERNMENT OF GUJARAT
Department of Agriculture & Co- Operation, GUJARAT STATE.

• Coverage of farmers

101
 • Compulsory component: - All farmers availing Seasonal Agricultural Operation
(SAO) loans from financial institutions (i.e. loanee farmers) for the notified crop/s are
to be covered compulsorily.
• Voluntary component: - The scheme is optional for non-loanee farmers. All farmers
who have not availed any crop loan and are willing to get covered under PMFBY can
purchase insurance through Banks/ Insurance Companies / their designate agents.
• Special efforts to ensure maximum coverage of SC/ST/woman famers.
• The farmers allotted with forest land for agricultural purpose also included

Premium rates:

Sum Insured /Coverage Limit: Sum Insured per hectare for both loanee and non-loanee
farmers will be same and equal to the Scale of Finance as decided by the District Level
Technical Committee, and would be pre-declared by State Level Coordination Committee
on Crop Insurance (SLCCCI) and notified.
Sum Insured for individual farmer is equal to the Scale of Finance per hectare
multiplied by area of the notified crop proposed by the farmer for insurance. Sum insured
for irrigated and un-irrigated areas may be separate.
Indemnity level (IL) and Threshold yield (TY): If ‘Actual Yield’ (AY) per hectare of
insured crop for the insurance unit (calculated on basis of requisite number of CCEs) in
insured season, falls short of specified ‘Threshold Yield’ (TY), all insured farmers
growing that crop in the defined area are deemed to have suffered shortfall in yield of
similar magnitude. PMFBY seeks to provide coverage against such contingency. ‘Claim’
shall be calculated as per the following formula:

102
Where,
Threshold yield for a crop in a notified insurance unit is the average yield of past seven
years (excluding a maximum of two calamity year as notified by State Government/ UT)
multiplied by applicable indemnity level for that crop. Three levels of Indemnity, viz.,
70%, 80% and 90% corresponding to crop Risk in the areas shall be available for all crops.

Illustration:
In table below, assumed yield of wheat for the last 7 years is given for insurance unit area
of “X”. Calculation of TY for Rabi 2014-15 seasons is as under:

The years of 2010-11, 2012-13 and 2014-15 were declared natural calamity years. Total of
yields of seven years is 22350 kg/ha and that of two worst calamity years is 3550 kg/ha i.e.
(1800+1750). Therefore according to the provision, average of past seven years excluding
maximum two calamity years will be (22350–3550=18800/5) i.e. 3760 kg/ha. Hence,
threshold yield at 90%, 80% and 70% of indemnity levels will be 3384 kg/ha, 3008 kg/ha
and 2632 kg/ha, respectively.

The years of 2010-11, 2012-13 and 2014-15 were declared natural calamity years. Total of
yields of seven years is 22350 kg/ha and that of two worst calamity years is 3550 kg/ha i.e.

103
 (1800+1750). Therefore according to the provision, average of past seven years excluding
maximum two calamity years will be (22350–3550=18800/5) i.e. 3760 kg/ha. Hence,
threshold yield at 90%, 80% and 70% of indemnity levels will be 3384 kg/ha, 3008 kg/ha
and 2632 kg/ha, respectively.

 Post-Harvest Losses - Coverage is available only up to a maximum period of

two weeks from the harvesting for those crops which are allowed to dry in cut
and spread condition in the field after harvesting against specific perils of
cyclone, cyclonic rains and unseasonal rains. (last date by which harvesting
should have been done is mentioned in seasonality discipline)
 Localized Calamities - Loss/damage resulting from occurrence of identified
localized risks of hailstorm, landslide and inundation affecting isolated farms
in the notified area.

• Exclusions
• General exclusions: - Losses arising out of war and nuclear risks, malicious damage
and other preventable risks (refer Para IV.2 of Operational Guidelines of PMFBY).

Premium rate and subsidy:

All farmers (loanee or non-loanee) enrolled under PMFBY would be entitled for subsidy on
the premium. Farmers will have to pay maximum 1.5% for Rabi-Summer of the sum
insured or actuarial premium rate, whichever is lower and maximum 5% of sum insured or
actuarial premium rate, whichever is lower, for annual commercial/annual horticulture
crops.
The difference between the actuarial premium rate and farmer share would be equally
borne by the State Government and Central Government in the ratio of 50:50.

Based on the fair estimates of coverage, State Government and Central Government will
ensure to make an advance payment of 50% (equally shared by state and Central
Government i.e. 25% : 25%) of total subsidy liability to insurance companies through AIC
or decided by SLCCCI/State Government and will settle the balance subsidy payment on
submission of final figures by insurance companies.

S. Season Crops Farmer's Premium Rate

No

1 Rabi-Summer Wheat (Irrigated), 1.5% of Sum Insured or Actuarial rate

Wheat (Un- whichever is less
Irrigated), Rapeseed
and Mustard, Gram,
Summer Groundnut,
Summer Bajra

104
2 Annual Cumin, Fennel, Isabgul, 5% of Sum Insured or Actuarial rate
commercial/ann Onion, Garlic, Potato whichever is less
ual horticulture
crops for
Rabi-Summer
Season

Nodal Agency for PMFBY : The Gujarat State Seed Corporation (GSSC), Gandhinagar
work as a Nodal Agency for PMFBY in Gujarat.
Livestock Insurance Scheme

The Livestock Insurance Scheme, a centrally sponsored scheme, which was implemented
on a pilot basis during 2005-06 and 2006-07 of the 10th Five Year Plan and 2007-08 of the
11th Five Year Plan in 100 selected districts.
 The scheme is being implemented on a regular basis from 2008-09 in 100 newly
selected districts of the country. Under the scheme, the crossbred and high yielding
cattle and buffaloes are being insured at maximum of their current market price.
 The premium of the insurance is subsidized to the tune of 50%.
 The entire cost of the subsidy is being borne by the Central Government. The benefit
of subsidy is being provided to a maximum of 5 animals per beneficiary for a policy
of maximum of three years.
 The scheme is being implemented in all states except Goa through the State Livestock
Development Boards of respective states.

The Livestock Insurance Scheme has been formulated with the twin objectives of;
1. Providing protection mechanism to the farmers and cattle rearers against any eventual loss
of their animals due to death and to demonstrate the benefit of the insurance of livestock to
the people.
2. Popularize it with the ultimate goal of attaining qualitative improvement in livestock and
their products.

Animals covered
The indigenous / crossbred milch animals, pack animals (Horses, Donkey, Mules, Camels,
Ponies and Cattle/Buffalo Male) , and Other Livestock (Goat, Sheep, Pigs, Rabbit, Yak
and Mithun etc.) are covered under the purview of this component.
Central assistance
 Benefit of subsidy is to be restricted to 5 animals per beneficiary per household for all
animals except sheep, goat, pig and rabbit.
 In case of sheep, goat, pig and rabbit the benefit of subsidy is to be restricted based
on "Cattle Unit" and one cattle unit is equal to 10 animals i.e a total of 50 animals.
 If a beneficiary has less than 5 animals / 1 Cattle Unit, /he can also avail the benefit of
subsidy.

105
Component Pattern of assistance

Premium rates Normal areas

Premium rates for one year Central share 25%, State share 25% and
policy in Beneficiary share 50% for APL, and Central
share 40%, State share 30%, and Beneficiary
share 30% for BPL / SC / ST

Premium rates for three year Difficult Areas

policy in

Central share 45%, State share 25% and

Beneficiary share 30% for APL, and Central
share 60%, State share 30%, and Beneficiary
share 10% for BPL / SC / ST

Process
 An animal will be insured for its current market price. The market price of the animal
to be insured w ill be assessed jointly by the beneficiary and the insurance company
preferably in the presence of the Veterinary officer or the BDO (Block Development
Officer).
 The minimum value of animal should be assessed by taking Rs.3000 per liter per day
yield of milk or as per the price prevailing in the local market (declared by
Government) for cow and Rs.4000 per liter per day yield of milk or as prevailing in
the local market (declared by Government) for buffalo.
 The market price of pack animals (Horses, Donkey, Mules, Camels, Ponies and
Cattle/Buff. Male) and Other livestock (Goat, Sheep, Pigs, Rabbit, Yak and Mithun)
are to be assessed by negotiation jointly by owner of animal and by insurance
company in the presence of veterinarians Doctor. In case of dispute the price fixation
would be settled by the Gram Panchayat / BDO.
 The animal insured will have to be properly and unique identified at the time of
insurance claim. The ear tagging should, therefore, be full proof as far as possible.
 The traditional method of ear tagging or the recent technology of fixing microchips
could be used at the time of taking the policy.
 The cost of fixing the identification mark will be borne by the Insurance Companies
and responsibility of its maintenance will lie on the concerned beneficiaries.
 The nature and quality of tagging materials will be mutually agreed by the
beneficiaries and the Insurance Company. The Veterinary Practitioners may guide the
beneficiaries about the need and importance of the tags fixed for settlement of their
claim so that they take proper care for maintenance of the tags.

106
  The tag already available on animal may be utilized with unique identity number
subject to the condition that it is mutually agreed by farmer and agency and there shall
not be any dispute in settlement of claims on account of utilization of existing tag.
 While processing an insurance proposal, one photograph of the animal with the
 Owner and one photograph of the animal clearly with the EAR TAG visible shall be
taken at the time of processing the insurance documentation.
 In case of sale of the animal or otherwise transfer of animal from one owner to other,
before expiry of the Insurance Policy, the authority of beneficiary for the remaining
period of policy will have to be transferred to the new owner.
 Only four documents would be required by insurance companies for settling the
claims viz. intimation with the Insurance Company, Insurance Policy paper, Claim
Form and Postmortem Report.
 In case of claim becoming due, the payment of insured amount should be made within
15 days positively after submission of requisite documents. If an Insurance company
fails to settle the claim within 15 days of submission of documents, the insurance
company will be liable to pay, a penalty of 12% compound interest per annum to the
beneficiary.

Chapter-21 and 22
Resource Economics: Concepts & Properties, Positive and
Negative Externalities in Agriculture

Introduction:
Basic human needs are fulfilled by materials provided by nature itself. They are air,
water, soil, minerals, coal, petroleum, animals and plants. These stocks of the nature, useful
to mankind are called natural resources. The resource that exists without the actions of human
being is also known as natural resources. The resources that exist in nature and having both
usefulness and economic value. In primitive age, man had used only those resources that
supported his life. But with the process of economic growth and increase in population, use
of resources increased manifold, had led to mismanagement of natural resources. If humans
are using these free goods up to extent of reducing their self stabilization then environmental
problems arises. Over the past 50 years resource degradation has increased considerably.
There are two types of natural resources:
1. Non-renewable Resources: The resources that formed in million numbers of years and
degraded sooner or later. Example: Coal, Petroleum, Nuclear etc. These resources are
present in limited quantity and exhaustible in nature.
2. Renewable Resources: These resources are present in unlimited quantity and non-
exhaustible in nature for the human kind. Example: Soil, Air, Water, Plants & Animals etc.

107
 Natural
Resources

Renewable Non-Renewable
Resources that can Resources that
be used over and can only be used
over again once

Resources that are Resources that can

Resources that Resources that are
always available, be exhausted by
can be recycled , consumed when
e.g. Wind & overuse e.g.
e.g. Metals used, e.g. Coal
Water Petroleum

Fish, forest, plants, animals etc. living renewable natural resources, which have specific life
cycle and can be replaced after that.
 Recyclable and Non-recyclable natural resources are subdivision of non-renewable
natural resources.
 Ex. of recyclable resources: Aluminum, copper etc.
 Ex. of non- recyclable resources: Mineral energy resources, eg. Fossil fuels.

Some examples of natural resources and the ways we can use them are listed in the table
below.
Natural Resource Products or Services
Air Wind energy, tires
Foods (milk, cheese, steak, bacon) and
Animals
clothing (wool sweater, silk shirt, leather belt)
Coal Electricity
Minerals Coins, wire, steel, aluminum cans, jewelry
Natural Gas Electricity, heating
Oil Electricity, fuel for cars and airplanes, plastic
Wood, paper, cotton clothing, fruits,
Plants
vegetables
Sunlight Solar power, photosynthesis
Water Hydroelectric energy, drinking, cleaning

108
Classification of Natural Resources
There are different ways to classify natural resources, including where they come from and if
they are renewable or not.
Biotic and Abiotic Natural Resources
If natural resources come from living things or organic materials, then they are considered
biotic resources. Biotic resources include plants, animals, and fossil fuels. The three fossil
fuels are coal, oil, and natural gas. Fossil fuels are classified as biotic resources because they
were formed from the decay of organic matter over millions of years.
On the other hand, abiotic resources originate from nonliving and inorganic materials. For
example, air, sunlight, land and water are abiotic natural resources. Minerals (gold, copper,
iron, diamonds) are also considered abiotic.
Renewable and Nonrenewable Natural Resources
Renewable resources are those that can be replenished during our lifetime, such as sunlight,
wind, water, plants, and animals. The rate at which renewable resources are replenished may
differ. For example, we will never run out of sun and wind in our lifetime because the Earth
constantly supplies these resources.

Renewable resources are generally living resources (fish, forests, for example), which can
restock (renew) themselves if they are not over-harvested but used sustainably. Once
renewable resources are consumed at a rate that exceeds their natural rate of replacement, the
standing stock will diminish and eventually run out. The rate of sustainable use of a
renewable resource is determined by the replacement rate and amount of standing stock of
that particular resource. Non-living renewable natural resources include soil and water.

Flow renewable resources are very much like renewable resources, only they do not need
regeneration, unlike renewable resources. Flow renewable resources include renewable
energy sources such as the following renewable power sources: solar, biomass, tides and
wind.

Non-renewable resources

A non-renewable resource is a natural resource that exists in a fixed amount that cannot be re-
made, re-grown or regenerated as fast as it is consumed and used up.

109
Some non-renewable resources can be renewable but take an extremely long time to renew.
Fossil fuels, for example, take millions of years to form and so are not practically considered
‘renewable’. Many environmentalists proposed to tax on consumption of non renewable
resources.

A nation’s natural resources often determine its wealth and status in the world economic
system, by determining its political influence. Developed nations are those which are less
dependent on natural resources for wealth, due to their greater reliance on infrastructural
capital for production. However, some see a resource curse whereby easily obtainable natural
resources could actually hurt the prospects of a national economy by fostering political
corruption. Political corruption can negatively impact the national economy because time is
spent giving bribes or other economically unproductive acts instead of the generation of
generative economic activity. There also tends to be concentrations of ownership over
specific plots of land that have proven to yield natural resources.

In recent years, the depletion of natural capital and attempts to move to sustainable
development have been a major focus of development agencies. This is of particular concern
in rainforest regions, which hold most of the Earth’s natural biodiversity – irreplaceable
genetic natural capital. Conservation of natural resources is the major focus of natural
capitalism, environmentalism, the ecology movement, and Green Parties. Some view this
depletion as a major source of social unrest and conflicts in developing nations.

110
Characteristics of renewable natural resources
(i) Regeneration: Renewable natural resources have abilities to regenerate, hence
inexhaustible in physical sense. They are self-regenerating and hence have perpetual
production potentials. The economic importance of this is that the consumption of one unit
does not reduce future inventory by the same amount. Although renewable, all biological
resources are potentially destructible, especially by their misuse and overexploitation leading
to depletion and perhaps extinction.
(ii) Multiplicity of species interaction and dependence: The diversity and complexity of
species are important properties of biological resources. These make their management
difficult due to variations in the quality and uses of different species.
(iii) Naturally determined growth rate: The rate of growth and accretion of stock of
biological resources are naturally determined by pre-determined biological processes.
However, man can and have been influencing this limited growth by research. Because
growth is naturally determined, time is a major decision variable on the management of
biological resources. This requires a minimum waiting period for the production of any
desired product, with of course, implication for cost and return.
(iv.) Possibility of Man-made Improvement: Technological advancement consequent upon
research leads to genetic improvement and hence high yield and thus reduction in
management cost. This is often achieved by deemphasizing complexity of species
composition in favour of few selected dominant species.
(v) Biological Resources as Ecosystem: Biological resources exist in and constitute an
ecosystem of flora and fauna. These conform to important elemental concepts or principles of
ecosystem such as selection, food chain, in which the organisms consume and are consumed
by others in a particular order or hierarchy. The ecosystem develops towards a climax or a
state of equilibrium when mortality balances with regeneration. However, ecosystem tends to
be in a dynamic rather than static because nature/situation is not constant all the time.
(vi) Common Property Effect: The principle of common property requires that title to all
environmental resources should rest with collectively, and that the private use of these
resources should be on the basis of usufructural right only. Everyone claims right to their
ownership. This lead to over-exploitation as it is generally believed that if one person does
not exploit the resource, someone else will do. This is contrary to their maintenance as they
are everybody’s property and hence no one can be held responsible. The consequences of
these actions are over-exploitation and neglect.

111
Exhaustible Resources
 A resource that does not replace (or renew) itself except over a long (geologic)
time frame.
 Stock: The quantity of a resource.
 The stock is fixed
 With extraction, stock is always reduced.
 Resource Economics: Emphasis is on allocating the fixed stock through time.
 Storage can be used to extend the economic life of a resource.
Examples:
 Energy Resources: Oil, Natural Gas, Uranium, Coal
 All other minerals and metals
 Confined groundwater
Renewable Resources
 A resource with a natural replenishment rate that augments its own stock (or biomass)
at a non-negligible rate.
 The stock can be replenished. With extraction the stock can be growing, unchanged,
or declining.
 Replenishment depends on maintaining a given stock. Excess extraction can result in
extinction (the renewable resource becomes an exhaustible resource).
 Resource Economics: Emphasis is on managing the flow of resources
 Storage smooths out cyclical imbalances of supply and demand.
 Examples:
 Plants and Animals
 Solar Energy
 Surface Water and Unconfined Groundwater

Natural Resource Management:

“Planning and management of resources so as to secure their wise use and continuity
of supply while maintaining and enhancing their quality, value and diversity".

112
 “It refers to the management of natural resources such
as land, water, soil, plants and animals, with a particular focus on how management affects
the quality of life for both present and future generations.

 Natural resource management is

based on the ecologically sound
traditional wisdom of farmers,
which are sustainable in nature
need to be compared with values of
modem systems.
 In recent years, degradations of
these resources like- water scarcity,
air and water pollution, energy
scarcity, deforestation and soil-
degradation and the environment
have increasingly become the focus
of attention because of their
harmful impact on people's lives.

The important cause of environment degradation is Market Failure, which means poor
functioning of market for environmental goods and services. In the real world, there is non-
attainment of Pareto-optimality due to a number of constraints in the working of perfect
competition. Pareto optimality means that it is not possible to make one individual better off,
without making another individual worse off. Market failure arises when the allocation of
resources is not Pareto optimal. A market fails when it is not efficient and so unable to reach
desirable outcomes in the use of resources. The important causes of market failures are:
Incomplete/ imperfect markets, Asymmetric information, Externalities, Public goods etc.
Incomplete markets: Markets for certain things are incomplete or missing under perfect
competition. The absence of markets for such things as public goods and common property
resources is a cause of market failure. There is no way to equate their social and private
benefits and costs either in the present or in the future because their markets are incomplete or
missing.

113
Asymmetric Information: It means that producers and consumers have imperfect
information regarding market behaviour due to ignorance and uncertainty. In some cases,
information about market behaviour in the future may be available but that may be
insufficient or incomplete and thus, fails to allocate efficiently.
Why to value natural resources?
 Situation of missing market
 If markets are present, they do not function well: The environmental goods and
factors are not infinitely divisible. The problem of divisibility arises in the production
of those goods and services that are used jointly by more than one person. An
example is of road in a locality. But the problem is how to share the cost of repairs
and maintenance of the road.
 Essential to understand and estimate its alternatives and alternatives uses
 Uncertainty about demand and supply of natural resources
 Government may use valuation as against the restricted, administered or operating
market prices for designing resource conservation programs
Externalities:
It refers to the beneficial and detrimental effects of an economic unit (a firm, a consumer
or an industry) on others. The beneficial externalities created by a consumer or a firm for
others are known as external economies or positive externality and detrimental externalities
imposed on others by a productive firm or a consumer are known as external diseconomies or
negative externality. When social and private costs and social and private benefits diverge,
perfect competition will not achieve Pareto-optimality. It includes External Economies and
Diseconomies of Production and Consumption, which prevents the attainment of Pareto-
Optimality.
Positive Externalities of Production: Example: The Public park, which is located far
away from main roads and cities and is settled nicely between a few surrounding
neighborhoods. The main traffic comes from families with small children using the smaller
and larger playgrounds during the day. The park has a few grills, picnic benches, and a small
shelter near the picnic area. It provides good scenery, fresh air and fresh environment for
homeowners as well as pollution free area for children to play. Therefore, Public Park is
believed to be a positive asset to the surrounding neighborhoods, subsequently increasing the
value of owner of homes. So, government bears more marginal private cost (MPC) as
compare to marginal social cost (MSC) to the home owners of the society.

114
Positive Externalities of Consumption: Example: When an individual installs a TV set, the
satisfaction of his neighbors increases because they can watch TV programes free at his
place. Here social benefit is larger and social cost is lower than the private benefit and cost.
But the TV owner is likely to use his TV set to a smaller extent than the interests of society
require because of the inconvenience and nuisance caused by the neighbors to him.

Negative Externalities of Production: When the production of a commodity or service by a

firm affects adversely other firms in the industry, social marginal cost is higher than social
marginal benefit. Example: A factory situated in a residential area emits smoke which affects
adversely health and household articles of the residents. In this case, the factory benefits at
the expense of residents who have to incur extra expenses to keep themselves healthy and
their households clean.
Negative Externalities of Consumption: It arises when the consumption of a good or
service by one consumer leads to reduce utility (dissatisfaction or loss of welfare) of other
consumers. Example: Smokers cause disutility to non-smokers. Such diseconomies of
consumption prevent the attainment of Pareto-optimality.

Public Goods: Another cause of market failure is the existence of public goods. A public
good is one whose consumption or use by one individual does not reduce the amount
available for others. An example of a public good is water which is available to one person
and is also available to others without any individual cost. Its consumption is always joint and
equal. It is non-excludable if it can be consumed by anyone. It is non-rivalrous if no one has
exclusive rights over its consumption. Its benefits can be provided to an additional consumer
at zero marginal cost. Thus public goods are both non-excludable and non-rivalrous.
Moreover, environmental quality is generally considerable as a public good and when it is
valued at market price, it leads to market failure.

115
PARETO OPTIMAL CRITERIA:
The great Italian economist VILFREDO PARETO (1848–1923) introduced this
criteria for maximizing social welfare or for achieving social welfare.
 STATEMENT: “ any change which harm no one and which
makes some people better off must be considered to be
improvement” OR
 “A situation in which it is impossible to make any one better off
without making some one worse off is said to be pareto efficient or
pareto optimal.
 Let us assume that society have two person X and Y. In the above
figure represent the utility of individual X along the horizontal axis
and that of Y along vertical axis.
 The pareto criteria state that if we start off the point A, than a
policy change by government is an improvement if it result in a
move to any point like B to C which lies to right of A or above. At
B, X is better off than at A with Y as well off as before, whereas
the move to C benefits Y without harming X and the move to D
benefits both the person.

116
 

Edgeworth Box Analysis: Two Consumers…

 Francis Edgeworth developed this method of analysis in the last
portion of the 19th century.
 It Provides a powerful way of graphically studying exchange and
the role of markets.
 It represents the two indifference curve in signal box with optimal
condition called efficient point.
 The model represents the general equilibrium condition either for
product or factor are at equilibrium point.
Thank You…
"Natural resources determine the course of development and constitute the challenge
which may or may not be accepted by the human mind“
W. Arthur Lewis

117