AGEC 407 Economic Decision Making Marginal analysis –changes at the “margin” –examining the results of an additional unit

AGEC 407 Production Functions Total Physical Product (TPP) –Total output produced with a given level of an input Average Physical Product (APP) –Average output for each unit of input Marginal Physical Product (MPP) –Additional output gained from and additional unit of input

AGEC 407 Production Functions Law of diminishing marginal returns –As additional inputs are used, in combination with fixed inputs, eventually MPP will decline Variable costs –change with production level Fixed costs –do not change with output level –are not considered in short-run decision making

AGEC 407 Production Functions Stage I –From zero input to max APP Stage II –From max APP to max TPP Stage III –Beyond max TPP

AGEC 407 Choosing Input Levels Marginal Value Product –additional income received by using an additional unit of input Marginal Input Cost –cost of an additional unit of input –usually the price of the input

AGEC 407 Choosing Output Levels Marginal Revenue –Change in revenue from selling one more unit –usually the output price Marginal Cost –Change in total cost from producing one more unit of output

AGEC 407 Choosing Input Combinations Maximize profits by finding the least-cost combination of inputs Isoquant line –Represents different combinations of two inputs that result in the same output

AGEC 407 Choosing Input Combinations Increase profits if different combo of inputs decreases costs more than increases Substitution Ratio –Δ input replaced / Δ input added Price Ratio –Price of input added / Price of input replaced Substitution Ratio = Price Ratio –SR not less than PR

AGEC 407 Choosing Output Combinations Find profit maximizing combination of outputs to produce with available resources Production Possibilities Curve (Frontier) –Maximum quantities that can be produced with the resources available

AGEC 407 Choosing Output Combinations Increase profits if different combo of outputs increases profits more than decreases Substitution Ratio –Δ output replaced / Δ output added Profit Ratio –Profit from output added / Profit from output replaced Profit Ratio = Substitution Ratio –PR not less than SR

AGEC 407 Economic Cost Theory Opportunity Cost –Value of input in its highest alternative use –Accounts for resources that are tied up by current production process –If you have $300,000 in equity invested in your farm, you could safely be earning 6% per year in a money market account Annual opportunity cost = $18,000

AGEC 407 Economic Cost Theory Short Run –Longest period of time during which at least one input cannot be varied –Usually one production cycle or year Long Run –All input quantities can be varied –More land can be acquired –All resources can be sold

AGEC 407 Economic Cost Theory Fixed costs –Do not change with changes in output level –Only exist in the short run Variable costs –Increase with increases in output –All costs variable in the long run

AGEC 407 Economic Cost Theory Total cost = Fixed cost + Total Variable cost Average Total Cost (ATC) –Total cost / Output Average Fixed Cost (AFC) –Fixed cost / Output Average Variable Cost (AVC) –Total variable cost / Output

AGEC 407 Economic Cost Theory Marginal Cost –Change in total cost from producing one more unit of output –Intersects AVC and ATC at their minimum points; Why is this always ture? When cost of last unit is greater than the average, it pulls the average up

AGEC 407 Economic Cost Theory Short Run Rule for Production –Produce where MR = MC –As long as MR > AVC If ATC > MR > AVC –Losses will be minimized by producing where MR = MC

AGEC 407 Economic Cost Theory Long Run Rule for Production –Produce where MR = MC –As long as MR > ATC –If ATC > MR Do not produce All inputs are variable in Long Run

AGEC 407 Economies of Size Based on Long Run Average Costs Exist where LRAC are decreasing as output increases Optimal to produce where LRAC are minimum

AGEC 407 Economies of Size Result from: –Spreading fixed costs over more output –Full utilization of labor, machinery, buildings –Some technologies Diseconomies of size –Where LRAC are increasing with output –Results from: Insufficient management skill Distance from barn to outlying fields