© Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008 Chapter Outline Input Combinations Enterprise Combinations

© Mcgraw-Hill Companies, 2008 Chapter Objectives 1.Explain the use of substitution in economics and decision making 2.Demonstrate how to compute a substitution ratio and a price ratio for two inputs 3.Use the input substitution and price ratios to find the least-cost combination of two inputs 4.Describe the characteristics of competitive, supplementary, and complementary enterprises 5.Show the use of the output substitution and price ratios to find the profit-maximizing combination of two enterprises

© Mcgraw-Hill Companies, 2008 Input Combinations Most products require two or more inputs, and the manager may choose the input combination or ratio to use. The economic question is whether one input can be substituted for another to reduce the cost.

© Mcgraw-Hill Companies, 2008 Input Substitution Ratio Input substitution ratio = amount of input replaced amount of input added

© Mcgraw-Hill Companies, 2008 Types of Input Substitution Constant rate (perfect substitution) Decreasing rate No substitution

© Mcgraw-Hill Companies, 2008 Figure 8-1 Three possible types of substitution

© Mcgraw-Hill Companies, 2008 Input Price Ratio Input price ratio = price of input being added price of input being replaced

© Mcgraw-Hill Companies, 2008 Decision Rule input substitution ratio = input price ratio If they cannot be exactly equal because of the choices available in the table, get as close as possible without letting the price ratio exceed the substitution ratio.

© Mcgraw-Hill Companies, 2008 Table 8-1 Selecting a Least-Cost Feed Ration Each ration puts the same weight gain on a steer; grain at 4.4¢ and hay at 3.0¢

© Mcgraw-Hill Companies, 2008 With Different Types of Substitution With a constant rate of substitution, the least-cost combination will be all of one input and none of the other (unless the price ratio is exactly equal to the constant rate of substitution). With a decreasing rate of substitution, the least-cost combination will usually include some of each input.

© Mcgraw-Hill Companies, 2008 Enterprise Combinations Another decision that must be made is the combination of enterprises to produce to maximize profits. If one or more inputs is limited, there is an upper limit on how much can be produced.

© Mcgraw-Hill Companies, 2008 Enterprise Relationships The first step in determining the profit-maximizing combination of enterprises is to determine the physical relationship among the enterprises.

© Mcgraw-Hill Companies, 2008 Types of Relationships Competitive: output of one enterprise cannot be increased unless output of the other decreases Supplementary: more output from one enterprise can be added without a change in the level of the other enterprise Complementary: as output of one enterprise increases, output of the other increases also

© Mcgraw-Hill Companies, 2008 Competitive Enterprises Competitive enterprises may have constant substitution or increasing substitution.

© Mcgraw-Hill Companies, 2008 Figure 8-3 Supplementary and complementary enterprise relationships

© Mcgraw-Hill Companies, 2008 Output Substitution Ratio Output Substitution Ratio = quantity of output lost quantity of output gained

© Mcgraw-Hill Companies, 2008 Output Price Ratio Output Profit Ratio = profit of output gained profit of output lost

© Mcgraw-Hill Companies, 2008 Decision Rule output substitution ratio = output price ratio If no available combination makes these exactly equal, get as close as possible without letting the price ratio drop below the substitution ratio.

© Mcgraw-Hill Companies, 2008 Table 8-2 Profit from Various Combinations of Alfalfa and Grain Sorghum Profit = $50/acre for alfalfa, $30/acre for sorghum

© Mcgraw-Hill Companies, 2008 Table 8-3 Profit-Maximizing Combination of Two Competitive Enterprise Profit = $50/acre for alfalfa, $30/acre for sorghum

© Mcgraw-Hill Companies, 2008 Summary This chapter emphasizes the use of substitution principles to decide how and what to produce. To decide how to produce, the manager finds the least-cost combination of inputs. To decide what to produce, the manager finds the profit-maximizing combination of enterprises.