Lecture 12 economic principles applicable to farm management

For undergraduate agricultural students of the course ‘Ag. Econ. 6.4 Farm Management, Production, and Resource Economics (2+1)’ of Junagadh Agricultural University, Gujarat and other State Agricultural Universities in India.

1. Lecture 12: Economic Principles
Applied in Farm Management

2. Farm Management
•Farmmanagementcanbedefinedasascience
dealingwithjudiciousdecisionsontheuseof
scarcefarmresources,havingalternativeusesto
obtainthemaximumprofitonsustainablebasis.
•Or,organizationandoperationoffarmswitha
viewtomakecontinuousprofits.
•But-howtomakefarmmanagement
actuallywork?
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3. Economic Principles Applied in Farm
Management
1.Law of diminishing (marginal) returns
2.Principle of factor substitution
3.Principle of product substitution
4.Principle of equi-marginal returns
5.Principle of opportunity cost
6.Principle of minimum loss
7.Principle of comparative advantage
8.Time comparison principle
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4. 4

5. 1. Law of Diminishing Marginal
Returns (LDMR)
•Definition:Ifthequantityofoneinputisincreased,keeping
otherinputsconstant,thentotaloutputfirstincreasesat
increasingrateandthenincreasesatdecreasingrateandfinally
startstodecline.
•FundamentalEconomicLaw/LawofVariableProportions.
•Whyinagriculture?
•Howmuchinputtouse?
•Howmuchoutputtoproduce?
•Define:(i)MC;(ii)MP;(iii)MVP;and(iv)MR
•ProfitRule???
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6. 6

7. 2. Principle of Factor Substitution
•How to produce?
•Objective: Cost minimization
•Most appropriate combination of inputs for least cost.
•Profit Rule ??????
(i)Least cost combination
(ii)Substitution > Price ratio
(iii)Substitution < Price ratio
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8. 8
Principle of Factor Substitution

9. 3. Principle of Product Substitution
•What to produce?
•Objective: Profit maximization
•Complementary | Supplementary | Competitive
•Most appropriate combination of products for max profit
•Profit Rule ??????
•MRPS < PR
•MRPS > PR
•MRPS = PR
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10. 10
Principle of Product Substitution

11. 11
Principle of Product Substitution

12. 4. Law of equi-marginal return
•Thelawofequimarginalutilitywaspresentedin19
th
centurybyanAustralianeconomistnamedH.H.Gossen.
•Itisalsoknownaslawofmaximumsatisfactionorlawof
substitutionorGossen'ssecondlaw.
•Thelawofequimarginalreturnstatesthatprofitfroma
limitedamountofvariableinputismaximizedwhenthatinput
isusedinsuchawaythatmarginalreturnorMVPfrom
thatinputisequalinalltheenterprises.
•Inotherwords,thefarmercangetmaximumutilityby
allocatingtheresource(e.g.money)insuchawaythatlast
rupeespentoneachitemprovidesthesamemarginalutility.
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13. Equi-Marginal Returns: Concept
•Limited inputs –Problem:
•The law of equimarginal return states that profit from a limited
amount of variable input is maximized when that input is
used in such a way that marginal return or MVP from that
input is equal in all the enterprises.
•The equi-marginal principle provides guidelines for the
rational allocation of scare resources.
•Principle: Allocate limited inputs in such a way that the MVP
of the last unit of the resource is equal in all the cases.
•Profit Rule: Allocate limited input where MVP is greatest.
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14. Application of the law
•Cultivator has limited capital and his main
objective is to maximise net profit.
•He has several alternatives for investing this
amount.
•He should spend the amount, in such a way
that he will get maximum profit.
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15. Example:
•Suppose,farmerishavingRs.50,000forinvestingin
aviableenterprise.Hislocalityisfavourabletotake
upcropenterprise,dairyenterpriseandpoultry
enterprise.
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16. Marginal returns to the capital
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17. Expenditure according to principle of
equi-marginal return
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18. Thereby,
•Profit is maximized i.e. Rs. 48,000 which is
more than the returns from any of the three
enterprises.
•MVP of the last batch of input is the same (i.e.
Rs. 19,000) in all the cases.
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19. 19
Application of Equi-marginal return principle

20. Suppose a consumer has six rupees that he wants to spend on
apples and bananas in order to obtain maximum total utility.
Money (Rs.)MU (Apple)MU (banana)
1 10 8
2 9 7
3 8 6
4 7 5
5 6 4
6 5 3
The following table shows marginal utility (MU) of spending
additional rupee of income on apples and bananas:
Using the concept of Law of Equimarginal returns, show the
level of spending at which the total utility can be maximized.
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More on equi-marginal returns…….

21. Inference on Equi-marginal returns:
•Total total utility for consumer is 49 utils that is
the highest obtainable with expenditure of Rs. 4
on apples and Rs. 2 on bananas.
•Here the condition MU of apple = MU of
banana i.e. 7 = 7 is also satisfied.
•Any other allocation of the last rupee shall give
less total utility to the consumer.
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22. 5. Principle of Opportunity Cost
•Closely related to the equi-marginal principle
•The income or returns from the next best alternativethat is
sacrificed or foregone or given up to produce any product or
good or output is called as OC.
•Opportunity cost is also known as real cost or alternate cost.
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23. 23
Profit rule: MVP > OC
Opportunity cost principle:
For e.g. if the farmer has Rs. 1000, it would be more advisable for him to
invest in sugarcane as its MVP is more than the other two.
If the farmer still invests in cotton, then he would be sacrificing Rs. 3200
(OC of cotton) to receive only Rs. 2,200 (MVP of cotton)

24. 6. Minimum Loss Principle
•The principle is associated with both fixed and
variable costs.
•Fixed Costs: Depreciation, rental value of
land.
•Variable Costs: Cost of inputs, wages for
casual labour, interest on working capital.
•This principle shows how the producer can
minimize losses under adverse price
environment.
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25. Minimum Loss: Costs and Returns
•Fixed Cost = Rs. 10,000
•Variable Cost = Rs. 5,000
•Net income = -Rs. 8,000
•The farmer should continue till the loss is less than fixed costs.
•If loss is > fixed costs, then production should be stopped
temporarily–to minimize the loss.
•In the long run, if selling price is less than ATC –then
continuous losses are incurred.
•Under such a situation, the farmer should stop the production
permanently.
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26. Minimum Loss Principle
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27. 7. Principle of Comparative
Advantage
•Regional Specialization -? (due to prevailing soil or climate)
•Punjab specializes in wheat, Andhra in rice and Gujarat in groundnut.
•Example:
Crop: Groundnut
Net Profit / quintal:
-Gujarat : Rs. 12,000
-Karnataka: Rs. 8,000
•Statementoftheprinciple:Individualsorregionswilltendto
specializeintheproductionofthosecommoditiesforwhich
theirresourcerealizeabetterrelativeorcomparativeadvantage.
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28. Illustration of Comparative Advantage
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Inference:
Region A has absolute advantage in both wheat and groundnut.
Region B has absolute disadvantage in both wheat and groundnut.
But to maximize profits, Region A can allocate maximum possible
acreage under wheat and Region B on groundnut.

29. 8. Time Comparison Principle
•There are two types of investments: (1) Investments on
operating inputs & (2) Investment on capital assets.
•The costs & returns from investments in operating resources
occur with a production period of a year or less.
•There is no need to bring in time element for working
investments as both cost and returns fall within the same
production cycle.
•But in case of capital assets where the costs & returns are in
different time periods and also capital expenditure involves
costs & returns over time (e.g. orchards).
•To examine profitability of such capital investments it requires
the recognition of time value of money.
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30. Time Comparison Principle
•Working capital: The costs & returns from
investments in operating resources occur
with a production period of a year or less.
•Why time element?
•Only for owned capital assets / fixed cost?
•Not for operating resources / VC.
•Principles: Compounding & Discounting
•Money has time value:
Because : -interest rate, inflation, uncertainty.
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31. Money has time value for the following reasons:
•(1) Earning power of money: represented by
opportunity cost of money (rate of interest )
•(2)Inflation: purchasing power of money varies
inversely with the price level. A rupee earned a year
from now is less valuable than a rupee earned today.
•(3) Uncertainty: Investment deals with future &
future is uncertain. Investments are made with the
expectation of receiving a stream of benefits in the
future.
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32. Time Comparison Principle
•Compounding: Future Value of Present Money
FV = P (1+i) ^ n
•Discounting: Present Value of Future Money
PV = P / (1+i) ^ n
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33. Growth of a cash outlay over time:
•Compounding:Compoundingistheproceduretofindthe
futurevalueofpresentmoney,giventheearningpower
(interestrate)ofmoney&thefrequencyofcompounding.
1st year 100 @10 % 100+10 110
2nd year 110 @ 10 % 110+11 121
3rd year 121 @ 10 % 121+12.10 133.1
4th year133.10 @ 10 %133.10 + 13.31146.41
For e.g. Find the future value of Rs. 100 after 4 years at
an interest rate of 10 %
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34. FV = PV (1+i)
n
FV = Future value of money
PV = Present value of money
i = Interest rate
n = number of years
Compounding: Future value of present money
FV = 100 (1+0.10)
4
= 100 * (1.10)
4
= 100 * 1.46
FV = Rs. 146.4
The future value of Rs. 100 with an interest rate of
10 % after 4 years is Rs. 146.40.
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35. Discounting:
•It is the procedure to determine the present
value of the future income.
•Future amount is discounted because the sum
of money to be received in future is worth
somewhat less now due to the time difference
assuming positive rate of interest.
•In short, future money has always a lesser
value than that of present money.
•Remember: A bird in the hand is worth two
in the bush.
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36. PV = FV / (1+i)
n
PV = Present value of money
FV = Future money to be received
i = Interest rate
n = number of years
PV = 5000 / (1+0.10)
4
= 5000 / (1.10)
4
= 5000 / 1.46
= Rs. 3424.65
The present value of Rs. 5000 to be received after 4 years
at an interest rate of 10 % is Rs. 3424.65.
Discounting: Present value of future money
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