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

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Page 1: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Farm ManagementChapter 8

Economic Principles - Choosing Input and Output Combinations

Page 2: © 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

Page 3: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Chapter Objectives1. Explain the use of substitution in economics

and decision making2. Demonstrate how to compute a substitution

ratio and a price ratio for two inputs3. Use the input substitution and price ratios to

find the least-cost combination of two inputs4. Describe the characteristics of competitive,

supplementary, and complementary enterprises5. Show the use of the output substitution and

price ratios to find the profit-maximizing combination of two enterprises

Page 4: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Input Combinations

Most products require two or moreinputs, and the manager may choosethe input combination or ratio to use.

The economic question is whetherone input can be substituted for another to reduce the cost.

Page 5: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Input Substitution Ratio

Input substitution ratio =

amount of input replaced amount of input added

Page 6: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Types of Input Substitution

• Constant rate (perfect substitution)

• Decreasing rate

• No substitution

Page 7: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Figure 8-1Three possible types of substitution

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

© Mcgraw-Hill Companies, 2008

Input Price Ratio

Input price ratio =

price of input being added price of input being replaced

Page 9: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Decision Rule

input substitution ratio = input price ratio

If they cannot be exactly equal becauseof the choices available in the table, getas close as possible without lettingthe price ratio exceed the substitution ratio.

Page 10: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Table 8-1 Selecting a Least-Cost Feed Ration

Each ration puts the same weight gainon a steer; grain at 4.4¢ and hay at 3.0¢

Input Input TotalFeed Grain Hay substitution price cost ofration (lbs) (lbs) ratio ratio ration

A 825 1350 76.80B 900 1130 2.93 > 1.47 73.50C 975 935 2.60 > 1.47 70.95D 1050 770 2.20 > 1.47 69.30E 1125 625 1.93 > 1.47 68.25F 1200 525 1.33 < 1.47 68.55G 1275 445 1.07 < 1.47 69.45

Page 11: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© 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.

Page 12: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Enterprise Combinations

Another decision that must be madeis the combination of enterprisesto produce to maximize profits. If oneor more inputs is limited, there is anupper limit on how much can be produced.

Page 13: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Enterprise Relationships

The first step in determining theprofit-maximizing combination ofenterprises is to determine thephysical relationship among theenterprises.

Page 14: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© 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

Page 15: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Competitive Enterprises

Competitive enterprises may haveconstant substitution or increasingsubstitution.

Page 16: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Figure 8-3 Supplementary and complementary

enterprise relationships

Page 17: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Output Substitution Ratio

Output Substitution Ratio =

quantity of output lostquantity of output gained

Page 18: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Output Price Ratio

Output Profit Ratio =

profit of output gained profit of output lost

Page 19: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Decision Rule

output substitution ratio = output price ratio

If no available combination makes theseexactly equal, get as close as possiblewithout letting the price ratio drop belowthe substitution ratio.

Page 20: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© 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

Acres of Acres of Profit from Profit from Total Alfalfa Sorghum Alfalfa ($) Sorghum($) Profit ($)

0 1,000 0 30,000 30,000100 975 5,000 29,250 34,250200 925 10,000 27,750 37,750300 845 15,000 25,350 40,350400 745 20,000 22,350 42,350500 620 25,000 18,600 43,600600 470 30,000 14,100 44,100700 270 35,000 8,100 43,100800 0 40,000 0 40,000

Page 21: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Table 8-3 Profit-Maximizing Combination of Two

Competitive Enterprise

Profit = $50/acre for alfalfa, $30/acre for sorghum

OutputAcres of Acres of Substitution Profit Alfalfa Sorghum Ratio Ratio

0 1,000 -- --100 975 0.25 1.67200 925 0.50 1.67300 845 0.80 1.67400 745 1.00 1.67500 620 1.25 1.67600 470 1.50 1.67700 270 2.00 1.67800 0 2.70 1.67

Page 22: © Mcgraw-Hill Companies, 2008 Farm Management Chapter 8 Economic Principles - Choosing Input and Output Combinations

© Mcgraw-Hill Companies, 2008

Summary

This chapter emphasizes the use ofsubstitution principles to decide howand what to produce. To decidehow to produce, the manager findsthe least-cost combination of inputs.To decide what to produce, the managerfinds the profit-maximizing combinationof enterprises.