farm management chapter 8 economic principles choosing input and output combinations
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Farm ManagementChapter 8
Economic Principles
Choosing Input and Output Combinations
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Chapter Outline
• Input Combinations
• Enterprise Combinations
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Chapter Objectives1. To explain the use of substitution in economics
and decision making2. To demonstrate how to compute a substitution
ratio and a price ratio for two inputs3. To use the input substitution and price ratios to
find the least-cost combination of two inputs4. To describe the characteristics of competitive,
supplementary, and complementary enterprises5. To show the use of the output substitution and
price ratios to find the profit-maximizing combination of two enterprises
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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.
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Types of Input Substitution
• Constant rate (perfect substitution)
• Decreasing rate
• No substitution
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Figure 8-1Three possible types of substitution
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Input Substitution Ratio
Input substitution ratio =
amount of input replaced amount of input added
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Input Price Ratio
Input price ratio =
price of input being added price of input being replaced
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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.
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Table 8-1 Selecting a Least-Cost Feed Ration
Input InputFeed Grain Hay Substitution Price ration (lbs) (lbs) Ratio Ratio
A 825 1350B 900 1130 2.93 1.47C 975 935 2.60 1.47D 1050 770 2.20 1.47E 1125 625 1.93 1.47F 1200 525 1.33 1.47G 1275 445 1.07 1.47
grain at 4.4¢ and hay at 3.0¢
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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.
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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.
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Enterprise Relationships
The first step in determining theprofit-maximizing combination ofenterprises is to determine thephysical relationship among theenterprises.
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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
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Competitive Enterprises
Competitive enterprises may haveconstant substitution or increasingsubstitution.
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Figure 8-2 Production Possibility Curves
for Competitive Enterprises
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Figure 8-3 Supplementary & complementary
enterprise relationships
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Output Substitution Ratio
Output Substitution Ratio =
quantity of output lostquantity of output gained
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Output Price Ratio
Output Price Ratio =
price of output gained price of output lost
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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.
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Table 8-2 Profit-Maximizing Enterprise Combination
Output OutputCombination Corn Wheat substitution pricenumber (bu) (bu) ratio ratio
1 0 6,0002 2,000 5,600 0.20 0.703 4,000 5,000 0.30 0.704 6,000 4,100 0.45 0.705 8,000 3,000 0.55 0.706 10,000 1,700 0.65 0.707 12,000 0 0.85 0.70
corn at $2.80/bu, wheat at $4.00/bu
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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.