Economics of Production

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Economics of Production
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Introduction

• Today we will discuss how input-output
  relationships are necessary to understanding
  problems with resource allocation.
• Advances in technology change aquaculture
  production constantly.
• No product is produced with a single input

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Production Economics

• Economics of production is really microeconomics
  applied to aquaculture in our case.
• Studying production principles should clarify
  issues such as costs, output response to input,
  and the use of resources to maximize
  profit/minimize costs
• A multi-disciplinary approach is necessary to
  truly appreciate production economics.
• Developed from agronomists considering more than
  the biology of production

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Production Economics Questions

• What is efficient production?
• How do we determine the most
• profitable amount of input?
• How will change in output price influence
  production?
• How do we maximize farm profits through
  utilization of different enterprises?
• How much should you pay for a pump?
• Is technology beneficial to production output?

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Production Economicscomplexity

• Crops grow seasonally and are affected by
  numerous inputs
• Some inputs we control, others are random e.g.,
  hurricanes!!)
• Time is also important (e.g. differences in
  production cycles)
• Can we cope?

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Economics and Production Complexity

• All the variables you manipulate (i.e. rates of
  fertilizer, stocking densities, feed, feed
  ingredient level, aeration, etc.) affect your
  response (yield)
• When we compile multiple years of data from these
  changes, we can predict the response in a similar
  vein to what economist do.
• However, aquaculture research and production
  lives in the here and now, economists are not
  experimental and use only existing data
• Key difference economists manipulate nothing.
  They simply look at what conditions were in
  effect when a previous production cycle occurred.
  

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Production Theory Classification of Inputs

• Manager has control over variable inputs such as
  rate of fertilization, feed rate, etc.
• What we dont control is called fixed input,
  unchanging during length of trial (harvesting
  pump feed silos, vehicles, land)
• Random inputs associated with nature or
  economics beyond that of the farm
• All this results in unique growing seasons.

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Production Theory Assumptions that make it work

1. Factors are continuous for entire production
   cycle (e.g., level of technology, land ownership,
   govt. programs)
2. Production curve is smooth, well-behaved (e.g.,
   fertilizer, labor is a bad ex.)
3. The manager has perfect insight (perfect
   certainty).
4. No time discounting of production, or discount
   in price for early payment of a bill (removes
   time element from consideration)
5. Manager is motivated by profits and optimization

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Production Theory Assumptions

• Assumpitons are used to simplify the analysis to
  a point where a reasonable starting point can be
  identified, not to discount real world events.
• Example following one experiment, to work with
  a wider stocking density, over more years
• After the elementary theory has been developed,
  each additional source of complexity can be
  evaluated

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Goals of Production Economics

• assist farm managers in determining the best use
  of resources, given changing needs, values and
  goals of society
• assist policy makers in determining the
  consequences of alternative public policies on
  output, profits, and use of resources on the farm
• evaluate the uses of the theory of the firm for
  improving farm management and understanding the
  behavior of the farm as a profit-maximizing
  entity

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Goals of Production Economics (continued)

1. evaluate the effects of technical and
   institutional changes on aquaculture production
   and resource use
2. determine individual farm and aggregated regional
   farm adjustments to output supply and resource
   use to changes in economic variables in the
   economy

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How it works

• The effect of a single input on output can be
  determined if only that input is varied and all
  others are held constant.
• Involves
• concept of the production function
• average and marginal physical product
• various stages of production

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Concept of a Production Function

• The production function represents an
  input-output relationship
• describes the rate at which resources are
  transformed into products
• relationships vary animal variety, soil types,
  water quality, technologies, El Niño
• any given input-output relationship specifies the
  quantities and qualities of resources needed to
  produce a particular product

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The Production Function

• The function can be expressed in many ways
  written form, tabular, graphical
• written form Y f(X1, X2, X3,, Xn)
• Y output or yield, the Xs are different inputs
  that take part in the production of Y
• examples yield is a function of stocking
  density, feed rate
• Note this written equation/form does not
  specify the importance or contribution of inputs
  to the production process

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The Production Function

• The production function can also be shown in
  either tabular or graphical form
• Usually picks one variable input and studies the
  effect on yield
• Yield is also referred to as total physical
  product or TPP
• Keeps all other variable inputs fixed as well
  as traditional fixed inputs
• lets look at an example

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Empirical Example

• Fertilizer Yield
• 0 lbs/ha 0 lbs
• 20 37
• 40 139
• 60 288
• 80 469
• 100 667
• 120 864
• 140 1045
• 160 1195
• 180 1296
• 200 1333
• 220 1291

TPP curve
Tabular form
Graphical form
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Empirical Example

• Data in the previous table/figure represent a
  production function relating shrimp yields to
  applied fertilizer
• units of fertilizer (e.g., nitrogen and
  phosphate) represent the variable input, while
  all other inputs needed to produce shrimp (seed,
  labor, fuel, land) are the fixed inputs
• But hey, I thought fuel, seed, etc. were variable
  inputs! Typically, yes, but in this case they
  remain constant
• As shown, large increases in yield result from
  initial fertilizer applications

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Empirical Example

• However, yield increases become smaller at higher
  levels of application
• A max of 1,330 lbs/ha was achieved with 200 lbs
  of fertilizer, afterwards declining
• Zero yield with zero input, in reality, is
  uncommon however, due to infertility of incoming
  water, soil, etc.
• Note Although farmers dont typically use these
  functions, as such, they have mental pictures of
  what would happen, based on experience

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More detail on the Classical Production Function

• Other characteristics of production function
  curves
• the production function is a continuous curve
• inputs and outputs are perfectly divisible
  (otherwise, it would look like a series of dots)
• inputs and outputs are homogenous (prices of
  product at one level of input are similar to
  others)

Total physical product (TPP) Curve
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Production Assumptions (1) Perfect Certainty

• To use the production function, economists,
  farmers, etc. must agree upon the outcome (yield)
  for each unit of input
• past results (e.g. shrimp yields in response to
  fertilizer) must at least approximate this years
  function (perfect certainty)
• thus, the production function is a planning device

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Perfect Certainty

• Knowing how inputs will perform is difficult year
  to year in new industries such as aquaculture
• It helps if you are reasonably sure and on top of
  results
• This is one of the big differences between
  standard agriculture and aquaculture
• In aquaculture, no two sites are the same
  inputs often function differently from one site
  to the next
• Reality care must be given to select the
  appropriate production function
• select the right one or suffer the consequences

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Production Assumption 2 level of technology

• If you produce, it is assumed that you do it via
  a certain methodology or process
• unfortunately, a product can be produced in many
  ways
• we normally assume in production economics that
  the manager uses the most up-to-date technology
• Translation we assume the farmer uses the
  process that yields the most output from a given
  amount of input

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Production Assumption 3 length of time period

• The production function shows output at various
  levels of input over a specific length of time
• As a result, all inputs (except the one youre
  evaluating ) are fixed
• reasons for fixing a variable
• maybe the amount used is just the right amount,
  any more or less would lower profits
• maybe the production time period is too short to
  change the amount of resource on hand (e.g.,
  land)
• the farmer just may not want to change the amount
  of resource (e.g., not changing the number of
  dairy cattle in order to evaluate a feed effect)

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How to Work with the Production Function

• There are several classical production functions
  for various agricultural situations
• a discussion of all the production functions that
  now exist in agriculture would involve more space
  than any book could provide
• Problem few are reported for aquaculture
• it would be impossible to record them all as they
  happen
• we are simply trying to gain a better
  understanding of input-output relations
• the following are general guidelines and
  indications useful to farm managers

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Three Stages of Production

• The classical production function can be divided
  into three stages
• First Stage the average rate at which variable
  input (X) is transformed into product (Y)
  increases until it reaches its maximum (i.e., Y/X
  is at its maximum)
• this maximum indicates the end of Stage 1

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Production Stage 1

• Stage 1 deals with increasing bang for your buck
  or the phase of increasing production efficiency
• production efficiency is not just the maximum
  production level
• This efficiency is known as average physical
  product, APP and is determined by dividing yield
  by its corresponding amount of input (Y/X)
• Stage 1 ends where Y/X is largest, around 150 lbs
  input

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Production Efficiency
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Three Stages of Production

• Stage 2 physical efficiency of the variable
  input is at a peak at the beginning of Stage 2
• Stage 2 ends when yield (APP) is at its maximum
• Bottom line maximum efficiciency does not equal
  maximum production

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II
III
APP curve
TPP curve
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Three Stages of Production

• Stage 3 starts once TPP starts to decline
• result of excessive quantities of variable input
  combined with fixed inputs
• in order for all this to make sense, we need to
  understand that production functions are used to
  determine the most profitable amount of variable
  input and output
• the production function allows you to make
  recommendations about input use even when
  input/output prices are unknown

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What this Describes Law of Diminishing Returns

• Originally developed by early economists to
  describe the relationship between output and a
  variable input, when other inputs are constant
• if increasing the amount of one input is added to
  a production process while all others are
  constant, additional output will eventually
  decrease
• implies there is a right level of variable
  input to use with the combination of fixed inputs

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Law of Diminishing Returns

• Requires that the method of production does not
  change as variable input changes
• does not apply when all inputs are varied
• when the LDR is applied to production you get the
  classical production function
• increasing marginal returns at first and
  decreasing marginal returns afterwards
• it is possible that marginal returns could
  decrease in the beginning with the first
  application of the variable input

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Economic Recommendations

• 1) using logic you can see that if your
  production follows that of the example given, you
  should increase inputs to achieve a production
  level at least until Stage 2 is reached
• it doesnt make sense to stop increasing input if
  its efficiency is increasing
• 2) even if inputs are free, you dont want to be
  in Stage 3
• the largest amount of input you would use is that
  at the end of Stage 2
• the area of economic relevance is within Stage 2
  for firms that buy and sell in competitive
  markets
• fine tuning comes from knowing prices

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Homework 3 due next time
1) Develop a production curve using the following
data Stocking (fry/ac) Harvest Biomass
(lb/ha) 0 0 1,000 185 2,000 695 3,00
0 1,440 4,000 2,345 5,000 3,335 6,000
4,320 7,000 5,225 8,000 5,975 9,000
6,480 10,000 6,665 11,000 6455 2) At what
level of input would Stage 2 start?
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Next Time Supply and Demand Relationships
(Seperich et al., 1994)