Economic Principles

1
Economic Principles

• Choosing
• Production Levels
• (Chapter 7)

2
Objectives

• Explain the concept of marginalism.
• Show the relationship between a variable input
  and an output using the production function.
• Describe how to calculate APP and MPP.
• Illustrate the law of diminishing marginal
  returns.
• Show how to find the profit maximizing amount of
  a variable input to use.
• Show how to find the profit maximizing amount of
  output to produce.
• Explain the equal marginal principal for
  allocating limited resources.

3
What good is economics?

• Provides a set of principles, procedures, and
  rules for decision making.
• Provides guidelines for processing data into
  useful information and for analyzing
  alternatives.
• Economic principles focus the decision toward
  ideas that maximum profit.

4
Using Economic Rules to Make Decisions

• Three Steps
• Acquire physical and biological data and process
  it into useful information.
• Acquire price data and process it into useful
  information.
• Apply the appropriate economic decision-making
  rule to maximize profit.

5
Marginalism

• Marginal Incremental changes (increases or
  decreases) that occur on the edge or on the
  margin.
• Substitute Extra or Additional
• Any marginal change being measured is a result of
  a change in some other factor.
• This incremental change is likely not constant.
• ? change in

6
How much of a variable input should you use?
7
The Profit Maximization Rule



Profit
Maximization Rule Maximum profits will be
realized where production is maximized.

• NOT!
• Management Myth 1

8
The Production Function

• Shows the amount of output that would be produced
  by using different amounts of an input.
• Table
• Graph
• Mathematical Equation

9
The Production FunctionTable
10
The Production FunctionGraph
11
The Production FunctionMathematical Equation

• Y X2 - .03X3
• Y Bushels of corn
• X Pounds of nitrogen

12
Total Physical Product (TPP)

• Output
• Yield
• The amount of production expected at each input
  level.
• Often represented by Y.

13
Variable Input

• What is put into the production process.
• Easiest is where there is only one input.
• Often represented by X.

14
Average Physical Product (APP)

• The average amount of physical output produced
  for each unit of input used
• APP Total Physical Product
• Input level (X)
• TPP Input level (X)

15
Marginal Physical Product (MPP)

• The additional output produced by using an
  additional unit of input
• MPP ? Total Physical Product
• ? Input level
• ? TPP ? Input level

16
TODAYS DETAILS(8/31/07)

• Thru Chap. 7 today?
• Chap. 7 notes posted.
• Post chap. 8 notes this afternoon.
• Chaps 7, 8, and 9 deal with production
  decisions.
• Questions, issues, or comments on production
  decisions so far?
• Any issues about labs, see me.

17
The Production FunctionTable
18
The Law of Diminishing Marginal Returns

• As additional units of a variable input are
  used, marginal physical product will eventually
  begin to decline.
• Three considerations
• Must be at least one fixed input.
• Diminishing marginal returns may begin with the
  first unit of variable input.
• This law is based on biological processes.

19
The Production Function
20
3 Stages of the Production Function

• Stage 1
• adding another unit of input increases the
  productivity of all previous inputs.
• APP is increasing.
• Stage 3 is irrational
• Additional input causes TPP to decrease and MPP
  to be negative.
• Stage 2 is the logical area of production!

21
Q How do you find the profit maximizing input
level in Stage 2?Q How much input should you
use?

• A ______________

22
The Production FunctionTable
23
Marginal Value Product (MVP)

• Marginal Value Product (MVP) the
• additional income received from using an
• additional unit of input.
• MVP ? Total value Product
• ? Input level
• MVP MPP x Output price

24
Marginal Input Cost (MIC)

• Marginal Input Cost (MIC) the addition to total
  input cost caused by using an additional unit of
  input.
• MIC ? Total input cost
• ? Input level
• ? Total input cost ? Input level
• MIC is usually constant for all levels of input.

25
MVP, MIC, and theOptimal Input Level
26
The Profit Maximizing Input LevelDecision Rule

• Marginal value product Marginal input cost
• MVP MIC
• When MVP gt MIC, more profit can be made by using
  more input.
• When MVP lt MIC, more profit can be made by using
  less input.

27
The Decision Rule in a Different View

• MVP MPP x Po
• MIC Pi
• Substitute these for MVP and MIC
• MVP MIC
• MPP x Po Pi
• MPP Pi
• Po
• At the profit maximizing level
• MPP the ratio of the input and output
  prices.

28
How much should you produce?
29
Q How do you find the profit maximizing output
level?Q How much output should you produce?

• A ___________________

30
Marginal Revenue(MR)

• Marginal Revenue the change in income received
  from selling one more unit of output.
• MR ? Total revenue
• ? Total physical product
• ? Total revenue ? TPP

31
Marginal Cost(MC)

• Marginal Cost the change in cost incurred from
  producing another unit of output.
• MC ? Total input cost
• ? Total physical product
• ? Total input cost ? TPP

32
MR, MC, and Optimal Output Level
33
The Profit Maximizing Output LevelDecision Rule

• Marginal revenue Marginal cost
• MR MC
• When MR gt MC, more profit can be made by
  producing more output.
• When MR lt MC, more profit can be made by
  producing less output.

34
Which Rule Should Be Used?

• To find the profit maximizing input level, use
  MVP MIC or MPP Price ratio
• To find the profit maximizing output level, use
  MR MC.
• Always use MVP with MIC and MR with MC.
• Both rules give same profit maximizing solution.

35
What Happens When Prices Change?

• A decrease in the input price or an increase in
  the output price
• gtincreases the profit-maximizing input and
  output levels.

• An increase in the input price or a decrease in
  the output price
• gtlowers the profit-maximizing input and output
  levels.

36
What if there is a limited amount of an input?
37
Allocating Limited Resources

• Fertilizer - among many acres, fields, and
  different crops.
• Irrigation water - between fields and crops.
• Feed between different types of livestock.
• Capital among fertilizer, water, feed, and
  other purchased inputs.
• Prevents you from reaching MVP MIC.
• You have to decide how the limited input will be
  divided among several alternatives.

38
The Equal Marginal Principal

• Equal Marginal Principal A limited input
  should be allocated among alternative uses in
  such a way that the marginal value products
  (MVPs) of the last unit used on each alternative
  are equal.

39
The Equal Marginal Principle

• Example
• Allocate irrigation water between three crops.
• 100 acres Wheat
• 100 acres Sorghum
• 100 acres Cotton
• Maximum of 2,400 acre-inches of water.
• Apply only in increments of 4 acre-inches.

40
The Equal Marginal Principal
41
The Equal Marginal Principal
42
The Equal Marginal Principal

• What if it isnt possible to exactly equate the
  MVPs of the last units applied to all
  alternatives?
• The MVP of the last unit allocated should always
  be equal to or greater than the MVP available
  from any other alternative use.

43
The Equal Marginal Principal

• Be careful not to use an input that is past the
  point where MVP MIC.
• The result would be less than the maximum
  profit.

44
The Equal Marginal Principal

• Prevents making the mistake of maximizing profit
  in one enterprise by using the input until MVP
  MIC, and then not having enough to use on other
  enterprises.
• Maximizing profit from the total business
  requires the proper allocation of limited inputs,
  which will not necessarily result in maximizing
  profit from any single enterprise.

45
Summary

• Economic principles provide useful guidelines for
  deciding how much to produce, how to produce, and
  what to produce.
• The production function describes the
  relationship between input levels and output
  levels.
• To find the proper input level, MVP MIC.
• To find the proper output level, MR MC.
• When you have a limited amount of input and
  several alternative uses, use the equal marginal
  principle to maximize profit.

46
Summary

• As a manager you will rarely have enough
  information to fully use these economic
  principles.
• The principles are still important, but there is
  usually insufficient physical and biological
  data.
• Prices have to be estimated which adds more
  uncertainty.
• A sound understanding of these economic
  principles will help you make changes in the
  right direction.