Lecture 12 economic principles applicable to farm management
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The document discusses the application of economic principles in farm management, emphasizing the need for judicious decision-making to maximize profits sustainably. Key principles include the law of diminishing marginal returns, factor and product substitution, and the equi-marginal return principle, which guide resource allocation and investment choices. Additionally, it covers concepts such as opportunity cost, minimum loss, comparative advantage, and the time comparison principle, all crucial for effective farm management.
Lecture 12 economic principles applicable to farm management
- 1. Lecture 12: Economic Principles Applied in Farm Management
- 2. Farm Management • Farm management can be defined as a science dealing with judicious decisions on the use of scarce farm resources, having alternative uses to obtain the maximum profit on sustainable basis. • Or, organization and operation of farms with a view to make continuous profits. • But - how to make farm management actually work? 2
- 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 3
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- 5. 1. Law of Diminishing Marginal Returns (LDMR) • Definition: If the quantity of one input is increased, keeping other inputs constant, then total output first increases at increasing rate and then increases at decreasing rate and finally starts to decline. • Fundamental Economic Law / Law of Variable Proportions. • Why in agriculture? • How much input to use? • How much output to produce? • Define: (i) MC; (ii) MP; (iii) MVP; and (iv) MR • Profit Rule ??? 5
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- 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 7
- 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 9
- 10. 10 Principle of Product Substitution
- 11. 11 Principle of Product Substitution
- 12. 4. Law of equi-marginal return • The law of equi marginal utility was presented in 19th century by an Australian economist named H. H. Gossen. • It is also known as law of maximum satisfaction or law of substitution or Gossen's second law. • 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. • In other words, the farmer can get maximum utility by allocating the resource (e.g. money) in such a way that last rupee spent on each item provides the same marginal utility. 12
- 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. 13
- 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. 14
- 15. Example: • Suppose, farmer is having Rs.50,000 for investing in a viable enterprise. His locality is favourable to take up crop enterprise, dairy enterprise and poultry enterprise. 15
- 16. Marginal returns to the capital 16
- 17. Expenditure according to principle of equi-marginal return 17
- 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. 18
- 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. 20 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. 21
- 22. 5. Principle of Opportunity Cost • Closely related to the equi-marginal principle • The income or returns from the next best alternative that 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. 22
- 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. 24
- 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. 25
- 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 • Statement of the principle: Individuals or regions will tend to specialize in the production of those commodities for which their resource realize a better relative or comparative advantage. 27
- 28. Illustration of Comparative Advantage 28 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. 29
- 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. 30
- 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. 31
- 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 32
- 33. Growth of a cash outlay over time: • Compounding: Compounding is the procedure to find the future value of present money, given the earning power (interest rate) of money & the frequency of compounding. 1st year 100 @10 % 100+10 110 2nd year 110 @ 10 % 110+11 121 3rd year 121 @ 10 % 121+12.10 133.1 4th year 133.10 @ 10 % 133.10 + 13.31 146.41 For e.g. Find the future value of Rs. 100 after 4 years at an interest rate of 10 % 33
- 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. 34
- 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. 35
- 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 36