Economics of Production

Introduction

• Today we will discuss how input-output input-output relationshipsrelationships are necessary to understanding problems with resource allocationresource allocation.

• Advances in technology change aquaculture production constantly.

• No product is produced with a single inputNo product is produced with a single input

Production Economics

• Economics of production 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

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?

Production Economics:complexitycomplexity

• Crops grow seasonally and are affected by numerous inputs

• Some inputs we control, others are random random e.g., hurricanes!!)

• TimeTime is also important (e.g. differences in production cycles)

• Can we cope?

Economics and Production: ComplexityComplexity

• All the variables you manipulate (i.e. rates of fertilizer, stocking densities, feed, feed ingredient level, aeration, etc.) affect your response (yieldyield)

• 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.

Production Theory: Classification of InputsClassification of Inputs

• Manager has control over variable inputsvariable inputs such as rate of fertilization, feed rate, etc.

• What we don’t control is called fixed inputfixed input:, unchanging during length of trial (harvesting pump; feed silos, vehicles, land)

• Random inputsRandom inputs: associated with nature or economics beyond that of the farm

• All this results in unique growing seasons.

Production Theory: Assumptions that make it workAssumptions 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 certaintyperfect 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

Production Theory AssumptionsAssumptions

• Assumpitons are used to simplify the analysissimplify the analysis to a point where a reasonable starting point can be identified, not to discount real world events.

• ExampleExample: 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

Goals of Production Economics

1)1) assist farm managers in determining the best use of assist farm managers in determining the best use of resourcesresources, given changing needs, values and goals of society

2)2) assist policy makersassist policy makers in determining the consequences of alternative public policies on output, profits, and use of resources on the farm

3) evaluate the uses of the theory of the firm for improving farm managementfarm management and understanding the behavior of the farm as a profit-maximizing entity

Goals of Production Economics (continued)

4) evaluate the effects of technical and institutional changes on aquaculture production and resource use

5) determine individual farm and aggregated regional farm adjustments to output supply and resource use to changes in economic variables in the economy

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:

1) concept of the production function

2) average and marginal physical product

3) various stages of production

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

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 X’s 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

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

• let’s look at an example

Empirical Example

Fertilizer Yield0 lbs/ha 0 lbs20 3740 13960 28880 469100 667120 864140 1045160 1195180 1296200 1333

220 1291

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Tabular form Graphical form

TPP curve

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

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 don’t typically use these functions, as such, they have mental pictures of what would happen, based on experience

More detail on the Classical Production Function

Other characteristics of production function curves:

1) the production function is a continuous curve

2) inputs and outputs are perfectly divisible (otherwise, it would look like a series of dots)

3) inputs and outputs are homogenous (prices of product at one level of input are similar to others)

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Total physical product (TPP) Curve

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 year’s function (perfect certainty)

• thus, the production function is a planning device

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

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

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 you’re evaluating ) are fixed

• reasons for fixing a variable1) maybe the amount used is just the right amount,

any more or less would lower profits2) maybe the production time period is too short to

change the amount of resource on hand (e.g., land)

3) 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)

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

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

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

Production Efficiency

Input (X) Output (Y) APP (X/Y) 0 0 -

20 37 1.9 40 139 3.5 60 288 4.8 80 469 5.9 100 667 6.7 120 864 7.2 140 1045 7.5 160 1195 7.5 180 1296 7.2 200 1333 6.7 220 1291 5.9

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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APP curveTPP curve

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

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

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

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 doesn’t make sense to stop increasing input if its efficiency is increasing

• 2) even if inputs are free, you don’t 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

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

3,000 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?

Next Time: Supply and Demand Relationships (Seperich et al., 1994)