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Selected Economic Concepts

This page addresses several selected economic concepts that a manager can use in analyzing a business. Application of these economic concepts require production information that is internal to business or from reliable/objective external sources.

Diminishing marginal productivity

• Business managers often wonder whether changing their business operation would increase profit; an objective that is consistent with the common business goal of earning a profit. The answer to this simple question, however, may not be obvious. It is not always clear whether " working more hours," "trying to process more material each day," or "applying more fertilizer" will increase profit. Part of the uncertainty in answering such questions is due to the natural phenomenom of diminishing marginal productivity. This section and supporting pages discuss diminishing margianl productivity and numerous related economic concepts.

• Production response (production function) -- illustrates the relationship between different amounts of inputs that can be used to produce a product and the corresponding output or yield of the product. This is a critical first consideration; that is, "how much will the quantity of output change if the quantity of input is changed."
  • "There is more than one recipe for baking a chocolate cake." Likewise, there is more than one combination of inputs for producing a product (such as raising corn); the manager's challenge is to identify the combination of inputs that works best for the manager's business; that is, generates the most profit.
  • Business managers can rely on published information in developing an understanding of the relationship between quantity of inputs and quantity of output, but the recommended approach is that the manager observe and document their own business operation.
  • How does GPS technology relate to the concept of production response? Will this technology allow crop producers develop a better understanding of the relationships between the inputs they use and the output they produce?
• The concept of diminishing marginal productivity assumes the "short-term" which implies there will be fixed and variable inputs, and fixed and variable costs.
  • What is the implication of fixed inputs and fixed costs?
• Diminishing marginal productivity also relates to the economic concepts of marginal productivity; marginal cost and marginal revenue; and profit maximization.
• Diminishing marginal productivity also illustrates that maximum profit seldom aligns with maximum production.
  • Do managers generally strive for maximum production or maximum profit?

• Resource: Kay, et al. Farm Management , McGraw Hill, 5th Ed. 2004, chapters 7 and 9.

• Production theory is based on the assumption that business managers strive to make decisions to maximize profit (TR -TC).
• A business can increase profit by increasing revenue (TPP * Py) and/or reducing cost (TFC + (X * Px)).
• Assuming that the business is in a competitive market and therefore cannot alter the market price for the output (Py) or inputs (Px), the primary way to increase revenue is to increase production (TPP) and the primary way to reduce cost is to reduce the quantity of input (X).
• Other than a change in technology, reducing input will reduce output, and an increase in input is assumed to increase output.
• However, diminishing marginal productivity describes the reality that increased input will not always increase production, especially if there is not enough time to increase the level of all inputs (i.e., the short run).

• Thus, a manager will increase use of input as long as the revenue from the increased production due to the additional input (VMP) is greater than the cost of the additional input (MIC). Restated, a manager will increase production as long as the revenue from the last unit of output (MR) is greater than the added cost of producing that last unit of output (MC).
• The manager has maximized profit when production has reached the level of production where the cost of the additional input equals the revenue generated by using the additional input (VMP = MIC and MR = MC).

• The price a manager is willing to pay for an input is the value of the product that the input produces (VMP is the business' derived demand for X).
• A manager is willing to produce and sell a product as long as the price of the product is equal to or greater than the added cost of producing that product (MC is the business' supply of Y).
• Likewise, a manger will continue operating the business even though it is incurring a loss as long as the loss incurred by operating is less than the loss that would be incurred if the business quit operating (TR > TVC).
• An advance in production technology will cause the business to increase output even though the price of the output has not increased.
• An increase in the price of the output also will cause the business to increase output; but the price increase for the output also may lead to an increase in the cost of inputs, especially if the input supplier faces imperfect competition. Restated, increased costs will take away from an anticipated increase in profit following an increase in the price of the output.

• In a business where the manager can use two different inputs to produce the output, the manager will use the combination of inputs where the ratio of the productivity of the first input relative to the cost of the first input equals the ratio of the productivity of the second input relative to the cost of the second input (MPx1/Px1 = MPx2/Px2).

• In a business where the manager can produce two different products from the same input, the manager will produce the combination of products where "the value of each product produced by the last unit of input applied [is equal] for all products using the ... input" (VMPy1 = VMPy2).

Sources of data

Use your own information.  What type of information is needed?  What information is needed to complete an enterprise budget, for example?   Where do you get that information?  How do you gather that information for your own business?

• What will be the cost and time commitment of gathering information about your business? What will be the benefit of having detailed information about your business?
  • There may be no need to keep track of when a flat tire occurs on the farm, but a food business probably needs to track the time in operating a processing plant so if a problem arises the manager knows what food was processed at the time the problem arose, in case that food needs to be kept off the market.

 

• Business Inventory – Step 1 of Strategic Planning Revisited

  Developing an enterprise analysis or understanding the relationship between inputs and output takes time.  This is an appropriate time to revisit step1 of the strategic planning process introduced previously.  That step suggests that business managers "inventory their business."  Now is an appropriate time to explicitly recognize that developing a business inventory is more than preparing a balance sheet. 

  A business inventory should describe all five categories of economic resources provided by the business owners and outside suppliers; not just the several categories of resources that are listed on a balance sheet.  The inventory also should describe how the business is operated – which enterprises comprise the business and what is the revenue and costs associated with each enterprise.  Likewise, current practices need to be considered, such as marketing, financing, research/development, and the list goes on.   This is a good time to review Business Inventory (step 1) and documenting Functional Plans (step 5).

  Bottom line – a business inventory is much more than preparing a balance sheet.  Developing enterprise analysis and production relationships are part of completing the “business inventory” step of strategic planning.  Professional farm managers state that it takes as much as three years to develop a complete inventory.

• Some questions to stimulate your thinking:
  • Prepare 1 or 2 sentences to describe the enterprise.
  • Summarize the operations/activities (e.g., production practices) involved in this enterprise.
  • What are the labor needs of this enterprise [type of skills, quantity of labor needed, timing of labor needs]?
  • What management skills are needed for this enterprise (supervisory, financial, negotiator, marketer, purchaser, production)?   When are these skills needed?
  • What are the equipment needs for this enterprise?  When is the equipment needed?  This reflects production practices and operations/activities involved in the enterprise.
  • What are the building needs for this enterprise?  When are the buildings needed?
  • What are the land needs for this enterprise?  When is the land needed?
  • What amount of cash needed for this enterprise and when it is needed?
  • Does this enterprise involve a government program?  If yes, briefly describe the involvement.
  • What is the risk exposure from operating this enterprise?
  • Prepare 1 or 2 sentences to describe marketing practices for this enterprise.
    • Are opportunities for this enterprise changing as a result of evolving practices of buyers, such as wanting/demanding that production practices are GAP compliant?
  • Consider new opportunities, such as new marketing opportunities, or opportunity to adopt or develop new technology.
  • Identify the regulations that impact the enterprise, such as environmental rules.

 

• Published sources; for example, NDSU Extension Service Farm Management Planning Guides and 2006 Planning Prices for ND; Iowa State U. Extension Service 2006 Iowa Crop Production Cost Budgets and Livestock Enterprise Budgets; University of Illinois 2004 Crop Enterprise Budgets.

• Some thoughts on Testing the Profitability of Making a Change

• Any thoughts on Testing the Feasibility (cash flow implications ) of Making a Change?

Which analytical tool or managerial concept should be used for which management decision?

The following list suggests some common managerial questions; the second list identifies several “tools” a manager might use in developing responses to the questions.  Review both lists. Which tool(s) from the second list might be used to develop information to help answer each of the questions posed in the first list?

Remember, it is the responsibility of the manager not only to identify the questions that need to be answered in order to make a decision, but also to identify and use the appropriate analytical/managerial “tool.”

Management Questions (List 1)

Did the business generate a profit in the past?
Did the business generate an adequate profit in the past?

• Is the business providing adequate return for the owner’s economic resources?
• Is the rate of return on assets and rate of return on equity adequate?

Is the business increasing its net worth?
When did the cash flow in and out of the business this past period?

Is the business likely to generate a profit in the future?
Is the business likely to be able to pay its bills on time in the future?
What is the business’ capacity or ability to assume risk?
Is the business likely to increase its equity in the future?

Did this segment of the business generate a profit?

• How much did it cost to produce the product?  What is the minimum price at which to sell the product to cover explicit costs?  What is the minimum price at which to sell the product to cover both explicit and implicit costs?
• How is the product being produced?
• How would changing the level of input impact the level of output?

Is this segment of the business likely to generate a profit?

• How is one activity (enterprise) likely to impact another activity (enterprise)?
• How should cost of resources be allocated among the business’ enterprises and production periods?

Should the manager change the level of input to increase profit?
Should the manager change the type of input to increase profit?
Should the manager change the product being produced to increase profit?

• Would adopting a different production practice increase profit?
• Would adopting technology increase profit?
• Would a change in the business increase profit?
• Would “taking on new expenses” increase profit?
• Would eliminating some expenses increase profit?
• Would “a more effective use of risk” increase profit?

How is uncertainty incorporated into deciding whether to change the business practices?

Would generating revenue now or generating revenue in the future best fulfill the owner’s goals?

• Would the business increase profit and achieve other goals by owning the resource or relying on an outside supplier?
• Would an investment at this time increase the business’ future profit and help achieve other goals?

Analytical Tools and Managerial Concepts (List 2)

• Income statement
• Balance sheet
• Cash flow statement and budget

• Enterprise analysis
• Partial budget analysis

• Marginal cost and marginal revenue
• Marginal input cost and marginal value product
• Marginal rate of substitution and inverse input price ratio
• Marginal physical product and inverse product price ratio

• Opportunity cost
• Depreciation
• Time value of money

Decision Making and Strategic Planning -- Revisited

This is an appropriate time to review the decision making processes previously discussed, especially the step of "analyze the alternatives."

It also is appropriate to revisit the strategic planning process previously introduced. Note how preparing financial statements and enterprise analyses that report past activities is part of the "business inventory" (step 1). Also, note how projecting future profit for enterprises, future profit for the whole business, and future cash flow are components of "testing the current operation" (step 5). Likewise, note how analyzing alternatives contributes to step 6 in the planning process: "identifying and testing alternatives."

Botton line -- recognize how the analytical tools and managerial concepts listed above are used in strategic planning and decision making.

Summary of Key Points

This web page addressed several critical management topics.

• Diminishing marginal productivity describes that there is a limit to how much a business can increase its production during a period of time by adding only some inputs, but not other inputs.
• Enterprise analysis allows the manager to understand individual components of the business.
• Partial budget analysis allows the manager to identify the impact a proposed change will have on the business profit.
• Time value of money helps managers recognize that the timing of a financial transaction impacts its value; that is, transactions further into the future have less value than transaction that occur sooner.

The next section is an opportunity to consider the current status of the agriculture industry.

Last Updated August 15, 2010

Email: David.Saxowsky@ndsu.edu

This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.

E-Mail:sswandal@ndsuext.nodak.edu
Published by Agricusiness and Applied Economics
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