INTRODUCTION TO FARM MANAGEMENT

Farm business management has assumed greater importance not only in

developed and commercial agriculture all round the world but also in developing
and subsistence type of agriculture. A farm manager must not only understand
different methods of agricultural production, but also he must be concerned with
their costs and returns. He must know how to allocate scarce productive
resources on the farm business to meet his goals and at the same time react to
economic forces that arise from both within and outside the farm.

The need for managing an individual farm arises due to the following
reasons:

i) Farmers have the twin objectives, viz., maximization of farm profit and
improvement of standard of living of their families.

ii) The means available to achieve the objectives, i.e., the factors of production,
are scarce in supply.

iii) The farm profit is influenced by biological, technological, social, economic,

political and institutional factors.

iv) The resources or factors of production can be put to alternative uses.

Farm management is concerned with resource allocation. On one hand, a

farmer has a set of farm resources such as land, labour, farm buildings, working
capital, farm equipments, etc. that are relatively scarce. On the other hand, the
farmer has a set of goals or objectives to achieve may be maximum family
satisfaction through increasing net farm income and employment generation. In
between these two ends, the farmer himself is with a specific degree of ability
and awareness. This gap is bridged by taking a series of rational decisions in
respect of farm resources having alternative uses and opportunities.

The study of farm management would be useful to impart knowledge and

skill for optimizing the resource use and maximizing the profit. The following
definitions would throw light on the meaning of farm management:

A. DEFINITIONS

Farm means a piece of land where crop and livestock enterprises are taken up
under a common management and has specific boundaries. All farm management

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economists can be categorized into three groups on the basis of whether they
consider farm management as an art, science or business.

The first group of farm management economists comprising of Andrew Boss,

H.C.Taylor and L.C. Gray viewed farm management as “an art of organization
and operation of the farm successfully as measured by the test of profitableness”.

The second group comprising of G.F. Warner and J.N. Effersen considered
farm management “as a science of organization and operation of the farm
enterprises for the purpose of securing the maximum profit on a continuous
basis”.

The third group of economists like L.A. Moorehouse and W.J. Spillman
defined farm management “as a study of the business phase of farming”.

The most acceptable definition of farm management is given below:

Farm Management is a science that deals with the organization and operation
of a farm as a firm from the point of view of continuous maximum profit
consistent with the family welfare of the farmer. Thus, in an environment where
a farmer desires to achieve objectives like profit maximization and improvement
of family standard of living with a limited stock of factors of production which
can be put to alternative uses, farm management in an essential tool.

B. FARM MANAGEMENT DECISIONS

Farmers must be able to take appropriate decisions at appropriate time.

Incorrect judgement and decisions would result in the failure of execution of
farm plan and in turn economic loss. The farm management decisions can be
broadly categorized into two ways.

i) The first method of classifications is according to the following criteria: a)

Importance, b) Frequency, c) Imminence, d) Revocability and e) Alternatives
available. Each of the above criteria is discussed briefly.

a) Importance: Farm management decisions vary as to the degree of importance

measured generally through the magnitude of profit or loss involved. For
example, a decision to engage in poultry is relatively more important than a
decision regarding the type and location of poultry shed.

b) Frequency: Many decisions assume importance on the farm because of their

high frequency and repetitive nature. The decision about what and how much to
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feed to the dairy animals is made more frequently than that regarding the method
or time of harvesting of paddy.

c) Imminence: It refers to the penalty or cost of waiting with respect to different

decisions on the farm. Experience shows that while it pays to act quite promptly
in some cases, postponement is necessary in other cases till the required
complete information becomes available. For example, the decision to harvest
paddy is much more imminent than a decision about buying a tractor.

d) Revocability: Some decisions can be altered at a much lower cost as

compared to others. For example, it is relatively easier to replace paddy with
groundnut, which perhaps becomes more profitable, than to convert a mango
orchard into a sugarcane plantation.

e) Alternatives available: The number of alternatives can also be used for

classifying farm management decisions. The decisions become more complicated
as the number of alternatives increase. For example, threshing of paddy can be
done manually or with thresher.

Classification of decisions based on the above criteria is not mutually exclusive and is
changing from individual to individual and from place to place for the same individual.

ii) The second method classifies farm management decisions into: a) what to produce? b)
when to produce? c) how much to produce? and d) how to produce?

The farm manager should choose the enterprises based on availability of

resources on the farms and expected profitability of the enterprise. This is
studied through product-product relationship. Once the farmer decides on what
to produce, he must also decide on when to produce, as most of the agricultural
commodities are season bound in nature. Then, he should decide how much of
each enterprise to produce, since the supply of agricultural inputs is limited.
This can be studied through factor-product relationship. In order to minimize the
cost of production, i.e., decisions relating to how to produce, factor-factor
relationship has to be studied. The farm manager should also take marketing
decisions like a) what to buy? b) when to buy? c) how much to buy? d) how to
buy? e) what to sell? f) when to sell? g) how much to sell? and h) how to sell?

iii) Factors Influencing Farm Management Decisions: Farm management

decisions continuously undergo a change overtime because of the changing
environment around the farm, farmer and his family. The factors which influence
the decision making process are:

a) Economic factors like prices of factors and products.

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b) Biological characteristics of plants and animals.

c) Technological factors like technological advancements in the field of

agriculture and suitability of different varieties and farm practices to varied agro
- climatic conditions.

d) Institutional factors like availability of infrastructural facilities which include

storage, processing, grading, transport, marketing of inputs and outputs, etc,
government policies on farm practices, input subsides, taxes, export and import,
marketing, procurement of produces and so on.

e) Personal factors like customs, attitude, awareness, personal capabilities and so

on.

One or more changes of the above categories in the environment around the
farmer may cause imperfections in decision-making. The process of decision-
making, therefore, has to be dynamic so as to adjust in such changes.

iv) Decision Making Process

Every farmer has to make decisions about his farm organization and
operation from time to time. Decisions on the farms are often made by the
following three methods:

a) Traditional method: In this method, the decision is influenced by traditions

in the family or region or community.

b) Technical method: In this method, the decisions require the use of technical
knowledge. For example, a decision is to be made about the quantity of nitrogen
requirement to obtain maximum yield of paddy.

c) Economic method: All the problems are considered in relation to the

expected costs and returns. This method is undoubtedly the most useful of all the
methods for taking a decision on a farm.

v) Steps in Decision Making

The steps in decision - making can also be shown schematically through a

flow chart. The important steps involved in the decision-making process are
formulating objectives and making observations, analyses of observations,
decision-making, action taking or execution of the decisions and accepting the
responsibilities. The evaluation and monitoring should be done at each and every
stage of the decision making process.

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 FORMULATING OBJECTIVES AND MAKING OBSERVATIONS

ANALYSIS OF OBSERVATIONS

ARE MORE YES

OBSERVATIONS
NEEDED?

NO
DECISION MAKING

IS THE
NO DECISION FINAL?
YES
ACTION TAKING

ACCEPTING RESPONSIBILITIES

YES
HAVE THE MANAGEMENT
NO OBJECTIVES BEEN FULFILLED?

THE END
Steps In Decision Making Process

vi) Functions of a Farm Manager: Some of the major areas, which form the
subject matter of farm management, are listed below:

a) Farm Management Functions: The major farm management functions are:

1) Selection of enterprises.

2) Organization of agricultural resources and farm enterprises so as to make a

complete farm unit.

3) Determination of the most efficient method of production for each selected

enterprises.
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4) Management of capital and financing the farm business.

5) Maintenance of farm records and accounts and determination of various

efficiency parameters.

6) Efficient marketing of farm products and purchasing of input supplies.

7) Adjustments against time and uncertainty elements on farm production and

purchasing of input supplies.

8) Evaluation of agricultural policies of the government.

b) Farm management activities are differently viewed by different authors.

Farm managers are generally responsible for taking up technical, commercial,
financial and accounting activities. These activities are elaborately discussed
below:

Farm Management Functions

Activities Functions Details

Enterprise-choice and
1) Technical Activities: D eciding what to
combinations.
These include produce? and
Input levels and
responsibilities for seeking how to produce?
combinations.
all production know-how so
Quality of output.
that production is
accomplished in time and Using Land Capacity –fertility.
adapting production process Tillage practices-
to changing economic and conservation.
technical conditions. Regulations-constraints.
Determining Capital requirements.
Level of Availability of services.
Mechanization Labour implications.
Economics in production
Determining the
on buying.
scale of
Shape of cost curves.
production (How
Degrees of specialization.
much to
Quantity of output.
produce?)
Capabilities of
management.

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 Activities Functions Details
2.Commercial Acquiring What to buy? -Type, Quality.
Activities: These How to buy-own? Rent/lease,
include all buying and inputs hire.
selling. They involve Financing.
procurement of inputs From whom?
in the quantities and When/How long?
combinations How much to buy? -Quantity.
necessary for efficient What to sell? -Quality/type
Marke ting
production, plus When to sell? -Store/immediate
orderly storage, produc ts sales.
handling and Where to sell? -Direct to buyer
marketing of or store, delivery point,
commodities produced. integration.
It also includes How to sell? –Open market,
forecasting and contract, hedge.
contracting for How much to sell? -Quantity
services of others. Forecasting Inputs.
price Products.
3.Financial Activities: Acquiring Quantity and terms of borrowing.
Sources.
These involve the fu nds Lender services.
acquisition and use of Equity position.
capital, presumably in Liquidity position.
an optimal manner. Using funds Relative profitability of
alternatives.
This requires Time horizon and pay-back
forecasting future period.
investment needs and Cash flows.
Forecasting Depreciation of assets.
arranging for their
future needs. Expansion / contraction.
financing. Changing technology.
4.Accounting Keeping Enterprise ownership.
production Input-output efficiency.
Activities: These recor ds
include physical, Reco rding Accounting method.
human, business and Choice of accounts.
business Periodic summery.
tax records. This area transactions Cash flow forecasting.
may involve setting Tax reporting. Income tax and other taxes.
standards for certain Filing Wages.
enterprises or documents Social security.
with Depreciation.
segments of the Governmental
business. and
Regulatory
Agencies.

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c) The third classification of farm management functions indicates that the farm
management decisions or functions can be categorized into production,
administration and marketing functions as depicted in the chart.

1) Production and Organization Decisions: The farm manager has to take vital
decisions on production of enterprises and organization of his business. His
decisions centre on what to produce and how to produce. Such decisions can be
further classified into i) strategic and ii) operational decisions.

i. Strategic Management Decisions: These are the management decisions,

which involve heavy investment and have long lasting effect. These decisions
give shape to overall organization of the business.

a) Deciding the best size of the farm: The size of farm depends upon type of
farm business, irrigation potential, level of mechanization, intensity of usage of
land and managerial ability of the farmer. The economic efficiency of each
crop/or live stock enterprise and their combinations, when they are operated on
different scales, are considered to decide upon the optimum size of the holding.

b) Decisions on farm labour and machinery programmes: Deciding the most

profitable combination of the factors to be used in producing a commodity is one
of the important farm management decisions. What combination of farm labour
and machinery should be adopted to get maximum returns? Would it be
profitable to vary labour or land to better utilize a given set of machinery? These
decisions are to be taken so as to reduce the cost of production.

c) Decisions on construction of buildings: Decisions on size and type of

buildings involve heavy investment, which become fixed resource for the
business. Type of buildings, for the present pattern and level of production
depends upon the kind and level of crops or livestock produced.

d) Decisions regarding irrigation, conservation and reclamation

programmes: As improvements of alkalinity, salinity and other soil defects
require heavy investments, soil conservation and reclamation programmes often
have to be spread over years. The choice of most economical method or a
combination of methods of reclamation has to be made from among mulching,
contouring, bunding, terracing and application of soil amendments, laying down
of proper drainage and so on. Decision on irrigation programme is also very
crucial because it involves heavy investment and it gives a flow service over
long period of time and also improves the productivity of other related inputs.

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 A. Strategic Decisions: (These involve
heavy investment and have long lasting
effects)
1. Size of the Farm
2. Machinery and Livestock
PRODUCTION Progranmmes
AND
3. Construction of Building
4. Irrigation, Conservation and
ORGANIZATION Reclamation Programme.
PROBLEM B. Operational Decisions: (more
DECISIONS frequent and involve relatively small
investments)
1. What to Produce? -Selection of
Enterprises
2. How much to Produce? - Enterprise
Mix and Production Process
3. How to Produce? – Selection of
Least Cost Method.
4. When to Produce? - Timing of
Production.

FARM 1. Financing the Farm Business:

PROBLEMS a) Optimum Utilization of Funds
ADMINISTRATIVE b) Acquisition of Funds-Proper
REQUIRING Agency and Time
PROBLEM
DECISIONS 2. Supervision of Work – Operational
DECISIONS
OF THE Timing
FARMER 3. Accounting and Book Keeping
4. Adjustment of Farming Business to
Government Programmes and
Policies
5. Production for Home Consumption
and the Market.

1.Buying
a) What to buy?
b) When to buy?
c) From whom to buy?
d) How to buy?
e) How much to buy?
MARKETING 2.Selling
PROBLEM a) What to sell?
b) When to sell?
DECISIONS c) To whom to sell?
d) How to sell?
e) How much to sell?

Farm Management Decisions

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2. Operational Management Decisions: Operational management decisions are
continuously made to carry out the day-to-day operations of the farm business.
The investment involved in such decisions is relatively small and hence, the
impact of such decisions is short-lived. These decisions are generally: i) what to
produce? ii) how much to produce? how to produce? and when to produce? A
brief discussion is made on these decisions below:

i) What to produce? (Selection of enterprises): The objective of the farm

business, i.e., maximization of returns, could be achieved through the best
combination of different enterprises. The relative profitability of these
enterprises will be useful to determine what to produce and what not to produce.

ii) How much to produce? (Enterprise mix): This decision has two aspects:
Enterprise mix and resource use.

a) Enterprise Mix: Combination of crop and livestock enterprises will depend

upon the level of resources available, fertility of the soil, prices of factors and
products in addition to the existence of complementary and supplementary
relationship. Principle of substitution is used to decide the level of each
enterprise, i.e., the scarce farm resources are first used for the most profitable
enterprise and then the next best profitable enterprise is considered for inclusion.
However, apart from profitability of each enterprise, factors like labour
availability for each enterprise, size of land holding, use of by-products,
maintenance of soil fertility, relative risks, distribution of incomes over time and
efficiency in the use of machine power and building are considered to decide the
level of each enterprise.

b) Resource Use: The best combination and optimum level of inputs can be
determined based on the substitution principle and these have to be decided for
minimizing the cost of production and maximization of returns.

iii) How to produce? (Selection of least - cost / efficient method or practice):

Decisions, here, are made on the best practice or combination of practices and
methods, which involve the least cost. The choice making from among the
various alternatives has become a management problem. Although the objective
generally is to select the least cost combination of inputs methods, consideration
has to be given on the availability of resources in required quality and quantity
at right time.

iv) When to produce? (Timing of production): Since the agricultural

production is season-bound, it’s timing has to be properly decided. However,
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farmer faces difficulty in selecting season, i.e., normal, early or late, for a
particular crop due to non-availability of inputs in time and as a result he could
not fetch maximum price for the produce.

3. Administrative Decisions
Along with production and organization decision, the former has to see that
the work is done in a right way. Such administrative decisions are briefly
discussed below:

i) Financing the farm business: While some farmers have their own sufficient
funds, others may have to borrow. The problem is two fold, viz., a) utilization of
funds within the farm business, and b) acquisition of funds, i.e., proper agency,
time, type, and terms of credit. Cash flow analysis would be used to decide the
timing and quantum of credit required.

ii) Supervision of work: The farm manager has to ensure that each job is
scrupulously done as planned.

iii) Accounting and book keeping: Collection, analysis and evaluation of data
have to be done in order to assess the performance of the farm at any point of
time. Here decision is to be made on the kinds of farm records, time allocation
and money to be spent on this activity.

iv) Adjustments to government programmes and policies: Government programmes and

policies on food zones, restriction on product movements, price support policy, input subsidy,
etc. influence farm production and marketing. The farmer has to decide on the level of
production and resource-use with the maximum economic efficiency at the farm level
consistent with the government policies concerned.

4. Marketing Decisions

A farm manager has to buy various farm inputs and sell out the produces in which he has
to take rational decisions. While purchasing inputs he has to consider the following aspects:
a) what to buy? b) when to buy? c) from whom to buy? d) how to buy? and e) how much to
buy? Similarly, in selling out the farm produces he has to carefully ponder over the following
points in order to maximize his farm income: a) what to sell? b) when to sell? c) to whom to
sell? d) how to sell? and e) how much to sell?

vii) Relationship between Farm Management and Other Sciences

Farm management is an integral part of agricultural production economics.
Farm management is an intra farm science whereas agricultural production
economics is an inter farm or inter region science. The distinction sometimes
112
made between production economics and farm management is based on macro
and micro level contents respectively. In so far as various agricultural economic
problems regarding agricultural finance, land tenure, marketing, etc, are
concerned at farm level, the field of specialization related to each problem
becomes an integral part of farm management.

Farm management is closely related with other social sciences like

psychology and sociology (Fig.1). Farmer’s ability to bear risk and uncertainty is
influenced by his psychological characteristics. His decisions are also influenced
by the customs, habits and cultural values of the society in which he lives. The
acceptance of new production techniques and methods in farming is influenced
by political decisions of the government like restriction or encouragement of
growing of crops, ceiling on land holding, price policies, etc.
Physical and
Biological Economic Relationships
Relationships Basic Economic Principles
Agronomy, Soil (Optimization of Resources,
Science, Plant Cost Minimization and Profit
Breeding, Plant Maximization), Agricultural
Protection, Animal Marketing, Price analyses,
Husbandry, Forestry Financing and Co-operation.
and Agricultural
Engineering.
FARM Supporting Sciences
MANAGEMENT Mathematics and
Social Statistics
Relationships
Rural Sociology,
Psychology, Ethics, Guides and helps the Political Relationships
Religion, Habits and farmer to solve Political Science, Agrarian
Customs. economic problems Laws, Tenurial System,
associated with Ceiling on Holdings,
maximization of Betterment Levy, Price
returns / or Stabilization Measures,
minimization of costs. Subsidies, Food Zones etc

BETTER LIVING STANDARDS AND HIGHER FAMILY SATISFACTION

Fig.1 Relationship between Farm Management and Other Sciences

Statistics is another science that helps in providing methods and procedures
by which data regarding specific farm problems can be collected, analyzed and
evaluated.

Farm management relies closely on other branches of agricultural sciences

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such as agronomy, soil science, plant protection studies, animal husbandry,
agricultural engineering, forestry, etc. These physical and biological sciences are
not directly concerned with economic efficiency. They provide input-output
relationships in their respective areas in physical terms, i.e., they define
production possibilities within which various choices can be made. It is the task
of the farm management specialist and agricultural economist to determine how
and to what extent the findings of these sciences should be used in farm business
management.

viii) Characteristics of Farming as Business: Farming as a business has many

distinguishing features from most of other industries in their management
methods and practices. The major differences between farming and other
industries are:

1) Agricultural production is biological is nature.

2) Agricultural production heavily depends on agro-climatic conditions.

3) Agricultural production is carried out mostly in small - sized holdings.

4) Frequent and speedy decisions are to be taken up in agricultural production.

For instance, there is no time to consider the merits of paying more wages to
drain the field when there is a sudden monsoon floods.

5) Agricultural prices and production usually move in opposite direction.

6) Lack of standardization of practices and products: By the use of machines

and trained personnel, it is possible to produce large volume of products exactly
the same in size, form and quality. Such standardization of practices and
products is not possible in agriculture. Grading system for agricultural
commodities is also very weak.

7) Slow turn -over: It takes long time to recover the investment.

8) Farm financing is more risky due to drought, pest and disease attack, yield
variations, etc.

9) The proportion of fixed cost is more in agriculture and so adjustment and

substitution of resources are more difficult.

10) Inelastic income demand for farm products: As income increases, the
demand for agricultural products will increase in lesser proportion when
compared with industrial goods.

11) Perishable and bulky nature of agricultural commodities cause storage,

processing and transportation problems.

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12) Lack of Knowledge: All farmers do not know the latest developments in
agricultural technologies.

13) Agricultural markets are not regulated properly and there are too many
middlemen in the agricultural marketing system, whereas in industry, the
distribution channels are well defined and controlled by producers.

14) Agriculture is considered not only a means of livelihood but also a way of
life to the farmers in all the under developed countries.

ix) Farm Management Problems under Indian Conditions

Farm management problems in India vary from place to place depending
mostly on the degree of infrastructural development and the availability of
resources. The following are some of the most common problems in the field of
farm management:

1) Small size of farm business: The average size of operational holding in India
was 1.55 ha in 1990-91. The holdings are fragmented, too. Unfavourable land-
man ratio due to excessive family labour depending upon agriculture have
weakened the financial position of the farmers and limited the scope for farm
business expansion.

2) Farm as a household: In most parts of the country, farmers, especially dry

land farmers, follow the traditional combinations of crops and methods of
cultivation. Work habits are closely associated with food commodities consumed
and living conditions. Farm has become the means of livelihood of farmers and
hence, subsistence farming is followed. Home management, thus, heavily
influences and gets influenced by farm management decisions.

3) Inadequate capital: The new technology demands costlier inputs such as

fertilizer, plant protection measures, irrigation and high yielding variety seeds as
well as investment on power and machinery. But perpetual debt and low
marketable surplus prevent the farmers from adopting new technologies.
4) Under employment: Unemployment results from 1) small size of farm, 2)
large supply of family labour, 3) seasonal nature of production and 4) lack of
subsidiary or supporting rural industries. It reduces efficiency and productivity
of rural manpower.
5) Slow adoption innovations: Small farmers are usually conservative and
sometimes skeptical of new techniques and methods. However, once they try a
new idea and find it effective, they are eager to adopt that. The rate of adoption,
however, depends on farmer’s willingness and his ability to use the new
information.
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6) Inadequacy of input supplies: Farmers may be willing to introduce change,
yet they may face the difficulty in obtaining the required inputs of proper
quality, in sufficient quantity and on time in order to sustain the introduced
changes.

7) Lack of managerial skill: Due to lack of managerial skill among small

farmers, adoption of new techniques and use of costly inputs could not be
followed up by them.

8) Lack of infrastructural facilities: Infrastructural facilities such as

marketing, transport, and communication are either inadequate or inefficient and
this results in the shortage of capital and quality inputs and non-availability of
inputs in time.
Chapter 8: Questions for Review.
1. Fill up the blanks
i) Farmers have the objectives like and improvement of their family living
standards.
ii) Farm management is the study of phase of farming.
iii) Management decisions, which involve heavy investment and have long lasting effect are
called .
iv) Perishable and bulky nature of agricultural commodities cause storage, processing and
problems.
v) Farm management is an intra farm science while, agricultural production economics is
science.
2. i) Define Farm Management as a science.
ii) Define agricultural production economics.
3. Write short notes
i) Different methods of farm management decisions.
ii) Factors influencing decision-making process.
iii) Farm management goals.
iv) Strategic decisions.
4. Answer the following:
i) Explain the functions of farm manager.
ii) What are the steps involved in the decision making process?
iii) Explain the scope of farm management.
iv) Explain how farm management is related to different disciplines.
v) Explain the farm management problems faced by the Indian farmers.
vi) Explain the characteristics of farming as a business.
vii) Explain the different operational management decisions.
viii) Explain the marketing decisions to be taken up by the farm manager.
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 BASIC CONCEPTS OF FARM MANAGEMENT

The basic concepts that are frequently used in farm management are discussed below:

i) Farm-Firm: Farm means a piece of land where crop and livestock enterprises
are taken up under a common management. A farm is a firm which combines
resources in the production of agricultural products on the lines of a business
firm, i.e., with the objective of profit maximization.

ii) Resources or Inputs or Factors of Production: Resources are those which get consumed
or transformed into products in the process of production. Services of resources are also used
up in the production process. All agricultural resources can be classified into two types. They
are i) fixed resources and ii) variable resources.

a) Fixed resources: Level of some resources like buildings, machinery, etc. is

fixed over a production-planning period irrespective of the level of enterprises
taken up. These are called fixed farm resources, E.g. Land, building,
machineries, etc. The quantum of fixed resources does not change with the level
of production. Some of the resources, which are fixed during a short period, may
become variable during a long term.

b) Variable resources: Some resources like seed, fertilizer, labour, etc vary
with the level of output. These are variable resources.

Resources can also be classified into stock and flow resources as detailed
below:

a) Stock resources: They are resources which are used up entirely in the
production process. Fertilizer, seed, feed, etc., are such resources that can be
stored up for using at later period.

b) Flow resources: Contrary to stock resources, there are factors of production

which give only flow of services in the production process. Hence, they are
called the flow resources. If the services of this category of resources are not
utilized, they go waste, as they cannot be stored up for later use. For example, if
the services of a farm building or machinery are not used in a particular day,
they go waste, as they cannot be stored up for future use.

iii) Ways of Mobilizing Farm Resources: The different types of farm resources
and ways of mobilizing them by a farm manager are discussed here.
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a) Owning: Resources like land, machinery, implements, tools, work bullocks,
etc, can be acquired by purchasing them. Farmers can own these resources due to
the following reasons:

1) The resources are to be continuously or more frequently used throughout the

year. The size of holding should be large enough to effectively use such assets.

2) If the farmer could not engage work bullocks, tractors/power tillers, power
sprayers, bullock cart and so on in his own farm economically, adequate demand
should be there for hiring out these resources.

3) The farmer should have either adequate owned funds or borrowed funds to
acquire these resources.

Owning of resources would be convenient to the farmer especially during

peak season so as to carry out the farm operation in time. However, during lean
season, it may be uneconomical to maintain owned resources. E,g. Bullocks,
thresher, etc. Hiring would be cheaper than owning the resource especially, when
the size of holding is too small.

b) Leasing: The immovable resources like land and buildings can be acquired by
leasing. Rent has to be paid based on the terms agreed by the lessees (tenants) to
the owner of such resources. The land owner may lease-out his lands to land less
agricultural labourers or to farmers who are capable of cultivating larger area.
The land owner leases out due to 1) his absenteeism at the village where his land
is located, 2) inefficiency in running farm and 3) running of other more
profitable enterprise in the same village. Sometimes, the widows and invalids
may lease out due to their physical inability. Leasing-in helps lessees (tenants)
to augment their farm returns. However, leasing-out becomes complicated due to
improper implementation of agrarian laws which are more favourable to tenants.
The fertility status of the leased-out land is gradually deteriorating because the
tenants do not apply organic manure and they do not properly maintain the farm
assets out of the fear of eviction from the land by the owner. Therefore, the
productivity of leased-out land is lesser than that of owned land. On the
contrary, as the tenancy legislations are more favourable to tenants, some of
them refuse to surrender their tenancy rights to the owners and hence, the owners
are reluctant to lease out their lands.

c) Hiring: The farmer can acquire human labour and bullock power through
hiring. The magnitude of employment of hired human labour and bullock power

118
depends upon: a) size of farm holding, b) number of family labourers available,
c) availability of owned bullocks, d) resourcefulness of the farmer to replace
labour with capital and e) diversification of crop activities practiced in the farm.
Hiring of human labour and bullock power is also difficult and costly during
peak season due to either costly human labour as a result of heavy demand for
such labour or difficulty in carrying the operations with human labour in time.
However, hiring of human labour and bullock power is more economical than
that of hired machinery to small and marginal farms, especially in areas where
the labour is cheaper.

d) Joint ownership: When the land, buildings and well are inherited by legal
heirs, the land gets sub-divided and buildings and wells are jointly owned among
them. Joint ownership is convenient and economical to those who have small and
fragmented inherited land. However, disputes arise due to lack of understanding
among joint owners in sharing the services and also in the maintenance of the
jointly owned assets.

e) Custom Services: Farmers could acquire custom services of machineries like

tractor, power tillers, threshers, power sprayers, etc. by paying custom hire
charges. Hiring of custom services of machineries depends upon 1) size of farm
holding, 2) availability of alternatives such as human labour and bullock power,
3) hire charges for human labour and bullock power, 4) custom hire charges, 5)
time of operation (peak or lean season), 6) availability of time to carry out the
farm operation and 7) quantum of work to be carried out. Custom services would
be more economical for small and marginal farms as they cannot afford to buy or
maintain costlier equipments and machineries.

iv) Product or Output: It is the result of the use of resources or services of

resources. The resources get transformed into what is known as output. E.g.
Paddy, groundnut, sugarcane, milk, etc.

v) Production: It is a process of transformation of resources or inputs like

labour, seed, fertilizer, water, etc. into products like paddy, wheat etc.

vi) Transformation or Production Period: The time required for a resource to

be completely transformed into a product is called transformation or production
period. E.g. Paddy is harvested in 3½ to 6 months.

vii) Production Economics: Farm production economics is a field of

specialization within the subject of agricultural economics. It is concerned with

119
choosing of available alternatives or their combinations in order to maximize the
returns or to minimize the costs. Agricultural production economics is an applied
field of science, wherein the principles of choice are applied to the use of land,
labour, capital and management in farming. The subject matter of production
economics explains the conditions under which the profit, output, etc. that can be
maximized and the cost, use of physical inputs, etc. that can be minimized. The
main objectives of production economics are:

a) to determine and define the conditions which provide for optimum use of resources;
b) to determine the extent to which the current use of resources deviates from the
optimum use;
c) to analyze the factors which influence the existing production patterns and
resources use; and
d) to identify the means and methods for optimal use of resources.

The principles that help attain these objectives are the same on a micro as on
a regional or national level. On micro level where intra-farm resource allocation
and production pattern are involved, it is the subject matter of farm management.
When choice principles involve a broader field on a macro-level, the subject is
known as production economics. The economist who focuses his attention on
individual farm cannot make rational recommendations unless he considers the
aggregate or overall aspect of production. Similarly, government programmes
and policies affect the decisions on the individual farms. Production economist,
therefore, must be able to integrate both individual and aggregate aspects of
agricultural resource use and levels and patterns of production.

viii) Production Function: Production function refers to input-output relationship in the

production process. Production function is a technical and mathematical relationship
describing the manner and extent to which a particular product depends upon the quantities of
inputs or services of inputs used in the production process. It describes the rate at which
resources are transformed into products. There are numerous input-output relationships in
agriculture because the rates at which inputs are transformed into outputs will vary among
soil types, animals, technologies, rainfall, etc. Any given input-output relationship specifies
the quantities and qualities of resources needed to produce a particular product.

a) Types of Production Function: There are different types of production

functions, viz., 1) continuous function and 2) discontinuous function.

1) Continuous function: The doses or levels of input and output can be split up
into small units. E.g. Fertilizers or seed can be applied to a hectare of land in
quantities ranging from a fraction of a kilogram upto hundreds of kilograms.

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2) Discontinuous or Discrete function: Such a function is obtained for input or
factors or work units which are used or done in whole numbers such as one
ploughing or a number of ploughings.

The difference between discrete data and continuous data is, thus, in the
divisibility of the inputs or outputs. An example of a discrete input is a cow. A
dairy herd may be composed of two, three, or most cows. However, one and a
half, three and a quarter, etc, will not be found in a dairy herd. Fertilizer on the
other hand is an example of a continuous input. Fertilizer can be divided into
any size unit and for each size unit, there is a resulting yield.

. ..
. . Output
Output

.
0 Input 0 Input
Fig.9.1 (a) Discrete Production Fig.9.1(b) Continuous Production
Function Function
The production function can also be classified into 1) very short run
production, 2) Short run production function and 3) Long - run production
function.

1) Very short run production function: The time period is so short that all resources are
fixed.
2) Short run production function: Production function, which relates factors
and products where some resources are fixed, can be termed as short run
production function. The time period is of such length that at least one resource
is varied while other resources are fixed.

3) Long - run production function: Production function, which permits

variation in all factors (none is fixed), can be called long-run production
function. The time is of such length that all resources can be varied.

The production function relates output (Y), to input (X). The definition of a
function is as follows: If an output (Y) depends upon an input (X), then Y is
called a function of X. The mathematical expression for a function is Y = f (X).
This functional notation is read, “Y is a function of X”. Y is usually called the
dependent variable, and X, the independent variable.

121
b) Subscripts: Subscripts are useful when symbols are used. Consider, for
example, the notation for the production function Y = f (X), where X is the
amount of input and Y, the resulting amount of output. In this, there can be no
confusion about identification of input or output because there is only one input
and one output. When more than one input or output is included in a problem,
subscripts can be used as a means of identification. For example, when output is
a function of three inputs, the production function can be written Y = f (X 1 , X 2 ,
X 3 ), where X 1 , X 2 and X 3 are distinct and different inputs. X 1 may be seeds; X 2
may denote labour and X 3 may indicate fertilizer. If amounts are to be denoted,
additional subscripts must be used. X 1 1 is an amount of X 1 ; X 12 is a greater
amount of X 1 ; X 21 is an amount of X 2 ; X 22 is a greater amount of X 2 ; etc.
Subscripts can also be used to identify outputs or any other variable. Thus, Y 1 ,
Y 2 and Y 3 can be distinct outputs and the amounts can be shown by adding
another subscript.

c) The “∆” (Delta) Notation: The change in any variable is denoted by “∆” (the
Greek letter “delta”) placed before the variable. For example, the change in the
variable X is denoted by ∆X. Production function is written as: Y = f (X 1 , X 2 ,
X 3 ,..., X n ) where, Y is output and X 1 , ..., X n are different inputs that are used in
the production of a product or output. The functional symbol “f” indicates the
form of relationship that transforms inputs into output. For each combination of
inputs, there will be a unique level of output. For example, Y may represent
paddy yield, X 1 , quantity of seed, X 2 , quantity of fertilizer, X 3 , labour and so on.
The above notation for a production function does not specify which inputs are
fixed and which are variable. For example, seed or fertilizers are variable inputs
that are combined with fixed input such as acre of land. Symbolically, fixed
inputs can be included in the notation for a production function by inserting a
vertical line between the fixed and variable inputs. For example, Y = f (X 1 , X 2 ,
X 3 , ... X n- 1 | X n ) states that X n is the fixed input while all other inputs are
variable.

d) Forms of Production Function: The technical functional relationship

between resources/inputs and product can be expressed by a functional form, a
few of which are given below:

1) Linear: The simplest form of linear production function is Y = a + bX with

one variable input and Y = a + b 1 X 1 + b 2 X 2 + b 3 X 3 + ... + b n X n with n variables.
n
Σ
Symbolically, Y= a + bi Xi . where, Y is output, a - constant, b i – unknown
i=1

122
parameters to be estimated and X i - variable inputs. The estimated equation is:

Y = 0.2151 + 0.0412X 1 - 0.0002X 2 + 0.0752X 3 - 0.0066X 4 - 0.0880X 5

2
R = 0.64; F = 3.56.
The values of X i ’s indicate the rate of change in Y due to one unit change in
Xi’s. For example, an unit change in X 1 results in 0.0412 units increase in Y
when all other variable inputs are kept constant at their respective mean levels,
i.e., ceteris paribus.

2) Cobb-Douglas Production Function (or) Power Function: The power

production function is a non-linear production function which is more commonly
known Cobb-Douglas production function, after the names of persons who first
applied it for empirical estimation and it is represented as:

Y = AL a K b
Where, L and K are labour and capital respectively and Y, the output. A, a and b
are parameters to be estimated. This can be generalized to ‘n’ inputs also.

Y = a 0 X 1 a1 X 2 a2 … Xn an = a 0 Π Xi a i , i =1, 2 ,…, n.
Since the model in the above equation is in multiplicative form, it has to be
converted into log-linear form so as to estimate parameters and it is given below:

ln = lna 0 + a 1 ln X 1 + a 2 lnX 2 + a 3 lnX 3 +…+ an lnXn

n
ln = lna0 + Σ ai ln Xi , where, i =1,2,3,…,n
i=1
In the above function, a 0 and a i are the efficiency parameters and elasticity of
production with respect to the input X i , respectively. The result of the Cobb-
Douglas production is as follows:
0 .63 15 0 .0234 - 0.0496 0 .1904 0 .076 0 -0 .0286 0 .0871
Y = 0.7342 X 1 X2 X3 X4 X5 X6 X7

The regression co-efficients indicate the percentage increase in Y with

respect to one per cent increase in the input X. For example, if we increase X 1 by
one per cent, holding other resources at a constant level, Y will increase by
0.6315 per cent, thus showing diminishing return with respect to X 1 , say, land in
hectares. The sum of elasticities turns out to be less than unit (0.9302), which
indicates diminishing return to scale.

3) Quadratic Form: The quadratic equation Y = a + bX 1 – cX 1 2 , with a minus

before C denotes diminishing returns. It allows both a declining and negative
marginal productivity, but not both increasing and decreasing marginal products.

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ix) Total Physical Product (TPP): TPP is the quantum of output (Y) produced
by a given level of input (X).

x) Average Physical Product (APP): APP is the quantity of output produced per
unit of input i.e., ratio of the total product to the quantity of input used in
producing that amount of product. Number of Units of Output Y
APP = =
Number of Units of Input X
xi) Marginal Physical Product (MPP): The term marginal refers to an
additional unit. If we use ∆ (delta) to mean “change in “, then ∆Y and ∆X
represent change in Y (output) and change in X (input) respectively. Marginal
physical product, therefore, refers to the change in output, which results from
applying an additional unit of input.
Change in Output ∆Y
Marginal Physical Product (MPP) = =
Change in Input ∆X
Chapter 9: Questions for Review:
1. Fill up the following blanks:
i) The level of fixed resources will with the level of output.
ii) In long run, no cost is .
iii) Farm management is generally considered to fall in the field of
economics.
iv) In Cobb-Douglas production function, the regression co-efficient are the
of production with respect to their respective inputs.
v) Interest on operational expenses falls under resource.
vi) In linear regression function, the regression co-efficients indicate .
vii) In the very short run production function, all resources are .
2. Define the following:
i) Farm.
ii) Short run and long run.
iii)Continuous and Discrete Production functions.
iv) Stock and flow resources.
v) Product and production period.
3. Write short notes:
i) Production function.
ii) Total, Average and Marginal Physical Products.
iii)Fixed and variable resources.
iv) Production economics and Farm management.
4. Answer the following:
i) Explain the different types of production functions and indicate how they are
useful in farm decision-making.
ii)Explain the different ways of mobilizing various farm inputs and indicate their
merits and demerits.
iii)How leasing is different from custom hire service of a resource?
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 FACTOR – PRODUCT RELATIONSHIP (OR)
INPUT – OUTPUT RELATIONSHIP

The objective of factor-product relationship is to determine the optimum

quantity of the variable input that will be used in combination with fixed inputs
in order to produce optimal level of output. Further questions such as, how much
fertilizer to be applied per acre? how much irrigation to be given? and so on are
all within the scope of factor – product relationship. There can be three types of
input-output relationships in producing a commodity where one input is varied
and the quantities of other inputs are fixed. The nature of relationships between
a single input and a single output can either be of the one or a combination of
types given below:

i) Constant Marginal Rate of Returns or Law of Constant Returns.

ii) Increasing Marginal Rate of Returns or Law of Increasing Returns.

iii) Decreasing Marginal Rate of Returns or Law of Decreasing Returns.

A. LAWS OF RETURNS

Let us consider the simplest case where one product is produced by varying
the level of only one factor of production at a time.

i) Law of Constant Returns: The level of output increases by an equal amount

for each additional units of the variable input
i.e., the relationship between the input and the
output is linear. Thus, graphically, the law of
Output (Y)

∆Y2 constant returns can be depicted by a straight-

∆X2
line production function. The production function
∆Y1 has the same slope throughout its entire range as
∆X1 shown in the figure 10.1. Mathematically, it can
be expressed as:
∆ Y1 ∆Y2 ∆Yi ∆Yn
Variable Input (X) = =...= = . . .= =k
Fig. 10.1.Law of Constant Returns ∆ X1 ∆ X2 ∆Xi ∆Xn
Where ∆Yi /∆Xi is the marginal product due to the use of the ith unit of variable input, X
( i = 1, 2,…,n ) and k is a constant. Such constant returns can occur under two situations:

125
 a) No resource is fixed and all the inputs are varied, increased or decreased
together.

b) One or more factors of production may be fixed but they have surplus
(unutilized) capacity. The constant returns may be explained with the data given
below:

Table 10.1 Yield of Maize at Varying Levels of Nitrogen per Hectare

∆Yi
Variable Inputs ∆Xi Output (quintals of ∆Yi MPP =
(Kg of N per ha) Maize per ha) ∆Xi

0 - 25 - -
25 25 26 1 0.04
50 25 27 1 0.04
75 25 28 1 0.04
100 25 29 1 0.04

The table (10.1) shows that every addition of 25 Kg of nitrogen ∆Xi causes
exactly the same increase of one quintal in the yield of maize per ha (∆Yi)
during the process of production.

ii) Law of Increasing Returns: Increasing returns are said to operate when every successive
unit of the variable input results in a larger increase in the output as compared to the
preceding unit. Such an input-output relationship is generally encountered at a relatively
lower level of input use. The resulting production function is a non-linear curve of the type
shown in the figure 10.2 and is convex to the input axis. Mathematically, the law can be
stated as under: ∆ Y1 ∆ Y2 ∆ Yi ∆Yn
< <...< < . . .<
∆ X1 ∆ X2 ∆ Xi ∆Xn

where, ∆ Y i / ∆ Xi , . i = 1, 2, 3, . . . , n is the
Output (Y)

marginal product due to the use of .i th unit of

∆Y2
the variable input (X). Thus, in terms of
∆ X2
marginal productivity of the variable factor of
∆Y1 production, the law of increasing return signifies
∆X1
an increasing marginal product with an addition
Variable Input(X) of every successive unit of the variable resource.
Fig.10.2 Law of Increasing Returns
At lower level of fertilizer application, the yield (marginal product) may
increase when fertilizer application is increased upto a certain level. The
following table illustrates the law of increasing returns with the help of data on
126
 paddy yield at varying levels of nitrogen application. The example given in the
table (10.2) indicates the response of paddy yield to increasing nitrogen
application at a very low level of the input–use. It may be observed that as the
input is increased from 0 to 25 kgs per hectare, a dose of 5 kg at each step, the

Table 10.2 Yield of Paddy at Varying Levels of Nitrogen per Hectare

∆ Xi ∆Yi ∆ Yi
Variable Input (Kg Output (Quintals
MPP =
of nitrogen per Ha) of paddy per Ha) ∆ Xi
0 - 20.0 - -
5 5 21.0 1.00 0.20
10 5 22.5 1.50 0.30
15 5 24.5 2.00 0.40
20 5 27.0 2.50 0.50
25 5 29.7 2.70 0.54

yield increases by 1.0, 1.5, 2.0, 2.5 and 2.7 quintals per hectare. Thus, every successive dose
of 5 Kgs of nitrogen results in more output of paddy signifying the operation of the law of
increasing returns.

iii) Law of Diminishing Marginal Returns: When one variable input used for
the production of a certain commodity is increased relative to other inputs, the
physical output obtained from each added unit of the variable input(s), tends to
decline after a certain point has been reached. Thus, each additional unit of the
variable input results in less and less addition to the total output as shown in the
figure 10.3. Mathematically, ∆ Y1 ∆ Y2 ∆ Yi ∆Yn
> > ... > ... >
∆ X1 ∆ X2 ∆ Xi ∆Xn
∆ X2 ∆ Y 2
Output (Y)

∆Y1 where ∆Y i / ∆Xi , i =1, 2, 3, . . . n is the marginal product

due to the use of ith unit of the variable input (X). Thus,
∆X1
the marginal productivity of the variable input X goes on
declining with the increasing level of total output as a
result of more intensified use of the variable factor. This
type of return can be shown geometrically by a non-linear
Variable Input (X)
curve of the type shown in the figure 10.3. Such a curve
Fig.10.3 Law of Decreasing
Returns would be concave to the input axis and convex upwards.
We can also demonstrate the operation of this law with the help of data on nitrogen
application and yield of paddy per hectare in Table 10.3 below:

127
 The table 10.3 would reveal that as more of the variable input (X) is used, the
yield of paddy also keeps on increasing till 90 kgs of nitrogen application and
results in 69 quintals of paddy yield per ha. However, the paddy yield remains
unchanged when the variable input level is increased from 90 to 120 Kg per
hectare. Further, it could be noted that every addition of one kg of nitrogen
nutrient (∆Xi) adds less and less of output, i.e., from 0.60 to 0.33, from 0.33 to
0.13 and so on. This is a technological law of biological responses and is
Table 10.3 Yield of Paddy at Varying Levels of Nitrogen per Hectare

Variable Input (Kgs ∆ Xi Output (Quintals of ∆ Yi ∆ Yi

MPP =
of Nitrogen per Ha) Paddy per Ha)
∆ Xi

0 - 37 - -
30 30 55 18 0.60
60 30 65 10 0.33
90 30 69 4 0.13
120 30 69 0 0

applicable in almost all-practical situations of agricultural production under

varied farm situations. This law also refers to diminishing marginal productivity
of a variable factor of production, with other factors held constant at some
specified levels, as its use is intensified.

a) Law of Diminishing Marginal Returns (LDMR)

Alfred Marshall stated the law thus: “An increase in labour and capital
applied in the cultivation of a land causes, in general, a less than
proportionate increase in the amount of produce raised, unless it happens to
coincide with an improvement in the arts of agriculture”.

The advancement in agricultural technology may bring about changes where

the operation of this law is delayed, for example, by evolving, varieties of crops,
which give higher yields at higher levels of fertilizer application. But so far,
science has not succeeded in stopping the operation of this law in agriculture.
The law of diminishing returns is also called the law of variable proportions.
E.O. Heady has stated that if the quantity of one productive service is increased
by equal increments, with the quantity of other resource services held constant,
the increment to total product may increase at first but will decrease, after a
certain point. In other words, as the amount of a variable resource used in the
production of an output is increased, the level of output will at first increase at
an increasing rate, then increase at a decreasing rate and finally a point will be

128
reached, where further applications of the variable resource will result in a
decline in the total output of the production.

b) Relationship between Total, Average and Marginal products (or) Three

Stages or Phases or Zones of Production Function: Since both average and
marginal products are derived from total product, the average and marginal
product curves are closely related to the total product curve. The input-output
relationship showing total, average and marginal productivity can be divided into
three regions in such a manner, that one can locate the portion of the production
function, in which the production decisions are rational. A non-linear total
product curve and the three zones of production are shown in the figure 10.4.

Stage I: As we increase the level of a variable input, say seed rate per hectare,
the total production (yield per hectare) increases at an increasing rate till point
‘L’ is reached on the TPP curve. Thus, upto this point (L) the marginal physical
product (MPP) is shown as increasing and then it starts declining. Point L is the
point of inflection on the TPP curve where the curvature changes from convex to
concave to the input axis as we move away from origin. The TPP curve is
continuously increasing but at a decreasing rate as we move from the point L to
M on TPP by increasing the seed rate from Xi to Xm. The stage I ends at the
point N where marginal product is equal to average product when the latter is at
its maximum. In this stage, APP keeps on increasing and MPP remains greater
than APP. It is not reasonable to stop the use of an input when it’s efficiency-in-
use is increasing (This is indicated by
M continuous increase in APP). In this
Ym stage, more use of variable input
Stage I
TPP = Y = f (X) increases its physical production
N efficiency in combination with fixed
Stage II Stage III inputs. So it is irrational to stop
increasing the use of variable input, as
.
Output (Y)

L
long as fixed inputs are not fully
utilized. For this reason, it is called
irrational stage of production.

APP Stage II: The Stage II occurs when MPP

O
Xi Xm is decreasing and is less than APP. In
Variable Input (X1) MPP Stage II, MPP is equal to or less than
Fig 10.4 Three Zones of Production APP but equal to or greater than zero. It
Function

129
starts at a point where APP is at its maximum and ends where the total product is
at its maximum. Within the boundaries of this region is the area of economic
relevance. It is only in this region that marginal product of variable and fixed
factors are positive. Optimum point of input-use must be somewhere in this
region. Hence, it is called rational stage of production. The optimum point can,
however, be located only when input and output prices are known. It needs to be
emphasized that this region of rational production embodies diminishing returns
phase. Both average and marginal products are decreasing in this region.

Stage III: A part of TPP curve beyond the point M is called the third phase of
production. As variable input use is extended beyond X m , the marginal product
beyond point M is negative. It is irrational to increase the input level for
obtaining lower total product. Thus, Stage III is also called irrational stage of
production. The difference between the irrationality in Stage I and Stage III can
be explained in terms of scarcity of the variable input in Stage I and its excess
use in Stage III in relation to the fixed factors of production. Thus, while the
marginal product of the variable factor is negative in the third stage of
production, the same is precisely true for the fixed factor in the first stage of
production. E.g.) more fertilizer dosage, excessive irrigation, etc. would result in
reduction of yield.

Total physical product function (TPP): Y = 4X+2X 2 - 0.1X 3

Average physical product function (APP): Y /X = 4+2X-0.1X 2

Marginal physical product function (MPP): = dY / dX = 4 + 4X - 0.3X 2

c) Relationship between APP, MPP and Elasticity of Production

The elasticity of production refers to the percentage change in output in

response to the percentage change in input. It can be denoted by Ep and can be
computed as: ∆Y × 100 ∆Y
Y Y ∆Y X ∆Y 1 MPP
Ep = = = × . Therefore, Ep = × =
∆X × 100 ∆X ∆X Y ∆X Y/X APP
X X

Thus, elasticity of production can also be worked out if MPP and APP are
known. In the figure 10.4, at the end of stage I, the Ep is unity (a one per cent
increase in input is always accompanied by a one per cent increase in output). In
stage I, MPP is greater than APP. Therefore, Ep is greater than 1. In stage II,
MPP is lesser than APP and Ep is lesser than one, but greater than zero,
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(0 ≤ Ep ≤ 1). In stage III, MPP is negative and Ep is also negative. E.g. when X
5 (0 + 1)
increases from 0 to 1 unit and Y increases from 0 to 5,
Ep = = 1.00
1 (0 + 5)
When X increases from 1 to 2 units and Y increases from 5 to 11 (Arc elasticity
method), 6 (1 + 2) 18
Ep = = = 1.125.
1 (5 + 11) 16

d) Impact of Technological Change on Production Function: Technology is

the knowledge applied by man to improve production or marketing process. The
physical and value productivities of farm resources have been changing
continuously due to the constant flow of innovations in agriculture. Technology
can help producing more quantity of product per unit of input. This means that
more total output can be produced from inputs that were used prior to the
technological innovation, or the same amount of total product can be produced
with fewer resources. There can be different levels and grades of technology
available to a farmer. For example, application of fertilizer is possible with the
broadcast method, band application and or spray method. Use of same quantity
of the fertilizer through different methods (technologies) will give different
yield levels. Similarly a different variety of a crop (paddy) such as white ponni,
IR 20, IR 50, etc will give different yields. For the same quantity of input,
different yield levels can be obtained (Y 1 , Y 2 and Y 3 ) using different types of
Y6 technologies (T , T and T ) as shown in
1 2 3

T3 Fig.10.5. The technological advances result

Y3 Y5
in:
Y2 T2
Y4
Y1 1) Factor saving technologies, or cost
reducing technologies, such as development
T1
Output

of improved tractors.

2) Yield increasing technology – high

yielding varieties and hybrid varieties.
0 X1 X4X5 X6
Variable Input 3) Both factor saving and yield increasing
Fig.10.5 Impact of Technological technology.
Change on Production Function
B. COSTS

Production costs play an important role in the decisions of the farmers.

Explicitly or implicitly, most of the producers keep in mind the cost of
producing additional units of output. In general, at given level of prices, a
farmer can increase his farm income in two ways, i.e., i) by increasing

131
production and / or ii) by reducing the cost of production. Since cost
minimization is an individual skill, degree of success in this direction directly
adds to the profits of the farm.

Costs refer to the money value of effort extended or sacrifice made in

producing an article or rendering a service or achieving a specific purpose.
Costs, thus, are the expenses incurred in organizing and carrying out the
production process. They include outlays of funds for inputs and services used in
production. Money value of all inputs used in the production process is termed as
the total cost. If the inputs used are represented by X 1 , X 2 ,..., Xn and the
respective prices by Px 1 , Px 2 , ..., Px n , then the total cost (TC) can be expressed
as: TC = Px 1 .X 1 + Px 2 .X 2 + ... + Px n X n.

i) Total costs: The total cost comprises of two components, i.e., fixed and
variable costs. Costs of fixed inputs are called fixed costs, while costs of
variable inputs are called variable costs. TVC and TC increase as output
increases. Fixed costs do not change in magnitude as the amount of output of the
production process changes and are incurred even when production is not
undertaken, i.e., fixed costs are independent of output. Land revenue, taxes,
contractual payments such as rent and interest on capital for the use of fixed
resources, and the value of services from fixed resources all represent fixed
costs. In farming, cash fixed costs include land taxes, rent, insurance premium,
etc. Non-cash fixed costs include depreciation of building, machineries and
equipments caused by the passing of time, interest on capital investment, charges
for family labour and charges for management. Variable costs constitute the
TC outlay of funds that are a function of output in a given
production period, i.e., they vary with the level of
output. The outlays of funds on seed, fertilizer,
Cost (Rs)

insecticide, casual labour, fuel and oil, feeds, etc, are

TVC a few examples of variable costs. Total fixed costs
and total variable costs are denoted by TFC and TVC
respectively. In short run, total costs include fixed and
variable costs. When no variable input is used,
TFC TC=TFC. The TC curve at any point is equal to the
vertical addition of TFC and TVC. In the long run, all
Output costs are considered variable costs because all inputs
Fig.10.6 Total Cost Curves are variable. Conventionally, total cost (TC) is
thought of as a function of output (Y), rather than that of inputs, i.e., TC =
f (Y).Such a cost curve is illustrated with TC on the vertical axis and Y (output)
132
on the horizontal axis. The total cost curve is similar to the production curve,
when the physical units of X (input) have been replaced with the corresponding
cost (P x X). Hence, the shape of the TC curve, like that of the TVC curve,
depends upon the production function. In symbolic notation, TC can be written
as:

TC = TFC + TVC = TFC + P x X, where TVC = P x X.

ii) Average Fixed Cost, Average Variable Cost and Average Total Cost
a) Average Fixed Costs (AFC): Average fixed costs, (AFC) are computed by
dividing total fixed costs by are amount of output. AFC varies depending on the
amount of production.
TFC
AFC =
Y
b) Average variable cost, AVC: It is computed by dividing total variable cost
by the amount of output. AVC varies depending on the amount of production.
The shape of the AVC curve depends upon the shape of the production function
while AFC always has the same shape regardless of the production function.

c) Average Variable Cost and Average Physical Product: Average variable

cost is inversely related to average physical product. When APP is increasing,
AVC is decreasing. When APP is at its maximum, AVC attains a minimum value.
When APP is decreasing, AVC is increasing. Thus, for a production function,
APP measures the efficiency of the variable input, while AVC provides the same
measure for cost curves. When AVC is decreasing, the efficiency of the variable
input is increasing; efficiency is at a maximum level when AVC is a minimum
and is decreasing when AVC is increasing. The relationship algebraically is as
follows:
TVC PxX X Px X 1
AVC = = = Px = , because =
Y Y Y APP Y APP

d) Average Total Costs, ATC: It can be computed in two ways. Total costs can
be divided by output or AFC and AVC can be added.

ATC = TC / Y. (or) ATC = AFC+AVC.

e) Nature and Relationship between Cost Curves: The shape of the ATC curve
depends upon the shape of the production function. ATC decreases as output
increases from zero, attains a minimum, and increases thereafter. ATC is
referred to as unit cost of production, i.e., the cost of producing one unit of
output. The initial decrease in ATC is caused by the spreading of fixed costs
133
 among an increasing number of units
MC of output and the increasing
ATC efficiency with which the variable
Cost (Rs)

AVC units is used (as indicated by the

decreasing AVC curve). As output
increases further, AVC attains a
minimum and begins to increase;
when these increases in AVC can no
longer be offset by decreases in AFC,
AFC
ATC begins to rise. AVC reaches its
Output lowest point earlier than ATC.
Fig.10.7 Average and Marginal Cost Curves

iii) Marginal Cost, MC: It is defined as the change in total cost per unit
increase in output. It is the cost of producing an additional unit of output. MC
is computed by dividing the change in total costs, ∆TC, by the corresponding
change in output, ∆Y, i.e., MC =∆TC / ∆Y. By definition, the only change
possible in total costs is the change in variable cost, because fixed cost does not
vary as output varies. Thus, ∆TC =∆TVC. Therefore, MC could also be
computed by dividing the change in total variable cost by the change in output.
Geometrically, MC is the slope of the TC and the TVC curve. The shape of the
MC curve is in an inverse relationship to that of MPP. For lower levels of
output, MC is decreasing while MPP is increasing. Algebraically, the
relationship between MPP and MC can be shown as:
∆ TC ∆TVC Px (∆X) ∆X Px
MC = = = = Px . =
∆Y ∆Y ∆Y ∆Y MPP
MC and AVC are equal, where MPP is equal to APP. For lower output levels,
MC is less than AVC and ATC and for higher output levels, MC is greater than
AVC and ATC. As long as there is some fixed costs, MC crosses ATC at an
output greater than the output at which AVC is at the minimum and MC is equal
to ATC at the latter’s minimum point. MC curve will intersect the AVC and
ATC curves at their lowest point from below.
Costs need be computed and graphed for input and output amounts only in
stages I and II of the production function; stage III is an area in which no
rational manager would produce. Stage II begins at the point where MC=AVC
and continues to the point where output is a maximum.

TC = 100 + 8Y - 0.4Y 2 + 0.02Y 3

TFC = 100

134
 TVC = 8Y - 0.4Y 2 + 0.02Y 3
AVC = TVC = 8 – 0.4Y + 0.02Y 2
Y
AFC = TFC = 100
Y Y
ATC = AFC + AVC = 100Y -1 + 8 – 0.4 Y + 0.02Y 2
MC = dTVC = 8 – 0.8 Y + 0.06Y 2
dY

iv) Methods of Determining the Optimum Level

The problem here is to determine the most profitable point of operation for
an enterprise in the short-run. This can be done by determining either the most
profitable amount of input or the most profitable level of output. As the
production function relates the input to output in a unique manner in stage II,
either method results ultimately the same answer. In economic terminology, the
“most profitable” amount can be called the “optimum” amount.
a) Determining the Optimum using Total Value Product and Total Costs:
Total Value Product, TVP, is the total value of the production of an enterprise.
TVP = Py. Y, where Py is the price per unit of the output and Y is the amount of
output at any level of input X. Total value product minus total cost is the profit
which is also called net returns or net revenue. As output increases, profit
increases and reach a maximum of Rs.30 at 8 units of input and 28 units of
output as could be seen from the table 10.4. Maximum profit from an enterprise
does not necessarily occur where output is at its maximum. Output reaches a
maximum of 29 units at 9 units of input. Therefore, the point of maximum yield
is not necessarily the same as the point of maximum profit.
Profit = TVP – TC = TVP –TVC – TFC = Py.Y – Px X – TFC.

b) Determining the Optimum Amount of Input

The criterion for determining the optimum amount of input is derived from
the slopes of total value product and total cost curves, when those curves are
plotted as functions of the input, X. First, consider the profit equation as the
function of input.
Profit = Py. f(X) – Px X – TFC, where, Y = f(X).
In order to maximize this function with respect to the variable input, the first
derivative is set to zero as follows:
d (Profit) dY
= Py Px = 0
dX dX
= Py.MPP – Px = 0
Py.MPP = Px , i.e., VMP = Px.

135
But, the term Py. MPP is the slope of TVP curve and is called the Value of
Marginal Product (VMP). The term Px is the slope of the total cost function. In
pure competition, Px will always be constant. Dividing both sides of Py, we get,
Px
MPP = . So, another method of stating the marginal criterion is to say that
Py
the marginal product of variable input must equal the inverse ratio of prices
(input - output price ratio).

c) Determining the Optimum Amount of Output

The marginal conditions for the maximization of profit as a function of

output can be derived from the following profit function:

-1
Profit = TR – TC = Py.Y – Px. X – TFC =Py.Y – Px.f (Y) – TFC

where, the concept of the inverse production function must be used to

express X as a function of Y. That is, X = f -1 (Y) in stages I and II. Taking the
derivatives of profit with respect to Y results in: d (profit) dX
= Py – Px =0
dY dY
Px
= Py – =0
MPP Px
Py = MC⋅ Since MC =
MPP
Therefore, Py = MC at the optimum output level. Differentiation of profit equation with
respect to Y would give .d ( Profit) d TR d TC
= − =0
dY dY dY
d TR d TC
= i.e., MR=MC
dY dY
where, the change in TR with respect to Y is defined as Marginal Revenue, MR,
while the change in TC with respect to Y is the Marginal Cost, MC. In pure
competition Py = MR.
d) Comparison of Input and Output Criteria: All methods of determining the
most profitable level of output or input lead to comparable answers. The input
criterion VMP = Px can be written as Py. MPP = Px (or)
∆Y
Py. = Px . That is, Py. ∆Y = Px. ∆X
∆X

136
 Table 10.4 Product-Cost Relationships
Input Total Average Marginal Total Total Total Average Average Average Marginal Marginal
(Units) Output Product Product Fixed Variable Cost= Fixed Variable Total Cost Revenue
(Units) =Y/X = ∆Y/∆X Costs Cost TFC+ Cost Cost Cost (MC) (MR)
(Units) (Units) (TFC) (TVC) @ TVC (AFC) (AVC) (ATC) =∆TC/∆Y =∆TR/∆Y
(Rs) Rs.2/Unit (Rs) =TFC/Y = TVC/Y = TC/Y
0 0 0 0 10 0 10 0 0 0 - -

1 2 2.00 2 10 2 12 5.00 1.00 6.00 1.00 2

2 5 2.50 3 10 4 14 2.00 0.80 2.80 0.67 2

3 9 3.00 4 10 6 16 1.11 0.67 1.78 0.50 2

4 14 3.50 5 10 8 18 0.71 0.57 1.28 0.40 2

5 19 3.80 5 10 10 20 0.53 0.53 1.06 0.40 2

6 23 3.83 4 10 12 22 0.43 0.52 0.95 0.50 2

7 26 3.71 3 10 14 24 0.38 0.54 0.92 0.67 2

8 28 3.50 2 10 16 26 0.36 0.57 0.93 1.00 2

9 29 3.22 1 10 18 28 0.34 0.62 0.96 2.00 2

10 29 2.90 0 10 20 30 0.34 0.69 1.03 - 2

11 28 2.55 -1 10 22 32 0.36 0.79 1.15 - 2

12 26 2.17 -2 10 24 34 0.38 0.92 1.30 - 2

137
 TR
TVP
TC

TC

X Y
0 0

PROFIT
TC
PROFIT
0 0 TR

X Y

MC

Py
ATC
AVC
Px

VMP AFC
X Y
0 0
Fig.10.8 (a) Determining the Optimum Fig. 10.8 (b) Determining the
Amounts of Input Using Total Value Optimum Amount of Output
Product, Total Cost, Profit and Value Using Cost and Revenue
of Marginal Product Curves. Curves

177
 The expression, Py.∆Y measures returns added by an increase in output while
Px.∆X measures the cost added by the increase in input. But from the output
criterion, Py = MC, the same added cost and added return can be derived.

Px ∆X
Py = MC = = Px
MPP ∆Y
Py. ∆Y = Px. ∆ X
Thus, the two methods of determining the optimum levels are comparable.
Table 10.5 Response of Paddy to Nitrogen:
Application of Profit Maximization Principle.
Variable Output Total Cost Total Value Product Profit =
Input (Y) =TFC (Rs.10)+TVC =Py.Y @Rs.2/unit of TVP-TC
(X) @Rs.2/unit of input output
0 0 10 0 -10
1 2 12 4 -8
2 5 14 10 -4
3 9 16 18 2
4 14 18 28 10
5 19 20 38 18
6 23 22 46 24
7 26 24 52 28
8 28 26 56 30
9 29 28 58 30
10 29 30 58 28
11 28 32 56 24
12 26 34 52 18

e. Minimum Loss Principle

There can be two decision situations: 1) when selling price covers the
average total cost and 2) when selling price is less than average total cost but
more than average variable cost. In short run, only variable costs are important
in decision-making. In short-run, if price falls below short-run average cost, the
firm has no choice but to incur losses. The firm will shut down production, if
price falls below average variable cost. So the minimum of average variable cost
is the shut down point. This minimum price at which shutting down becomes the
preferred alternative is the shut down price.

While production should be maintained in the short run if selling price is

above variable cost, it cannot be continued indefinitely unless selling price
178
exceeds average total costs. Unless all fixed costs are returned over long period,
the farmer must either switch over to other occupations or experience a
continuous decline in living standards. Thus, if the total returns are more than
the total costs, the objective of the producer is to maximize the profit. If the MR
is less than the ATC, but more than AVC, the objective of the producer is to
minimize the loss in short run. When price of output is at P 0 , there is profit as
the equilibrium (MC = MR) is above the minimum of ATC. When price is at P 2 ,
the loss in short run, is EP 2 or CD or EP 2
MC CD. The price P 3 is the shut down price.
Break Even Point
Cost and Price

ATC When price of output is at P 4 , the farm

P0 B
would incur loss, as it does not cover even
AVC
E D F
P1 the minimum of AVC. When price is at
P2 C minimum of ATC (P 1 ), there is neither
AFC
P3 profit nor loss. Hence, minimum of ATC is
Shut Down Point
P4 the break-even point where both fixed and
O Y3 Y2 Y1 Y0 variable costs are covered.
Fig.10.9 Break-Even and Shut Down
Points
f) Factor - Product Price Changes and Production Decisions
The decision-maker or farmer has to expect changes in optimum output, if
either the price of output (Py) or the price of factor (Px) changes.
MC2
AVC2
MC1 AVC1
Cost and Return

MC AVC AVC2
P0 MR0=AR0
P1 MR1=AR1 MR (PRICE ) =AR
MR =AR
P2 MR20=AR20

Y1
0 Y2 Y0 Y1 Y0
Fig.10.10 (a) Effect of Changes in Output Fig. 10.10 (b) Effect of Changes in Input
Prices Prices
1) Effect of changes in output prices: A decrease in product price would result
in decrease of marginal revenue for each level of output. Thus, the optimum
output level would decrease from Y 0 to Y 1 , if output price decreases from P 0 to
P 1 and this would indicate a direct relationship between product price and
optimum output levels (Fig. 10.10 (a)).

2) Effect of changes in input prices: An increase in price of variable input

causes the cost curves to move upward Fig. 10.10 (b). The intersection of MC 2
179
with MR will be at a lower output point and production will be reduced from Y 0
to Y 1 in order to maximize the profit. There is an inverse relationship between
the factor price and optimum output, i.e., the optimum output level decreases if
input price increases.

g) Importance of cost study: The cost study is useful: 1) to calculate profit or

loss of an enterprise; 2) to determine the relative profitability of various
enterprises; 3) to identify the causes for variations in the unit cost of production;
4) to determine the efficiency and intensity of input-use; and 5) to determine the
optimum requirements of variable inputs for each enterprises.

i) Cost of Production and Cost of Cultivation: Cost of production is referred

to the expenses incurred per unit of output whereas cost of cultivation is referred
to the expenditure incurred per unit area. Cost of production for major crops is
often discussed for government’s policy formulation in price fixation. Moreover,
farmers often lodge complaints on the ground that the price does not cover the
cost of production. Hence, the need to study the cost components and cost of
production of various crops is evident. Better understanding of various cost
components would be useful to control and manage different cultivation
practices.

ii) Cost Concepts: Some of the cost concepts used in farm management studies
by the Commission on Agricultural Costs and Prices (CACP) of Government of
India are A 1 , A 2 , B 1 , B 2 , C 1 and C 2 , which are defined as follows:

Cost A 1 includes:

1. Value of human labour (casual and permanent).

2. Value of bullock power (owned and hired).

3. Value of machine power (owned and hired).

4. Value of seeds.

5. Value of manures and fertilizers.

6. Value of plant protection chemicals.

7. Value of weedicides.

8. Irrigation charges.
180
 9. Land revenue and other taxes.

10. Depreciation on farm implement and farm buildings.

11. Interest on working capital.

12. Other miscellaneous expenses.

The following concepts can be used for easy calculation of the cost of
cultivation.

1) Depreciation for buildings: 2 per cent for pucca building; 5 per cent for
tiled building and 10 per cent for katcha building.

2) Depreciation for implements: 10 per cent for major implements and 20

per cent for minor implements.

3) Depreciation for cattle: Appreciation in the value of animals during the

first 3 years would be at the ratio of 1:3:5.It remains constant during 4 th and 5 th
year. Then it is assumed that the value of animal depreciates @ 12.5 per cent per
year from 6th to 14 th year in straight-line method.

4) Interest on working capital: 12 per cent per annum or opportunity cost of

capital.

Cost A 2 = Cost A 1 + Rent paid for leased in land.

Cost B 1 = Cost A 1 + Interest on the value of owned capital assets (excluding

land).

Interest rate of long - term government floated loans or securities: 10 per cent.

Cost B 2 = Cost B 1 + Rental value of owned land (less land revenue) and Rent
paid for leased in land.

Cost C 1 = Cost B 1 + Imputed value of family labour.

Cost C 2 = Cost B 2 + Imputed value of family labour.

iii) Income measures in relation to different cost concepts

1. Farm Business Income = Gross Return - Cost A 1.

2. Owned Farm Business Income = Gross Return - Cost A 2.

181
 3. Family Labour Income = Gross Return - Cost B 2.

4. Net Income = Gross Return - Cost C 2.

5. Farm Investment Income = Net Income + Imputed rental value of owned

land + Interest on fixed capital.

iv) Opportunity Cost

Every resource used in the production process has but one true cost; its
opportunity cost. The opportunity cost of a resource is the return, the resource
can earn when put to its best alternative use. Suppose, a farmer applies fertilizer
(50 kgs) to paddy will add Rs.500 and application of fertilizer (50 kgs) to
sugarcane would add Rs.600. Now, if he fertilizes sugarcane, the opportunity
cost of fertilizer is Rs.500; he has foregone Rs.500 to earn Rs.600. Every
resource used in the production process, thus, has but one true cost; opportunity
cost, the next best alternative foregone.

v) Economic Efficiency

Economic efficiency refers to the combinations of inputs that maximize an

individual’s objectives. Economic efficiency is defined in terms of two
conditions, namely, necessary and sufficient.

a) Necessary condition: This condition is met in a production process where

there is (1) no possibility of producing the same amount of product with fewer
inputs (reducing one or more resources) and (2) no possibility of producing more
product with the same amount of inputs. In production function analysis, this
condition is met in stage II; that is, when the elasticity of production is equal to
or greater than zero and is equal to or less than one (0 ≤ εp ≤ 1). The necessary
condition refers only to the physical relationship. It is universal because it is
applicable in any economic system. No one would knowingly produce in stage
III because the same or larger output could be obtained by moving to stage II
with lesser input. In a given input-output relationship, many input-output
combinations will satisfy the necessary condition. For this reason, an additional
condition is needed to single out one alternative from the many that meet the
necessary condition.

b) Sufficient Condition: Unlike the necessary condition, which is objective, the

sufficient condition for efficiency encompasses individual or social goals and
values. In abstract theory, the sufficient condition is often called a choice
182
indicator. The choice indicator helps the manager determine input-use
compatible with his objectives. The sufficient condition for an individual
striving for high yields per acre will be different from that of an individual
whose objective is maximization of profits per acre. In either of these cases,
while the choice indicators satisfying the sufficient condition vary, economic
efficiency is met because the manager is achieving his goals. Thus, the above
elementary variations consider all the possible inter and intra planning period,
rate of transformation, technical substitution and product transformation for the
input-output, input-input and product-product relationships. The set of necessary
and sufficient conditions for profit maximization, corresponding to the above
three elementary operations is in Table 10.6 below:

Table 10.6 Necessary and Sufficient Conditions

Necessary condition Sufficient condition

1. The marginal product of any 1.There must be a diminishing

factor with respect to any marginal product of a factor with
product must equal the ratio of respect to a product.
their prices. ∆Y Px
=
∆X Py 2.The rate of technical substitution
2. The rate of technical substitution between inputs must be diminishing
between any two inputs must equal (Iso quant is convex towards
the ratio of their prices.
∆ X1 Px2 origin).
=−
∆ X2 Px1
2. The rate of product
3.The rate of transformation between
transformation for every pair of
products must be increasing (product
products must equal the ratio of
transformation curve is concave
their prices: ∆ Y1 Py2
=− towards origin).
∆ Y2 Py1

vi) A Choice Indicator: A choice indicator is a yard stick or an index or a

criterion indicating which of the two or more alternatives is optimum or will
maximize a given objective or end. E.g. Price ratio, substitution ratio, etc. A
product can be produced in many ways through different combinations of
resources and techniques. The most desirable combination of products or factors
cannot be determined without a choice indicator.
183
 a) Optimum Input: P y MPP = P x (or) VMP = P x

b) Optimum Output: P y = MC
∆X1 Px2 MPPx2y
c) Least Cost Combination: = =
∆X2 Px1 MPPx1y

∆Y1 Py2 MPPxy1

= =
d) Maximum Revenue Yielding Combination:
∆Y2 Py1 MPPxy2
A choice must be made with the help of an indicator listed above. It is
usually expressed in monetary terms, but could be any other index that reflects
likes and dislikes of the farmers. For example, while making a decision, a farmer
might ask himself whether paddy is yielding the return twice as much or one-half
as much as a competing crop, say irrigated ground-nut. In the study of
production economics, the commonly assumed goal of the farm manager is
economic efficiency, which would subsume the narrower goal of profit
maximization.

Chapter 10: Questions for Review:

1. Fill up the following:

i) The co-efficient of elasticity of production ranges from to in
the second stage of production.
ii) Average physical product is inversely related to , while is
inversely related to marginal cost.

iii) Law of diminishing marginal returns will not operate, unless there is a
change in .

iv) MPP =APP, when APP is at its level.

v) Slope of the total physical product is indicated by .

vi) MC cuts AVC at its level.

vii) In the short run, the objective in farming should be to cover cost.

viii) Gross return is equal to total production times .

ix) When output increases, the average fixed cost continuously.

x) The ratio between MPP and APP is called .

184
2. Define the following:

i) Cost.

ii) Optimum Input level and Optimum Output level.

iii) Average Variable Cost.

iv) Marginal cost and Marginal revenue.

v) Elasticity of production.

vi) Opportunity Cost.

vii) Cost of cultivation and Cost of production.

viii) Law of increasing returns and law of constant returns.

ix) Physical optimum and Economic optimum.

x) Value of Marginal Product.

xi) Choice indicator.

3.Write short notes on the following:

i) Objectives of factor-product relationship

ii) Impact of technological change on production function (or) Impact of

improvement in technology on optimum levels of input and output.

iii) Shut down point and Break-even point (or) Minimum loss principle.

iv) Impact of prices of input and output on optimum quantity of output to be

produced.

v) Necessary and Sufficient conditions of optimality.

3. Answer the following:

i) Define the law of diminishing marginal returns. Explain the three zones of
production function with illustration. How Zone II is rational when compared to
the other Zones of production function?

185
ii) Explain the seven cost curves with suitable illustrations.

iii) Discuss the various components cost of cultivation.

iv) What is the significance studying of cost concepts? How will you derive the
following income measures using these cost concepts: a) Farm business income,
b) Family labour income and c) Farm investment income?

FACTOR – FACTOR (OR)

INPUT – INPUT RELATIONSHIP

In factor-product relationship, we studied the situation where only one input

is varied and all other variables are held constant. But in most real world
situations, two or more inputs are often varied simultaneously. So a farmer must
choose the particular combination of inputs which would minimize the cost for a
given output level. Thus, the main objective here is minimization of cost at a
given level of output. When two or more inputs are variables, a given amount of
output may be produced in more than one way, i.e., there is a possibility of
substituting one factor (X 1 ) for another (X 2 ) as product level (Y) is held
constant. The objectives of factor-factor relationship are i) minimization of cost
at a given level of output and ii) optimization of output to the fixed factors
through alternative resource-use combinations. In this case, the production
function is given by Y = (X 1 , X 2 / X 3 ,..., Xn), i.e., the production depends on the
amounts of X 1 and X 2 while the other inputs are held constant.

A. ISOQUANT (OR) ISO PRODUCT CURVE

An isoquant is defined as the locus of all combinations of inputs, X 1 and X 2 ,

for obtaining a given level of output, say, Y (0) . Mathematically, such an
isoquant is written as: X 1 = f (X 2 , Y (0) ) or X 2 = f (X 1 , Y (0) ). Some of the
important types of isoquants depending upon the degree of substitutability
between the inputs, are given in figures below:

i) Linear Isoquant: In this case, two inputs substitute at constant rates. Labour
input supplied by different persons substitutes at a constant rate. Ammonium
sulphate containing 20.6 per cent nitrogen and urea containing 46 per cent
186
nitrogen would substitute for each other at a constant rate. The decision rule is
simple, i.e., use either of the two factors of production depending on their
relative prices. The rate at which one factor (X 1 ) is substituted for one unit
increase in another factor (X 2 ) at a given level of output is called Marginal Rate
of Substitution (MRS). The marginal rate of substitution of X 2 for X 1 is denoted
by:

In linear isoquant, the rate at which these two inputs can be substituted at a
given level of output is constant regardless of the level of the two inputs used.
∆ X11 ∆ X1 2 ∆ X1n
MRSx2 x1 = = =...=
∆ X21 ∆ X2 2 ∆ X2n

X1 X1

X1 = f (X2, Y (0))
. X1 = f (X2, Y (0) )

.
X2
X2
Fig.11.1 Linear Isoquant Fig.11.2 Inputs Combine in Fixed Proportion
ii) Fixed Proportion Combination of Inputs (Perfect Complements): Inputs
that increase output only when combined in fixed proportions are called
technical complements. Only one exact combination of inputs will produce the
specified output. A tractor and a driver may serve as a fairly good example.
Here, there is no economic problem in decision-making because there exists no
alternative choice.

iii) Varying (Decreasing) Rate of Substitution: The amount of one input (X 1 )

required to be substituted for by one unit of another input (X 2 ) at a given level of
production decreases. This is known as decreasing rate of substitution. Thus,
decreasing rate of substitution means that every subsequent increase in the use of
one factor replaces less and less of the other.
∆ X11 ∆ X1 2 ∆ X1n
MRSx2 x1 = > >...>
∆ X21 ∆ X2 2 ∆ X2n

187
 Each point on the isoquant is the maximum output that can be achieved with
the corresponding input combination. Isoquants are convex to the origin
Fig.11.3. Two isoquants do not intersect each other.

iv) High contours represent higher output levels: Isoquant map indicates the
shape of the production surface, which again indicates the nature of output
response to the inputs. An isoquant which is far away from the origin represents
higher level of output than an isoquant which is closer to the origin.

v) Marginal Rate of Input (Factor) substitutions (or) Rate of Technical

Substitution (RTS): Marginal Rate of Substitution of X 2 for X 1 (MRS X2X1 ) is
defined as the amount by which X 1 must be decreased to maintain output at a

constant level when X 2 is increased by one unit. Between the two points (X 2 =2,
X 1 =10) and X 2 =3, ∆XX
1 = 5),5 the
- 10 MRS
-5 of X 2 for X 1 is,
1
MRSx2 x1 = = = = -5 .
∆ X2 3–2 1

The MRS is negative, because the isoquant slopes downward and to the right;
that is, the isoquant has a negative slope.

Table 11.1 Decreasing Rate of Substitution

Variable Variable ∆X 1 ∆X 2 ∆X1
MRS =
Input (X 1 ) Input (X 2 ) ∆X2

23 0 - - -
16 1 7 1 -7
10 2 6 1 -6
5 3 5 1 -5
1 4 4 1 -4
0 5 1 1 -1

vi) Isocost line: Isocost line determines all combinations of the two inputs that
cost the same amount. Each point on the isocost line represents a combination of
X1
X1
X1 = f (X2, Y (0)) Isocost Line

X2
188
 X2
Fig.11.3 Convex Isoquant. Fig.11.4 Isocost Line
inputs that can be purchased with the same outlay of funds (Fig.11.4). Under
constant price situation, each possible total outlay has a different isocost line.
As total outlay increases, isocost line moves higher and higher and moves farther
away from the origin. Changes in the input prices will change the slope of
isocost line as the slope indicates the ratio of input prices. A decrease in the
input price means that more of that input can be purchased with the same total
variable cost; an increase means that less can be purchased.

Total Outlay = Rs.36; Price of X1

= Rs. 4; Price of X2 = Rs.3;
When X 1 = 0, X 2 = 12; When X 2 = 0, X 1 = 9.

The equation of the isocost line can be found by solving the TVC equation
for X 1 as an explicit function of X 2 .Px 1 X 1 = TVC – Px 2 X 2 and
TVC Px2
X1= X2
Px1 Px1
From this expression, it can be seen that the slope of isocost line is – Px 2 /
Px 1 while the intercept on X 1 is TVC / Px 1 .

vii) Least cost combination: The problem here is to find out a combination of
inputs, which should cost the least, i.e., minimization of cost. The tangency of
isocost and isoquant would indicate the least cost combination of X 1 and X 2 , i.e.,
slope of isoquant = slope of isocost. Least cost combination is given,
algebraically, by equating th e MRS X2∆XX Px2ratio.
1 1to price
MRSx2 x1 = = ,i.e., - Px1 (∆ X1) = Px2 (∆ X2)
X1 ∆ X2 Px1
If - Px 1 (∆X 1 ) > Px 2 (∆X 2 ), then, the
Isoquant
cost of producing the given output amount
Iso Cost Line could be reduced by increasing X 2 and
decreasing X 1 because the cost of an added
Least Cost
unit of X 2 is less than the cost of the units
Combination
of X 1 , it replaces. On the other hand, if
between two points of the isoquant,
X2
Px 1 (∆X 1 ) < - Px 2 (∆X 2 ), then the cost of
Fig.11.5 Least Cost Combination
producing the specified quantity of output can be reduced by using less X 2 and
adding X 1 .

The marginal physical product equations can be used to determine the returns
per rupee spent at the least cost point. Rewriting the least cost combination as:
189
 MPPx1 MPPx2 Y = f (X1 , X2 )
=
Px1 Px2 Total differential is:
∆X1 dX1 MPPx2 Px2 δY δY
= = = dY = dX1+ dX2 = 0
∆X2 dX2 MPPx1 Px1 δX1 δX2
dX1 (δY/δX2) MPPx2
= MRS (or) RTS = =-
dX2 (δY/δX1) MPPx1

viii) Isoclines, Expansion Path and Profit Maximization: Isoclines are lines
or curves that pass through points of equal marginal rates of substitution on an
isoquant map. That is, a particular isocline will pass through all isoquants at

points where the isoquants have a specified slope. There are as many different
isoclines as there are different slopes or marginal rates of substitution on an
isoquant. The expansion path is also an isocline that connects the least cost
combinations of inputs for all yield levels. On expansion path, the marginal rate
of substitution must equal the input price ratio:
∆X1 Px2
Expansion Path (MRS X2X1) = =
∆X2 PX1
Ridge lines represent the limits of the economic relevance, the boundaries
beyond which the isocline and isoquant maps have no economic meaning. The
horizontal ridge line represents the points where MPPx 1 is zero and the vertical
line represents the points where MPPx 2 is zero.

On the ridge line for X 1 , MPP X1 is zero, and tangent to the isoquant which is
vertical having no defined slope. On the ridge line for X 2 , MPP X2 is zero and
the isoquant has a zero slope and thus MRS = 0. Ridge lines are so named
∆X2 MPPx1 0
Ridge Line for X1= =0, = =0
∆X1 MPPx2 MPPx2
X1
Irrational Zone
9 Y=140 ∆X1 Px2
Expansion Path = =
Irrational Zone

∆X2 PX1
Y=130
Y=120 Isoclines
∆X1 MPPx2
Y=108 Ridge Line for X2 = = 0, =
Y=100 ∆X2 MPPx1
0
= =0
190 MPPx 1
 Y= 45
7
Fig. 11.6 Isoclines and Expansion Path X2
MPPx2
The slope of the isoquant was shown to be: MRS of X2 for X1 = -
MPPx1
because they trace the high points up the side of the production surface, much
like mountain ridges that rise to the peak of the mountain. Ridge lines represent
the points of maximum output from each input, given a fixed amount of the other
input. When X 1 = 1, output can be increased by adding X 2 upto the amount
devoted by the ridge line (7 units). At that point, output from X 2 is a maximum
given one unit of X 1 and MPP X2 is zero. Past X 2 = 7, MPP X2 is negative while
MPP X 1 is positive; the inputs have an opposite effect on output and are no
longer substitutes. Thus, the ridge lines denote the limits of substitution. Outside

the ridge lines, the inputs do not substitute in an economically meaningful way.
Output is maximum (140) where the ridge lines, and all other isoclines,
converge. For 140 units of output, the least cost and only possible combination is
9 units of X 1 and 7 units of X 2 .

ix) Expansion Path and Profit Maximization

The expansion path traces out the least cost combination of inputs for every
possible output level. The question now arises; which output level is the most
profitable? Conceptually, this question is answered by proceeding out the
expansion path that is increasing output until the value of the product added by
increasing the two inputs along the expansion path is equal to the combined cost
of the added amount of two inputs. Viewed from the input side, this is same as
saying that the VMP of each input must equal the unit price of that input; viewed
from the output side, it is the same as saying the marginal cost must equal
marginal revenue. Thus, while all points on an expansion path represent least
cost combinations, only one point represents the maximum output level. For one
output and two variable inputs, the equation is:

Profit = Py Y - Px 1 X 1 - Px 2 X 2 – TFC.

Maximizing this function with respect to the variable inputs gives two
equations in two unknowns. δProfit δY δProfit δY
= Py - Px1= 0 . = Py - Px2 = 0
δX1 δX1 δY δX2

191
 The above two equations can be written as: VMPx 1 = Px 1 (or) VMPx 2 = Px 2 .
Thus, the profit-maximizing criterion requires that the marginal earnings of each
input must be equal to its cost.
Y = 18X 1 - X 1 2 + 14X 2 - X 2 2
The marginal physical products of X 1 and X 2 are multiplied by Py = Rs.
0.65. Then, VMPx 1 = (18 - 2X 1 ) 0.65; VMPx 2 = (14 - 2X 2 ) 0.65
Equating VMP’s with the input prices of Rs.9 and Rs.7 for X 1 and X 2
respectively, we get, (18 – 2X 1 ) 0.65 = 9; (14 – 2X 2 ) 0.65 = 7
The solutions are 2.08 for X 1 and 1.6 for X 2 . Substituting these values in the
production function predicts a value of Y equal to 53 units.
Then, Profit = 0.65 (53) - 9 (2.08) - 7 (1.60) - TFC= Rs. 4.53 - TFC
The optimum criterion for two variable inputs is often expressed as:
VMPx1 VMPx2 VMPx1 VMPx2
=1; = 1 or because both equal 1, = =1
Px1 Px2 Px1 Px2
All variable inputs must be earning as much as they cost on the margin.
Rewriting in a different form, yields : Px1 MPPx1 1 1
MPPx1= ; = = , Since Py =MC
Py Px1 Py MC
Px2 MPPx2 1 1
MPPx2z= ; = =
Py Px2 Py MC
The above expression is the same as MR = MC under perfect competition.

B. ECONOMIES OF SCALE

The scale of production influences the cost of production. In general, larger the scale of
production, the lower is the average cost of production. The term ‘economies’ means
‘advantages’ and the term ‘scale’, here, means ‘large-scale production’. Thus, economies of
scale refer to the advantages of large-scale production. Economies of scale can be categorized
into i) internal economies and (ii) external economies of scale.

i) Internal Economies

Internal economies are those economies in production (those reductions in

production costs), which occur in the farm (firm) itself when it expands its
output or enlarges its scale of production. Internal economics are those
advantages that are exclusively available to a particular firm, as a result of its
own expansion in the scale of production. The internal economies are dependent
on the resources of the individual house of business, on their organization and
the efficiency of their management. Internal economies are of the following five
192
types: a) Technical economies, b) Managerial economies, c) Marketing
economies, d) Financial Economies, and e) Risk bearing economies.

a) Technical Economies: A large-scale production unit can use large and

modern or sophisticated machines so as to reduce production costs. A large
establishment can prevent wastage by utilizing the by-products efficiently.
Latest technologies can be used in larger units to reduce the cost of production
(E.g.) A big vegetable oil mill can have a cattle feed industry and a big dairy
unit.

b) Managerial Economies: These economies arise from the creation of special

(separate) departments for different functions like production, maintenance,
purchase, sales etc. In a small factory, a manager is a worker, organizer and
salesman. Much of his time is wasted on things of little economic importance. In
a big concern, such jobs can be allotted to junior employees and the manager can
concentrate on jobs which bring more profits. Such kind of division of labour is
possible in large units. Thus, the job can be done more efficiently and more
economically in large units.

c) Marketing Economies: They arise from the purchase of materials and sale of
goods. Large business firms have better bargaining advantages and are provided
with a preferential treatment by the firms they deal with. They are able to secure
freight concessions from railways and road transport firms, prompt delivery and
careful attention from all dealers. A large firm can employ expert purchase
managers and sales managers. In selling, it can cut down selling costs and in
purchasing, it can have a wider choice.

d) Financial Economies: A big firm has better credit facilities and can borrow
on more favourable terms. It encourages prospective investors with incentives
and higher returns and therefore, its shares have a wider market. A big firm can
issue its shares and debentures more easily than an unknown small firm.

e) Risk-Bearing Economies: A big firm can spread risks and can often eliminate
them. It can diversify the output. It can also establish wider marketing net work
for its products. If demand for any one of its products slackens in any one
market, it may increase it in other markets. Thus, it can reduce the risk of
fluctuations in the demand for its product.

ii) External Economies

193
 External economies are those economies, which are available to each member
firm as a result of the expansion of the industry as a whole. Expansion of
industry may lead to the availability of new and cheaper raw materials,
machineries and to the use of superior technical knowledge. External economies
are advantages available to all the firms. For instance, construction of a new
railway line benefits all firms set up in that locality and not to any particular
firm alone. Various types of external economies are given below:

a) Economies of concentration: These economies arise from the availability of

skilled workers, the provision of better transport and credit facilities, benefits
from subsidiary units and so on. Scattered firms cannot enjoy such economies.
Concentration of firms enables the transport system to reduce the cost.

b) Economies of Information: All big-sized units can join together to publish

trade journals and also to set up research and development facilities, which
would benefit all firms.

c) Economies of Disintegration: When an industry grows, it becomes possible

to split up some of the processes which are taken up by specialist firms. This
may be beneficial to all the firms.

iii) Diseconomies of Scale

Large-scale production also has some disadvantages, which are known as

diseconomies of scale. They are as follows: a) If the growth of the firm expands
beyond the optimum limit, it will become unwieldy. As a result, the management
becomes inefficient. (b) There may be frequent breakdown of machines due to
poor maintenance. (c) There may be indiscipline among labourers and this would
result in frequent strikes and lock outs. (d) Some times the over production
exceeds demand and causes depression and unemployment. (e) The average cost
of production will be more.

C. ECONOMIES OF SIZE

A study on economies of size would be useful to assess the optimum size of

the plant. The collection of all durable assets owned by a farm is called the plant
and this term, therefore, includes land, machinery, buildings and other durable
assets found on farms. An increase in any one of these durable assets would
increase plant size.

194
 The long run average cost curve has the same shape as the short run ATC
curve. (But, long run cost has no fixed cost). When the firm is small, expansion
of output usually increases efficiency, and average costs per unit of output will
fall. The reasons for this decrease include specialization of labour and capital.
As the size of the business
increases, the manager may be able
Economies of Size Diseconomies of Size to purchase inputs at a discount,
thereby gaining market economies.
LRAC
Cost

Expansion of the firm enables

workers to specialize and use more
advanced or efficient technologies.
Eventually, the long-run average
Y
curve will turn up; costs per unit of
Optimum Plant Size
Fig.11.7 Economies of Size output begin to increase as output is
expanded. As firm size increases, the
manager encounters increasing difficulty in maintaining control of his
organization, communications and coordination become more difficult, mistakes
are both more frequent and more costly. As a result, costs rise. When LRAC are
falling, the firm is experiencing economies of size. The minimum point on the
LRAC curve indicates the optimum plant size. A plant of this size will produce
the product at the lowest possible cost. Diseconomies of size occur where the
LRAC curve is rising.

i) Relationship between Long run and Short-run Cost Curves

In the short - run, the farmer has a fixed plant-the number of acres, the
buildings and the size and type of equipment are all fixed in amount. He can

X1

SRTC LRTC
Cost

B
H B’
E A’
D’ E’
F A Y3 F C’
C Y2
G D
Y1

0 X2 X2 0 Y1 Y2 Y3 Y
Fig 11.8 (a) Fig.11.8 (b)
Relationship between Short-Run
195 and Long-Run Cost Curves
expand output in the short run only by changing the amount of variable input.
This situation is depicted in Fig.11.8 (a). Plant size is fixed in the short run at
X 2 . That particular plant size, X 2 will produce output Y 2 at the least average
total cost when combined with OF amount of X 1 , the variable input. To produce
outputs other than Y 2 in the short run, the manager must vary the amount of X 1
and by so doing, restrict input use to the combinations represented by the
vertical line above X 2 . For example, to produce output Y 1 in the short run, the
manager would use OG of X 1 with the fixed plant, X 2 and to produce output Y 3
in the short run the manager would use OH of X 1 with X 2 .

The combination of inputs at point A represents the least cost combination

for the production of Y 2 in the long run, as do the combinations of by C for Y 1
and E for Y 3 . Thus, the combination of inputs at D, OG of X 1 and X 2 , necessarily
costs more than the combination of inputs at point C on the long-run expansion
path. Similarly, the combination at point B costs more than the combination at E.
As a result, total costs in the short run along the line DAB will be higher than
total costs in the long-run along the segment CAE on the long-run expansion
path. The exception will occur at point A, where short-run and long - run costs
will be equal.

This argument is also indicated in Fig. 11.8 (b). Fixed costs of amount OF
are associated with X 2 amount of X 2 . There are no fixed costs in the long-run.
Short-run total costs, SRTC, increase with output but remain above long-run
total costs, LRTC, until output Y 2 is reached. Point A’ on LRTC and SRTC
represents the cost of input combination at A in Fig.11.8 (a). At A’ the two cost
curves are tangent. At output levels greater than Y 2 , SRTC increases more
rapidly than LRTC. The costs of the input combinations C, D, E and B in
Fig.11.8 (a) are represented by C’, D’,
SRMC1 SRATC4 E’ and B’ in Fig.11.8 (b). In Figure
SRATC1
F SRMC2 11.9, the relationship between long-run
A SRMC4 D average cost curve and several plant
Cost

SRATC2 SRMC3 sizes is shown. SRATC1 and SRMC1

SRATC3 LRAC
are the average and marginal costs for
B plant size 1. SRMC2 and SRATC2 are
C
the marginal and average costs for a
0 M Y
larger plant size, plant size 2. Each
Fig.11.9 Long-Run Average Cost for
Several Plan Sizes plant size represents a set of durable
196
inputs fixed at a certain level. Many plant sizes exist between 1 and 2, but to
avoid clutter, their cost curves are not shown. Plant size 2 produces all outputs
larger than (to the right of) the amount OM more efficiently than does plant size
1. As output increases further, plant size 3 becomes more efficient than 2. For
plant sizes larger than 3, expansion of output is obtained only at increased cost
per unit. As explained, the LRAC will be tangent to each of the SRAC curves.
Because of this, the LRAC is called Envelope Curve. To the left of C, the LRAC
curve is tangent to short - run curves to the left of the latter’s minimum. At C,
both long-run and short-run costs attain a minimum. Therefore, plant 3
represents the optimum plant size. To the right of C, LRAC is tangent to the
short-run curves to the right of the latter’s minimum.

The LRAC curve depicts the minimum average cost for each output level and
thereby determines the most efficient plant size for each output level. Plant size
1 is most efficient in the production of the output corresponding to A, plant size
2 for B, plant size 3 for C, etc. Thus, the LRAC is the envelope curve that is
tangent to each SRATC curve at the output for which that plant size is most
efficient in the long-run.

D. RETURNS TO SCALE

Returns to scale measures the change in output resulting form a proportionate

change in all inputs. It describes the technical economies of scale and is a long-
run concept, when none of the inputs is fixed. Returns to scale in increasing,
constant or decreasing depending on whether a proportionate increase in all the
inputs increases the output by a greater, same or smaller proportion. If the
proportionate change in output is lesser than the proportionate change in inputs,
diseconomies of scale result. If the change in output is equal to the
proportionate change in inputs, constant returns to scale exist. If the change in
output is greater than the proportionate change in inputs, economies of scale
exist. This concept can be expressed with an homogeneous production function Y
= f (X 1 , X 2 ,...,Xm) where, Y is output and X 1 , X 2 , ...,Xm are inputs used in the
production process. Let K denote the amount by which each input will be
changed (1<K), i.e., K is any positive real number. The returns to scale will be
defined by n where,

YK n = f (KX 1 , KX 2 ,. . . ,KXm)

197
 The factor K n represents the change in output when all inputs are changed by
the factor K. For example, if n equals one, the change in output is equal to the
changes in the inputs and the returns to scale are constant. If n is greater than
one, the change in output exceeds the proportionate change in all the inputs and
returns to scale are increasing. Conversely, if n is less than one, the returns to
scale are decreasing. In case of constant returns to scale, the distance between
successive isoquants is constant, i.e., AB=BC=CD (Fig. 11.10 (a)). The distance
goes on widening between isoquants when diminishing returns operate, i.e.,
AB<BC<CD (Fig.11.10 (b)). Finally, in case of increasing returns to scale, the
distance between the successive isoquants becomes smaller and smaller as we
move away from the origin on the isoquant map i.e., AB>BC>CD (Fig.11.10 (c)).

Returns to scale must be measured along a scale line, that is a straight line,
passing through the origin. Proportionate input changes are possible only on
such a line or ray. Thus, economies (diseconomies) of size are the same as
economies (diseconomies) of scale only when the long long-run expansion path
is a straight line passing through the origin. In most agricultural production
situations, input proportions representing least cost combinations vary with the
level of output. Therefore, strict interpretations of scale concepts are probably
not of great value in agriculture.

X1 X1 X1

Scale Line

D D D
C C
C Y=400
B Y=400 Y=400 B
B Y=325
A Y=300 Y=275
A A Y=225
Y=200 Y=175
Y=100 Y=100 Y=100
0 X2 0 X2 0 X2
Fig.11.10 (a) Constant Return Fig.11.10 (b) Decreasing Fig.11.10 (c) Increasing
to Scale Return to Scale Return to Scale

E. ELASTICITY OF FACTOR SUBSTITUTION

In the factor-factor relationship, the elasticity of factor substitution is

defined as the percentage change in one input, X 1 , in response to the percentage
change in other input, X 2 . Thus, ∆X1
X1 ∆X1X2 X2
Es = = = (MRS of X2 for X1)
198
∆X2 ∆X2X1 X1
X2
 Elasticity of factor substitution is negative for inputs that are technical
substitutes because the slopes of isoquants are negative; as one input increases,
the other input decreases on the same isoquant. Elasticity of substitution for
inputs that are technical complements is zero because MRS is zero. The
elasticity of substitution measures and indicates the rate at which the slope of an
isoquant changes. This is useful because it is expressed independent of unit of
measurement.
Problem: Nitrogenous and Phosphorus fertilizer combination necessary to
produce 2000 kgs of paddy is given in the following table. It shows how and to
what extent nitrogen could be substituted for phosphorus fertilizer.
Table 11.2 Nitrogen and Phosphorus combinations Necessary to Produce
Two Tonnes of Paddy
Combination Nitrogen ∆X 1 Phosphorus ∆X 2 MRS of X 2 for X 1
Number (X 1 )(Kgs) (X 2 )(Kgs) =(∆X 1 / ∆X 2 )
1 52 - 11 - -
2 44 -8 12 1 - 8.00
3 38 -6 14 2 - 3.00
4 33* -5 18* 4 - 1.25
5 30 -3 23 5 - 0.60
6 28 -2 29 6 - 0.33

(*Least cost combination of X 1 and X 2 inputs. If Px 1 and Px 2 are Rs. 6 and

Rs.7.50 per kg respectively, the price ratio would be Px 2 / Px 1 = 7.50 / 6.00=
1.25). Thus, as shown in the table, we find that it is from combination 4, the
least cost combination of 33 kgs of N and 18 kgs of P 2 O 5 can be obtained,
because it is at this point, the price ratio is equal to MRS or RTS, i.e.,
∆ X1 Px2
=
∆ X2 Px1

Chapter 11: Questions for Review

1. Fill up the blanks
i) Slope of the price line .
ii) When MRTS = price ratio, the cost of inputs is .
iii) Ridge lines are border lines which separate from .
iv) Expansion path is also an .
2. Define the following:

199
 i) Least cost combination.
ii) Elasticity of factor substitution.
iii) Expansion path.
iv) Returns to scale.
v) Isoproduct / Isoquant curve.
vi) Marginal rate of factor substitution.
vii) Isocost line.
viii) Isocline.
ix) Ridge line.
x) Envelope curve.
3. Write short notes on the following:
i) Perfect complements and Perfect substitutes.
ii) Economies of scale and Diseconomies of scale.
iii) Relationship between short run and Long run cost curves.
4. Answer the following:
i) Explain the least cost combination of inputs with illustration.
ii) Discuss the internal and external economies of scale.

PRODUCT-PRODUCT (OR)
OUTPUT - OUTPUT RELATIONSHIP

In this section, instead of considering the allocation of inputs to an

enterprise or among enterprises, we discuss enterprise combinations or product-
mix involving product-product relationships. We deal with what combination of
enterprises should be produced from a given level of fixed and variable inputs.

A. PRODUCTION POSSIBILITY CURVE (ISO-RESOURCE CURVE)

The production possibility curve or product transformation curve is the locus

of maximum amounts of two products, say Y 1 and Y 2 , that can be produced from
a given quantity of resources (X (0 ) ). Mathematically, such product transformation
curve is represented by: Y 1 = f (Y 2 , X (0 ) ) or Y 2 = f ( Y 1 , X (0 ) ). The Rate of
Product Transformation (RPT) (or) Marginal Rate Product Substitution (MRPS)
200

dY1 ∆Y1
(Point concept) (or) (Average or arc concept)
dY2 ∆Y2
between two products, Y 1 and Y 2 , is given by the negative slope of this curve.
The RPT of Y 2 for Y 1 can either be expressed as:

dY 1 / dY 2 , the slope of the product transformation curve can be defined as the

change (increase or decrease ) in the level of Y 1 that must be accompanied by a
unit change (decrease or increase ) in the product (Y 2 ) at a given level of
resource.

i) Relationship among Products: The basic product relationships can be: joint,
complementary, supplementary and competitiveness.

a) Joint Products: Products, which result from the same production process, are
termed joint products. In the extreme case, two products are combined in fixed
proportions and the production of one without the other is impossible. E.g. Grain
and straw. Production possibility curves for joint products of this type are
presented in Figure 12.1 (a). No substitution is possible in this case. However,
for example, different varieties of paddy produce varying proportions of straw
and grain. Thus, the proportions may be changed by technologies or cropping
practices usually associated with the fixed inputs. For such products, a narrow
range of product substitution may exist as presented in Figure12.1 (b).

b) Competitive Products: Products are termed competitive when the output of

one product can be increased only by reducing the output of the other product.
Outputs are competitive because they require the same inputs at the same time.
E.g. the manager can expand production of one output only by divert ing inputs-
∆Y1
land, labour, capital and management-from one enterprise to another. <0
∆Y2
Y1 Y1
C .
B .
A .
0 Y2 0 Y2
Fig.12.1 (a) Joint Products Fig.12.1 (b)

201
 Y1 Y1
Y1
∆Y11
∆Y21
∆Y11
∆Y11 ∆Y12
∆Y21 ∆Y22
∆Y21 ∆Y12
∆Y12 ∆Y22
∆Y22
Y2 Y2 Y2
Fig.12.2(a)Constant RPTY2Y1.Fig.12.2(b)Decreasing RPTY2Y1.Fig.12.2(c)Increasing RPTY2Y1
∆Y11 ∆Y12 ∆Y1n ∆Y11 ∆Y12 ∆Y1n ∆Y11 ∆Y12 ∆Y1n
= =. . . = > >. . . > < <...<
∆Y21 ∆Y22 ∆Y2n ∆Y21 ∆Y22 ∆Y2n ∆Y21 ∆Y22 ∆Y2n

When the production possibility curve has a negative slope, the products
concerned are competitive. Two competitive products can substitute each other
either at a constant or increasing or decreasing rate. Substitution of one product
for another product at a constant rate is only a short-run phenomenon because
such a relationship may not hold for long. Two varieties of any crop with all
inputs held constant, during any single season provide an example of this type of
substitution. Economic decision-making is easy in this case, i.e., the farmer
would produce only one of these products depending upon yields and prices.
Whenever a decreasing RPT exists between two products, every unit addition of
one product, say Y 2 replaces less and less of other product, Y 1 .The product
transformation curve is concave away from origin and convex toward the origin.
This type of relationship is quite rare. This type of decreasing RPT can be found
in very small farms where capital is very limited and the produce of none of the
two competitive commodities can be extended beyond the first stage of
production. Decision-making is simple in this case, i.e., the farmer would
produce only one of the two products depending on relative yields and prices. An
increasing rate of product transformation between two products occurs when
both products are produced in the stage of decreasing returns. The product
transformation curve is concave towards the origin, i.e., increasing amounts of
Y 1 must be sacrificed for each successive gain of one unit of other product, Y 2
for a given level of input.

c) Complementary Products: Two products are complementary, if an increase

in one product causes an increase in the second product, when the total amount
of inputs used on the two are held constant.
Y1 Y1 C

202
 A

0 B Y2 0 B Y2
Fig.12.3 (a) Complementary Products Fig.12.3(b)

In the figure 12.3(a), Y 2 is complementary with Y 1 until the point A is

reached. To the right of A, both are competitive. Thus, if the farmer wishes to
produce the maximum possible amount of Y 1 , he should grow at least OB amount
of Y 2 . When larger quantities of Y 2 are produced, the two products become
competitive. In Fig.12.3 (b), there is a situation where each output is
complementary to the other output over a certain range. Thus, Y 2 is
complementary to Y 1 , upto C, and Y 1 is complementary to Y 2 upto D. The two
products become competitive between C and D.

Complementary usually occurs when one of the products produces an input

used by the other product. An example of this is the use of a legume in rotation
with cash crop. The legume may add nitrogen and improve soil structure or tilth
and improve weed and insect control. These factors, in turn, serve as “inputs” for
cash crops thus causing, over a period of time required by the rotation, an
increase in the production of cash crop. The complementary products may
eventually become competitive. For example, while one year of alfalfa in a four-
year rotation may be complementary, two, three or four years of alfalfa could be
produced only by successive reductions in the cash crops. ∆Y1
MRPS = > 0.
∆Y2
d) Supplementary Products: Two products are called supplementary, if the
amount of one can be increased without increasing or decreasing the amount of
the other. In figure 12.4 (a) Y 2 is supplementary to Y 1 . Y 2 can be increased from
zero to OH amount without affecting the amount of Y 1 produced. Beyond E, the
two outputs become competitive. In Fig.12.4 (b), each enterprise is
supplementary to the other and competitive between FG.

Supplementary enterprises arise through time or when surplus resources are

Between EF, Y 2 is supplementary to Y 1 .
Between GH, Y 1 is supplementary to Y 2
Y1 Y1 Between FG, Y 1 and Y 2 are substitutes
E F
E

203
G
 Y2
O H Y2 O H
Fig. 12.4 (a) Supplementary Products Fig. 12.4 (b)

available at a given point of time. Once purchased, a tractor is available for use
throughout the year. Its use in one month does not prevent its use in another
month. Thus, a tractor purchased to plough and plant may be put to a lesser use
during the off-season. If two crops were harvested at the same time, however, the
relationship would be competitive-use on one could reduce the amount of use on
the other.

The supplementary relationship between products depends upon amount of

use left in the resource. If the harvester is completely worn out harvesting corn
in June, it will not be available for use in July. Milk cows and family gardens
represent supplementary enterprises on some farms. In each case, labour or some
other input is available for use on a small scale and rather than let it go idle, a
small enterprise is undertaken.
∆Y1
MRPS of Y2 for Y1 = =0
∆Y2
Production possibility curve is also known as opportunity curve as it presents
all possible production opportunities.

ii) Marginal Rate of Product Substitution or Rate of Product

Transformation: RPT is nothing but the slope of production possibility or
∆Y1
opportunity curve.MRPS of Y for Y =
2 1
∆Y2
The marginal rate of product substitution means the rate of change in
quantity of one output (Y 1 ) as a result of unit increase in the other output (Y 2 ),
given that the amount of the input used remains constant. As the amount of Y 2
produced increases, the amount of Y 1 sacrificed steadily increases. This is due to
the decreasing marginal physical products displayed by the production functions.

iii) Iso Revenue Line: It is the line which defines all possible combinations of
two commodities which would yield an equal revenue or income. Iso revenue
line indicates the ratio of prices for two competing products. The point on Y 2
axis is always equal to TR/PY 2 while the point on the Y 1 axis equal TR/PY 1 . The
distance of the Iso revenue line from the origin is determined by the magnitude
of the total revenue. As total revenue increases, the iso revenue line moves away
204

TR = Py1Y1 + Py2 Y2
TR Py2
Y1= - Y2
Py1 Py1
from the origin. The slope of the iso revenue line is determined by the output
prices.

Y1
Change in Py1

Y2
0 Change in Py2
Fig.12.5 Iso Revenue Line

Thus, the output prices ratio is the slope of the iso revenue line. The negative
sign means that the iso revenue line slopes downward to the right. The iso
revenue lines are used for revenue optimization, while iso cost lines are used for
cost minimization.

iv) Revenue Maximizing Combination of Outputs

The maximum revenue combination of outputs on the production possibility

curve can be determined using the criterion. ∆Y1 Py2

MRPS of Y2 for Y1 = =-
Y1 ∆Y2 Py1
Production Possibility Curve
∆Y1 Py2 This can be rewritten as follows:
MRPS of Y2 for Y1 = =- . Py 1 (∆Y 1 ) = - Py 2 (∆Y 2 ). This criterion
∆Y2 Py1 states that at the maximum revenue point,
the increase in revenue due to adding a
Iso Revenue Line
minute quantity of Y 2 is exactly equal to
the decrease in revenue caused by the
reduction in Y 1 . Thus, there is no incentive
Y2
to change the output combination. When
Fig.12.6 Maximum Revenue Yielding
Combination Py 1 (∆Y 1 ) > - Py 2 (∆Y 2 ), the amount of Y 2
should be decreased in favour of Y 1 . When Py 1 (∆Y 1 ) < - Py 2 (∆Y 2 ) , then Y 2
should be increased at the expense of Y 1 . As could be seen in the Figure 12.7,
the line connecting maximum revenue points is called output expansion path. For
each level of input, the maximum revenue combination of outputs will fall on the
expansion path.

205
 v) Opportunity cost and Marginal criterion for Resource Allocation:
Maximum revenue from a limited amount of input was shown to occur when,
∆Y1 Py2
=- and this could be written as:
Y1 ∆Y2 Py1
- Py2 (∆Y2) = Py1 (∆Y1)
where ∆Y 1 is negative. But the decrease in
Output Expansion Path Y 1 could only be caused by shifting some
86.0 amount of input, X, from enterprise (Y 1 )
9 to enterprise Y 2 . Denote the amount of
74.5
7 input shifted by ‘∆X’. Dividing both sides
of the above expression by ∆X and
35.0 4 48.5
31.5 multiplying both sides of the equality by
27 Iso Revenue Line minus one gives.
17.5
2 ∆Y2 ∆Y1
9.0 Py2 = Py1 ;
Production Possibility Curve
∆X ∆X
Py2 . MPPxy2 = Py1. MPPxy1;
9.0 15.5 21.5 25.5 Y2 VMPxy2 = VMPxy1
Fig.12.7 Output Expansion Path

Thus, revenue from the limited amount of input, X, will be a maximum when
the value of the marginal product of the input is the same in each enterprise.
(The notation, MPP xy 1 and VMP xy 2 , is used to denote the MPP of X on Y 1 and
VMP of X used on Y 2 respectively). Equating the VMP’s of the input in the two
enterprises leads to the identical solution obtained from the production
possibility curve. The two criteria are compared in Table 12.1 (a) and 12.1 (b)
below:
Table 12.1(a) Comparing the Marginal Criteria for Resource Allocation and
Production Possibility Curve
Variable Output MPP X Y 1 VMP X Y 1 Variable Output MPP X Y 2 VMP X Y 2
Input (X) (Y 1 ) @Py 1 = Input (X) (Y 2 ) @Py 2 =
Re.1/unit Rs.2/unit

0 0 - - 0 0 - -
1 12 12 12 1 7 7 14
2 22 10 10 2 13 6 12
3 30 8 8 3 18 5 10
4 36 6 6 4 22 4 8
5 40 4 4 5 25 3 6

206
6 42 2 2 6 27 2 4
7 43 1 1 7 28 1 2

For two units of input, one to Y 1 where it would earn Rs.12 and the second to Y 2
for an earning of Rs.14, the total revenue would be Rs.26. The second unit could
also go to Y 2 and the earning would be unchanged. From the production
possibility curve for 2 units of input, in Fig.12.7, maximum revenue combination
Table 12.1(b) Comparing the Marginal Criteria for Resource Allocation and
Production Possibility Curve
Units of Solution Equating VMP Solution using Production
Inputs Possibility Curve
Available
Y2 Y1 TR Y2 Y1 TR
2 7 12 26 9 9 27.0
4 13 22 48 15.5 17.5 48.5
7 22 30 74 21.5 31.5 74.5
9 25 36 86 25.5 35.0 86.0

Py 1 = Re.1; Py 2 = Rs.2.

of outputs is 9 each of Y 1 and Y 2 and the total revenue is Rs.27 which is slightly
more than the allocation using “average” marginal criteria. The numbers 2, 4, 7
and 9 given the fig.12.7 are input levels of production possibility curves. The
numbers 27, 48.5, 74.5 and 86 are revenue levels of iso revenue lines. Thus, the
geometric approach is more accurate. This allocation of inputs between products
can also be viewed in terms of opportunity cost. It demonstrates the cost in terms
of the value of an alternative product that is given up rather than the purchase
price of variable input. As long as VMP in one enterprise, that is sacrificed,
equals the VMP in the other enterprise, that is gained, the opportunity costs for
both enterprises are equal and total returns are maximum.

B. EQUI - MARGINAL PRINCIPLE

In input-output relationship, MC=MR is the economic principle used to

determine the most profitable level of variable input. But it is under the
assumption of unlimited availability of variable input. Such an assumption of
unlimited resources is unrealistic. So, in real world situations, the equi-marginal
principle is useful in determining how to allocate limited resources among two or
more alternatives. The principle says: If a scarce resource is to be distributed
among two or more uses, the highest total return is obtained when the marginal
return per unit of resource is equal in all alternative uses.

207
 i) One Input - Several Products: Suppose, there is a limited amount of a
variable input to be allocated among several enterprises. For this, the production
function and product prices must be known for each enterprise. Next, the VMP
schedule must be computed for each enterprise. Finally, using the opportunity
cost principle, units of input are allocated to each enterprise in such a way that
the profit earned by the input is a maximum. Profit from a limited amount of
variable resource is maximized when the resource is allocated among the
enterprises in such a way that the marginal earnings of the input are equal in all
enterprises. It can be stated as: VMPxy 1 = VMPxy 2 = .... = VMPxyn where,
VMPxy 1 is the value of marginal product of X used on product Y 1 ; VMPxy 2 is
the value of marginal product of X used on product Y 2 ; and so on.
VMP xy 1 = Py 1 MPPxy 1 ; VMPxy 2 = Py 2 MPPxy 2 and so on.
Table 12.2 Allocation of Limited Variable Input among Three Enterprises
Enterprise I (Maize) Y 1 Enterprise II (Sorghum) Y 2 Enterprise III (Ragi) Y 3
X Y1 VMP XY1 X Y2 VMP XY2 X Y3 VMP XY3
0 0 - 0 0 - 0 0 -
1 10 20 1 18 18 1 7 14
2 18 16 2 31 13 2 13 12
3 24 12 3 42 11 3 18 10
4 29 10 4 51 9 4 22 8
5 33 8 5 58 7 5 25 6
6 36 6 6 64 6 6 27 4
(Py 1 = Rs2; Py 2 = Rs 1; Py 3 = Rs 2)
Suppose that the farmer has five units of X. According to the opportunity
cost principle, he will allocate each successive unit of input to the use where its
marginal return, VMP, is the largest; i.e., first unit of X used in I earns Rs.20;
second on first unit of II earns Rs18; third on second unit of I earns Rs.16;
fourth on first unit of III earns Rs.14; and fifth on second unit of II earns Rs.13.
Two units of inputs go on I, two on II and one on III. Used in this manner, the
five units of inputs will earn Rs.81. No other allocation of the five units among
the three enterprises will earn as much. What is the maximum amount of input
needed for enterprises I, II and III? To find out this, the manager must
determine the most profitable amount of input for each enterprise. When input
cost is Rs.6.5 per unit, the optimum amounts are 5 for I, 5 for II and 4 for III.
Cost is Rs.91 (5+5+4=14) (6.5)=Rs 91. Thus, the manager would never use more
than a total of 14 units of inputs on I, II and III, no matter how many units of
inputs he could afford to buy.

ii) Algebraic Example

208
Corn response to nitrogen production function is: C=65.54+1.084NC – 0.003N C 2 . . .(1)

Sorghum response to nitrogen function is: S = 68.07+0.830N S – 0.002 N S 2 . . . . . . (2)

Assume that the farmer has 100 kgs of nitrogen available for 2 acres- one
acre to be used for corn and one to be used for sorghum and that the price of
corn is Rs.3 per kg and the price of grain sorghum is Rs2.50 per kg.

The allocative equations would be VMP NC =VMP NS (or) P c MPPnc =P s MPPns

From (1), dC = 1.084 – 0.006 NC and from (2), dS = 0.830 – 0.004Ns
d Ns dNc
VMP N c =(1.084 – 0.006 Nc ) (3) = Rs. (3.252 – 0.018 Nc)
VMP Ns = (0.830 – 0.004 Ns) (2.50) =Rs. (2.075 – 0.01 Ns)
Substituting Ns = 100 – Nc, we get, 3.252 – 0.018Nc = 2.075 – 0.01 (100 –
Nc), 2.177 and Ns = 100 – 77.8 = 22.2.
Nc = = 77.8
0.028
C = 65.54 + 1.084 Nc + 0.003 Nc 2 = 131.71668 x 3 = Rs.395.15
S = 68.07 + 0.83 Ns – 0.002 Ns 2 = 85.51o32 x 2.5 =Rs. 213.78
Thus, the corn would get 77.8 kgs of nitrogen and sorghum would get 22.2
kgs. This allocation equates the value of marginal products and assures the
largest return from 100 kgs of nitrogen. Substituting 77.8 Kgs of nitrogen into
VMPNc equation and 22.2 Kgs into VMPNs equation, demonstrates that the
VMP’s are equal to Rs.1.85.

iii) Two inputs - Two outputs: Consider the case in which two inputs X 1 and X 2
can be used to produce two products, Y 1 and Y 2 . When the inputs are used in the
first enterprise, the equi-marginal principle dictates the following equality:
Py1. MPPx1y1 Py1.MPPx2y1 (or) VMPx1y1 VMPx2y1
= =
Px1 Px2 Px1 Px2
Thus, the marginal earnings of each input must be the same per unit cost,
even within a specific enterprise. When both ratios equal one, the optimum has
been reached. The same condition must hold for the use of the two inputs in the
VMPx1y2 VMPx2y2
second enterprise.
=
Px1 Px2
Marginal returns per rupee spent on input must be same for both inputs in
enterprises. Thus, the general condition is:
VMPx1y1 VMPx2y1 VMPx1y2 VMPx2y2
= = =
Px1 Px2 Px1 Px2

Chapter 12: Questions for Review

209
1. Fill up the blanks
i) Marginal rate of product substitution means the rate of change in quantity of
one as a result of an unit increase in the other , given that the
amount of input used remains the same.
ii) An increasing rate of product transformation between two products occurs
when both products are produced in the stage of returns.
iii) Beyond certain level of production, both supplementary as well as
complementary products become .
iv) The slope of the iso revenue line is determined by the .
v) When the input is scarce, it is allocated to each enterprise in such a way that
the profit earned by the input is .
vi) At maximum revenue yielding combination of outputs, the slope of
production possibility curve is equal to the slope of .
vii) Complementary occurs when one of the products produces an used
by the other product.
viii) In case of complementary products the value of MRPS will be .
2. Define the following:
i) Production possibility curve.
ii) Iso revenue line.
iii) Marginal Rate of Product Transformation.
3. Write short notes or short answers on the following:
i) Distinguish between Iso product curve and Iso resource curve.
ii) Law of equi marginal returns.
iii) Output expansion path.
4. Answer the following:
i) Explain the maximum revenue yielding combination of outputs with
illustration.
ii) Explain the different types of relationships between products.

TYPES AND SYSTEMS OF FARMING

A. CLASSIFICATION OF FARMING

Farming may be classified on the basis of similarity in i) combinations of

products, crop and livestock raised and ii) the mode of economic and social
functioning - private, co-operative, state or collective, etc. The combinations of
products on a given farm and the methods or practices that are used in the
production of these products based on the ways of economic and social
functioning in farming are known as system of farming. It is concerned with the
organizational set up under which the farm is being run. Systems mainly deal
with questions like who is the owner of the land, whether the resources are
pooled or used individually, and who makes the managerial decisions. It is

210
classified into five groups, namely, peasant, co-operative, state, capitalistic and
collective farming. When farms in a group are quite similar in the kinds and
productions of the crops and livestock that are produced and the methods and
practices followed in production, the group is described as type of farming. It
includes specialized, diversified, mixed and ranching.

i) Type of Farming

a) Specialized Farm: Specialization means that the farmers specialize in one

enterprise such as crop, dairying, poultry or tea estate, etc.

1) Advantages of specialized farming

i) Better use of land: It is more profitable to grow a crop on a land best suited
to it. E.g.) Jute cultivation on a swampy land.

ii) Better Marketing: Specialization allows for better assembling, grading,

processing, storing, transporting and financing of the produce.

iii) Better Management: As there are fewer enterprises, wastage can easily be
detected and they can be better managed.

iv) Less equipment and labour are needed.

v) Costly and efficient machinery can be used.

vi) Efficiency and skills are increased: Specialization allows a man to be more
efficient and expert at doing a few things.

2) Disadvantages of specialized farming

i) There is a greater risk - failure of crop and market together may ruin the
farmer.

ii) Productive resources – land, labour and capital are not fully utilized.

iii) Fertility of soil cannot be properly maintained due to lack of suitable

rotations.

iv) By products of the farm cannot be fully utilized due to lack of sufficient
livestock on the farm.

v) Farm returns in cash are not generally received more than once in a year, i.e.,
there is no regular farm return.

b) Diversified Farming

211
 A Farm on which no single or source of income yields 50 per cent of the total
receipt is called a diversified farm. More number of enterprises are taken up on
the farm and no single enterprise is relatively much more important.

1) Advantages of diversified farming

i) Better use of land, labour and capital: Better use of land through adoption
of crop rotations, steady employment generation and more efficient use of
equipment are obtained.

ii) Business risk is reduced due to a crop failure or unfavourable market prices.

iii) Regular and quicker returns are obtained from various enterprises.

2) Disadvantages of diversified farming.

i) Because of varied jobs in diversified farming, a farmer can efficiently

supervise only limited number of workers.

ii) Better equipping of the farm is not possible because it is not economical to
have extensive implements and machinery for each enterprise.

c) Mixed Farming

Mixed farming is a type of farming under which crop production is combined

with livestock rearing. The livestock enterprise is complementary to crop
production programme so as to provide a balanced and productive system of
farming. In mixed farming, the contribution of livestock activities to gross farm
income should be a minimum of 10 per cent and a maximum of 49 per cent.

1) Advantage of Mixed Farming

i) Mixed farming helps in the maintenance of soil fertility. By products of

crop production, namely, green and dry fodder, rice bran, gram husk and so on
are better used for live stock. On the other hand, farm yard manure enriches the
soil with important nutrients.

ii) Draught animals are used in crop production and transport.

iii) It provides regular income and employment.

d) Ranching

A ranch differs from other type of crop and livestock farming in that the
livestock graze the natural vegetation. Ranch land is not utilized by tilling or

212
raising crops. The ranchers have no land of their own and make use of the public
grazing land. Ranching is followed in Australia, America, Tibet and certain parts
of India (Bikaner in Rajesthan).

e) Determinants of Type of Farming

The type of farming is determined by 1) Physical, 2) Economic and 3) Social

factors.

1) Physical Factors: The physical factors namely climate, soil and topography
have influence in determining the type of farming.

2) Economic Factors: Marketing cost, changes in input and output prices,

availability of resources like land, labour and capital, competition between
enterprises, miscellaneous factors such as personal likes and dislikes, prevalence
of pest and diseases, etc. influence type of farming.

3) Social Factors: The kind of people in the community and the provision of
protection of crops against the hazards of bird and animal ravages may influence
the farming community to change the pattern of cropping. The co-operative spirit
in providing security to crops, benefits resulting from low transport costs
through collective sale and better marketing facilities permit farmers to expand
some enterprises like fruit farming, dairying or poultry rearing.

ii) System of Farming

System of farming is generally referred to the method of agriculture and the

type of ownership to land. The system of farming is comprised of i) co operative
farming, ii) collective farming, iii) capitalistic farming, iv) state farming and v)
peasant farming.

i) Co-operative Farming

Co-operative farming means a system under which all agricultural operations

or part of them are carried on jointly by the farmers on a voluntary basis in order
to exploit modern cultivation practices and economies of scale. Co-operative
farming societies have four different forms:

a) Forms of co-operative Farming: There are four different forms of co-

operative farming. They are: Co-operative Better farming, Co-operative Joint
farming, Co-operative Tenant farming and Co-operative Collective farming.
213
1) Under the system of co-operative better farming, the land is not pooled and
cultivation is carried on by each farmer separately. The co-operative better
farming society promotes the interest of the members through the adoption of
better farming practices. It arranges for the purchase of seeds, manure, joint use
of machinery etc. A member is free to follow his own way of farming except in
respect of the purpose for which he joins the society, e.g. irrigation, purchase of
seeds or marketing of produce, etc.

2) In co-operative joint farming, the land of the members is pooled for joint
cultivation. The ownership of each member over his own land is recognized by
payment of a divided in proportion to the value of his land. Members work on
the land under the direction of managing committee and each member receives
wages for his daily labour.

3) Under the system of co-operative tenant farming, the land is held by the
society and not by the members individually. The land is divided into plots
which are leased out for cultivation to individual members. The society also
arranges for inputs like credit, seeds and manure besides arranging for marketing
of the produce. Each member pays rent of his plot to the society.

4) In co-operative collective farming, the land is owned by the society and

cultivation is done jointly. The method of work of the society is similar to that
of co-operative joint farming society. But the right or share of individual
members in the land is not recognized by the co-operative collective farming
societies and hence, they have no appeal to the farmers due to their strong
attachment to the ownership of land.

ii) Collective Farming

In collective farming, the members surrender their land, livestock and dead
stock to the society. The members work together under a management committee
elected by them. The committee allocates work to members, distributes income
and market surpluses and puts all members into labour to see that the work is
done. The main source of income is through labour earnings.

iii) Capitalistic Farming

The capitalistic farming is based on capitalistic methods where land lordism
exists as in America or England. The role of capital is more; wage (hired) labour
is more than family labour under this farming. In India, this type of farming can
be seen in commercialized agricultural areas where farm production is market
214
and profit oriented. In such farms, improved methods of agriculture are followed
and the application of capital input is high, because the landlords happen to be
capitalists and non-cultivating owners provide necessary fixed and working
capital.

iv) State Farming

Under this system, farms are managed by government officials. The workers
are paid wages on weekly or monthly basis. In India, all state farms are governed
by an independent body, i.e., State Farms Corporation. Various activities of
research can be facilitated under state farming.

Table 13.1 Characteristics of Types of Farming

S.No. Types of Farming Type of Type of
Ownership Operationship
I Co-Operative Farming
1. Co-operative Better farming Individual Individual
2. Co-operative Joint farming Individual Collective
3. Co-operative Tenant farming Collective Individual
4. Co-operative Collective Collective Collective
farming
II. Collective Farming Society (or) State Society (or)
State
III. Capitalist Farming Individual Individual
IV. State Farming State Paid
Management
V. Peasant Farming Individual Individual

v) Peasant Farming
The peasant farming, farmers follow agricultural practices in their own way
and are managers and organizers of their farm business. Living and working are
closely related. The entire farm family has a part in making decisions and
executing the farming programme. The peasant farming, on the one hand, places
a greater impotance on management and the use of family labour which
maximizes farm business income and on the other hand allows the organization
of the farm to be adjusted to the capabilities of the various members of the
family.

Chapter 13: Questions for Review:

215
1. Fill up the Blanks
i) The contribution of income from livestock enterprise to gross farm income
ranges from per cent to per cent.
ii) In Co-operative better farming, the type of ownership and operatorship are
and respectively.
iii) In ranching, the farmers have their own land for grazing the animals.
iv) In Mixed farming, crop and livestock production are to each other.
v) In farming, the risk is minimized.

2. Define the following:

i) Systems of farming and Types of farming.
ii) Capitalistic farming.
iii) Peasant farming.
iv) Ranching.
v) Mixed farming.

3. Distinguish between the following:

i) Co-operative Collective Farming and Collective Farming.
ii) Collective farming and State farming.
iii) Specialization and Diversification.
iv) Co-operative tenant farming and Co-operative better farming.
v) Capitalistic farming and Collective farming.
vi) Ranching and Mixed farming.

4. Answer the following:

i) Explain the functioning of different types of co-operative farming.
ii) Explain the factors influencing the type of farming.
iii) Explain the advantages and disadvantages of different types of farming.

216
 COMPARATIVE ADVANTAGE PRINCIPLE
AND TIME COMPARISON PRINCIPLE

A. COMPARATIVE ADVANTAGE PRINCIPLE

According to this well-known principle, different areas will tend to produce

those products for which they have the greatest comparative and not just absolute
advantage. The main factors involved in the law are simply an extension and
application of the principles of specialization and diversification. The physical
and economic conditions influencing production vary from country to country,
region-to-region and farm-to-farm and even within a farm from field to field.
Each farm or region produces those crops or raises that livestock which it can
grow more profitably. In other words, the individuals or regions tended to
specialize in the production of the commodities for which their resources give
them a relative or comparative advantage. For example, farmers in Tamil Nadu
specialize sugarcane cultivation and those in Punjab specialize in paddy
cultivation.
Table 14.1 Yield per Hectare (in Quintals) During 1996 - 1997
Crop Punjab Tamil Nadu
Paddy 34.0 26.7
Sugarcane 638.2 993.0

Punjab has to give up 34 qtls of paddy for 638 qtls of sugarcane whereas
Tamil Nadu has to give up 27 qtls of paddy for 993 qtls of sugarcane. The
principle of comparative advantage is reflected in the market prices for farm
products. The following factors may change regional production pattern over
time:
i) Changes in product or output prices.
ii) Changes in biological factors such as increased pest infestations.
iii) Introduction of new technology such as high yielding varieties, IPM, etc.
iv) Conversion of dry lands into irrigated lands.
v) Change in mode or cost of transportation, so as to decrease or increase the
disadvantage associated with being distant from markets.
vi) Change in population that results in large, new consumption centres.

217
vii) Shifts in resources, such as labour and capital between regions.

B. TIME COMPARISON PRINCIPLE

In previous chapters, future prices, yields and other events relevant to the
production process were assumed to be known, and problems unique to the
passage of time were not considered. Since such an environment is far from
reality, it is necessary to study the effect of time, risk and uncertainty on
production process.

i) Decision - Making over Time

A farm manager has to take decisions over varying horizons of time. Two
aspects of such decisions are important, i.e., i) differences in profitability
growing out of time alone and ii) differences in the desirability of investments
due to risk and uncertainty factors. Time has a very significant influence on
costs and returns. There are many decisions where this time comparison principle
finds application, such as: soil conservation programmes which bear fruits over a
long time; putting land under an orchard which may not give returns for 5-10
years; and so on. Two aspects of the problem are considered under such
situations: a) growth of a cash outlay over time and b) discounting of future
income.

ii) Growth of a Cash Outlay or Compounding Present Costs

The cash outlay grows over time due to the compounding of interest charges or opportunity
costs involved in using the capital; if Rs.100 are put in a saving account with an annual
interest at 12 per cent compounded, it will increase to Rs.125.44 by the end of second year. In
symbolic terms, you now have the amount earned at the end of the first year. P + Pi, plus the
interest that amount earned during the second year (P + Pi) i which could be expressed as:
(P + Pi) + (P + Pi) i (or) P (1 + i) + Pi (1 + i) which after factorising (1 + i), results in
Table 14.2 Compounding the Present Value
(Amount in Rs.)
Year Beginning Interest Earned by the Beginning Amount +
Amount End of Year Interest
1 100.00 100.00(0.12)=12.00 112.00
2 112.00 112.00(0.12)=13.44 125.44
3 125.44 125.44(0.12)=15.05 140.49
4 140.49 140.49(0.12)=16.86 157.35
5 157.35 157.35(0.12)=18.88 176.23

(P + Pi) (1 + i). Factorising P from the left term gives: P (1 + i) (1 + i) = P (1 + i)2. In

general, the compounded value, F (future value), of a present sum (P) invested at an annual
218
interest rate (i) for ‘n’ years is given by F = P (1 + i)n .This procedure is called compounding.
iii) Discounting Future Revenues
Costs incurred at one point of time cannot be compared with validity to
revenues forthcoming at a later date. The future value of the present sum is
estimated through: F = P(1 + i) n . Dividing both sides of this equation by
(1 + i) n , the following equation is obtained: F
P=
(1 + .i )n
Thus, if a pay-off, F, is due in ‘n’ years in future, its present value, P, can be
determined using the above expression where ‘i’ is the interest rate. This
procedure is known as discounting future returns. The present value of Rs.176.23
that could be at the end of 5 years if the appropriate discount rate is 12 per cent,
is: 176.23
P= = Rs.100.00.
5
(1.12)
Discounting can be used to determine the present value of the future income
stream earned by a durable input (asset).
Table 14.3 Discounting the Future Values
(Amount in Rs.)
Year Value at the End of the Year Present Value, if Discount Rate is
(Rs) 12 Per Cent per Annum (Rs)
1 100 89.29
2 100 79.72
3 100 71.18
4 100 63.55
5 100 56.74
Total 500 360.48
The interest rate used to discount or compound sums of money should be at
least as large as the current or market rate of interest. How much higher it might
be depends upon the manager’s opportunity costs. The important variables
determining present and future values of a single payment or series of payments
are: i) the number of years and ii) size of interest rate. Both factors interact to
determine the total effects of discounting or compounding on present or future
values.
Chapter 14: Questions for Review:
i) Explain the principle of comparative advantage and its influencing factors.
ii) Explain compounding and discounting techniques and their usage in farm
investment.
iii) What are the factors that influence compounding and discounting?

219
 DECISION MAKING UNDER RISK AND
UNCERTAINTY

Frank knight classified the knowledge situation into the following logical
possibilities.

KNOWLEDGE SITUATION

PERFECT IMPERFECT

RISK UNCERTAINTY

A PRIORI STATISTICAL

i) Perfect Knowledge: Under this situation, technology, prices and institutional

behaviour would be known with certainty for any period of time in future.
However, this situation does not reflect the real world situation.

ii) Imperfect Knowledge: An imperfect knowledge situation can be classified

either as risk or uncertainty. Risk represents less imperfection in knowledge than
does uncertainty. Under risk, the occurrence of future events can be predicted
fairly accurately by specifying the level of probability. When a risk situation
prevails, at the time of harvesting paddy, the chances for a cyclone are 5: 95 or
20: 80. A priori risk prevails, when sufficient advance information is available
about the occurrence of an event. E.g. the probability of a head or a tail turning
up is 50: 50, if an unbiased coin is tossed. Contrary to this, statistical risk can
only be predicted on the basis of occurrence of several observations made in the
past. Mortality tables of insurance companies provide good examples of
statistical risk. An insured vehicle meeting with an accident or an insured house
catching fire or being burgled can be assigned probabilities based on the past
experience of any country. Because of the quantification of imperfect
knowledge- under risk situation, the event can be insured. If the occurrence of an
event cannot be quantified with the help of probability, then that situation is
220
called uncertainty. Thus, future occurrence of an event cannot be predicted.
Therefore, it becomes essential to formulate some estimates, however wild, of
the most likely outcomes. E.g. price uncertainty.

iii) Types of Risks and Uncertainties: Risks and uncertainties can be classified
into the following five categories.

a) Economic Uncertainties: In general, farmers in most countries face

differences in price for the inputs and outputs from what they might have
anticipated at the time of preparing farm plan.

b) Biological Uncertainties: Rain or storm, drought and also by increased

incidence of pest and diseases may all affect the yield in agriculture directly or
indirectly.

c) Technological Uncertainties: Technological improvement necessarily

implies that the same level of input can
now produce larger quantity of produce.
Y1 T1 The upward shift in the production
T0 function signifies that more output can be
Y0 produced at each level of input after
technological progress. This effect would
Output

be due to the delayed operation of the law

of diminishing marginal returns. Thus,
improvement of knowledge or
Input X0 technological progress, which is a
Fig.15.1 Upward Shift of Production continuous phenomenon, may render some
Function due to Technological Progress
techniques less efficient and finally
obsolete. In the fig.15.1, for the same input level X 0 , the yield is increased from
Y 0 to Y 1 due to technological improvement from T 0 to T 1 .

d) Institutional Uncertainties: Institutions like government, bank, etc may also

cause uncertainties for an individual farmer. Crop cess, credit squeeze, price
supports, subsidies, etc. may be enforced or withdrawn without taking an
individual farmer into confidence. This type of uncertainty may also result in
non-availability of resources in appropriate quantity and at the appropriate time
and place.

e) Personal Uncertainties: The farm plan may not be executed or delayed

221
because of some mishap in the farmer’s household or in his permanent labour
force.

iv) Safeguards Against Risks and Uncertainty

Some farmers take more risk than others. However, all farmers use one or more measures
of different types to safeguard themselves against risks and uncertainties on their farms. The
various measures generally used to counter risks and uncertainties in agriculture are as
follows:

1) Selection of enterprises with low variability: There are certain enterprises

where the yield and price variability are much lower than for others. For
example, rice has relatively much less variability in its yields and prices than
tomato. Thus, the inclusion of enterprises with low variability in the farm plans
provides a good way to safeguard against risks and uncertainties. In practice, the
data on yields and prices of different enterprises over a period of time may be
used to measure the extent of variability by using statistical concepts like
variance or co-efficient of variation.
v ariation.
n
Σ (Xi – X ) 2.
i =1
Variance =
.n n
Σ ( Xi – X )2
. i =1
Standard Deviation =
n .
SD
Co-efficient of Variation = × 100 %
MEAN
Table 15.1 Estimates of Farm Income
Year Farm Income (Rs / Year) (Xi – X) 2
1996 2500 688900
1997 3000 108900
1998 3200 16900
1999 3800 220900
2000 4150 672400
Total 16650 1708000
Mean = 3330; Standard Deviation = √1708000/5 = 584.4656
CV = 584.4656 / 3330 = 17.55 per cent.
2) Discounting Returns: At this stage,we refer to discounting only as a function
of risk and uncertainty, and not time. In terms of the profit maximization
222
condition of VMP = Px, discounting means that either the output price (Py) is
decreased or input price (Px) is increased by some proportion or it can be of
both. Thus, the profit maximization level of the variable input X 1 may now be
lower with discounting than otherwise.

3) Insurance: Insurance covers the cost to some extent so as to minimize the

loss.

4) Forward Contracts: They reduce the future prices of both inputs and outputs
into certainty. Pre-harvest contracts of mango, share cropping, i.e., forward
contract in kind are some examples for this.

5) Flexibility: This refers to the convenience with which the organization of

production on a farm can be changed.

a) Time Flexibility: Time flexibility may be introduced either through proper

selection of products or production methods or partly by both. Orchard
plantation is a relatively rigid enterprise than annual crops. A short-lived farm
structure is more flexible that the durable.
b) Cost flexibility: Wherever time flexibility is of limited use, cost flexibility
becomes important. Cost flexibility refers to variations in output within the
structure of a plant of a longer life. Extension or concentration of output,
whenever desired by favourable prices or yields can be brought about at lower
cost for a given farm (plant). Owning rather than custom hiring a power tiller
may have more cost flexibility.

c) Product flexibility: Product flexibility aims at changes in production in

response to price changes. In this category, machines, farm structure, etc, can be
readily shifted from one product to another.

6) Liquidity: This refers to the case with which assets in a farm can be
converted into cash, the most “liquid” of all assets. If some of the assets are held
in the form, which can be easily converted, into cash, it provides a safeguard to
the farmer by enabling him to make necessary adjustments in response to risks
and uncertainties of various types.

7) Diversification: It is a means of stabilizing incomes rather than profit

maximizing technique relating to receive benefits of complementarity or
supplementarity. Under risky environment, a farmer may not specialize in a
single enterprise over a period of time even if substitution and price ratios may
so dictate as discussed under product-product relationship. Instead, he may

223
choose several enterprises in some proportion overtime, so as to distribute the
risk factor. Like flexibility, it has no provision to reap large gains due to high
prices or yields over time, but serves as a good method to prevent heavy losses.
However, the diversification of farm activities may deprive the entrepreneur of
all the advantages of specialization.

8) Maintenance of resources in reserve: Many a time, there is a risk or

uncertainty about the availability of the right inputs, in the required quantity at
the right time and place and at a reasonable price. This may be due to the
imbalance between demand and supply of the resources. To overcome this
problem, the best way is to maintain sufficient stocks of such inputs.
Maintenance of sufficient stocks depends on the availability of funds, his ability
to fore cast prices and the availability of resources and storage facilities in the
farm.

9) Adjustment to uncertain of Inputs: When a resource is not available, the

best way the farmer can safeguard against such risk and uncertainty is by
exploring the use of some other resource as a substitute. If a farmer is uncertain
about the availability of inputs, he would do better by choosing the best
alternatives, i.e., sowing the second best variety, using the second best fertilizer,
using the second best method of harvesting etc.
Chapter 15: Questions for Review:
1. Fill up the blanks.
i) If the occurrence of an event cannot be quantified with the help of probability,
then that situation is called ; while the occurrence of an event can be
quantified with the help of probability, in case of .
ii) Inclusion of enterprises with low variability in the farm plans reduces .
iii) Diversification is a means of stabilizing rather than profit
maximizing technique.
2.Define the following:
i) Risk and Uncertainty.
ii) Forward contract.
3.Write short notes
i) Perfect knowledge and imperfect knowledge situations
ii) Technological uncertainty
iii) Flexibility.
iv) Diversification of enterprise as a measure of reducing risk
2. Answer the following:
i) Explain the different types of uncertainties with suitable examples.
ii) Explain the different measures to safeguard against risk and uncertainty.
224
 FARM BUSINESS ANALYSIS

A. FARM BUSINESS AND CONTROL

Efficient managers want to be able to determine the position of a business at

any point of time. They also want a basis for evaluating where the business is
going on. This helps their control of the business operations overtime. Thus, the
objectives of farm business at a particular point of time are:

i) to evaluate the performance of the business at a particular point of time;

ii) to identify the weakness of the business;

iii) to remove the hurdles and improve the business; and

iv) to prepare financial documents like balance sheet and income statement
so as to acquire credit, design farm policies and prepare tax statement.

i) Steps or Stages of Farm Business Analysis

a) Proper recording of accounts and activities.

b) Analysis of the data.

c) Interpretation of the results.

a. Recording of data: A systematic recording of information on financial

aspects of the farm is essential for farm business analysis and for this purpose, a
sound knowledge on book keeping and accounting is essential.

b. Analysis of data: The data collected would be useful to construct balance

sheet and income statement. Financial ratio analysis would also increase the farm
efficiency.

c. Interpretation of the results: The financial analysis would indicate the

performance of the business and suggest measures for improvement. The
interpretation of results would be more useful to understand the performance of
the business.

ii) Advantages of Farm Records and Accounts

a) They are the means to increase the farm income.

225
b) They are the basis for diagnosis and planning.

c) They show the ways to improve the managerial ability of the farmer.

d) They are useful for credit acquisition and management.

e) They provide database for conducting research in agricultural economics.

f) They form the basis for designing government policies - land policy, price
policy, national farm policies, etc.

iii) Problems in Farm Accounting

a) As Indian farmers carry out only subsistence nature of farming, recording is
not essential to them.

b) Indian farmer acts as an owner, manager and labourer. Hence, recording

becomes complex.

c) Illiteracy and lack of business awareness of farmers prohibit them to have

farm records.

d) Fear of taxation prevents farmers from recording and accounting the

information.

e) Forecasting becomes complicated because of very high risk and uncertainties

involved in farming.

iv) Types of Farm Records: Farm records can be classified into three
categories, i.e., inventories, production records and financial records.
a) Inventory: Farm inventory includes a complete listing of all that a farm owns
and owes at a particular date, generally at the beginning and the end of each
agricultural year. It includes not only the listing of physical assets but also
assigning values of all such assets, liabilities and debts as well. There are two
steps involved in taking a farm inventory.

1) Examination of Physical Assets: It includes a complete listing of all the

physical assets including a verification of weights and measurements. The losses,
wastages, shrinkages or gains, which accrue over time, are all accounted for.

2) Valuation of Physical Assets: A few common methods of valuation are

discussed below:

i) Valuation at Cost: The amount of money actually invested on the asset when

226
it was acquired is entered in the inventory. This method has the following
limitations: a) it cannot be used for the valuation of farm products; b) the effects
of inflation and deflation are ignored; and c) original investment value has only
a limited use, when valuation is taken up somewhere in the middle of the
business.

ii) Cost or market prices whichever is lower: This is used for valuing the
purchased farm supplies.

iii) Net Selling Price: It represents market price less the selling costs. For all
assets that will be sold within the year, the net selling price is used. Crops or
livestock produced for the market can be valued with this method.

iv) Cost Less Depreciation: The value of asset in subsequent years can be
estimated by subtracting the depreciation from its cost. Machinery, breeding
livestock and buildings constructed recently can be evaluated with this method.
But this method cannot be applied for products produced from the farm.

v) Replacement Cost: It represents a value of an asset, which is equal to the

cost needed to reproduce the asset at the present prices and under the existing
technological improvements. This method may be successfully employed for the
valuation of fixed and long-lived assets.

vi) Replacement Cost less Depreciation: It represents an improvement over the

previous method as it provides a more realistic valuation of fixed and long-lived
assets like buildings, particularly, when wide price changes occur. However, this
method should be used very carefully as it may often lead to over valuation.

vii) Income Capitalization: For assets like land whose contribution towards the
income can be measured for each production period and which has long life,
income capitalization is an ideal method of valuation. If a certain piece of land is
expected to give an uniform income of Rs.1,000 per year indefinitely and the
rate of interest is 10 per cent per annum, the present value of the land, then, can
be easily assessed by using this method, i.e.,

Return per Year ( R ) 1,000

Present Value (PV) = = = Rs. 10,000
Interest Rate per Annum ( r ) 0.10

Thus, the piece of land in question would be valued at Rs.10,000.

227
viii) Depreciation

Depreciation is the decline in the value of a given asset as a result of the use,
wear and tear, accidental damages and time obsolescence. The loss in value of an
asset over time is, therefore, determined by i) remaining life, ii) extent and
nature of use and iii) obsolescence. The relative importance of the above factors
varies with the kind of assets and the extent to which it is put into use.
Depreciation charges may either be spread uniformly over the entire useful life
of an asset or they can be relatively heavier during the early life of an asset. The
amount of depreciation charged should correspond to the loss in the value of
asset over time. The computation of depreciation would not be necessary, if all
items purchased were completely worn out by the end of the year of its purchase.
However, the items such as buildings, equipments, livestock, etc are used up
gradually over a long period of years and an important question arises about the
determination of cost of such articles for one specific accounting year.

The span of an asset can be examined in two ways. In developing economies,

any asset once acquired remains in use so long as it can be kept in use. But in
developed countries, new improved assets, especially machines that provide
more efficient and economical services, are continuously developed and the
farmer replaces much before its full working life, even while it is in working
condition. The “time” depreciation in such cases known as obsolescence is
equally important as that of “use” depreciation. While considering life span (or
working life) of an asset, the past experience (or experience of the neighbouring
farmers) and the expert opinion (of engineers) should be sought. The chance of
obsolescence and the residual (or junk or scrap or salvage) value should also be
carefully considered. The value of the asset may become completely exhausted
or reduced to its junk value at the end of its useful life.

a) Calculation of Depreciation

Depreciation charges are merely a method of distributing the cost of the

assets over the period of their use. Both the elements of depreciation, viz., use
and time should be considered in working out the depreciation. There are three
methods of calculating annual depreciation as discussed below:

1.Straight-Line Method: This method is relatively easy and simple to

understand. The annual depreciation of asset is computed by dividing the
original cost of the asset less salvage value by the expected years of life.

228
 Original Cost (OC) – Salvage Value (SV)
Annual Depreciation (AD) =
Expected Years of Life (EL)
12000 – 1200
AD = = Rs. 1080 per year.
10
The life of the asset may be calculated in terms of years (time) or units of
production, viz., acres or hours of work. In case of tractor, its life may be 10
years or 10,000 hours of work. The actual depreciation of the asset may not be
uniform in value every year during the entire useful life of an asset. It may be
more during the early years, when asset depreciates at a faster rate and less in
the later years of its life. It can be the other way also. Thus, the straight-line
method may not be realistic for the estimation of depreciation of all assets.
However, it may be suitable to long lasting assets like buildings and fences,
which may require uniform maintenance during their lifetimes.

2.Declining or Diminishing Balance Method: In this method, a fixed rate of

depreciation is used every year and applied to the remaining value of the asset at
the beginning of each year. It is important to note that salvage value is not
subtracted from the original cost as in straight-line method. A fixed rate of
depreciation which should be nearly twice that is used under the straight-line
method is applied to uncovered balance amount every year until the salvage
value is reached and after that no depreciation is worked out. The annual
depreciation under this method is estimated as follows:

AD= (OC – D) x R

Where, OC- Original Cost; D – Accumulated depreciation occurred in prior

years; and R-Rate of Depreciation.

In this method, the amount of depreciation decreases year after year and
ultimately the asset is reduced to its junk value. This method may be suitable to
those assets which depreciate at a faster rate in the beginning of their lives. E.g.
Tractor, pump-set, etc. Assume a Rs.12,000 worth of an oil engine with an
expected life of 10 years and salvage value of Rs.1,200.

The rate of depreciation would obviously be 20 per cent for this method as 10
per cent was used under straight-line method.

3.Sum-of-the-Year Digit Method (or) Reducing Fraction Method: If it is

desired to distribute depreciation charges more heavily in the earlier life of an
asset and more lightly in the later years, the sum-of-year-digits method can be

229
 Table 16.1 Estimation of Annual Depreciation using
Diminishing Balance Method
Year Value at the Beginning Annual Depreciation Remaining
of the Year (Rs) (Rs) Balance (Rs)
1 12,000.00 12,000.00x0.2=2,400.00 9,600.00
2 9,600.00 9,600.00x0.2=1,920.00 7,680.00
3 7,680.00 7,680.00x0.2=1,536.00 6,144.00
4 6,144.00 6,144.00x0.2=1,228.80 4,915.20
5 4,915.20 4,915.20x0.2=983.04 3,932.16
6 3,932.16 3,932.16x0.2=786.43 3,145.73
7 3,145.73 3,145.73x0.2=629.15 2,516.58
8 2,516.58 2,516.58x0.2=503.32 2,013.26
9 2,013.26 2,013.26x0.2=402.65 1,610.61
10 1,610.61 1,610.61x0.2=322.12 1,288.49

used. As no undistributed balance is left over in this method, it has an advantage

over the diminishing balance method. In case of declining balance method, the
value at the end of the useful life is different from the expected salvage value.
By this method, the annual depreciation is found out by multiplying a fraction by
the amount to be depreciated (original cost minus salvage value).
N
AD = (OC – SV )
SD
N – The years of life remaining at the beginning of accounting period.
SD – The sum of the years of life of the asset

In this method, the digits upto the expected life of the asset are added (the
digits can be summed up using a formula i.e., n (n+1) / 2; where n is the total
number of years of life). As the value of the fraction N/SD keeps on declining
each year, the annual depreciation also declines with the advancement in the age
of an asset as in the declining balance method.

Assume an oil engine with the original cost of Rs.12,000, an expected life of
10 years and salvage value of Rs. 1,200. Annual depreciation for this asset over
its life can be calculated as shown in the table below:

This method also suits those assets for which relatively higher depreciation
needs to be charged during earlier years of their lives. This method differs from
the declining balance method in that the rate of decline in depreciation is
uniform from year to year whereas in the declining balance method, it keeps on

230