WOLLO UNIVERSITY

SCHOOL OF VETERINARY MEDICINE

Animal Health Economics

Engidaw Abebe (DVM, MSc, Assistant professor)

2016 E.C
Dessie, Ethiopia
1
 Introduction to Principles of Economics
 Objectives

 At the end of this introduction chapter the students will

able to:

 Define economics and animal health and production

economics

 Differentiate between macroeconomics and

microeconomics

 Elaborate different economics concepts and factors

of production

2
 Definitions of Economics
 The word "economics" is derived from a Greek word
"okionomia", which means "household management" or
"management of house affairs”.

 Oxford dictionary def: A branch of knowledge concerned

with production, consumption and transfer of wealth.

 Economics is a social science that studies how individuals,

firms, governments, and nations make choices on
allocating scarce resources to satisfy their unlimited
wants (Investopeida).

 Economics is a science concerned with making rational

choices/decisions in allocation of scares resources for
achievement of competing needs (Rushton, 2009).
3
 Cont’d
 Economics is decision science.
 It is social because it involves people and their behavior.
 There are two fundamental facts that laid foundation for
the discipline called economics
 Resource are scarce
Economic resources are limited
It is not possible to produce all goods and services
needed by the society.
 Human wants are unlimited.
Society's wants for material goods and services are
unlimited
4
 Cont’d
 Limited resource + Unlimited wants = Scarcity

Hence, economics is the study of how society manages its

scarce resources. 5
 Animal health economics
 Is the area of economics that applies the principles and
methods of economic analysis to animal health problems

 Concerned with the allocation of the available resources

to improve animal health in order to satisfy human needs.

 Provide quantitative insights into the economic impact of

disease and disease control in livestock to support
decision-making process in optimising animal health
management.

 It is an important aid in decision making on animal health

intervention at various levels.

6
 Cont’d
 The level of decision making ranges from the individual
animal to the national herd and finally to international
disease control efforts (Otte and Chilonda, 2000).

 Animal health economics asks and answers animal health

issues like the following:

 What is the best option to prevent a disease, using a

vaccine or to treat the disease when it occurs?

 A disease control program works effectively but are

other options cheaper?

 Money is available for capital investment, should it be

spent on a new tractor or a cattle dip to control ticks?

7
 Livestock production economics
 Is basically a production economics

 Production economics is a study of the process of

workers combing material inputs and immaterial inputs
(plans and knowledge) to create an output (goods and
service) for consumption.

 So livestock production economics is an economics

concerned with economics related to production of
livestock commodities.

8
 Cont’d
 Livestock production economics will help to answer the
following types of question within the livestock sector:

 What is efficient production? By examining the

different stages of production.

 How is the most profitable amount of an input

determined? By assessing the relationship between
input (factor) and product.

 What is the best combination of a number of inputs?

By examining the relationship between inputs called a
factor/factor relationship.

9
 Cont’d
 How will farm production respond to a change in the price
of an output (milk or meat)?

 How much can a livestock farmer pay for a durable input,

such as a bullock cart

 What should a manager do if they are uncertain about

livestock production levels? For example, livestock
production will be uncertain if a farmer is in a region with
animal diseases. This requires risk analysis tool

 How will technical change affect output? etc.

10
 Why Veterinarians (epidemiologists)
need to learn economics?
 The livestock sector is an economic
component of the national as well as
household economy.
 Veterinarians are service provider to the
livestock sector.
 To act as a valuable service provider, veterinarians need
to have an understanding of how the live stock sector
operates and what motivates the people with in it.
 Issue involving animal health cannot simply decided only on
technical ground.
 The presence or absence of a disease is immaterial by
itself.
11
 Cont’d
 In addition to technical efficiency, disease control
decision should also consider economic efficiency.

 This is particularly true with endemic disease whose

control benefit is not straight forward.

 Unlike the veterinarian (who is usually preoccupied with

eliminating disease and increasing production) his clients
(the farmer, farmer group, or government) interest
primarily lies on economic efficiency (benefit) of control
measure.

 Economic considerations, expressed either as cost-

effectiveness or cost-benefit, frequently determine
which strategy is most effective in disease control.
12
 Cont’d
 The most effective strategy may not be the
one that results in the lowest incidence of disease, but
rather the one that results in the greatest profit.

 Veterinary practitioners must learn to think in these

terms if they are to deal effectively with producers.

 Epidemiological information is not enough information to

make decision about a disease control and requires
economic analysis support.

 Other technical information like production parameters

are also needed for the economic analysis.

13
 Branches of (animal health) economics
 There two braches or levels of economics which also
apply to animal health economics

Economics

Microeconomics Macroeconomics

14
 Cont’d
 Microeconomics

 Is that branch of economics which is concerned with the

decision-making of a single unit of an economic system.

 The study of economic decision-making by micro-units

 Is a part of economics which studies about the behavior

of individual economic units (in animal health such as
livestock farmer, farm’s association or processor etc).

 As far as the cost of animal disease control activities are

concerned microeconomic studies, the benefit of the
disease control is from the perspective of individual
livestock producers or single animal industry.

15
 Cont’d
 Macroeconomics

 Is the branch of economics which is concerned with the

economic magnitudes relating to the economic system as
a whole.

 Is the study of economics from national perspective and

concerned with national income, employment, saving,
investment, balance of payment etc.

 As such macroeconomics studies the interaction between

the different sectors of the economy.

 E.g. in animal health economics it deals with the effect of

disease control activities on national and international
trade.
16
 Some economic concepts and principles
 Resources scarcity, choice and opportunity cost
 Economics is the study of choice.
 All choices mean that one alternative is selected over
another.
 Selecting among alternatives involves three ideas central
to economics:
 Scarcity
 Choice, and
 Opportunity cost.

17
 Cont’d
 Scarcity
 Resources are used to fulfill human needs and wants.
 Humans wants are unlimited and this creates shortage of
resources to fulfill the wants which is called scarcity.
 Is the condition that arises because wants exceeds the
ability of resources to satisfy them.
 It is the basic foundation economics as it forces to make
choice or decision in using the scarce resource.

18
 Cont’d
 Choice
 Resource scarcity forces individuals and societies to make
choices.
 Choice involves sacrifice.
 Economists assume that individuals make choices that
they expect will create the maximum value of some
objective, given the constraints they face.

19
 Cont’d
 Opportunity cost
 Opportunity cost is the value of the best alternative
forgone in making any choice or you give up to get it.
 When an action is chosen, the highest-valued alternative
NOT chosen is called the opportunity cost.
 Is the sacrifice of alternatives in production (or
consumption) of a good or service.
 For example:
 The more money a government spends on disease
control the less money it has available for other
projects.
 The more money a farmer spends on veterinary advice
the less money he has available for other inputs.
20
 Cont’d
 Rational decision
 Rationality is one of the basic assumption of economics
 It simply means the weighing-up of the costs and
benefits of any activity.
 Rational decision making involves choosing what will give
the best value for money, i.e. the greatest benefit
relative to cost.
 Examples:
 a government deciding which projects to fund
 a farm deciding what and how much to produce

21
 Cont’d
 Margin
 Rational decisions are often made on marginal costs and
benefits not on the total or average values.
 Marginal Analysis is weighing costs and benefits for an
extra/additional unit activities.
 Economic analysis is mostly done at the margin
 The aim of marginal analysis is to determine the change in
net benefits
 Change in net benefits = marginal benefits - marginal
cost

22
 Cont’d
 Production and Productivity
 What is the measure for making rational decisions?
 Generally the technically oriented professionals will be
focused on production (production levels).
 But the livestock keepers will be more interested in
productivity (profitability) from their livestock
enterprises.
 Production refers the total quantity of product/yield
produced.
 But productivity refers quantity produced per unit of
input.
 In an economic analysis scarce resources used in the
production system should be identified and productivity
should be calculated per unit of this scarce resource.
23
 Cont’d
 Financial vs economic analysis

 There is a distinction between a financial and economic

analysis.

 Financial analysis

 It is done for individual economic units (farms,

companies etc).

 Uses market prices for inputs and outputs

 It ignores that the prices may include taxes, subsidies or

be influenced by an exchange rate that does not reflect
the true value of the local currency.
24
 Cont’d
 Economic analysis.
 Is the analysis made at regional or national level.
 However, government investments at a regional or
national level, the analysis is more complicated because:
– Prices generally include taxes, or subsidies (direct &
indirect) or in some countries the exchange rate may
not reflect the true value of the currency
 It considers true social cost or value not market
price.
 It uses shadow prices instead of market prices.
 Shadow prices are artificial prices calculated for certain
items in order to ensure that their real opportunity cost
is taken in to consideration when making decision.
25
 Cont’d
 Focus of analysis (perspective)

 When conducting an economic analysis clarification must be

made is whose point of view will be considered in the
analysis?

 With respect to animal diseases the alternatives point of

views include, the farmer, veterinarian, the processor, the
farming community and or the whole society.

 For individual farms the analysis is financial which deals

with money and market prices.

 It is concerned with its impact the disease or the impact

of control measures on the profitability of the enterprise –
the prices which matter are market prices.
26
 Cont’d
 However, these prices may not reflect the real costs or
values to a society as a whole, for example because of
taxes, subsides or price controls.

 In addition as his farm is likely to have external effects,

for example disease control on one farm may also
improve the disease environment for neighboring farms
at no cost to them.

 So the analysis concerns only the farmer not the whole

society in which it could be affected positively or
negatively.

 When the analysis is at regional or national level, it is an

economic analysis which deals with everything that has
value but not necessary a market price.
27
 Factors of production
 The economic process begins with a set of inputs.
 These inputs are often referred to as resources or
factors of production.
 Resources can be defined as the inputs used in the
production of those things that we desire.
 When resources are productive, they are typically called
factors of production.
 They are classified into three categories :– labor, land,
capital.
 Sometimes a fourth factor entrepreneurship or
management is added to cover management and risk
taking.
28
 Cont’d
 Labor

 Labor is the work time and work effort that people

devote to produce goods and services.

 It can be physical or mental.

 The quality of labor depends on how skilled people are—

what economists call human capital.

 Human capital is the knowledge and skill that people

obtain from education, on-the-job training, and work
experience.

 The payment for labor is usually called wages (payments

might be commissions, salary, bonus or whatever).
29
 Cont’d
 Land
 Land includes all the things we call natural resources.
 Land with its inherent mineral deposits is a resource or
input that is a “gift of nature”.
 The original fertility of land is also a natural resource.
 It exists independently of human activities.
 Soil, a forest, a deposit of oil, a river, the climate are a
few examples of land.
 Resources can be classified as either renewable (e.g
forests) or non renewable (e.g. minerals).
 In economics the payment for land is often called rent.
30
 Cont’d
 Capital

 In the context of production, it refers to manufactured

durable goods such as fuel, chemicals, tractors and
buildings.

 Capital goods don't provide consumer satisfaction

directly.

 Used for the further production of goods and services.

 Other examples- dairy cow, a cow barn or a money used

to buy feeds and medicines etc.

31
 Cont’d
 Entrepreneurship

 It is the process of creating new goods or processes.

 Come up with new ideas about what and how to produce,

make business decisions, and bear the risks that arise
from these decisions.

 Innovation and risk are important elements of the

entrepreneurial function.

32
 Market behavior
 Objectives

 At the end of this chapter the students will able to:

 Define market, consumer and producer behaviors

 Describe supply, demand and market equilibrium

 Elaborate and calculate the demand, supply, cross-

price, and income elasticities.

 Describe consumer surplus and producer surplus

33
 Market behavior
 Market is a place where exchanges of goods and services
takes place.

 Is any arrangement that enables buyers and sellers to

get information and do business with each other.

 In market, buyers (consumers) and sellers (producers)

meet and exchange goods and services for a price.

 The main actors in the market are consumers and

producers;

 The prices in the market is determined by the

consumers demand and producers supply.

 Study of market behavior is, therefore, study of

consumers’ and producers’ behaviors.
34
 Consumer behavior
 Consumer behavior is the study of how individual
customers, groups or organizations select, buy, use, and
dispose ideas, goods, and services to satisfy their needs
and wants.

 It refers to the actions of the consumers in the

marketplace and the underlying motives for those actions.

 In the words of Engel, Blackwell, and Mansard, “consumer

behavior is the actions and decision processes of people
who purchase goods and services for personal
consumption”.

 According to Schiffman “Consumer behavior is defined as

behavior that consumers display in searching for
purchasing, using evaluating and disposing of products and
services that expect will satisfy their needs”. 35
 Demand
 The working of the market system is governed by two
forces, demand and supply.

 These two forces play a crucial role in determining the

price of a product and size of the market.

 To an economist, demand refers to both willingness and

ability to pay.

 The law of demand states: Other things remaining the

same or “everything else remains the same” is known as
the “ceteris paribus”, the higher the price of a good, the
smaller the quantity demanded; and the lower the price
of a good, the larger the quantity demanded.

 Demand is an inverse relationship between price and

quantity demanded.
36
 Cont’d
 Only in unusual circumstances (in highly inferior good also
called Giffen good) may a demand function have a positive
relationship).
 A giffen good occurs when a rise in price causes higher
demand because the income effect outweighs the
substitution effect.
 Demand Curve: is a graphical representation of the
relationship between price and quantity demanded.
 Shows how much a consumer is willing to purchase at
different market prices.

37
 Demand function
 A demand function is a mathematical equation that
represents the relationship between the quantity
demanded for a commodity (dependent variable) and the
price of the commodity (independent variable).

 Dx = f (Px)

 Represents the behavior of buyers, and can be

constructed for an individual or a group of buyers in a
market.

 The market demand function is the horizontal

summation of the individuals' demand functions.

38
 Cont’d
 Determinants of Demand
 The behavior of a buyer is influenced by many factors;
 The price of the good
 The prices of related goods (compliments and
substitutes)
 Incomes of the buyer
 The tastes and preferences of the buyer
 The period of time and a variety of other possible
variables.
 The quantity that a buyer is willing and able to purchase
is a function of these variables

39
 Change in Quantity demanded
 When demand is stated Q = f(P) ceteris paribus, a change
in the price of the good causes a "change in quantity
demanded.“
 The buyers respond to a higher (lower) price by
purchasing a smaller (larger) quantity.
 Change in quantity demanded is a movement along a
demand function caused by a change (increase or
decrease) in product price.

40
 Change/shift in demand
 Change in demand is a "shift" or movement of the
demand function.
 An increase in demand is a shift to the right and at
every price larger quantity will be purchased.
 A decrease in demand is a shift to the left and at every
price smaller quantity will be purchased.
 A shift of the demand function
can be caused by a change in:
Prices of related goods
Incomes
Preferences
The number of buyers etc.
41
 Cont’d
 Prices of Related Goods
 A substitute is a good that can be used in place of another
good.
 A complement is a good that is used in conjunction with
another good.
 A change (increase or decrease) in the price of substitutes
directly affects the demand for a given commodity.
 When price of substitute goods (eg. coffee) rises,
demand for the given commodity (eg. tea) also rises.
 An increase or decrease in the prices of complementary
goods inversely affects the demand for the given
commodity.
 When price of complementary goods (eg. sugar) rises,
demand for the given commodity (eg. tea) falls. 42
 Cont’d
 Income
 When income increases, consumers buy more of most
goods and the demand curve shifts rightward.
 A normal good is one for which demand increases as
income increases.
 An inferior good is a good for which demand decreases as
income increases.
 Preferences
 People with the same income have different demands if
they have different preferences.
 Population
 The larger the population, the greater is the demand for
all goods.
43
 Producers' Behaviour and Supply
 Producers’ behavior is concerned with the behavior of
firms in hiring and combining productive inputs to supply
commodities at appropriate prices.
 Supply is used in the vernacular to mean a fixed amount.
 Supply is not just the amount of something there, but the
willingness and ability of potential sellers to produce and
sell it.
 The law of supply states that; other factors remaining
the same;
 The higher the price of a good, the greater the
quantity supplied; and
 The lower the price of a good, the smaller the quantity
supplied. 44
 Cont’d
 The supply curve shows the relationship between the
quantity supplied of a good and its price when all other
influences on producers’ planned sales remain the same.

Determinants of Supply
 Cost production
• Prices of factors of production
(inputs)
• Technologies used in production
 The prices of related goods
produced
 Expected future prices
 The number of suppliers’
 State of nature
45
 Supply function
 Supply function is a model that represents the behavior
of the producers and/or sellers in a market.

 QXS= fS (PX, Pinputs, technology, number of sellers,

laws taxes. . .)
 Where:
 PX= price of the good,
 Pinputs= prices of the inputs (factors of production
used)
 Technology is the method of production (a production
function),
 laws and regulations may impose more costly methods
of production
 taxes and subsidies alter the costs of production
46
 Cont’d
 Like the demand function, supply can be viewed from two
perspectives;

 Supply is a schedule of quantities that will be

produced and offered for sale at a schedule of prices
in a given time period, ceteris paribus Or

 A supply function can be viewed as the minimum

prices sellers are willing to accept for given quantities
of output, ceteris paribus.

 Generally, it is assumed that there is a positive

relationship between the price of the good and the
quantity offered for sale.

47
 Change in the quantity supplied
 A change in quantity supplied is a movement along a
supply function that is caused by a change in the price of
the good.

 For example, it is a change from A to B.

48
 Change/shift in supply
 A change in supply leads to a shift in the supply curve for
the same price.
 An increase in the change in supply shifts the supply
curve to the right.
 A decrease in the change in supply shifts the supply
curve left.
 Causes of Change/shift in
supply
Number of sellers
Expectations of sellers
Price of raw materials
Technology
Other prices 49
 Market equilibrium and price
 Equilibrium is a situation in which opposing forces balance
each other.

 In economics, “equilibrium” is perceived as the condition

where the quantity demanded is equal to the quantity
supplied.

 The behavior of all potential buyers is coordinated with

the behavior of all potential sellers.

 The equilibrium price is the price at which the quantity

demanded equals the quantity supplied.

 The equilibrium quantity is the quantity bought and sold at

the equilibrium price.
50
 Cont’d
 Graphically, economists represent a market equilibrium
as the intersection of the demand and supply
functions
 Equilibrium is a point where the demand intersects the
supply.

51
 Market disequilibrium and adjustment
 The process of achieving a state of equilibrium is based
on buyers and sellers adjusting their behavior in response
to prices, shortages and surpluses.
 When the market price is below the equilibrium price, the
quantity demanded exceeds the quantity supplied.
 At the price below equilibrium, buyers are willing and able
to purchase an amount that is greater than the suppliers
produce and offer for sale. The buyers will “bid up” the
price by offering a higher price to get the quantity they
want.
 When the price goes up producers produce to get the
higher price but when the supply reach above the clearing
quantity, the quantity demanded will fall and supply has to
decreased this way & the equilibrium is reached. 52
 Elasticity
 Is the measure of responsiveness.

 Is the degree of consumer/producer responsiveness to

change in price and incomes.

 Is the ratio of the percentage change in a dependent

variable to the percentage change in an independent
variable.

 Mathematically, elasticity is calculated as:

 Elasticity= % change in dependent variable
% change in independent variable

53
 Demand Elasticity
 The elasticity of demand refers to the degree to which
demand responds to a change in an economic factor.
 Different elasticities of demand measures the
responsiveness of quantity demanded to changes in
variables which affect demand so:
 Price elasticity of demand
 Income elasticity of demand
 Cross elasticity of demand

54
 Cont’d
 Price elasticity of demand
 Measures the responsiveness of quantity demanded by
changes in the price of the good.
 Shows how demand changes due to changes in price
 Price elasticity of Demand (EP)=
percentage change in quantity demanded =
percentage change in price
 If elasticity is:
Greater than one in absolute
value- it is said to be elastic,
 Equals to one- unitary elastic
Less than one- it is said to be
55
inelastic.
 Cont’d
 The above formula is for point elasticity which is
specific for specific price on the demand function.

 For example, suppose that a 10-percent increase in the

price of a meat causes the amount of meat you buy to fall
by 20 percent.

 The price elasticity of demand is calculated as,

= % change in quantity demanded = 20% / 10%=2
% change in price
 Thus, the elasticity is 2, reflecting that the change in the
quantity demanded is proportionately twice as large as
the change in the price.

56
 Cont’d
 Elasticity of demand between two points
 We can use the midpoint method that computes a
percentage change by dividing the change by the
midpoint of the initial and final levels.
 Or we can use
 Price elasticity of demand = (Q2-Q1)/[(Q2+Q1)/2]
(P2- P1)/[(P2+P1)/2]
 Example;

57
 Cont’d
 A to B: (6-4)/5 *100= 40%; (80-120)/100*100= 40%
 Price elasticity of demand (PED) between A to B =
40%/40%= 1
 We can also calculate PED as;
= (80-120)/[(80+120)/2)] = 0.4=40% = 1 (unitary elastic)
(6-4)/[(6+4)/2] 0.4=40%

58
 Cont’d
Total Revenue and the Price Elasticity of Demand
 Total revenue is the amount paid by buyers and received
by sellers of a good.
 It is computed as the price of the good (P) times the
quantity sold (Q)
 Total revenue= P*Q

 It equals the area of

the box under the
demand curve.

59
 Cont’d
 The relationship between elasticity of demand and
revenue generally can expressed by the following rule:

 When a demand curve is inelastic (a price elasticity less

than 1), a price increase raises total revenue, and a
price decrease reduces total revenue.

 When a demand curve is elastic (a price elasticity

greater than 1), a price increase reduces total revenue,
and a price decrease raises total revenue.

 In the special case of unit elastic demand (a price

elasticity exactly equal to 1), a change in the price does
not affect total revenue.

60
 Cont’d
 Income elasticity of demand
 It is the effects of changes in income on changes in
quantity demanded in percentage.
 It measures the sensitivity to changes in income.
 It is a measure of the responsiveness of the quantity of a
good purchased due to changes in income.
 Income elasticity (Ey) = percentage change in quantity =
percentage change in income

61
 Cont’d
 Ey < 0 means the good is inferior
 For an increase in income the quantity purchased will
decline or
 For a decrease in income the quantity purchased will
increase
 1 > Εy > 0
 The good is a normal good
 For an increase in income the quantity purchased will
increase but by a smaller percentage than the
percentage change in income.
 Ey > 1
 The good is considered a superior/luxury good.
 Change in demand is more than proportionate change in
income 62
 Cont’d
 Example: Suppose the income of the consumer rises from
16,000Br to 20000Br and as a result, the quantity
demanded of a good increase from 15units to 18 units.
 Calculate the Ey?

= 16,000 * 18-15 = 0.8 (normal good)

15 20,0000-16,000

63
 Cont’d
 Cross elasticity of demand
 Measures the relationship between two goods
 Measures the responsiveness in the demand of a good
when a price of a related good changes
 Cross elasticity of two goods X and Y (Ec) =
Percentage change in quantity of X
Percentage change in price of Y

64
 Cont’d
 When Εc > 0, suggests that the two goods are substitutes
 When Εc < 0, suggests that the two goods are
compliments
 When Εc = 0, suggests that the two goods are not related
 Example: Consider two goods X and Y and assume that the
price of Y rise from 10 Br to 20 Br the quantity demand
of X decreases from 40 units to 35 units.
 Calculate the cross elasticity of demand and identify what
type of commodities are X and Y?
 E= = 35-40 *10 = -0.125
20-10 40
 Since the cross elasticity of demand is negative, X and Y
are compliment goods.
65
 Elasticity of supply
 Is the measurement of what happens to the supply of a
good with regards to change in supply determinants.
 Measures the percentage change in the quantity of supply
compared to the percentage change in a supply
determinant.
 Price elasticity of supply (PES)
 Measures the responsiveness of quantity supplied to a
change in price.
 PES = Percentage change in quantity supplied
percentage change in price
 PES is positive in value, it may range from 0 to infinite

66
 Cont’d
 If the quantity supplied is
fixed, regardless of the price,
the supply is perfectly inelastic.
 When the percentage change in
quantity supplied is equal to the
percentage change in price, the
supply is unit elastic.

If there is a price at which sellers are willing to offer any

quantity for sale, the supply is perfectly elastic.
For example, suppose that an increase in the price of milk
from $2.85 to $3.15 per gallon raises the amount that
dairy farmers produce from 9,000 to 11,000 gallons per
month.
67
 Cont’d
 Using the midpoint method, we can calculate the
percentage change in price as
 Percentage change in price =(3.15 -2.85)/3.00 *100 =10
percent.
 Similarly, we can calculate the percentage change in
quantity supplied as
 Percentage change in quantity supplied (11,000 -
9,000)/10,000 *100 = 20 percent.
 Price elasticity of supply (PES) = 20 percent/ 10 percent
= 2.0
 We can also calculate the PES using this formula
 PES=

68
 Cont’d

= 11,000- 9000 * 3.15+2.85 = 2000 * 6 = 2.0

3.15-2.85 11,000+9000 0.3 20000

 The elasticity of 2 reflects the fact that the quantity

supplied moves proportionately twice as much as the
price.

69
 Consumers’ (buyers’) and producers’ (sellers’) surplus
 Consumer Surplus
 Is defined as the difference between a consumer’s
willingness to pay and what he or she actually has to pay
(the price of the good).

70
 Cont’d
 As shown in graph, someone Consumer Surplus

is willing and able to pay $9

or more for the first 2
units.
 If the market price were at
equilibrium ($5 in this
graph), the consumer would
pay $5 while they were
willing to pay in excess of
$9 for each of the two
units.
 Therefore, they received more utility (that they were
willing and able to pay for) than they had to pay.
 The area RPE on the graph represents the consumer
surplus 71
 Cont’d
 Producer Surplus
 Is the difference between the market price and the
minimum price that the seller will accept for each unit
 Is the total amount that a producer benefits from
producing and selling a quantity of a good at the market
price.
 Producer surplus measures the benefits to producers as
the excess of the price they received for each unit of
output over the minimum price that would have induced
them to produce it.

72
 Cont’d
 The areas CPE represents the producer surplus.
 The consumer surplus plus the producers represented by
the area RCE is called total welfare or social welfare

Social
welfare

Producer Surplus
73
 Production economics
 Objectives

 At the end of this chapter the students will able to:

 Define and describe production and production

concepts.

 Elaborate the relationship between inputs and out puts

 Determine the optimum combination of inputs and

products

74
 Introduction
 Production economics is a field as specialization witihin
the subject of agriculture economics.
 It examines producer decisions.
 Production
 Production is the process of transforming inputs into
output.
 Inputs are resources /means of production/ factors of
production.
 Fixed input - is an input that can`t be changed in
amount in a given period of time
 Variable input- is an input that can vary with in a
given period of time.
 Output: is any good/service that comes out from the
production process.
75
 Cont’d
 Period of production: is the time required for a resource
to be transformed into a product.

 Livestock production (like any production process)

requires decision about the level of input that is
appropriate.

 This requires the use of information on the technical

relationship between the inputs and the outputs, and the
prices of the inputs and output.

76
 Production function
 The technical relationship between inputs and outputs in
production process is called production function.

 Is a model that relates possible levels of physical outputs

to various sets of inputs.

 Represents the quantity of output a firm can produce

given a certain quantity of input combination.

 The production function can be expressed in three ways:

 Equations/ algebraic form

 Tables
 Graphs

77
 Cont’d
 Mathematically/equation/ algebraic form
 Algebraically production function can be expressed as Y=
f(X);
 Where,
 Y represents dependent variable, output
 X represents independent variable, input
 f = denotes function of
 Output= f(labor, land, capital ....)

78
 Cont’d
 Tabular form
 Production function can be expressed in the form of a
table.
 One column represents input, while another indicates the
corresponding total output of the product.
 The two columns constitute production function.
Daily Inputs Daily Outputs
0 0
1 2
2 5
3 10
3 20
4 30 79
 Cont’d
 Graphical form
 The production function can also be illustrated in the
form of a graph.
 Horizontal axis (X axis) represents input and the vertical
axis (Y axis) represents the output.

80
 Concepts of Production
 Total product (TP)
 Amount of product produced by all factors employed
during given time period.
 Average Product (AP)
 It is the ratio of total product to the quantity of input
used in producing that quantity of product.
 AP= Y/X Where; Y is total product and X is total input.
 Marginal product (MP)
 Additional quantity of output resulting from an additional
unit of input.
 MP= Change in total product / Change in input level (ΔY/
Δ X)
81
 Cont’d
 Total Physical Product (TPP), Average Physical Product
(APP) and Marginal Physical Product (MPP),

 Are the Total Product (TP), Average Product (AP) and

Marginal Product (MP) expressed in terms of physical
units like Kgs, Kuntals, etc..., respectively.

 Total Value Product (TVP)

 Is expression of TPP in terms of monetary value

 TVP = TPP*P y

82
 Cont’d
 Average Value Product (AVP):
 The expression of Average Physical Product in money
value.
 AVP = APP * P y
 Marginal Value Product (MVP)
 When MPP is expressed in terms of money value; it is
called Marginal Value Product.
 MVP = MPP *Py

83
 Cont’d
E.g. Calculate the TPP, MPP, APP

Daily Input Daily output APP MPP

10 1 0.1
16 3 0.19 0.33
20 4.8 0.24 0.45
22 6.5 0.3 0.85
26 8.1 0.31 0.4
32 9.6 0.3 0.25
40 10.8 0.27 0.15
50 11.6 0.23 0.08
62 12 0.19 0.03
76 11.7 0.15 -0.02
84
 Measures of productivity
 There are two measures of productivity
 The average physical product (APP)
 Is the average output per unit of variable input
 This is a measure of how efficiently input is converted to
output.
 The marginal physical product (MPP)
 Is the change in the amount of product produced over
the change in the amount of input that is used.
 This can be represented by equation: MPP: dY/dX1
 MPP is equal to the slope of TPP and therefore represents
the rate at which an input is transformed into an output. 85
 Types of Basic Production Relationships
 Production of farm commodities involves numerous
relationships between resources and products.
 Some of these relationships are simple, others are
complex.
 Knowledge of these relationships is essential as they
provide the tools by means of which the problems of
production or resource use can be analyzed.
 Major production relationships are:
 Factor-Product relationship (input and out put
relationship)
 Factor-Factor relationship (input combination)
 Product-Product relationship (out put combination)
86
 Factor-Product Relationship (input – out put
relationship)
 Is a basic production relationship between the input and
output.
 It deals with the production efficiency (technical and
economic efficiency) of resources.
 Technical efficiency–Achieved when maximum amount
of output is produced with a given combination of
inputs.
 Economic efficiency–Achieved when firm is producing a
given output at the lowest possible total cost.
 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. 87
 Cont’d
 Optimization of production is the goal of this relationship.
 This relationship is known as input-output relationship by
farm management specialists and fertilizer responsive
curve by agronomists.
 It guides the producer in making the decision ‘‘how much
to produce?’’.
 This relationship is explained by the law of diminishing
returns.
 Algebraically, this relationship can be expressed as:
Y = f (X1 / X2, X3……………… Xn); Where; X1 is variable
input and X2 – Xn are fixed input

88
Marginal analysis and law of diminishing marginal
return
 Economists use the term marginal change to describe a
small incremental adjustment to an existing plan of action.
 Keep in mind that margin means ‘edge’, so marginal changes
are adjustments around the edges of what you are doing.
 Marginal = the next unit
 A rational decision maker takes an action if and only if the
marginal benefit of the action exceeds the marginal cost.
 Marginal analysis
 The analysis of the benefits and costs of the marginal unit
of a good or input.
 A technique widely used in business decision-making and
ties together much of economic thought. 89
 Cont’d
 Law of diminishing marginal returns

 Diminishing marginal product is the property whereby

the marginal product of an input declines as the quantity
of the input increases.

 It is a general law in economics which says as successive

units of a variable input are added to a production
process with the other inputs held constant, the marginal
physical product (MPP) eventually declines.

 States that there comes a point when each additional

units of input (factor of production, eg. Labor) generate
less and less additional output with the other inputs held
constant.

90
Cont’d

91
 Stages of production function
 There are three phases/stages of production that are
represented by the production function.
Stage I
Stage II
Stage III
 The three stages of production are characterized by the
slopes, shapes, and interrelationships of the total,
marginal, and average product curves.
 Understanding these stages are useful in determining
the region of rational production in a production process.

92
 Cont’d
 Stage I
 It extends from the origin up to the maximum point of
APP.
 During this stage, the TPP is increasing at an increasing
rate.
 Productivity is therefore increasing during this stage.
 We call this stage increasing return.
 During this stage, APP is increasing and MPP is greater
than APP.
 MPP reaches a maximum during this stage.

93
 Cont’d
 Stage II
 It goes from the point where APP is maximum up to the
point where MPP is zero.
 TPP is increasing at a diminishing rate and therefore
productivity is decreasing.
 This is the stage of decreasing marginal returns.
 APP is decreasing and it is greater than MPP.
 The efficiency of using a variable input is at its greatest
where stage II begins; however, the efficiency of using
the fixed inputs is greatest at the end of stage II.
 Optimal use of inputs lies somewhere in stage II and it
depends upon the input costs and output prices.
94
 Cont’d
 Stage III
 Starts when the TPP is maximized and MPP is zero.
 TPP declines, MPP is negative and APP is declining.
 This is the stage of negative marginal returns.
 MPP become negative because the number of variable
factors become too large relative to the fixed factors.
 It would be wasteful if producers were at this stage of
the production function.

95
Cont’d

96
 Relationship between Total Product (TP) and
Marginal Product (MP)
 When TP is increasing, the MP is positive.
 When TP remains constant, the MP is zero.
 When TP decreases, MP is negative.
 As long as MP increases, TP increases at increasing rate.
 When the MP remains constant, the TP increases at
constant rate.
 When the MP declines, TP increases at decreasing rate.
 When MP is zero, the TP is maximum.
 When MP is less than zero (negative), total physical
product declines at increasing rate.
97
 Relationship between Marginal and Average
Product
 When Marginal Product is more than Average Product,
Average Product increases.

 When Marginal Product is equal with the Average

Product, Average Product is Maximum.

 When Marginal Product is less than Average Product,

Average Product decreases.

98
 Cont’d
 Determination of optimum input to use (How much
input to use).
 An important use of information derived from a
production function is in determining how much of the
variable input to use.
 Given a goal of maximizing profit, the farmer must
select from all possible input levels, the one which will
result in the greatest profit.
 To determine the optimum input to use, we apply two
marginal concepts
 Marginal Value Product and
Marginal Factor Cost

99
 Cont’d
Marginal Value Product (MVP)
 It is the additional income received from using an
additional unit of input.
 Is the change in Total Value Product (TVP) caused by a
small change in the input level.
 Marginal Value Product = ΔTVP/ Δ input level
 If the price of output is constant, then:
 TVP = TPP × Price of output
 MVP = MPP × Price of output
 The MVP gives the monetary value that a unit of input
generates on the farm.
100
 Cont’d
 Marginal Input Cost (MIC) or Marginal Factor Cost
(MFC)
 It is defined as the additional cost associated with the
use of an additional unit of input.
 Marginal Factor Cost = ΔTotal Input Cost/ Δ Input level
 Total Input Cost (TIC)- is the cost from buying the total
amount of input.
 MFC or MIC = Δ X.Px /Δ X = ΔX .Px/ Δ X = Px
where X- input Quantity; Px -Price per unit of input
 MFC is constant and equal to the price per unit of input.
 This conclusion holds provided the input price does not
change with the quantity of input purchased.
101
 Cont’d
 Decision rules
 If MVP is greater than MIC, additional profit can be
made by using more input.
 Using an extra unit of input will generate more value
than it costs to purchase
 If MVP is less than MIC, more profit can be made by
using less input.
 Using an extra unit of input will cost more than the
value it generates
 Profit maximizing or optimum input level is at the point
where MVP= MFC

102
 Cont’d
 Example: By using the following data determine the
optimum input to use? Input price: 12 Birr per unit,
Output price: 2 Birr per unit

Input TPP MPP TVP MVP MIC

level X
0 0 - 0 - -
1 12 12 24 24 12
2 30 18 60 36 12
MVP > MIC, additional
3 44 14 88 28 12
profit is being made
4 54 10 108 20 12
5 62 8 124 16 12
6 68 6 136 12 12 MVP=MFC, profit
maximizing point
7 72 4 144 8 12
MVP < MIC, use less
8 74 2 148 4 12
input 103
 Cont’d
 Determination of optimum output to produce (How
much output to produce)
 To determine the optimum output to produce, two new
marginal concepts are required.
 Marginal Revenue (MR)
 It is defined as the additional income from selling
additional unit of output.
 It is calculated by using the following equation;
 Marginal Revenue = Change in total revenue
Change in Total Physical Product
 MR = ΔTR/ ΔTPP

104
 Cont’d
 Marginal Cost (MC)
 It is the change in cost caused by a change in output.
 Derived by dividing the change in total cost by the
change in the quantity of output.
 In deciding how many units to produce, the most
important variable is MC.
 Marginal Cost = Change in Total Cost
Change in Total Physical Product
 MC = ΔTC/ ΔTPP

105
 Cont’d
 Decision rules
 If MR is greater than MC, additional profit can be made
by using more input.
 If MR is less than MC, more profit can be made by using
less input.
 Profit maximizing or optimum input level is at the point
where MR = MC.

106
 Cont’d
 Example: By using the following data determine the
optimum output to be produced? Input price: 12 Birr per
unit, Output price: 2 Birr per unit
Input TPP MP TR MR MC
level X
0 0 - 0 - -
1 12 12 24 2 1= (12/12)
2 30 18 60 2 0.67=(12/18 MR > MC, use
3 44 14 88 2 0.86=(12/14 more input
4 54 10 108 2 1.2=(12/10)
5 62 8 124 2 1.5=(12/8)
6 68 6 136 2 2=(12/6)
MR = MC, optimum
input level
7 72 4 144 2 3= (12/4)
8 74 2 148 2 6=12/2 MR<MC, use less input

107
 Factor-Factor Relationship
 This relationship deals with the resource combination and
resource substitution.
 It helps in making a management decision of how to
produce.
 Under this relationship, output is kept constant, input is
varied in quantity.
 It answers the crucial question of finding out the optimum
or least cost combination of two or more resources in
producing the given amount of output.
 Cost minimization is the goal of factor-factor relationship.
 Algebraically, it is expressed as
 Y = f(X1, X2 / X3, X4 ….. Xn): Where; X1 & X2 are
variable input and X3 – Xn are fixed input 108
 Cont’d
 The objectives of factor-factor relationship are:
 Minimization of cost at a given level of output and
 Optimization of output to the fixed factors
 In the production, inputs are substitutable.
 Capital can be substituted for labor and vice versa, grain
can be substituted for fodder and vice versa.
 The producer has to choose that input or inputs, practice
or practices which produce a given output with minimum
cost.
 The producer aims at cost minimization i.e., choice of
inputs and their combinations.
109
 Cont’d
 Isoquant
 Is also known as iso-product curve or equal product curve
or product indifference curve.
 An isoquant represents all possible combinations of two
resources (X1 and X2) physically capable of producing the
same quantity of output.

X2

Isoquant

X
O
X1

110
 Cont’d
 Isoquant Map or Iso product Contour
 If number of isoquants are drawn on one graph, it is
known as isoquant map.
 Isoquant map indicates the shape of production surface
which in turn indicates the output response to the inputs.

Y3= 30
X2
Y2= 20

Y1= 10

O
X1

111
 Cont’d
Types of Factor-Factor Relationship
 There can be three types of combinations of inputs:
 Fixed Proportion combination of inputs
 To produce a given level of output, inputs are combined
together in fixed proportion.
 In this case there is no substitution between inputs and
thus there is strict complementarily between the two
inputs.
 Isoquants are ‘L’ shaped.
 Eg. tractor and driver combination. To operate another
tractor, normally we need another driver.
112
 Cont’d
Constant rate of Substitution
 For each one unit gain in one factor, a constant quantity of
another factor must be sacrificed.
 When factors substitute at constant rate, isoquants are
linear (straight line), negatively sloped (from left to right).
 When inputs substitute at constant rate, it is economical
to use only one resource, and which one to use depends up
on relative prices.

113
 Cont’d
 Varying Rate of Substitution

 In this there can either be increasing rate or decreasing

rate of substitution.

 Substitution at an increasing rate is not common, but

decreasing rate of substitution is more common.

 In decreasing rate of Substitution, every subsequent

increase in the use of one factor replaces less and less of
other factor.

 In other words, each one unit increase in one factor

requires smaller and smaller sacrifice in another factor.

114
 Cont’d
 Marginal Rate of Technical Substitution (MRTS)/
Input Substitution Ratio (ISR)
 Is the rate at which one input can be substituted for
another input without changing the level of output.
 Is equal to the slope of isoquants.
 MRTS = Reduction in input A = -∆A
Increase in input B ∆B
 An increase input B by one unit, the MRTS tells us how
much input A we can save
 The MRTS gives the value of a unit of B in terms of units
of A on the farm.

115
 Cont’d
 When inputs are Substitutes, MRTS is always less than
zero.
 A range of input combinations which will produce a given
level of output.
 When one factor is reduced in quantity, a second factor
must always be increased.
 Perfect Substitutes
 When two resources are completely interchangeable, they
are called perfect substitutes (constant rate of
substitutes).
 The isoquants for perfect substitutes is negatively sloped
straight lines.
 The MRTS is constant.
 Example: Family labor and hired labor, Farm produced and
purchased seed etc., 116
 Cont’d
 Complements
 Two resources which are used together are called
complements.
 In the case of complements reduction in one factor can
not be replaced by an increase in another factor.
 MRTS is zero .
 Perfect Complements
 Two resources which are used together in fixed
proportion are called perfect complements.
 It means that only one exact combination of inputs will
produce a particular level of output.
 The isoquant in this case is of a right angle.
 Example: Tractor and driver 117
Cont’d

118
 Cont’d
 Input Price Ratio (IPR)
 Is the ratio of the prices of two inputs
 IPR= Price of input being added
Price of input being replaced
 IPR = price of input B/price of input A

 IPR gives the value of a unit of B in terms of units of A

on the market.
 Cost minimization decision rule
 The condition for cost minimization is where the MRTS is
just equal to the ratio of input prices.
 MRTS = IPR
119
 Cont’d
 If they cannot be exactly equal because of the choices
available in the table, get as close as possible without
letting the price ratio exceed the substitution ratio.
 Example: find the minimum cost of feed ration, if the
price of grain is 4.4birr/lbs, and hay 3/lbs

120
 Product-Product Relationship
 Farmers have limited resources and have a number of
enterprises/or enterprise combinations of crops and
livestock to choose from.
 This relationship is concerned with the determination of
optimum combination of products (enterprises).
 Deal with what combination of enterprises should be
produced from a given level of fixed inputs.
 The goal of Product-Product relationship is profit
maximization.
 Inputs are kept constant while products (outputs) are
varied.
 Guides the producer in deciding ‘What to produce’.
121
 Cont’d
 Production Possibility Curve (PPC)
 Is a curve which represents all possible combinations of
two products that could be produced with given and fixed
amounts of inputs.
 Known as Opportunity Curve because it represents all
production possibilities or opportunities available with
limited resources.
 It is called Isoresouce Curve or Iso factor curve because
each output combination on this curve has the same
resource requirement.
 It is also called Transformation curve as it indicates the
rate of transformation of one product into another.
122
 Cont’d

Production Possibility Curve (PPC)

123
 Types of Product-Product Relationships or
Enterprise Relationship
 The basic product-product relationships can be:
 Joint Products
 Are produced through single production process.
 Production of one (main product) without the other (by-
product) is not possible.
 The level of production of one decides the level of
production of another.
 All farm commodities are mostly joint products.
 Example: Wheat and Straw, cotton seed and lint, cattle
and manure, butter and buttermilk, beef and hides,
mutton and wool etc. 124
 Cont’d
 Complementary Products
 Two products (or enterprises) are complementary when a
change in the level of production of one, the other also
changes in the same direction.
 That is when increase in output of one product (Y1), with
resources held constant, also results in an increase in
the output of the other product (Y2) .
 The two enterprises do not compete for resources but
contribute to the mutual production by providing an
element of production required by each other.
 PPC for complementary products have positive slope.
 The marginal rate of product substitution is positive (>
0).
 Example: Cereals and pulses, crops and livestock
enterprises. 125
 Cont’d
 Supplementary Products
 Two products are called supplementary if one product can
be increased or decreased without increasing or
decreasing the other product.
 They do not compete for resources but make use of
resources when they are not being utilized by one
enterprise.
 The marginal rate of product substitution is zero.
 All supplementary relationships should be taken advantage
by producing both products up to the point where the
products become competitive.
 Example: Small poultry or dairy or piggery enterprise is
supplementary on the farm. 126
Cont’d

127
 Cont’d
 Competitive enterprises
 This relationship exists when increase or decrease in the
production of one product affect the production of other
product inversely.
 Output of one can be increased only through sacrifice
(decrease) in the production of another.
 Competitive enterprises compete for the same resources.
 The marginal rate of product substitution is negative (<
0).
 When two products are competitive, they may substitute
at constant rate, increasing rate or decreasing rate.

128
 Cont’d
Constant rate of Substitution
 For each one unit increase or gain in one product, a
constant quantity of another product must be decreased
or sacrificed.
 When products substitute at constant rate, the
Production Possibility Curve is linear and negatively sloped.
 When two products substitute at constant rate, only one
of the two products will be economical to produce
depending on their relative prices.

129
 Cont’d
 Increasing rate of product substitution
 Each unit increase in the output of one product is
accompanied by larger and larger sacrifice (decrease) in
the level of production of other product.
 As each additional unit product Y2 is produced, an
increasingly greater sacrifice has to be made in terms of
units of product Y1 .
 The production possibility curve is concave to the origin.

130
 Cont’d
 Decreasing rate of Product Substitution:
 Each unit increase in the output of one product is
accompanied by lesser and lesser decrease in the
production of another product.
 As the output of product Y2 is increased, the rate at
which the output of product Y1 is curtailed, steadily slows
down.
 The production possibility curve is convex towards the
origin.

131
Determination of optimum combination of products
 Algebraic Method

 There are three steps to determine the optimum product

combination through algebraic method.
Compute Marginal Rate of Product Substitution (MRPS)
 The term marginal rate of product substitution under the
product-product relationship has the same meaning as
MRTS under the factor-factor relationship.
 Marginal rate of the product substitution refers to the
absolute change in one product associated with a change by
one unit of the competing product.
 The quantity of one product to be sacrificed so as to gain
another product by one unit is given by MRPS.
132
 Cont’d
MRPS = Number of units of replaced products or
Number of units of added product
= Reduction in output A = - ∆A
Increase in output B ∆B
 Workout Output Price Ratio (OPR)
 Is the ratio of the prices of two outputs
 OPR= Price per unit of added product/Price per unit of
replaced product OR
 OPR = price of output B/price of output A
 When we want to sell the extra unit of output B on the
market, the OPR tells us how many units of output A we
could buy with the additional revenue
 The OPR give the value of a unit of B in terms of units
of A on the market.
133
 Cont’d
Optimum combination of enterprises

 The principle of product substitution says that we should

go on increasing the output of a product as long as
decrease in the returns from the product being replaced
is less than the increase in the returns from the product
being added.
 Profit rules or Decision rules:

 If MRPS < OPR, profits can be increased by producing

more of added product.

 MRPS > OPR, profits can be increased by producing more

of replaced product.

 Optimum combination of products is when MRPS = OPR134

 Cont’d
Example: Selecting an optimum combination of enterprises
(P Y1 = Rs. 280 per kuntal; P Y2 = Rs. 400 per Kuntal)
Y1 Y2 ΔY1 ΔY2 MRPS OPR Decrease Increase
(Kuntals) (Kuntals) Y1, Y2 in In
returns returns

MRPS< OPR
0 60 - - - 0.7 - -
20 56 20 4 0.2 0.7 1600 5600
40 50 20 6 0.3 0.7 2400 5600

60 41 20 9 0.45 0.7 3600 5600

80 30 20 11 0.55 0.7 4400 5600

100 16 20 14 0.7 0.7 5600 5600

120 0 20 16 0.8 0.7 6400 5600

MRPS= OPR, the optimum or profit maximizing

combination
135
 Cont’d
 Graphic Method
 Draw production possibility curve and isorevenue line on
one graph.
 Slope of production possibility curve indicates MRPS and
the slope of isorevenue line indicates price ratio of
products (OPR).
 The point of optimum combination of products is at point
where the isorevenue line is tangent to the production
possibility curve.
 At this point, slope of the isorevenue line and the slope of
the production possibility curve will be the same.
 In other words, the MRPS = OPR. Production
Possibility Curve

Optimum Combination
Y of products
2
Iso-revenue Line
O
Y1 136
 Cont’d
Tabular Method
 Compute total revenue for each possible output
combination and then select that combination of outputs
which yields maximum total revenue.
 This method is useful only when we have few
combinations.
Y1 Y2 Py1=50 Py2=80 Total revenue
8 2 400 160 560
7 3 350 240 590
6 4 300 320 620
5 5 250 400 650
4 6 200 480 680
3 7 150 560 710
 3 units of Y1 and 7 units of Y2 yield maximum revenue.137
138