FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

FARM MANAGEMENT

For plant science students (3rd year)

Course code: AgEc3112

Name of instructor: Mr. Estifanos T. (MSc)

FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Farm Management

Introduction
Agriculture is the art and science of cultivating crops, raising livestock, provision of raw
materials for industries and agricultural products for man’s use. There are many branches of
agriculture which among others include: agricultural economics, crop science, soil science,
animal science, fishery, forestry and agricultural engineering.

Agricultural economics involves the application of economic principles in agriculture. One of

the important branches of agricultural economics is farm management. Generally speaking,
management is the ability of some people to compel economic progress through other
people’s efforts. When applied to farm business, management could be seen as a practice
undertaken of the farm business with respect to production of crops and livestock as a means
of obtaining high profit.

Agricultural production of a country is the sum of the contributions of the individual farm
units and the development of agriculture means the development of millions of individual
farms. Hence, welfare of a nation depends upon accomplishments of each farm unit. The
prosperity of any country depends upon the prosperity of farmers, which in turn depends upon
the rational allocation of resources among various uses and adoption of improved technology.
Human race depends more on farm products for their existence than anything else since food,
clothing – the prime necessaries are products of farming industry. Even for industrial
prosperity, farming industry forms the basic infrastructure. Thus the study of farm
management has got prime importance in any economy particularly in the agrarian one.

Management is the art of getting work done by others working in a group. It involves the
process of designing and maintaining an environment in which individuals working together
in groups accomplish selected aims. Management is the key ingredient of any activity
conducted for a purpose. The manager makes or breaks a business. Management takes on a
new dimension and importance in agriculture which is mechanized, uses many technological
innovations, and operates with large amounts of borrowed capital.
Learning Task Objectives
The objective of this Learning Task is to train professionals with basic principles and tools of
economics and management for effective farm level decisions and thus improve the
performance of farm business. After the end of the learning task students are expected to:
 Apply management science and economics tools to solve farm related problems,
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 Apply farm planning and budgeting techniques in farm management decision-making,

 Indentify various production relations in pursuit of optimal resources combination that
suites specific farm situation,
 Identifying farm costs
 Expect the various risks and device different methods to avoid and/or reduce impact of
risk and uncertainty in farm operations,
 Analyze gender roles in farming activities
 Prepare farm plan and recommend on the feasible alternative activities.
Farm Management Learning Task Sections
Concepts of Farm Management and Decision Making (5 Hours)
Pre-test questions
- Define what farm management is?
- What decisions are made in farm business? Can you classify them in to different groups?
- Mention some distinguishing features of farming from other industries.
Definitions:
Farm management is a science that deals with the proper combination and operation of
production factors including land, labor and capital, and the choice of crop and livestock
enterprises to bring about the maximum and continuous return to the most elementary
operational units of farming.
Farm management as a subject matter is the application of agricultural science, business and
economic principles in farming from the point of view of an individual farmer. The principles
may serve as a guideline for collecting and using requisite information for rational decision
making. They also provide a set of tools for the preparation of farm budgets and production
programs.
Farm management can also be defined as a sub-branch of agricultural economics which deals
with decision making on the organization and operation of a farm for securing maximum and
continuous net income consistent with the welfare of farm family.
This definition best fits the two aspects of farm life by providing an area of common ground
for their close inter-relationship in the direction of maximizing profit and utility functions
from the output of the farm as a whole.

Thus, in simple words, farm management can be defined as a science which deals with
judicious decisions on the use of scarce farm resources, having alternative uses to obtain the
maximum profit and family satisfaction on a continuous basis from the farm as a whole and
under sound farming programs. Farm management seeks to help the farmer in deciding
problems like:
 What to produce? (e.g. selection of profitable enterprises)
 How much to produce? (e.g resource use level)
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 How to Produce? (e.g. selection of least cost production method)

 When to buy and when to sell, and in organization and managerial problems relating to
these decisions.
In other words, Farm Management tries to answer the basic economic questions related to a
given farm conditions. Thus, Farm management may in short be called a science of decision-
making or science of choice in farm business. The need for it arises out of changes in the farm
conditions as well as changes occurring outside of the farm, and hence need of continuous
adjustment of farm operations to these changes becomes inevitable. The principal changes
frequently encountered by the farmers are: fluctuations in price, variations in weather,
inventions in farming methods, and changes in socio-economic environment including
changes in government policy and social responses and values.
Preliminary Concepts
Agriculture defined as the sum total of the practices of crop and livestock production on
individual farms. Hence, the agricultural production of country is the sum of contributions of
the individual farm units, and the development of agriculture means the sum of developments
of millions of farm units.
Farm defined: A farm is the smallest unit of agriculture which may consist of one or more
plots cultivated by one farmer or group of farmers in common for raising crop and livestock
enterprise. It is both a producing unit as well as a consuming unit.
Family farm: A family holding (farm) may be defined briefly as being equivalent, according
to the local conditions and under the existing conditions to technique, either to a plough unit
or to a work unit for a family of average size.
Farm Firm: The farm is a firm because production is organized for profit maximization.
Hence, it is a business unit of control over factors of production. On the other hand, it is a
household unit demanding maximum satisfaction of the farm family. The manager of the farm
comes to understand the twin objectives by linking one with the other.
Stock and flow inputs: Stock inputs are resources which are consumed during the production
period, like seeds, fertilizers, pesticides and the like. They can be stored, if not used currently,
for future use. As against this, flow inputs like labor and management, if not used, cannot be
stored for the next season.
Management of Farm vs. Farm Management: Generally speaking, management of farm
aims at maximizing production in the sphere of agronomy, whereas, farm management is
concerned with maximizing profit in the realm of agricultural economics.
Economic unit: It is the sum of resources for which costs, returns and net income can be
worked out. As such, a farm is an economic unit.
The very concept of farm management has a fascinating appeal to the mankind, as there is not
a single creed which is not affected by this bread-butter subject. It is the study of farmer, as a
producer of food and other raw materials, who occupies a strategic position in the economic
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life of a country. Politically, farmers together exert a considerable influence on the type of
government they like in the developing countries.
Farm management investigations give thrust and direction to farm business improvement by
providing useful information to planners, farmers and extension workers. Better
understanding of the sequential flow of new technology is provided by farm management
research that contributes to more realistic projection of production potential. Again, basic
information provided by farm management studies on specific farm projects, such as land
reclamation, settlement, irrigation and drainage, serves as an aid to formulating national
policies. Farm management has an inherent capacity of developing strategic approaches to
making the best use of scarce resources and, as such, can view the threats and problems that
lie ahead as veiled opportunities for showing its potential as one of the nation’s saviors.
Hence, there is bound to be far greater awareness and understanding of the role of farm
management in the nation’s economy.
Nature and Characteristics of Farm Management
Farm Management is basically both an applied and pure science. It is a pure science because it
deals with the collection, analysis and explanation of factors and the discovery of principles
(theory). It is an applied science because the ascertainments and solutions of farm
management problems (technology) are within its scope. Farm management science has the
following distinguishing characteristics from other fields of agricultural sciences.
1. Practical science: It is a practical science, because while dealing with the factors of
other physical and biological sciences, it aims at testing the applicability of those facts
and findings and showing how to put these results to use on a given farm situations. A
farmer has to select a method which is more practicable and economical to his particular
farm situation taking into consideration the volume of work and financial implications.
2. Profitability oriented: Farm management is interested in profitability (considers the
costs involved in producing each unit of output in relation to returns). Biological fields
such as agronomy and plant breeding concern themselves with distaining the maximum
yield per unit irrespective of the profitability of inputs used. Farm management is
interested in optimum results/yields which may not necessarily coincide with the
maximum production point. In brief, when other sciences deal with physical efficiency,
farm management deals with economic efficiency.
3. Integrating science or interdisciplinary science: The facts and findings of other
sciences are coordinated for the solution of various problems of individual farmers with
the view of achieving desired goals. It involves different disciplines to decision making.
It considers the findings of other sciences in reaching its own conclusions. Principles of
farm management integrate results by physical sciences under specific set of conditions.
4. Broader field: It uses more than one discipline to make decisions. It gathers knowledge
from many other sciences for making decision and farm management specialists have to
know the broad principles of all other concerned sciences in addition to specialization in
the business principles of farm management.
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5. Micro-approach: In farm management, every farm unit is considered as unique in terms

of available resources, problems and potentialities. It recognizes that no two farms are
exactly identical with respect to soil, other production resources, farmers’ managerial
ability, etc. Each farm unit has to be, therefore, studied, guided or planned individually.
6. Farm unit as a whole: In farm management analysis, a farm as a whole is considered to
be the unit for making decisions because the objective is to maximize the returns from
the whole farm instead of only improving the returns from a particular enterprise or
practice. Farm management considers all possible aspects of crop and livestock
enterprises of a given farm. The principles of farm management, thus, help to get the
optimum enterprise mix that would yield the highest income to the farmer from the total
farm organization.

Objectives and Scope of Farm Management

The central theory of farm management is the theory of optimal decision-making in the
organization and operation of a farm for profit maximization. To this end, the objectives and
scope of farm management are discussed as follows:
Objectives of Farm Management
Looking at the farm structure as a whole, it is apparent that the objective of farm management
are those that have to do with the two aspects of the same farm as a producing unit and as a
consuming unit along with the harmonization of their behavior and goals. Broadly speaking
the objectives of farm management are:
 To study the existing resources-land, labor, capital and management-and the production
pattern on the farm.
 To perform the strategic task of finding out the deviation of the resources from their
optimum utilization.
 To explain the means and the procedure of moving from the existing combination of
resources to their optimum use for profit maximization.
 To outline conditions that would simultaneously obtain its objectives of profit
maximization and maximization of family satisfaction through optimum use of
resources and judicious income distribution.
 To workout costs and returns on individual enterprises and on the farm as a whole.
Scope of Farm Management
Farm management is generally considered to fall in the field of microeconomics. That means,
in a way concerned with the problems of resource allocation in the agricultural sector, and
even the economy as a whole, the primary concern of farm management is the farm as a unit.
It deals with the allocation of resources at the level of an individual farm. It covers the whole
aspects of individual farm business which have bearing on the economic efficiency of the
farm. These include:
 The types of enterprises to be combined/enterprise relationships
 The kinds of crops and varieties to be grown/choice of input-output combinations
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 The dosage of fertilizer to be applied

 The implements to be used
 The way the farm functions are to be performed
 Investment decisions
 Appraisal of farm resources
 Farm planning and budgeting
 Farm prices, credit and profits
 Risk and uncertainty
 Planning the marketing of farm produce
All the above aspects of farm business, which fall within the purview of the subject of farm
management, are so interlinked and drawn together, that is systematic study of all of them is
required to understand the business of farms within the circle of scarcity and choice.
Farm Management Problems in Developing Countries
Farm management problems in developing countries may vary from place to place depending
largely upon the degree of agricultural development and the availability of resources. The
following are some of the most common problems in the field of farm management.
Small size of farm business: The average land holding size or operational holding in
developing countries like Ethiopia is very small. The land holdings are fragmented too.
Excessive pressure of population creates unfavorable man-land ratio in most parts of the
country. This combined with excessive family labor, which depends upon agriculture, has
weakened the financial position of the farmers and limited the scope for business expansion.
Farm as a household: In most parts of the country family farms perpetuate the traditional
combinations of crops and methods of cultivations. Thus the equation between agricultural
labor and household labor becomes an identity. This makes difficult for the farmer to
introduce business content and incorporate new management idea in his farm operations.
Home management, thus, heavily influences and gets influenced by farm decisions
Inadequate capital: Capital shortage is peculiar feature of farming in developing countries.
Most often, peasant agriculture (which is mostly subsistence) is labor intensive and
characterized by serious deficiency of capital. Generally small size of farms, problems of
tenureship and unremunerative prices have set the farmer under perpetual poverty. New
technologies demand higher inputs such as more fertilizers, plant protection measures,
irrigation and better seeds as well as investment in power and machinery. Small farmers
cannot meet the financial requirements from their own funds. Hence, low cost, adequate and
timely credit is their most pressing need if they have to put their firm-farms on growth paths.
Under-employment of factors of production: Underemployment of factors of production in
developing countries emanate from: small size of the farms, large family labor supply,
seasonal nature of production, lack of subsidiary or supporting rural industries, etc.
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Slow adoption of innovations: Small farmers are usually conservative and sometimes
skeptical of new technologies and methods. The rate of adoption, however, depends; largely
on the farmers’ willingness and ability to use the new information (once they get it effective
they will become eager to adopt it). However, since established attitudes and values do not
change overnight the extension efforts take time to get the research results commercially
adopted and existed on the farms. It calls for training and substantial financial requirements.
Inadequacy of input supplies: Farmers may be willing to introduce change yet they may
face the difficulty in obtaining the required inputs of required quality, in sufficient quantity,
and on time to sustain the introduced changes. Shortages of foreign exchange in developing
countries seriously limit importation of needed supplies and materials. Domestic industries
generally lack raw materials, skills, capital or combination of these to manufacture the needed
farm supplies or inputs.
Managerial skill: The most important and difficult problem for many years has been the
managerial skills of large number of small-scale farmers in the country. This is necessary to
make millions of ultimate users of research results develop progressive attitudes and be
responsive to the technological charges. Education of the farmers on a mass scale is, thus
most important. Even illiterate people can be educated through demonstration of the
application of new techniques and better uses of the inputs available.
Communication and markets: These are two important elements of infrastructure necessary
for introducing economic content in the farm organizations. Lack of adequate communication
systems and the regulated market organization stand as a major bottleneck in the way of
improving the management of farms on business lines. Substantial investments therefore need
to be made on roads, marketing systems, and other communication facilities in almost all
parts of the country.
Characteristics of Farming as a Business
Farming as a business has many distinguishing features from most other industries in its
management methods and practices. The major differences between farming and other
industries are:
a. Primary forces of production: Agriculture is primarily biological in nature. A slight
change in the environment may cause serious difficulties. One day of cold, for example,
may destroy the whole of a standing crop. Unforeseen changes in the environment such
as plant or animal diseases and storm can cause a considerable damage. Most of the other
industries are less likely to be affected by such circumstances.
b. Size of the production unit: Farming is a small-sized business as it gives little scope for
division of labor. In this business the farmer is both the laborer and the capitalist.
c. Heavy dependence upon climatic factors: Weather changes may involve
readjustments. As a result of dependence on climatic factors, management practices in
farming must be much more flexible than in other industries.
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d. Frequency and speed of decisions: Farming requires many and speedy decisions on the
part of the farmer and the farm workers.
e. Changes in prices: Agricultural prices and production usually move in opposite
directions. Because of the effects of climate and biological factors, a relatively large
volume of production of a given farm commodity is usually followed by a decrease in
price, and a smaller volume results in increase in prices.
f. Fixed and variable costs: Of the total costs, portion of fixed costs is more in agriculture
than in other industries. This high proportion of fixed costs tends to make the adjustments
in production more difficult.
g. Inelastic demand for farm products: Agriculture deals with production of food and
raw materials. As standard of living improve and income increases, the demand for
agricultural products will increase less rapidly than that for industrial products. On the
one hand, if increased production comes from the decreased marginal returns phase, costs
will go high. Higher production may reduce prices so low that total returns might not
increase or even may decrease.
Farm Decision Making Process
As indicated before, farm management is concerned with the allocation of limited resources
among a number of alternative uses which requires a manager to make decisions. A manager,
first, must consider the resources available for attaining goals which have been set. Limits are
placed on goal attainment because most managers are faced with a limited amount of
resources. Decision-making is the most important responsibility of a manager of a farm
business or other type business. Decisions form the life-wire of the farm business. A
successful manager is one who has the skill to choose between alternatives in a constrained
environment and effective at attaining the stated objectives at best.

In a farm business, goal attainment is confined within some limits set by the amount of land,
labor and capital available. These resources may change overtime, but they are never
available in infinite amounts. The level of management skill available or the expertise of the
manager may be another limiting resource. If the limited resources could only be used one
way to produce one agricultural product, the manager’s job would be much easier. The usual
situation allows the limited resources to be used in several different ways to produce each of a
number of different products. In this case, the manager may be faced with a number of
alternative uses of the limited resources and must make decisions on how to allocate them
among the alternatives to maximize profit from the total business. This is one of the reasons
why decision making is mentioned in the definition of farm management. Without decision
nothing would happen. Even allowing things to continue as they are implies a decision,
perhaps not a good decision but a passive decision nevertheless.

The process of making a decision can be formalized into a logical and orderly series of steps.
Following these steps will not ensure a perfect decision but ensure that the decision is made
in a logical and organized manner.
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1. Identify and define the problem: A manager must constantly be alert to identify
problems as quickly as possible. Most problems will not go away by themselves and
represent an opportunity to increase the profitability of the business through wise
decision making. Once identified the problem, it should be concisely defined. Good
problem definition will minimize the time required to complete the remainder of the
decision making steps. Definition of the problem involves locating the root cause of the
problem identified. This helps to identify factor responsible for the problem identified.
For the case of low yield identified as a problem, the possible cause can include low
input use such as fertilizer which may depend on several factors.
2. Collecting relevant data and information: Once a problem has been identified, the next
step should be to gather data, information and facts, and to make observations which
pertain to the specific problem.
3. Identifying and analyzing alternatives: Once the relevant information is available, the
manager can begin listing alternatives which are potential solutions to the problem.
Several alternatives may become apparent during the process of collecting data and
transforming data into information. Each alternative should be analyzed in a logical and
organized manner to ensure accuracy and to prevent something from being overlooked.
4. Making decision: Choosing the best solution to a problem is not always easy, nor is the
best solution always obvious. Sometimes the best solution is to do nothing or to go back,
redefine the problem and go through the decision-making steps again.
5. Implementing decision: Selecting the best alternative will not give the desired results
unless the decision is correctly and promptly implemented. Resources may need to be
acquired and organized. This requires some physical actions to be taken.
6. Evaluation: This is the last step in the process of decision making. It involves comparing
the result or performance of your farming business before and after the implementation
of the solution.
Classifying Decision
Decision made by farm manager can be classified in a number of ways. One way of
classification system may be to consider decisions as either organizational or operational in
nature.
Organizational decisions are those decisions made in the general areas of developing plans
for the business, acquiring the necessary resources and implementing the overall plan. Some
of such decisions include: decisions regarding selection of the best size of the farm, what
scale should be the farm operation, decisions regarding (how much land to purchase or lease;
how much capital to borrow; the level of mechanization; construction of buildings and
irrigation facilities, etc.). Therefore, organizational decisions are related to planning and
organization of the farm that tend to be long run decisions which gives shape to the overall
organization of the farm and are not modified or reevaluated more than once a year.
Compared to operational decisions, organizational decisions require heavy investment and
have long lasting effect.
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Operational decisions are made more frequently than the organizational decisions and
related to the many details made on a daily, weekly or monthly basis and are repeated more
often than the organizational decisions as they follow the routines and cycles of agricultural
production. Operational decisions are frequent which involve relatively lower investment
and their effect is short lived. Some of such decisions include:
 Selecting fertilizer and seeding rates for a given field and year
 Making changes in livestock feed ration
 Selecting planting and harvesting dates
 Marketing decisions and daily work schedules
 What to produce (selection of enterprises)
 How much to produce (enterprise mix and production process)
 How to produce( selection of least cost method)
 When to produce (timing of production)
Continuous assessment
Quiz at the end of this section.
Summary
Farm management is a science which deals with the application of economics and business
principles and the scientific principles of agriculture to farm business. It is a science that
enables individual farmer how to make optimum decisions on the organization and operation
of his/her farm. In this regard, farm management examines the general environment in which
the farmers make decisions and take actions. In general, this section is about meaning of farm
management, its objectives and importance, the nature and characteristics of farming as a
business.
Production Resources and Management (5 Hours)
Pre-test questions
- What are the basic factors of production?
- Mention the reward for basic factors of production..
- Give examples for fixed resources and variable resources.
- How farmers decide on the value of their resources at a point in time (e.g. during selling)
- What is depreciation?
Farm Resources
Productive resource is any good (commodity) or service used in the production process to
create another good (commodity) or service. In the production process, firms use factors
(inputs or agents of production) which are often classified into four categories: land, labor,
capital and entrepreneurship.
Land: It consists of those gifts of nature which are not the result of human effort and it
includes land, water, sunshine, natural forests, minerals, wild animals and local climate. It is
often made productive as a result of human effort. Land is the basic resource which supports
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the production of all agricultural commodities with unique characteristics compared to other
resources. The specific characteristics of land include:
1. Land doesn’t depreciate or wear out provided that soil fertility is maintained and
appropriate conservation means are used.
2. Area space and location of land are immobile: that is land cannot be moved or shifted
to be combined with other resources such as machines, seed, fertilizer or water, rather the
latter have to move to the land in the production of crops or livestock.
3. Each farm or specific parcel of land is unique: each parcel of land contains one or
more distinct feature such as soil types, topography, climatic factors and the existence of
natural hazards such as flooding, wind, etc.
4. Land is said to be fixed and limited in quantity (Supply): this is to say that the area of
land at country level cannot be increased or decreased (supply of land is fixed) but for an
individual farmer, land can be increased or decreased.
Therefore a farm manger should use these unique qualities of land for proper decision making
to make the farm enterprise perform well.
Labor: The term labor describes the effort of human beings that include hired labor, family
labor and farmers' labor. Labor is needed for every type of production. It can be more
productive as a result of time and effort devoted to training.
The amount of labor (the labor input) used over a particular farm or plot of land depends on
the number of individuals employed and the number of hours worked. Mostly labor is
measured in man-day, where one man-day is equal to 8 hrs of work for an average man with
average strength, skill and experience. The most important characteristics of labor useful for
managerial decisions include:
1. Labor is flow resource that it cannot be stored like seed or labor is available for specified
time.
2. It is the service that is hired or purchased not the labor unlike land and capital items, i.e
the worker sells his/her work or services.
3. Labor is a lumpy or indivisible input. This is to say that it is not possible to employ half a
man (but possible to divide seed or fertilizer).
4. In agricultural sector, the operators and other members of the family provide all or largest
part of labor in a farm. This labor (family or community labor) doesn’t generally receive
direct cash payment unlike manufacturing sector, so its costs and values can be easily
overlooked or ignored.
5. The human factor is another characteristics distinguishing labor from other resources.
That is if an individual employee is treated as inanimate object, productivity and
efficiency suffers. Therefore, the hope, fears, ambitions, likes and dislikes, worries and
personnel problems of the owner/operator and the employees must be considered in any
labor management plan.
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Capital: It presents all resources which are the result of past human effort. Which means it
consists of all manmade goods which are used in the production of other goods. The capital
category includes a wide variety of items ranging from durable items such as building, dams,
roads, and machinery to stock of materials like seed and fertilizer which may be used in a
single production season. Capital should not be confused with money since money itself is not
a productive resource. It only becomes productive when it is used to buy physical items or
hires services.
Management (Entrepreneurship): Entrepreneurship involves organizing and coordinating
the different farm resources (land, labor and capital) so as to get the maximum output and
profit. Management function is primarily a mental process, each choice and action whose
results are conditioned by the attitudes, values and goals of the manager. The manager’s goals
and value systems unconsciously determine what he will observe, what variables he will
consider, what information he will gather, and which alternatives he will choose. Thus, the
formulation of these goals is essential in effective management because they give direction to
the whole managerial process.
Factors of production could be fixed or variable. The difference between fixed and variable
factors relates to the time horizon involved. In economics, there are two main horizons: the
short run and the long run. The short run is a relatively short period of time in which the
quantity of some factors of production such as equipments and buildings cannot be varied.
Such factors are called fixed factors. Factors of production whose quantity can be varied in
the short run are called variable factors. The long run, on the other hand, is a relatively long
period which allows the variation of all factors of production including plants and
equipments.
Variable resources in summary:
a. The resources whose uses vary with the level of production are known as variable
resources.
b. Volume of output directly depends on these resources.
c. Costs corresponding to these resources are known as variable costs.
d. Variable resources exist both in the short run and in the long run.
Seeds, Fertilizers, Plant protection chemicals, feeds, medicines etc., are examples of variable
resources.
Fixed resources in summary:
a. Resources whose use remains the same regardless of the level of production are called
fixed resources.
b. Volume of output does not directly depend up on these types of resources.
c. Costs corresponding to these resources are known as fixed costs
d. Fixed resources exist only in the short run and in the long run they are zero
Example: machinery, farm buildings, equipment, implements, livestock, etc.
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Rewards for using farm resources

The reward for using land is rent. Rent can be paid in cash or in kind by using farm produce.
Rent can be paid annually, seasonally, etc. based on the terms of agreement.
The reward for using labor is either salary or wage. It is salary for those who are on the
payroll receiving monthly salaries and wage for the casual laborer.
The reward for using capital is interest (cost of using money). The rate of interest charged
depends on the source of the capital. For instances private money lenders charge higher rates
as compared to formal financial institutions.
The reward for using management/entrepreneur is profit. This is so because the ultimate aim
of any producer is to maximize profit. Here the principle of “carrot and stick” holds. If a
manager performs well, he is given a carrot in the form of a pat on the back for a job well
done or promotion or an award. On the contrary, if he fails by recording a loss or poor
performance, he is given a “Stick” in form of query, dismissal, warning or demotion.
Farm Resources Valuation
Valuation is the practice of attaching prices to a given asset like buildings, vehicles, growing
crops, and stored products at the end of an accounting period or at the time of sale for a
particular farm organization. The price shows what farm assets worth at a particular time.
Valuation process involves getting a realistic measure of the current value of the assets of the
farm business. The first step in asset valuation is to list the resources available in physical
terms and the second step is placing values on the assets. The five methods of valuation
include are briefly explained below
Valuation at cost: This method involves entering the actual amount invested on the asset
when it was originally acquired. A major set-back of this procedure is that after the business
has been in operation for some time, the original cost is not of much value since the
conditions might have changed at the time of valuation.
Valuation at market price: The market price of an asset at the time of consideration can be
taken as its value. Example grains, feeder, livestock and land. This method may, however,
over or under-estimate the value depending on the states of affairs in the economy. For
instance the market price for the land may be based on the price of a similar piece of land or
what the owner is willing to sell it for. Yet, it’s common phenomenon that land appreciates in
value over time.
Valuation at net selling price (P NS): Some costs such as cost of advertisement and
transportation may incur at a time of selling an asset. In this valuation method, whatever price
that can be obtained in the market for the asset, that is, market price (P m) less the cost of
selling (CS) is taken as a price of asset at a particular point in time. Mathematically it can be
shown as: PNS = Pm – CS.
Valuation by reproductive value: An asset can be valued at what it would cost to produce it
at present prices and under present methods of production. This method is more useful for
long-term assets and has little or no application for short-lived assets.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Cost less accumulated depreciation: This method is appropriate only for depreciable assets
like machinery and buildings. Value of the asset is set equal to the ‘book value’. Book value
is computed as the difference between the initial cost and the accumulated depreciation of the
asset from acquisition to the time of valuation.
Depreciation
Depreciation is the loss in value of capital asset overtime due to age, obsolescence and wear
and tear. Depreciation, therefore, is a function of time and use, and it involves prorating the
original cost of an asset over its useful life. An important but difficult consideration is the rate
at which depreciation should take place. Some managers assume 10%, 20%, etc. but the best
choice depends on the depreciation rate that is closest to the actual rate of loss in value for the
period under consideration. Different assets loss values at different rates; hence different
methods of depreciation have been developed. These methods of depreciation are discussed as
follows:
Annual Revaluation Method
The annual revaluation method is based on the resale value of the asset in the market.
In this approach Depreciation (D) = Original Price – Resale Price of the asset to date

If the original price of an asset was Birr 2,000 in 2009 and Birr 1,800 in 2010 the depreciation
is 200 (i.e., 2,000 – 1,800 = 200). The problem with this method is that it may not be easy to
find a comparable product being sold in a market at a time of estimating depreciation. Or in
an economy with run-away inflation, a recent experience of rising world price, appreciation
rather than depreciation of assets might be apparent. For instance an asset purchased in 1975
for Birr 2,100 was sold for Birr 2,500 in 1983 because the new price of virtually the same
asset has gone up to Birr 6,000.
Straight Line Depreciation Method
The straight-line depreciation method assumes that an asset depreciates at a constant rate over
its economic life. The method is, therefore, useful for assets that loss value constantly over
their entire life. Depreciation (D) by this method is the difference between the purchase price
(P) and the salvage value1 (SV) divided by the use full life of the asset in years
(n).Mathematically:

Example, An asset costing Birr 4,000 initially has a salvage value of Birr 400 and expected
life of 10 years. For this asset the yearly depreciation is given by [(4000 – 400)/10 = 360].The
depreciation schedule over years appears as shown in the table below.
Table 1: Straight line depreciation for an asset initial cost Birr 4000 and SV Birr 400 and n=10 years
Year Depreciation Remaining value at the end of the year
1 360 3640

1
Salvage value is the value of an asset at the end of its economic life
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

2 360 3280
3 360 2920
4 360 2560
5 360 2200
6 360 1840
7 360 1480
8 360 1120
9 360 760
10 360 400

Declining Balance Method

The declining balance method assumes a fixed rate of depreciation every year. Since the value
of the asset is greater at the beginning, if the rate is applied the amount of depreciation is also
greater at the beginning and less at the end. The salvage value is not subtracted from the
initial cost. Yet, the rate is applied to each successive remaining balance till the salvage value
of an asset is reached. This method is, therefore, useful for asset which loss value fast at the
beginning of its economic life. Considering rate of depreciation to be 20% annually, schedule
of depreciation using the declining balance method is shown in the table below.

Table 2: Depreciation of an asset using declining balance method (Cost Birr 4000, SV Birr 400 & n=10 years)
Year Depreciation Remaining value at the end of the year
1 20% of 4000 = 800 3,200
2 20% of 3200 = 640 2,560
3 20% of 2560 = 512 2,048
4 20% of 2048 = 409.60 1,638.40
5 20% of 1638.4 = 327.68 1,310.72
6 20% of 1310.72 = 262.14 1,048.58
7 20% of 1048.58 = 209.72 838.86
8 20% of 838.86 = 167.77 671.09
9 20% of 671.09 = 134.22 536.87
10 20% of 536.86 = 107.37 429.50
Sum-Of-Years Digit Method (SOYD)
Annual depreciation is given by multiplying cost less salvage value (i.e., salvage value is the
estimated residual value of a depreciable asset or property at the end of its useful life) by the
fraction of remaining useful life (RL) to sum-of-years digit (SOYD).

The sum-of-years-digit (SOYD) is obtained by summing up the digits 1 to n for an asset with
a useful life of n years. For example, if the useful life of an asset is 10 years the sum of the
digits is given as 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55. Or use simple formula below to
find SOYD.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

The sum forms the denominator for the fraction while the numerator is the remaining useful
years of life of the asset at the beginning of the accounting period. Thus the fraction for the
first year of the asset is 10/55. For the second and third years the fractions are 9/55 and 8/55,
respectively. The depreciation schedule for the asset costing Birr 4,000 and salvage value of
Birr 400 is shown in the table below. In this method the asset losses values at a fairly constant
rate.

Table 3: Depreciation of an asset using the sum-of-years-digits method (Cost Birr 4000, SV Birr 400 & n=10 years)
Year Annual Depreciation Remaining balance
1 10/55 (4000-400) = 654.55 3345.45
2 9/55 (4000-400) = 589.09 2756.36
3 8/55 (4000-400) = 523.64 2232.73
4 7/55 (4000-400) = 458.18 1774.55
5 6/55 (4000-400) = 392.73 1381.82
6 5/55 (4000-400) = 327.27 1054.55
7 4/55 (4000-400) = 261.82 792.73
8 3/55 (4000-400) = 196.36 596.36
9 2/55 (4000-400) = 130.91 465.45
10 1/55 (4000-400) = 65.45 400.00

Analysis of Farm Records and Accounts (6 Hours)

Pre-test questions
- What are farm records?
- Mention some farm records a farmer is expected to keep on his/her farm.
- Can we conclude that a positive net farm income is a guarantee for financial success in a
given farm business?

Farm Records and Accounts

Farm records are important to the financial health of the farm. Good records do not ensure the
successfulness of the farm; however, success is unlikely without them. Farm records are like
grade report papers students receive in higher institutions. With a farm record report, you can
tell how well you are managing your business operation and you can also see the strengths
and weaknesses of your farm operation.
Farm record is an account of the various activities carried out on the farm on a regular basis.
Such activities include farm purchases, utilization of farm inputs, number of livestock kept
and equipment procured. It also includes crop cultivated, seed planted, cultural activities
carried out, quantity harvested, etc.
Types of Farm Records
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

There are different types of records that are important for decision-making. And there is no
single widely accepted design for farm record. However any farm record has to provide the
most important requirements. These most important requirements include simplicity,
specificity, ease of accessing information, and comprehensible to another user. The most
important farm records are discussed below.
Inventory Records: Inventory is the listing of assets owned by the farming business. The
farm tools and equipment inventory contains information of the asset such as name, the year
of purchase, the cost price, the expected years of life, the annual depreciation and the
beginning and end of year values. The common types of farm records are production record
and sales record. Farm inventory record contains list of assets owned by the farm. Examples
include crop and livestock inventory records. The crop inventory record contains information
concerning the quantity and value of crops at the beginning and end of the accounting period;
and the livestock inventory record shows the number of each type of livestock owned and
their value at the beginning and end of the accounting period.
Income or Receipts Records: Income or receipts records can be classified by enterprise with
details of each transaction like product sold, units produced and total value.
Home Consumption Record: The home consumption record usually contains the product,
price per unit, total weight and the value of home consumed products. In subsistence small
scale farming the proportion of home consumed products out of the total production could be
substantial.
The Crop and Livestock Expenses Record: The crop or livestock expense record, which is
similar to the direct expense record shows date of purchases, the seller, quantity purchased,
unit price and total cost.
Farm Labour Record: This often includes both family and hired labour components. On
enterprise basis the number of workers, the hour spent by each person and the wage are
recorded. Hired labour costs are often transferred to the general expense record.
Durable Assets Depreciation Record: It records type of asset, purchase date and condition
at purchase, purchase value, expected useful life (service period), and the rate of depreciation
of the asset. The methods of determining the depreciation of farm durable items is already
discussed earlier. The data will help in determining the salvage value which is the value of the
assets at the end of its useful life i.e., scrap value.
Net Farm Profit Record: It records the values and sources of receipts (crop, livestock), value
of home consumed products and the gross farm receipts for a given year.
Farm Accounting
Commercial farming involves many transactions and book keeping. Books of account present
summary of records on business transactions. Accounting systems should be designed to
provide information efficiently and quickly at the least cost as well as capable of offering
protection to the business by exposing theft or fraud.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Types of Farm Accounts

Some farm accounts that could be prepared and kept by a farm management include balance
sheet and net income statements. We will discuss these independently.
a. Balance Sheet
It is also called the net-worth statement. It shows the value of farm assets that would remain if
the farm business is liquidated and all outside clams paid. It is like taking a snap shot of the
business at a particular point in time. The net-worth statement sometimes gives information
on the solvency of the business and is used as a basis for credit access because it shows the
ability of the business to meet short-run financial demands. If the total assets exceed the total
liabilities the business is solvent, that is, the greater the net-worth, the better the solvency
position of the business. Components of balance sheet are given below:
Assets
An Asset is anything of value owned by a business entity. In order to ascertain the condition
of a business with regard to its immediate obligations, its assets are categorized according to
their liquidity. A net-worth statement requires an inventory of all properties or assets as well
as records of all liabilities of the business. There are three classes of assets. These are:
 Fixed Assets: Are those assets which cannot be easily converted into cash to meet
current obligations. Examples of fixed assets are land, buildings and other permanent
improvement like fence.
 Working Assets: Are those assets which are used up within the production process of
the business. Their values may be regarded as being transferred slowly to the products
during the farm operations. They are liquidated at a faster rate than fixed assets.
Examples of working assets are farm equipment (like hoes and machete), and donkeys.
 Current Assets: Are also called liquid assets. Examples of current assets are cash in
hand bills receivable within a short time, crops and feeds in hand.
Liability
Liabilities are those legitimate claims that can be made against a business. It is useful to have
classification of the liabilities that correspond to that of the assets. Liabilities are classified
according to the time they become due for payment. These classifications of liability include
long-term, intermediate and current liabilities.
 Long-Term Liabilities: Are those that will not fall due for payment in a lump sum
within a short period of time. They may fall due to a period like twenty years. Examples
of long-term liabilities are real estate mortgages 2 and long-term land leases. These are not
commonly used by subsistence farmers.
 Intermediate Liabilities: Are those obligations that are deferred for the time being but
which will be paid within a few years like five years or less. Examples of intermediate

2
An agreement by which somebody borrows money from a money-lending organization such as a bank or
savings-and-loan association and gives that organization the right to take possession of property given as
security if the loan is not repaid
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

liabilities are promissory notes, obligations based on crop or livestock in the process of
production and ready to mature within a few years.
 Current Liabilities: Are those obligations that are payable within a year. These
payments when due demand the immediate attention of the farm manager.
Net-worth
The net-worth statement is supposed to show absolute equity or the amount by which assets in
the business exceed its outstanding liabilities. The term “balance sheet” depicts that the total
assets be equal or greater than total liabilities in case the entire business is to close down and
all liabilities are to be met. The net-worth figure indicates ultimate rather than immediate
solvency of the business. Ultimate solvency measures whether total assets are equal to or
greater than total liabilities. When total liabilities are not covered by total assets the business
is said to be insolvent or bankrupt. The size of the net-worth figure, therefore, gives the farm
manger an idea of the distance of the business from solvency. The greater the net-worth
means the farther away from insolvency. Immediate solvency refers to the relationship
between current liabilities and current assets which can be used to pay them off if the need
arises. A farmer could be immediately insolvent, that is, unable to pay its immediate debt if
current, working and long-term assets do not exceed the sum of the current, intermediate and
long-term liabilities.
It should be noted, however, that the effect of changes in price level on the value of
permanent assets such as land, building and livestock might have a marked effect on the net
worth. If the market price of a piece of item such as land increases continuously and if this is
not reflected in the net-worth statement, the true net-worth has not been shown. If the net-
worth statement is being used as a basis for credit, the credit worthiness of the business is
understated. Therefore caution must be taken when looking at net-worth statements.
Examination of the individual item to get a true picture of the financial standing of a business
is necessary. Also, the net-worth does not tell the whole story. A man with larger net-worth
may have more to worry about than one with a smaller net-worth. It depends largely on the
ratio of total assets and liabilities in the form of obligations and the nearness of their maturity.
Table 4: Example of Balance Sheet Statement as of December 31 st, 2009
Current assets 56,400 Current liabilities 54,900
Noncurrent assets 478,000 Noncurrent liabilities 173,000
Total assets 534,400 Total liabilities 227,900
Net-worth 306,500
Total liab. and Net-worth 534,400

Once balance sheet statement is prepared, ratio analyses can be used to drive financial control
functions which include measuring performance of business, monitoring financial progress,
determine trend of a farm. Ratios can be compared across types and sizes of businesses more
than money value.
b. Net Income Statement
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

It is the statement which presents the difference between the gross receipt and total cost of
production. It is also explained as the surplus resulting from business operations which could
be withdrawn without reducing the future scale of the business. Sometimes it is referred to as
farm income or operating statement. For the purpose of constructing the income statement,
four types of record are required. These are the farm inventory, receipt records, expense
records, and home consumption records. In a nutshell, the net farm income is the difference
between gross receipts and total cost of production. These two components of the net income
statement are explained as follows
Gross receipt: Also called the total value of product or the total output multiplied by price
per unit of produce. It is composed of:
i. Sales of capital (e.g., machinery, if any)
ii. Sales of crops, livestock and livestock products
iii. Change in inventory of crops, livestock and livestock products
iv. Product consumed in home
v. Accounts receivable
vi. Non-farm receipts
Total cost of production: It is the sum of operating costs and fixed costs. This excludes
family and operator’s labour and management. These elements are excluded here because the
farm and family are closely associated in a traditional agricultural setting.
Operating Costs are those costs that vary with the level of output and which need to be re-
incurred at each period of the production process. Items included in the operating costs
include cost of hired labour, machinery and equipment repairs & maintenance costs, crop
expenses, livestock expenses, utilities (e.g., light, water, telephone, etc.), etc.
Fixed Costs are those costs that do not vary with output in the short run. They are costs that
must be met whether the harvest is good or not and whether we produce or not. Items
included in this cost category are: depreciation on machinery and buildings, wages of
permanent workers, interest on debt, property tax, insurance, repairs of buildings,
improvement on land, etc.
Net farm income: This is the difference between total revenue (gross receipt) and total cost.
It measures the return to unpaid family labour, land, capital and management. The net farm
income which measures the return to unpaid family labour, operators land, labour capital and
management is traditionally represented as:
Farm income = Gross Receipts – total cost of production + change in inventory
Table 5: Net income statement for year ending 31st December, 2010
Inputs Value Outputs Value
Variable costs Sales and receipts
Seeds 50 Livestock 44
Fertilizer 150 Chickens 150
Hired labour 200 Eggs 200
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Feeds 120 Cotton 600

Groundnut 300
Sorghum 400
Sub-total 520 Sub-total 1,694
Fixed costs Home consumed product
Taxes 10 Sorghum 600
Permanent staff 300 Vegetables 50
Repairing on buildings 50 Maize 420
Interest on debt 60
Sub-total 420 Sub-total 1070
Total cost of production 940 Total farm receipts 2,764
Opening inventory Closing inventory
Sheep 144 Sheep 100
Chickens 150 Chickens 350
Ducks 50 Ducks 60
Grains 240 Grains 260
Fertilizer 100 Fertilizer 80
Goats 120 Goats 160
Sub-total 804 Sub-total 1,010
Change in inventory 1010 – 804 = 206
Net farm income = total farm receipts – total cost of production + change in inventory
= 2,764 – 940 + 206
= 2,030

Measures of Financial Success and Capital Position

Components of the net-worth statement and the net income statements of the farm business
can be used to indicate the strengths and weakness of the farm business in financial terms. An
important function of management is to make use of these indicators in developing new plan
and learn for better performance of the farm business.
The net income defined as the gross farm income less gross farm cost. The net farm income
could be improved by increasing the gross farm income or decreasing the farm costs or both.
If the net farm income, however, is low the manager should examine the gross farm income
which is directly related to the yield.
For some factors might be over or under utilized by the farm firm, input factors used in the
production of the output need to be re-examined. The farmer being a price taker needs to
improve the efficiency of use of the resources (factor inputs) at his disposal. If low gross farm
income is due to low output price the demand elasticity of the product will be instrumental in
determining the revenue position of the farm. Logically, the farmer might explore all possible
ways of bargaining for better prices for his output through co-operatives, government
legislation, etc. However, attaining higher product price does not necessarily guarantee higher
gross income, for a product with inelastic demand will result in low gross income.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Also a low net farm income might be due to high cost. Examine such cost items as feeds,
labour, machinery and other supplies might reveal areas of possible wastage that need to be
avoided to cut down on input costs. However, if waste is minimal a different set of input
package might have to be considered.
The net farm income might be misleading because it may not be a good reflection of the
amount of capital, labour and management involved in the production process. It is, therefore,
necessary to examine other measures of financial success such as return to labour,
management, land and capital and three ratios (gross, operating and fixed) which are also
obtained from the net income statement.
Measures of Financial Success
The Gross Ratio
The gross ratio (GR) is the total farm expense (TFE) divided by the gross income (GI), that is:

The total farm expenses figure is obtained by summing the operating and fixed costs. In the
case of farm given above (Table 5), farm total operating cost is Birr 520 and the total fixed
cost is Birr 420 and Birr 2,970 is gross income. Gross ratio (GR) = 940/2,970 = 0.32. This
ratio shows that the total farm cost was about 32% of the gross income. A less than 1 ratio is
desirable for any farm business. The lower the ratio, the higher the return per dollar invested.
A higher but less than 1 ratio might be tolerated for a large farm involving heavy capital
investment. A greater than 1 ratio is disastrous for a farm business and might indicate over
utilization of certain resources. If this happens management should consider ways of reducing
costs and increasing gross income. The gross ratio measures the overall financial success of a
farm. It is a long run planning tool for determining the performance of the entire farm
business.
Operating Ratio
The operating ratio (OR) is the total operating cost (TOC) divided by the gross income, that
is, OR = TOC/GI. For the typical farm with data given in Table 5 the operating ratio
calculated as: OR = 520/2,970 = 0.17. The operating ratio shows the proportion of the gross
income that goes to pay for the operating costs. The operating cost is directly related to the
farm’s variable input usage. An operating ratio of 1 means the gross income barely covers the
expenses on the variable inputs used on the farm. In other words, such a business could
survive only in the very short run and could fold up if correct adjustments are not made to
improve the usage of variable resources in terms of reducing costs and / or increasing gross
income. A thorough investigation into the details of such component part will definitely help
in identifying the necessary adjustments needed to correct the situation.
The Fixed Ratio
The fixed ratio (FR) is the total fixed cost (TFC) divided by the gross income (GI), that is:
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Fixed ratio for the stated farm is calculated as FR = 420/2970 = 0.14. The ratio shows that the
fixed expense is 14% of the gross income. If the fixed ratio is close to 1, some of the fixed
resources are either left idle or underutilized. However, in the event that these resources are
fully utilized the high fixed ratio might be due to the farmer’s over estimation of the expected
gross returns in his choice of enterprise or due to unpredicted biological conditions militating
against yield.
Among the aforementioned ratios measuring the financial success of a farm business, the
gross and the operating ratios are the most import. The gross ratio measures the ultimate
solvency and success of the farm business. The decision of whether to liquidate the farm or
not depends on the gross ratio figure. A greater than 1 gross ratio means that an alternative
and more profitable enterprise should be considered. The operating ratio which is directly
related to the variable resources is the decision making tool with regards to factor adjustments
during a production period. The fixed ratio which is an indication of the percentage of the
gross income accruing to the fixed resources is an exante decision tool, that is, an important
decision parameter before and not during the production period.

In the traditional farm setting, the operating ratio is more important than the fixed ratio for
most of the resources used are variable while fixed items are almost negligible.
Measures of Capital Position
While the measures of financial success are based solely on the income statement, the
measures of capital position are based on data presented in the net-worth statement. The ratios
which indicate how solvent the business is over different time periods are the current ratio,
working capital ratio, net capital ratio, asset-to-debt ratio and debt-to-net worth ratio.
Current Ratio
The current ratio (CR) is defined as the current asset (CA) divided by the current liabilities
(CL). Mathematically:

Based on the balance sheet statement given in Table 4the current assets worth Birr 56,400,
and the current liabilities amount to Birr 54,900, hence the current ratio is 56,400/54,900 =
1.03. The current ratio generally shows the ability of the business to meet financial
obligations or its solvency. A current ratio of greater than 1 implies that the current asset is
more than the amount the farm need to pay for the current liabilities. A narrow current ratio
shows that problems exist especially if bills fall due for payment at the wrong time. The
current ratio is often called the acid test because it is a test that can be performed quickly.
Net Capital Ratio
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

The net capital ratio (NCR) is defined as the total asset (TA) divided by the difference
between the liabilities (TL) and the proprietor’s equity (PE).

This ratio shows the overall solvency of the business, and indicates changes that are possible
in the future. It shows the degree of safety of the entire farm business and determines the
possibility of borrowing more capital. If the proprietor’s equity of the farm is Birr 100,000,
the NCR is given by the total asset (TA) divided by the difference between total liabilities and
the proprietor’s equity (TL-PE). Which means 534,400/(227,900-100,000) = 4.18. Total asset
and Total liabilities figure are taken from Table 4. This ratio shows at a glance by how much
the assets on the farm have to decline to be exceeded by the liabilities other than the
proprietor’s equity. A high ratio is desirable for a risky firm business. Yet, a safe ratio
depends on the type of farm and the degree of uncertainty and risks involved.
Asset-to-Debt Ratio
The asset to debt ratio (ADR) is the total asset (TA) divided by the total liability (TL), that is:

The asset to debt ratio is a close approximation of the net capital ratio if the proprietor’s
equity is negligible. The asset-debt ratio is, however, not as useful as the net capital ratio
because it may give a distorted position of the business. Using data from balance sheet
statement in Table 4 the ADR is calculated as:
ADR = 534,400/227,900 = 2.34

The asset to debt ratio of 2.34, which is lower than the 4.18 calculated for the net capital ratio,
indicates a less solvent capital position of the business. The larger the proprietor’s equity the
less useful is the asset to debt ratio for measuring the capital position of the farm business.
Debt-to-Net Worth Ratio
The debt to net worth ratio (DNR) is defined as the total liabilities (TL) divided by the net
worth (NW), that is:

This ratio indicates the ease with which the proprietor can meet financial debts internally
when, and if the creditors demand. A less than 1 ratio is preferred to enable the proprietor
meet his financial obligations internally. The total liabilities (current, intermediate and long-
term) given in Table 4 are summed up to Birr 227,900 and the net worth was Birr 306,500.
Therefore, debt-to-worth ratio is equal to 227,900/306,500 = 0.74. This ratio of 0.74 indicates
that the total liabilities were less than the value of the net worth. Hence the proprietor can
meet its debts internally.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Learning Activities:
Students will be provided with data in order to analyze and also provide professional suggestions
for a farm that is in bankruptcy
Continuous assessment
Quiz, test and assignment
Summary
Farm records are the systematic documentation of all activities taking place in a farm
enterprise over a given period of time. There are seven types of farm records that a given farm
operator can keep; viz., farm tools and equipment inventory records, income or receipts
records, home consumption records, farm expense records, durable assets records,
depreciation records and farm profit records. These records are the basis to prepare different
financial statements like balance sheet and income statements needed to assess the
performance of farm business. Balance sheet provides an overall financial snapshot of the
farm business on specific date, while income statement shows the net income situation of the
farm business over a given period of time.

3.5.3.4 Production Functions and Relations (6 Hours)

Pre-test questions
- What are inputs and outputs?
- Can you mention the basic production decisions in farm business?
- What does a production function represent in farm production?
- State the possible types of production relations.
Production function is defined as the technical relationship between inputs and output
indicating the maximum amount of output that can be produced using alternative amounts of
variable inputs in combination with one or more fixed inputs under a given state of
technology. It is usually presumed that unique production functions can be constructed for
every production technology. The relationship of output to inputs is non-monetary; that is, a
production function relates physical inputs to physical outputs, and prices and costs are not
reflected in the function.

Forms and Types of Production Functions

Production Function Forms
Production functions can be expressed in three forms: tabular, graphic and algebraic forms.
Tabular form: Production function can be expressed in the form of a table where one column
represents input and the other indicates the corresponding total output for each input level . The
two columns constitute production function.

Input (x) Output (y)

0 2
10 5
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

20 11
30 18
40 25

Graphical Form: The production function can also be illustrated in the form of a graph. In
graphical form the horizontal axis (X-axis) represents input and the vertical axis (Y- axis)
represents the output.

From the graph above, we notice that:

 the production function is a continuous curve
 inputs and outputs are perfectly divisible (otherwise, it would look like a series of
dots)
 inputs and outputs are homogenous
Algebraic Form: Algebraically production function can be expressed as Y= f(X). Where ‘Y’
represents dependent variable - output (yield of crop, livestock enterprise) and ‘X’ represents
independent variable- input (seeds, fertilizers, manure etc), ‘f =’ denotes function. When all
inputs in the production process individually expressed, the function is represented as Y=f(X 1,
X2, X3, X4 ……… Xn). In the case of single variable production function, only one variable is
allowed to vary keeping others constant, the function can be expressed as:
Y=f(X1 | X2, X3 ………. Xn). The vertical line used mark between variable and fixed input
type. In such expression all inputs before the line represent variable type. The function
denotes that the output Y depends on the variable input X 1, with all other inputs held constant.
If more than one variable input is varied and others are held constant, the relationship can be
expressed as:
Y=f(X1, X2 | X3, X4 …….. Xn)
There are different functional forms to represent production function. Some of the functional
forms include:
Linear production function, Y= a+bX
Quadratic equation, Y = a+bX ± cX2
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

The constant ‘a’ represents the amount of product obtained from the fixed factor if none of the
variable input is applied, while ‘b’ is the amount of output produced for each unit of X (input)
applied.
Exponential function, -commonly known as Cobb-Douglas production
function
The representation of the various symbols used in the above function is given below
Y- Dependent variable,
a - constant,
b - Coefficient,
X’s - independent variable
Types of Production Functions
Continuous Production Function: A production function applicable for those inputs which
can be split up in to smaller units. All those inputs which are measurable result in continuous
production function. Example: Fertilizers, Seeds, Plant protection chemicals, Manures, Feeds,
etc.
Discontinuous or discrete Production Function: Such a function is obtained for resources or
work units which are used or done in whole numbers. In other words, production function is
discrete if inputs cannot be broken in to smaller units. Alternately stated, discrete production
function is obtained for those inputs which are counted. Example: Ploughing, Weeding,
Irrigation etc.
Short Run Production Function (SRPF): Production Function in which some inputs or
resources are fixed. Y= f (X1 | X2, X3,…………..,Xn) Eg: Law of Diminishing returns or Law
of variable proportions
Long Run Production Function (LRPF): Production function which permits variability in
all factors of production. Y = f (X1, X2, X3… Xn).
Production Relations
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 or means by which the problems of
production or resource use can be analyzed. The major production relationships include:
Factor -Product relationship, Factor -Factor relationship and Product-Product relationship

Factor-Product Relations
The Factor-Product Relations deal with the production efficiency of resources. The rate at
which the factors are transformed in to products is studied by this relationship. The central
goal of this relationship is optimization of production. The relationship is known as input-
output relationship by farm management specialists and fertilizer responsive curve by
agronomists. Factor-Product relationship guides the producer in making the decision on ‘how
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

much to produce?’ It helps the producer to decide the optimum input level to use and
optimum output level to produce. The decision on the optimal levels of input and output is
made by using price ratio as the choice indicator. Algebraically, this relationship can be
expressed as

Y = f (X1 / X 2, X3………………Xn)

The factor - product relationship or the amount of a resource that should be used and
consequently the amount of output that should be produced is directly related to the operation
of law of diminishing returns. This law explains how the amount of product obtained changes
as the amount of one of the resources is varied keeping other resources fixed. It is also known
as law of variable proportions or principle of added costs and added returns.
The law of diminishing returns states:
An increase in capital and labor applied in the cultivation of land causes in general less than
proportionate increase in the amount of produce raised, unless it happens to coincide with the
improvements in the arts of agriculture

If the quantity of one of productive service is increased by equal increments, with the quantity
of other resource services held constant, the increments to total product may increase at first
but will decrease after certain point

The Law originally developed by early economists to describe the relationship between output
and a variable input keeping all other inputs constant if increasing amount of one input is
added to a production process while all others are constant, additional output will eventually
decline the law implies there is a “right” level of variable input to use with the combination of
fixed inputs

Limitations:
The law of diminishing returns fails to operate under certain situations. They are called
limitations of the law. These limitations under which the law doesn’t hold include: improved
methods of cultivation, new soils and insufficient capital.
Why the law of diminishing returns operates in agriculture?
The law of diminishing returns is applicable not only to agriculture but also manufacturing
industries. This law is as universal as the law of life itself. If the industry is expanded too
much, supervision will become difficult and the costs will go up. The law of diminishing
returns, therefore, sets in. The only difference is that in agriculture it sets in earlier and in
industry much later. There are several reasons for the operation of law of diminishing returns
in agriculture. Among them is:
 Excessive dependence on weather
 Limited scope for mechanization
 Soil gets exhausted due to continuous cultivation
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

 Cultivation extends to inferior lands

Concepts of product curves
Total product (TP): Amount of product which results from different quantities of variable
input. Total product indicates the technical efficiency of fixed resources.
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.
Average product indicates the technical efficiency of variable input.
Marginal product (MP): Additional quantity of output resulting from an additional unit of
input used. MP = Change in total product / Change in input level (ΔY/ΔX) for discrete
change.
Total Physical Product (TPP): It is the Total Product (TP) expressed in terms of physical
units like Kgs, quintals, etc. Similarly if AP and MP are expressed in terms of physical units,
they are called Average Physical Product (APP) and Marginal Physical Product (MPP)
respectively.
Total Value Product (TVP): Expression of TPP in terms of monetary value is known as Total
Value Product. TVP = TPP*Py or Y*Py
Average Value Product (AVP): The expression of Average Physical Product in money value.
AVP = APP * Py
Marginal Value Product (MVP): When MPP is expressed in terms of money value; it is called
Marginal Value Product. MVP = MPP * Py or (ΔY/ΔX) * Py or ΔY* Py / Δ X
Relationships between Total Product (TP) and Marginal Product (MP):
– If Total Product is increasing, the Marginal Product is positive.
– If Total Product remains constant, the Marginal Product is zero.
– If Total Product is decreasing, Marginal Product is negative.
– As long as Marginal Product increases, the Total Product increases at increasing rate.
– When the Marginal Product remains constant, the Total Product increases at constant
rate.
– When the Marginal Product declines, the Total Product increases at decreasing rate.
– When Marginal Product is zero, the Total Product is at maximum.
– When marginal product is less than zero (negative), total physical product is declining
at increasing rate.
Relationship between Marginal and Average Product
– If Marginal Product is more than Average Product, Average Product is increasing.
– If Marginal Product is equal with the Average Product, Average Product is Maximum.
– When Marginal Product is less than Average Product, Average Product is decreasing.
Table 6: Relationship between TP, AP and MP
Input Total Product Average Product Marginal Product Remark
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

(X) (Y) (AP= Y/X) (MP=ΔY/ΔX

0 1 - -
1 2 2 1
Increasing Returns
2 5 2.5 3
3 9 3 4
4 14 3.5 5
Constant Returns
5 19 3.8 5
6 23 3.83 4
7 26 3.71 3
8 28 3.5 2 Decreasing Returns
9 29 3.22 1
10 29 2.9 0
11 28 2.54 -1
Negative Returns
12 29 2.16 -2
Three Regions of Production Function
The production function showing total, average and marginal product can be divided into
three regions or stages or zones in such a manner that one can locate the zone of production
function in which the production decisions are rational or not. The three sages are shown in
the figure below.

Figure 1: Stages of production

Stage I: In this stage, the average rate at which variable input (X) is transformed into product
(Y) increases until it reaches its maximum (i.e., Y/X is at its maximum). This maximum
indicates the end of Stage I.
The first stage starts from the origin i.e., zero input level. In this zone, Marginal Physical
Product is more than Average Physical Product and the Average Physical Product increases
throughout zone. Marginal Physical Product (MPP) is increasing up to the point of inflection
and then declines. Since the marginal Physical Product increases up to the point of inflection,
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

the Total Physical Product (TPP) increases at increasing rate. After the point of inflection, the
Total Physical Product increases at decreasing rate. Elasticity of production is greater than
unity up to maximum Average Physical Product (APP) and becomes one at the end of the
zone (MPP = APP). In this zone fixed resources are in abundant quantity relative to variable
resources. The technical efficiency of variable resource is increasing throughout this zone as
indicated by Average Physical Product. The technical efficiency of fixed resource is also
increasing as reflected by the increasing Total Physical Product. Marginal Value Product is
more than Marginal Factor Cost (MVP >MFC) and Marginal revenue is more than marginal
cost (MR > MC). This is irrational or sub-optimal zone of production. And this zone ends at
the point where MPP=APP or where APP is Maximum.

For Economic decisions Stage I is irrational zone of production. Any level of resource use
falling in this region is uneconomical. The technical efficiency of variable resource is
increasing throughout the zone (APP is increasing). Therefore, it is not reasonable to stop
using an input when its efficiency is increasing. Which means more products can be obtained
from the same resource by reorganizing the combination of fixed and variable inputs. For this
reason, it is called irrational zone of production.
Stage II: The second zone starts from where the technical efficiency of variable resource is
maximum i.e., APP is Maximum (MPP=APP)
– In this zone Marginal Physical Product is less than Average Physical Product.
Therefore, the APP is decreasing throughout this zone.
– Marginal Physical Product is decreasing throughout this zone.
– As the MPP declines, the Total Physical Product increases but at a decreasing rate.
– Elasticity of production is less than one between maximum APP and maximum TPP
and becomes zero at the end of this zone.
– In this zone variable resource is more relative to fixed factors.
– The technical efficiency of variable resource is declining as indicated by declining
APP.
– The technical efficiency of fixed resource is increasing as reflected by increasing TPP.
– The condition Marginal Value Product is equal to Marginal Factor Cost (MVP=MFC)
and Marginal Revenue is equal to Marginal Cost (MR= MC) exists in this stage
– This is rational zone of production in which the producer should operate to attain his
objective of profit maximization.
– This zone ends at the point where Total Physical Product is at maximum or Marginal
Physical Product is zero.
Stage II is rational zone of production. The area within the boundaries of this region is of
economic relevance. Optimum point must be somewhere in this rational zone. It can,
however, be located only when input and output prices are known.
Stage III: This zone starts from where the technical efficiency of fixed resource is maximum
(TPP is Maximum). In Stage II:
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

– Average Physical Product is declining but remains positive

– Marginal Physical Product becomes negative
– The Total Physical Product declines at faster rate since MPP is negative.
– Elasticity of production is less than zero (Ep < 0)
– In this zone variable resource is in excess capacity
– The technical efficiency of variable resource is decreasing ( declining APP)
– The technical efficiency of fixed resource is also decreasing ( declining TPP)
– Marginal Value Product is less than Marginal Factor Cost (MVP < MFC)
– Marginal Revenue is less than Marginal Cost ( MR < MC)
– This zone is irrational zone of production.
Producer should never operate in this zone even if the resources are available at free of cost.
Stage III is also an area of irrational production. TPP is decreasing at increasing rate and MPP
is negative. Since the additional quantities of resource reduces the total output, it is not
profitable zone even if the additional quantities of resources are available at free of cost. If
farmer operates in this zone, he will incur double loss, that is, reduced production and
unnecessary additional cost of inputs.
In summary, for a Factor-Product type production relation, the optimal use of variable factor
is the level for which the VMP is equal to the factor price. It is located in stage II. The
economic meaning of the optimal solution would mean:
Increasing use of a factor by one unit is profitable if the increase in the total revenue resulting
from increased input (= the VMP) is higher than the increase in cost (i.e., the price P x paid
for one unit of the factor). If this condition fulfilled profit is maximized.

Factor-Factor Relations
This relationship deals with the resource combination and resource substitution. Cost
minimization is the goal of factor-factor relationship. Under factor-factor relationship, output
is kept constant while inputs are varied in quantity. This relationship guides the producer for a
decision on ‘how to produce’. Such a relation is explained by the principle of factor
substitution or principle of substitution between inputs. Factor-Factor relationship is
concerned with the determination of least cost combination of resources. The choice
indicators are the physical substitution ratio and price ratio. It is expressed algebraically as:
Y = f(X1, X2, / X3, X4… Xn), where we consider two variable inputs
In the production process inputs are substitutable. For instance 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 through choice of inputs and their combinations.
Concept of Isoquants:
The relationship between two factors and output
X1 X2 Output
cannot be presented with a two dimensional
3 20 60
graph. Three variables can be presented in
4 15 60
6 10 60
10 6 60
15 4 60
20 3 60
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

a three dimensional diagram giving a production surface. An isoquant is a convenient method

for compressing three dimensional picture of production into two dimensions. Hence,
isoquant is defined as all possible combinations of two resources (X 1 and X2) physically
capable of producing the same quantity of output. Isoquants are also known as isoproduct
curves or equal product curves or product indifference curves. Graphical representation of
isoquant is given below.

X2 Isoquant

X
O
X1
 FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Figure 2: Isoquant curveIsoquant

Map or Isoproduct Contour
If a 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
Figure 2: Isoquant Map
Isoquants further from the origin represent higher production level. The Y’s in the graph are
ordered as Y1< Y2< Y3
Characteristics of Isoquant
– Slope downwards from left to right or negatively sloped
– Convex to the origin
– Nonintersecting
– Isoquants lying above and to the right of another represent higher level of output
– The slope of isoquant denotes the marginal rate of technical substitution (MRTS).
Marginal Rate of Technical Substitution (MRTS)
MRTS refers to the amount by which one resource is reduced as another resource is increased
by one unit. Or the rate of exchange between some units of X 1 and X2 which are equally
preferred. MRTS can be represented as:

MRTS X1 for X2 = ΔX2/ΔX1

MRTS X1 for X2 = ΔX1/ ΔX2

MRTS gives the slope of Isoquant. Substitutes indicate 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. Hence MRTS is always less than zero or it is negative.
Types of factor substitution
The shape of isoquant and production surface will depend up on the manner in which the
variable inputs are combined to produce a particular level of output. There can be three such
categories of input combinations.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Fixed Proportion combination of inputs: Under fixed combination, to produce a given level
of output, inputs are combined together in fixed proportion. Isoquants are ‘L’ shaped. It is
difficult to find examples of inputs which combine only in fixed proportions in agriculture.
An approximation to this situation is provided by tractor and driver combination. To operate
another tractor, normally we need another driver.
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
& negatively sloped.
Decreasing Rate of substitution: Every subsequent increase in the use of one factor in the
production process can replace less and less of the other factor. In other words, each one unit
increase in one factor requires smaller and smaller sacrifice in another factor.
Ex: Capital and labour, concentrates and green fodder, organic and inorganic fertilizers etc.
Isoquants are convex to the origin when inputs substitute for each other at decreasing rate.
Decreasing rate of factor substitution is more common in agricultural production.

Figure 3: Input Substitution Types

Isocost Line (price line or budget line)

Isocost line defines all possible combinations of two resources (X 1 and X2) which can be
purchased with a given outlay of funds. Isocost line is used in the concept of optimal input
combination in the production process.
Characteristics of Isocost line:
As the total outlay increases, the isocost line moves farther away from the origin.
Isocost line is a straight line because input prices do not change with the quantity purchased.
The slope of isocost line determined as the ratio of factor prices.
Least Cost Combination of inputs
There are innumerable possible combinations of factors which can be used to produce a
particular level of output. The problem is to find out a combination of inputs which cost the
least; a cost minimization problem. There are three methods to find out the least cost
combination of inputs. These methods are explained below.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

cost of X1 Cost of X2
Units of X1 Units of X2 Total Cost
(price 3 Birr/unit) (Price 2 Birr/unit)
10 3 30 6 36
7 5 21 10 31
5 6 15 12 27
3 8 9 16 25
2 12 6 24 30
1. Simple Arithmetical calculations (presented in Table)

One possible way to determine the least cost combination is to compute the cost of all
possible combinations of inputs and then select the combination with minimum cost. This
method is suitable where a limited number of combinations produce a particular level of
output. The above table shows five combinations of inputs which can produce a given level of
output. The price per unit of X 1 is Birr 3 and of X 2 is Birr 2. The total cost of each
combination of inputs is computed and given in the column with Total Cost. Out of five
combinations, 3 units of X1 and 8 units of X2 is the least cost combination of inputs at a cost
of Birr 25 to produce the specified unit of a product.
2. Algebraic method:
Compute Marginal Rate of technical substitution
MRTS = Number of units of replaced resource / Number of units of added resource
MRTS X1 for X2 = Δ X2/ΔX1
MRTS X2 for X1 = ΔX1/ΔX2
Compute Price Ratio (PR)
PR=Price per unit of added resource/Price per unit of replaced resource
PR=Px1/Px2 if MRTS X1X2 or PR= Px2/ Px1 if MRTS X2X1
Least combination occurs at a point where MRTS and PR are equal. i.e.
ΔX2/ΔX1= P x1/Px2 MRTS X1X2
ΔX1/ΔX2= Px2/ P x1 MRTS X2X1
The same can be expressed as
ΔX2* Px2= Px1*ΔX1 or ΔX1*Px1 =ΔX2*Px2
The least cost combination is obtained when Marginal Rate of substitution is equal to Price
Ratio. If they cannot be exactly equal because of the choices available in the table, take closer
figures without letting the price ratio exceed the substitution ratio.
Units of X1 Units of X2 MRTSX2 X1 PR = Px2 /Px1
10 3 - 0.67
7 5 (7-10) /(4-3) = 3.00 0.67
5 6 (5-7) /(6-5) = 2.00 0.67
3 8 (3-5) / (8-6) = 1.00 0.67
2 12 (2-3) /(12-8) = 0.25 0.67
Price of X1 is Birr 3 per unit, and price of X2 is Birr 2 per unit
3. Graphical Method:
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Since the slope of isoquant indicates MRTS and the slope of isocost line indicates factor price
ratio, minimum cost for a given output will be indicated by the tangency of these isoclines
(isocost and isoquant lines). For this purpose, isocost line and isoquant are drawn on the same
graph.. The least cost combination will be at the point where isocost line is tangent to the
isoquant line i.e., slope of isoquant=slope of isocost line i.e. MRTS=PR
X Isocost

LCC

X2
Isoquant
X
O
X1

Product-Product Relations
Product-Product relationship deals with resource allocation among competing enterprises
(individual crop production and animal rearing). The goal of Product-Product relationship is
profit maximization through optimal combination of enterprises. Under Product-Product
relationship, inputs are kept constant while products (outputs) are varied. This relationship
guides the producer in deciding on ‘What to produce?’ Product-Product relationship is
explained by the principle of product substitution. The relationship is concerned with the
determination of optimum combination of production (enterprises). The choice indicators are
product substitution ratio and price ratio. Algebraically, product-product relation is expressed
as:
Y1=f (Y2, Y3… Yn)
Production Possibility Curve (PPC)
Production Possibility Curve is a convenient device for depicting two production functions on
a single graph. Production Possibility Curve represents all possible combinations of two
products that could be produced with a given amounts of inputs. Production Possibility Curve
is known as Opportunity Curve because it represents all production possibilities or
opportunities available with limited resources. It is called Isoresouce Curve or Isofactor 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.
How to draw Production Possibility Curve
Production Possibility Curve can be drawn either directly from production function or from
total cost curve. The method of drawing Production Possibility Curve from Production
Function is explained below.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

A farmer has five acres of land and wants to produce two products namely cotton (Y 1) and
Maize (Y2). Assume all other inputs are fixed. Now the farmer has to decide how much of
land input to use for each product. This implies that amount of land that can be used to
produce Cotton (Y1) depends upon the amount of land used to produce Maize (Y 2).
Therefore, Y 1= f (Y2)
The allocation of land resource between the two products and the output from different doses of
land input are presented below
Allocation of Land in Acres Output in quintals
Y1 Y2 Y1 Y2
0 5 0 60
1 4 8 48
2 3 15 36
3 2 21 24
4 1 26 12
5 0 30 0
As evident from the above data, if all 5 acres of land are used in the production of Y 2 we
obtain 60 quintals of Y2 and do not get any of Y1. On the other hand, if all the five acres of
land are used in the production of Y1 we can obtain 30 quintals of Y1 and do not get any of Y2.
But these are the two extreme production possibilities. In between the two, there are many
other production possibilities. Plotting these two points on a graph, we get the Production
Possibility Curve.

Production Possibility Curve (PPC)

Output of Y2

O
Output of Y1

Production Possibility Curve

Types of Product-Product Relationships or Enterprise Relationship
Farm commodities bear several physical relationships to one another. These basic product
relationships include:
1) Joint Products: such relationship happen when two products are produced through single
production process. As a rule the two are combined products. 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. Most farm commodities are joint products.
Ex: Wheat and Straw, cattle and manure, beef and hides, mutton and wool etc.
 FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Y2 A

O
Y1

Graphically the quantities of Y1 and Y2 that can be produced at different levels of resources
will be shown as points AB in the figure.
2) Complementary enterprises: Complementarity between two enterprises exists when
increasing the production from one enterprise increases the production of the other enterprise.
Change in the level of production of one enterprise causes change in the other enterprise in
the same direction. That is when increase in output of one product, with resources held
constant, also results in an increase in the output of the other product. Temporarily, the two
enterprises do not compete for resources but contribute to the mutual production by providing
an element of production required by each other. The marginal rate of product substitution is
positive (> 0). Ex: crops and livestock enterprises.

As shown in the figure, range of complementarities is from point A to point B when increase
A in the production of one enterprise (crop) followed by increase in the production of the other
enterprise (Livestock). After point B the enterprises will become competitive. All
complementary relationships should be taken advantage by producing both products up to the
point where the products become competitive.
Crop Production

3) Supplementary enterprises: Supplementarity exists between enterprises when increase or

decrease in the output of one product does not affect the production level of 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. For example, small
poultry or dairy or piggery enterprise is supplementary on the farm. All supplementary
relationships should be taken advantage by producing both products up to the point where the
products become competitive.

Livestock production
 FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

B
Y2
A

Y1

The two products (Y1 and Y2) stay supplementary from A to B as shown in the graph. After
point B they become competitive enterprises.

4) Competitive enterprises: This relationship exists when increase or decrease in the

production of one product affect the production of other product inversely. That is when there
is an increase in output of one product, with resources held constant; production of the other
product decreases. Competitive enterprises compete for the same resources. Two enterprises
are competitive in the use of given resources if output of one can be increased only through
sacrifice in the production of another. The marginal rate of product substitution is negative (<
0)

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.
MRPS = Number of units of replaced product / Number of units of added product
MRPSY1 for Y2 = ∆Y2/∆Y1
MRPSY2 for Y1 = ∆Y1/∆Y2
Types of Product Substitution
When two products are competitive, they substitute either at constant rate or increasing rate or
at decreasing rate.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

1) 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. Or Production Possibility Curve is linear
when products substitute at constant rate. When two products substitute at constant rate, only
one of the two products will be economical to produce depending on their relative prices. This
is to say that specialization is the general pattern of production under constant rate of product
substitution. This relationship can be expressed as

∆1Y2/∆1Y1 = ∆2Y2/∆2Y1 = ……. = ∆nY2/∆nY1

Y1 Y2 ∆Y1 ∆Y2 ∆Y2/∆Y1

16 2 - - -
12 4 4 2 0.5
8 6 4 2 0.5
4 8 4 2 0.5

2) 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. Increasing rates of substitution holds
true when the production for each independent commodity is one of decreasing resource
productivity (decreasing returns) and non-homogeneity in quality of limited resource. The
production Possibility Curve is concave to the origin when product substitutes at the
increasing rate. Increasing rate of the product substitution is common in agricultural
production. The general pattern of production is diversification i.e., profits are maximized by
producing both products.

∆1Y2/∆1Y1 < ∆2Y2/∆2Y1 < ……. < ∆nY2/∆nY1

Y1 Y2 ∆Y1 ∆Y2 ∆Y2/∆Y1

1 14 - - -
2 11 1 3 3
3 7 1 4 4
4 2 1 5 5
3) 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. This type of product substitution holds good under
conditions of increasing returns. Production Possibility Curve is convex to the origin when
products substitute at decreasing rate. This relationship is algebraically expressed as

∆1Y2/∆1Y1 > ∆2Y2/∆2Y1 > ……. > ∆nY2/∆nY1

FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Y1 Y2 ∆Y1 ∆Y2 ∆Y2/∆Y1

1 10 - - -
2 6 1 4 4
3 3 1 3 3
4 1 1 2 2

IsoRevenue Line
Isorevenue line represents all possible combination of two products which would yield an
equal (same) revenue or income. Let R is the revenue from two products Y 1 and Y2 and the
prices for both products is given as Py 1 and Py2 respectively. The Isorevenue equation will be
given as:

R= Y1 * Py1 + Y2 * Py2, the line is linear as long as prices for both products do not change

Characteristics:
Isorevenue line is a straight line because product prices do not change with quantity sold.
As the total revenue increases, the isorevenue line moves away from the origin
The slope indicates ratio of product (output) prices. As long as product prices remain
constant, the isorevenue line showing different total revenues are parallel. But change in
either price will change the slope.
Determination of optimum combination of products (Economic decision):
The Economic optimum combination of the two products can be determined through three
different ways:

1) Algebraic Method:
There are three steps to determine the optimum product combination through algebraic
method.
a) Compute Marginal Rate of Product Substitution
MRPS =Number of units of replaced product/Number of units of added product
MRPSY1 for Y2 = ∆Y2/∆Y1
MRPSY2 for Y1 = ∆Y1/∆Y2
b) Workout price ratio (PR)
Price Ratio (PR) = Price per unit of added product/Price per unit of replaced product
PR= P y1/Py2 if it is MRPSY1Y2
PR= Py2/ Py1 if it is MRPSY2Y1
c) Find the combination at a point where substitution ration (MRPS) is equal to price ratio
(PR). This gives us the Optimum combination of enterprises.

∆ Y2/∆Y1= Py1/Py2 or ∆Y1/∆Y2 = Py2/ Py1

FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

For profit maximization, a rational producer should operate in the range where two products
are competitive and within this range the choice of products should depend upon the MRS and
PR.

2) Graphic Method:
In this method follow the procedure given below to find the optimal product combination.
Draw production possibility curve and isorevenue line on one graph.
Slope of production possibility curve indicates MRPS and the slope of isorevenue line
indicate price ratio of products.
The point of optimum combination of products is at a point where the isorevenue line is
tangent to the production possibility curve.
At the tangency point, slope of the isorevenue line and the slope of the production possibility
curve will be the same. In other words, the MRPS=PR which gives the optimum combination.
Production Possibility Curve

Optimum Combination of products

Y2

Isorevenue Line
O
Y1

3) 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 Revenue from Y1 (Py1=50) Revenue from Y2 (Py2=80) Total Revenue

8 2 400 160 560
5 3 250 240 490
6 4 300 320 620
4 5 200 400 600
3 7 150 560 710

Accordingly, the optimum combination includes 3 units of Y 1 and 7 units of Y2 where the
revenue at this combination is the maximum as indicated in the table.
Table 7: Summary of basic production relationships
Factor – Product Factor – Factor Product – Product
Deals with resource
Deals with resource use Deals with resource
combination and resource
efficiency allocation among enterprises
substitution
Optimization of the Profit optimization is the
Cost minimization is the goal
production is the goal goal
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Answers the question ‘How Answers the question ‘How Answers the question ‘What
much to produce?’ to produce?’ to produce?’
Considers single variable Inputs or resources varied Output of products are varied
production function keeping the output constant keeping the resource constant
Guides in the determination Concerned with the Helps in the determination of
of optimum input to use and determination of Least cost optimum combination of
optimum output to produce combination of resources products
Substitution ratio and Price
Price ratios are choice Substitution ratio and price
ratio are the choice
indicator ratios are choice indicators
indicators.
Explained by the law of Explained by the principle of Explained by the principle of
diminishing returns factor substitution product substitution
Y=f(X1 | X2, X3 ……Xn) Y = f(X1 X2 / X3, X4 ...Xn) Y1=f(Y2 ,Y3, ……. Yn)
Continuous Assessment
Quiz, test and Assignment

Summary
Production function is a technical relationship between inputs and output in the production
process. Production functions can be represented in different forms (tabular, graph, and
algebraic) and also categorized in to different types (continuous, discontinuous, short-run and
long-run). A production function has three regions which are used to identify product curves
relationships and optimal level of production.

Farm Planning and Budgeting (6 Hours)

Pre-test questions
- What is farm planning?
- Can you mention the importance of farm planning?
- What is budget? (Please link to farm business operations)
Farm Planning
A successful farm business is not a result of chance factor. Good weather and good prices
help but a profitable and growing business is the product of good planning. With recent
technological developments in agriculture, farming has become more complex business and
requires careful planning for successful farm business.

Farm Planning means the preparation of an operational program for a farm which will ensure
the conservation of land and other resources. It’s important for the efficient use of production
factors thereby increase the net income and farmer satisfaction. Farm plans are particularly
required when there are limiting factors such as land, labour and capital. This necessitates
efforts to maximize returns to the limiting factors. A farmer makes plans before starting
production. For example, in crop production, the farmer decides on the crop types (such as
maize, yam, beans, etc.) and resources to put into production (such as farmland, seed,
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

fertilizer, labor for farm operations, etc.). The result of crop production is the output, while
the resources are the production inputs.

Production inputs and output are measured in different units-hectares, person-days, kilograms,
liters, and so on. Aggregation of the components is possible by using a common unit of
measurement. The unit of measurement is usually monetary (currency unit). Thus, the values
(quality and quantity) of inputs and output are expressed in monetary terms in a budget. The
monetary symbol used can for instance be ETB (Ethiopian Birr) or USD (US –dollar).

Farm planning enables the farmer to achieve his objectives (e.g. Profit maximization or cost
minimization) in a more organized manner. It also helps in the analysis of existing resources
and their allocation for achieving higher resource use efficiency, farm income and farm
family welfare. Farm planning is an approach which introduces desirable changes in farm
organization and operation and makes farm a viable unit. Farm plan is a programme of total
farm activity of a farmer drawn up in advance. It should show the enterprises to be taken up
on the farm; the practices to be followed in their production, use of labor and other resources ,
investments to be made and similar other details. Farm planning can be done at two levels:
simple farm planning and whole/complete farm planning. They are explained below.

Simple farm planning: It is procedure adopted either for a part of the land or for one
enterprise or to substitute one resource to another. This is very simple and easy to implement.
The process of change should always begin with these simple plans.

Complete or whole farm planning: This is the planning for the whole farm. A whole-farm
plan is an outline or summary of the type and volume of production to be carried out on the
entire farm and the resources needed to do it. This planning is adopted when major changes
are contemplated in the existing organization of farm business. When the expected costs and
returns for each part of the plan are organized into a detailed projection, the result is a whole-
farm budget. Whole-farm planning and budgeting are used to assess the combined
profitability of all enterprises in the farming operation. Linear programming (explained in the
following subsection) can be used to select the optimal enterprise combination for a farm.
Farm Budgeting and Types of Budget
Farm budget is a detailed physical and financial plan for the operation of a farm and prepared
for specified period of time or season. The aim of a farm budget is to compare how profitable
different kinds of enterprises and their combinations are. There are two major categories of
farm budget. These are the total or complete budget and partial budget. A total or complete
budget is prepared when contemplating a complete reorganization of the entire farm
enterprise, like introducing irrigation technology to the farm. Partial farm budget, which is
more common, is used when introducing a new enterprise or purchasing a new equipment of
the farm. The aim of preparing a farm budget is to enable the farm manager get several
alternative plans for analysis so that he would be in a position to know which of them gives
the highest net farm income.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Farm Budgeting and Advantages

Farm budgeting involves considering the resources to be used, the choice of enterprises to be
pursued and calculation of expected receipts, expenditures and net farm income. Some of the
several advantages of budgeting are:

- Budgeting assists the farm manager to select factors of production more wisely. For
instance, once some fixed resources are invested in the farm business budgeting can be
used to test and compare returns from the whole farm and other added resources.
- As a planning tool, budgeting lets the farm manager to think more accurately, plan more
carefully and completely. Through the process of budgeting, the farm manager refines his
ideas and is better able to make more accurate decisions.
- Budgeting is money saving activity because it is cheaper to make mistake on paper than in
practice.
- Budgeting provides an excellent learning device on how to organize and reorganize farms.
- Lending agencies use budgeting process as a basis for appraising the farm business of
their clients.
- Budgeting helps a farm manager to determine when to borrow money and how much to
borrow. It can also help him in setting up repayment schedules.
- Budgeting makes early warning possible where one can discover certain items, and
therefore costs, that could easily be dropped.
Budgeting Pre-requisites/Steps in Budgeting
Information needed to prepare a farm budget, whether complete or partial must follow the
following pattern
– Stating objectives and listing of all the resources available to the farm. It is essential to list
all the resources available to the farm business - land, labour and capital. Making changes
which require more resources than the farmer can acquire could be disastrous. Hence,
objectives of making the farm plan or planned change must be carefully laid down,
properly understood and strictly operationalized within the resources listed.
– Estimate crop land size and livestock number. This helps to sketch map of available land
with crops on farm. In the case of crop enterprises the proposed changes could be
sketched out in other map for ease of reference.
– Estimating physical inputs and outputs. The farm manager needs to produce a list of
available labour in man-days; the quantity of hired labour, permanent labour and family
labour available should be specified by periods preferably on monthly basis. The available
capital including farmer’s savings and any amount borrowed need to be clearly indicated.
Finally the farmer or farm manager should examine his ability in effecting any anticipated
change (partial or whole farm).
– Estimating factors and product prices- Current market prices or a few years’ moving
average could be used as a proxy for factor and product prices.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

– Decide which plan is possible- from the whole range of alternative plans available to the
farm manager he can reject outright those plans that do not interest him or those that he
cannot manage properly.
– Budget the Possible Alternative - The possible alternative plans are compared on the basis
of the gross margin per unit of the most limiting resources. For example,if labour is the
most limiting resource; the plan with the highest gross margin per man-day should be
selected.
– Implement the Best Plan- Once the farmer selects the best plan; it must be put into
operation. Farm owners should be ready to accept responsibility for the outcome of its
implementation.
Budget, an outcome of budgeting procedure, is a formal quantitative expression of plans on
production inputs and output. Budgets indicate the type, quality, and quantity of production
resources or inputs needed, and the type, quality, and quantity of output or product obtained.
Three types of budgets are used in agriculture: whole-farm budget, enterprise budget and
partial budget.

Whole-farm budget- A whole-farm budget is a quantitative expression of the total farm plan
summarizing the income, costs, and profit (Table 8). Income is what a farmer realizes from
farming activities, costs are what the farmer puts into production, and profit is the difference
between income and costs. In a whole-farm budget, the unit of analysis is the entire farm. A
whole-farm budget may consist of several enterprises. Example for whole-farm budget is
given in the table below.
Table 8: A whole-farm budget showing projected income, input costs, and profits
Amount Amount
Nr Income Nr Variable input costs (cont…)
(Birr) (Birr)
1 Maize 56,000 15 Custom machine hire 9,350
2 Cassava 48,000 16 Miscellaneous 3,560
3 Beans 13,600 17 Total variable input cost (Σ7...16) 87,060
4 Yam 32,000 18 Income above variable input cost (6 – 17) 102,540
5 Poultry 40,000 Fixed costs
6 Total income (Σ1...5) 189,600 19 Land charge 2,000
Variable input costs 20 Insurance 4,850
7 Fertilizers 12,900 21 Interest on loans 24,000
8 Seeds and cuttings 3,000 22 Machinery depreciation 9,200
9 Chemicals 8,900 23 Building depreciation 3,600
10 Fuel, oil, and grease 4,000 24 Total fixed costs (Σ19...23) 43,650
11 Machinery repairs 3,650 Total costs
12 Feed 2,600 25 Total input costs (17 + 24) 130,710
13 Point-of-lay chickens 35,000 Profit
14 Labor 4,100 26 Profit (6 – 25) 58,890
Enterprise budget- An enterprise is a single crop or livestock type produced on a farm. An
enterprise budget lists all income and costs of a specific enterprise to provide an estimate of
its profit. Each enterprise budget is developed on a single common unit, such as hectares for
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

crops or head for livestock. An enterprise budget allows comparison of profitability among
different enterprises on the same farm.
Enterprise budgets, like whole-farm budgets, have three parts: income, costs, and profit. Table
9 gives an example of enterprise budget. The enterprise budget in Table 9 presents different
levels of the same single technology.
An enterprise budget is different from a whole-farm budget in aspects:
– the number of enterprises considered (only one in an enterprise budget; in a whole-
farm budget, all enterprises in the farm are included)
– the size of enterprises (a single unit for an enterprise budget, the entire farm for a
whole-farm budget)
Table 9: An enterprise budget for the production of an improved open-pollinated maize variety at different N-fertilizer
application levels
N-fertilizer level (kg N/ha)
N
100(Treatment 200
r 0 (Treatment 1)
2) (Treatment 3)
Gross income
1 Average yield (kg/ha) 2,592 3,983 4,331
2 Adjusted yield (kg/ha) (1 x 0.9) 2,333 3,585 3,898
3 Price (Birr/kg) 2.5 2.5 2.5
4 Sale revenue (Birr/ha (2 x 3)) 5832 8961.75 9744.75
Input costs (Birr/ha)
5 Land preparation 350 350 350
6 Planting
Materials (maize seed and seed
40 40 40
dressing)
Labor 20 20 20
Weed control (herbicides and
7 400 400 400
application costs)
8 Thinning 25 25 25
9 N-fertilizer 0 150 300
10 Other fertilizers 135 135 135
11 Miscellaneous 200 200 200
12 Harvesting (labor) 70 85 90
13 Shelling 30 32 35
14 Drying 60 64 67
15 Cost of capital 211 237 261
16 Depreciation costs( Brr/ha) 75 75 75
Total variable input costs (Birr/ha)
17 1,541 1,738 1,923
(Σ5...15)
18 Total fixed costs (Birr/ha) (16) 75 75 75
19 Total input costs (Birr/ha) (17 + 18) 1,616 1,813 1,998
Net profit
20 Net profit (Birr/ha) (4 – 19) 4,216 7,149 7,747
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Partial budget- A partial budget is prepared to show the effect of change(s) in farm
operations. For example, farmers know that fertilizer application will likely increase maize
yield, and thus the gross income. The use of fertilizer also results in additional costs. To
decide whether to use fertilizer for maize production or not requires a partial budget analysis.
A partial budget could be prepared to ascertain the effect on net benefit of the following
possible changes:

– substituting one enterprise for another without any change in the entire farmland area,
for example, substituting 1 ha of soybean for 1 ha of maize
– changing to different levels of a single technology, for example, estimating the effect
on net benefit of changing from one level of N-fertilizer application to another in
maize production
– changing to different technology(ies), for example, changing from hand weeding to
herbicide use for weed control
Developing a partial budget for on-farm maize research involves collecting, organizing, and
analyzing experimental data in order to quantify the income, costs, and benefits of various
alternative maize technologies.
Table 10: A partial budget for maize production under different weed control methods
Weed control method
Boom Knapsack
Nr Item Description No weeding Hand
spraying spraying
(1) weedig (2)
(3) (4)
Gross farm gate benefits
1 Average yield (kg/ha) 1,266 3,986 3,797 2,833
2 Adjusted yield (kg/ha) (1 x 0.9) 1,139 3,587 3,417 2,550
3 Farm gate price (Birr/kg) 0.75 0.75 0.75 0.75
4 Gross farm gate benefits (Birr/ha) (2 x 3) 854 2,690 2,563 1,913
Variable input costs (Birr/ha)
5 Weed control
– Labor 0 360 10 60
– Machinery 0 0 50 25
– Herbicides 0 0 160 160
6 Harvesting 42 70 70 70
7 Shelling 20 30 30 25
8 Total variable input costs (Birr/ha) (Σ5...7) 62 460 320 340
Net benefit
9 Net benefit (Birr/ha) (4 – 8) 792 2,230 2,243 1,573
Changes in net benefits from Treatment 1 to
10 1,438 1,451 781
Treatment 2, 3, or 4* (Birr/ha)
Change in total variable input costs from
11 398 258 278
Treatment 1 to Treatment 2, 3 or 4* (Birr/ha)
Marginal rate of return
12 Marginal rate (%) of return (100 x 10/11) 361 562 281
* Change in net benefits between Treatments 1 and 2 is 2,230 – 792= 1,438
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Change in net benefits between Treatments 1 and 3 is 2,243– 792= 1,451

Change in net benefits between Treatments 1 and 4 is 1,573– 792= 781
* Changes in the total variable costs calculated in similar ways

A partial budget, like an enterprise budget, is based on a unit (for example, one ha maize
farm) but it is different from an enterprise budget in the type of costs used. An enterprise
budget uses total costs (variable input costs plus fixed input costs) while only variable input
costs are used in a partial budget. In a partial budget, income is the gross farm gate benefit.
The net benefit is the difference between the gross farm gate benefit and total variable input
costs. Table 10 gives an example of partial budget. The partial budget in this case shows
different levels of the same single technology.
The objective of a partial budget in maize production is to recommend technology that is
agronomically different, economically superior, and socially acceptable to farmers.
Learning Activities
 Preparing partial budget and also estimate efficiency measures (students provided with
data or possible source )
Continuous Assessment
Quiz and assignment
Summary
Farm planning is an operational program of the farm and is prepared to ensure efficient use of
farm resources. Basically there two types of farm planning. One is Simple farm planning
which is prepared either for a part of the land or for one enterprise or to substitute one
resource to another. The other is Complete or whole farm planning done for whole farm
outlining the type and volume of production to be carried out on the entire farm and the
resources needed to do it. Farm budget is the detailed expression of physical and financial
plan for the operation of the farm. Farm budgeting includes the process of considering the
resources to be used, the choice of enterprises to be pursued and calculation of expected
receipts, expenditures and net farm income. Farm budgets can be classified in to three groups
(whole-farm, enterprise and partial budgets) depending on the details included in their
preparation.

Production Costs (3 hrs)

Pre-test question
 What is cost?
 What are the components of costs in agriculture?
Meaning of farm costs

Cost concepts are of profound importance in farm business since they enable us to make
choices among present alternative actions. For each possible present action, the measure of
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

the present and future forsaken opportunities is the "cost." The sacrifice is made inevitable
when the present action is taken and in this sense, the present action involves present cost.

We can define cost in strict business connotations as the change in equity that is caused by the
performance of some specified operations. In everyday usage, farm costs comprise
expenditures in money and imputed terms, which a farm operator incurs in the operation of
his business. This simplistic definition often masks a lot of complexities that are found in
allocating costs in farm business. These complexities are such that various measures of costs
are employed in clearly determining net returns in practice, as opposed to the simplified
notions in production theory.

8.3. Allocation of costs

Production processes do not always yield only one product or output. As a matter of fact,
many farm enterprises give joint products. Joint products are interdependent in supply, since
more of one product generally involves more of the other. In fact, a higher price of one of the
products of joint outputs will, by inducing a larger output, also lead to an increased output of
the other commodity. Thus, the supply of a good is dependent not only on its own price, but
that of other goods -- especially of joint product goods. In fact, the ratio in which joint
products are produced is variable, justifying why they also are substitutable at the same time
as they are joint.
One problem which plagues farm producers is how one should allocate the costs of the
common resources employed in producing each of the joint products. For example, hides and
meat are produced from one steer fed on a ration of mixed feeds. The problematic question is:
what portion of the cost of feed is the cost of the hide and what portion is the cost of beef?
This boils down to the relevant and specific question: Can a "common" cost be allocated
among joint products?
The valid answer to this specific question will depend on how we treat each product. In other
words, which of the two joint products is treated as a residual or by-product helps us to decide
the different allocation of costs. Thus, by calling one of the two products the "basic" product,
and the other, the "by-product", we can implicitly as well as explicitly assign the "common
costs" between the two goods. This, it must be stressed, is merely an arbitrary allocation
which depends solely on which product one calls the basic product.
Another problem which plagues farm operators is how to assess the costs of unpaid inputs.
The farm inputs that are conventionally referred to as unpaid or non-cash inputs are operator
and family labor services plus farmer-owned or farmer-supplied inputs. Although the
measurement in physical terms per se of each of these inputs presents some problems, the role
of judgment becomes magnified when we have to weigh these items by constant prices in
order to make aggregation possible. The fact that these inputs are not bought and sold as are
most other farm inputs, complicates the determination of what prices we should consider most
appropriate to use as weights.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Three techniques are usually adopted in deriving prices for unpaid labor and capital inputs in
farm business. The first technique is that of deducting from gross income all expenses other
than unpaid capital and labor and to call the residual the value of the composite unpaid
factors. The second technique is to assign to unpaid labor and capital inputs the prices paid for
the labor and capital that are purchased, and used in the way most similar to that of the unpaid
inputs. In other words, we use the per unit price of hired farm labor and borrowed farm capital
to estimate the prices of the unpaid inputs, which means using hired farm wage rates and
interest rates on borrowed capital as price weights for the unpaid labor and capital
respectively. The third technique is that of using a combination of the first and second
techniques. This implies deducting from the composite residual either labor or capital costs
calculated at the rate which uses the second technique, the rest of the residual is then
associated with either unpaid labor or unpaid capital, as the case may be.

Agricultural cost functions

Cost functions represent the mathematical presentation of the relationships between total cost
of production and the output produced. The costs of production might also be defined not in
terms of the use of the input, but in terms of the output. To do this, some basic terms need to
be explained.
Variable costs (VC) are the costs of production that vary with the level of output produced by
the farmer. For example, in the production of corn, with the time period being a single
production season, variable costs might be thought of as the costs associated with the
purchase of the variable inputs used to produce the corn. Examples of variable costs include
the costs associated with the purchase of inputs such as seed, fertilizer, herbicides,
insecticides, and so on. In the case of livestock production within a single production season,
a major variable cost item is feed.
Fixed costs (FC) are the costs that must be incurred by the farmer whether or not production
takes place. Examples of fixed-cost items include payments for land purchases, and
depreciation on farm machinery, buildings, and equipment.

The categorization of a cost item as fixed or variable is often not entirely clear. The fertilizer
and seed a farmer uses can only be treated as a variable cost item prior to the time in which it
is placed in the ground. Once the item has been used, it is sometimes called a sunk, or
unrecoverable, cost, in that a farmer cannot decide to sell seed and fertilizers already used and
recover the purchase price.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Although depreciation on farm machinery is normally treated as a fixed cost, given sufficient
time, the farmer does have the option of selling the machinery so that the depreciation would
no longer be incurred. Payments for the purchase of land would not be made if the farmer
elected to sell the land. The categorization of farm labor is very difficult. A farm laborer on an
annual salary might be treated as a fixed cost which the farmer incurs whether or not
production takes place. But if the laborer is laid off, the cost is no longer fixed. Temporary
workers hired on an hourly basis might be more easily categorized as a variable cost.

Over a very short period of time, perhaps during a few weeks within a single production
season, a farmer might not be able to make any adjustment in the amounts of any of the inputs
being used. For this length of time, all costs could be treated as fixed. Thus the categorization
of each input as a fixed- or variable-cost item cannot be made without explicit reference to the
particular period involved. A distinction between fixed and variable costs has thus been made
on the basis of the period involved, with the proportion of fixed to variable costs increasing
as the length of time is shortened, and declining as the length of time increases.

Some economists define the long run as a period of time of sufficient length such that the size
of plant (in the case of farming, the farm) can be altered. Production takes place on a short-run
average cost curve (SRAC) that is U shaped, with the manager equating marginal revenue (the
price of the output in the purely competitive model) with short-run marginal cost (SRMC).
There exists a series of short-run marginal and average cost curves corresponding to the size
of the particular plant (farm). Given sufficient time, the size of the plant can be altered.
Farmers can buy and sell land, machinery, and equipment. Long -run average cost (LRAC)
can be derived by drawing an envelope curve which comes tangent to each short run average
cost curve (Figure 6.2).
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Figure 6.2 Short and Long-Run Average and Marginal Cost with Envelope Long-Run
Average Cost

Variable costs are normally expressed per unit of output(y) rather than per unit of input(x).
This is because there is usually more than one variable cost item involved in the production of
agricultural commodities. A general expression for a variable cost function is:
VC=g(y)
Since fixed costs do not vary with output, fixed costs are equal to some constant money value k; that
is: FC=k
Total costs (TC) are the sum of fixed plus variable costs.
TC=VC + FC or,
TC= g(y) + k
Average variable cost (AVC) is the variable cost per unit of output
AVC = VC/y = g(y)/y
Average fixed cost is equal to fixed cost per unit of output
AFC = FC/y = k/y
There are two ways to obtain average cost (AC), sometimes also called average total cost
(ATC). One way is to divide total cost (TC) by output (y)
AC=ATC=TC/y
Another way is to sum average variable cost (AVC) and average fixed cost (AFC)
AC=ATC=AVC + AFC
AC=ATC=VC/y +FC/y
Marginal cost is defined as the change in total cost, or total variable cost, resulting from an
incremental change in output.
MC = ΔTC/Δy = ΔVC/Δy
Since the value for fixed costs (FC) is a constant k, MC will be the same irrespective of
whether it is based on total costs or total variable cost.

Continuous Assessment
Quiz, test and Assignment
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

Summary
A firm’s costs reflect its production process. A typical firm’s production function gets flatter
as the quantity of an input increases, displaying the property of diminishing marginal product.
As a result, a firm’s total-cost curve gets steeper as the quantity produced rises. A firm’s total
costs can be divided between fixed costs and variable costs. Fixed costs are costs that do not
change when the firm alters the quantity of output produced. Variable costs are costs that
change when the firm alters the quantity of output produced. A firm’s costs often depend on
the time horizon considered. In particular, many costs are fixed in the short run but variable in
the long run.

Risk and Uncertainty in Agriculture (3 Hours)

Pre-test questions
- What is risk and uncertainty mean?
- Do you think there is similarity between the two terms?
- Can you mention the impact of risk in farming activity?
Farmers must make decisions on crops to be planted, seeding rates, fertilizer levels and other
input levels early in the cropping season. The crop yield obtained as a result of these decisions
will not be known with certainty for several months or even several years in the case of
perennial crops. Changes in weather, prices and other factors between the time the decision is
made and the final outcome is known can make previously good decision very bad.
Because of time lag in agricultural production and our inability to predict the future
accurately, there are varying amounts of risk and uncertainty in all farm management
decisions. If everything was known with certainty, decision would be relatively easy.
However, in the real world more successful managers are the ones with the ability to make the
best possible decisions, and courage to make them when surrounded by risk and uncertainty.

Biological nature of farm enterprise entails some uncertainties in their production and prices
in addition to uncertainties related to availability of inputs. Some of them are measurable in
their parameters of probability, yet others are more or less random phenomena that cannot be
estimated with any acceptable degree of accuracy. The first category uncertainties lead to the
business risks that can be, to a considerable extent, provided for either through adjustments in
the production programs and resource use planning or through hedging, forward contracts,
insurances, etc. The latter category cannot be treated as calculable risks and are not amenable
to programs of production or resource use adjustments. How these risks and uncertainties are
accounted for in the production programs of the farmers is the central objective of this
chapter. Discussion here center around i) how do the farmers in their normative production
programs account for estimable uncertainties (risks) of price fluctuations and yield
(production) variability of farm products, and ii) how do they provide for uncertainties on the
availability of factor inputs.
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Definitions
Risk is a situation in which all possible outcomes (results) of an activity are not certain (not
known), but the probabilities of alternative outcomes (results) are known or can be estimated.
Example, if a farmer know that his maize crop is likely to fail in one of the four years of
consecutive production period by 25% then this is a risk because even if he doesn’t know the
exact year he is expecting failure in one the four years of production period.

Uncertainty is a situation where all possible outcomes and the probability of the outcomes
are unknown or neither the outcome nor the probability are known . Uncertainty is not
insurable. It is a situation where an action has got a set of possible outcomes the probability of
which is completely unknown. For example, no one can assign probability to how many times
he will fall sick within a year. Farmer normally calculates his labor requirements on the
ground that his workers will be healthy throughout the year and that each labor will supply at
least eight working hours per day. Similarly, no one can precisely predict when he is going to
die. Farm manager may project his activity for the whole year and he may not reach the end of
that year before he dies. Any situation where one cannot predict what can happen is normally
regarded as uncertain situation.
Types of risk and uncertainty in agriculture
The more common sources of risk can be summarized into the general types as: production
risk, marketing risk, financial risk and technological risk

Production or yield risk: refers to the unpredictable impact of climate, crop and livestock
diseases and pests, and other natural and manmade calamities on outcome (output).
Price or marketing risk: are risk associated with the variability of output of price and its
effect on the farm income. Commodity prices vary from year to year and may have substantial
seasonal variation within a year.
Financial risk: a risk incurred when money is borrowed to finance the operation of the
business. That is, any time money is borrowed there is some chance that future income will
not be sufficient to repay the debt without using equity capital.
Technological risk: Another source of production risk is new technology. Will the new
technology perform as expected? Will it actually reduce costs and increase yields? These
questions must be answered before adopting new technology.
Probability and Expectations
To make decision in a risky world, a manager needs to understand how to form expected
value, how to use probability (chances of occurrence), and how to analyze the variability
associated with the potential outcome.
Forming expected values: The major methods used to form expected values are:
 Average (simple and weighted average)
 Most likely method
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

 Mathematical expectation
Average (simple average)
Consider the following price over years for maize
Table 11: Annual maize price variation
Year Average of annual price
4 years ago 2.50
3 years ago 3.05
2 years ago 2.00
Last year 4.50
Summation 12.05
Average (expected value) = 12.05/4 = 3.01
Weighted average
This method usually weights the more recent values heavier than the older using some
predetermined weighing system on the basis of the decision maker’s experience, judgment
and performance. Example, using weighted averages to form expected value:
Table 12: Annual maize price variation with weight
Year Average annual price Weight price Result price times weight
4 years ago 2.50 1 2.50
3 years ago 3.05 2 6.10
2 years ago 2.00 3 6.00
Last year 4.50 4 18.00
Total 10 32.60
Weighted average 32.60/10 = 3.26
Most likely method
By this method, an expectation is formed by choosing the value most likely to occur (this is
the value that is relatively sure to occur). This procedure requires knowledge of the
probability associated with each possible outcome. The outcome with the highest probability
would be selected on the likely to occur.
Table 13: Possible maize yield with probability
Year Possible maize yield (qt/ha) over 4 years Probability
Year 1 15 0.1
Year 2 18 0.3
Year 3 25 0.4
Year 4 30 0.2
Total 1.00

Four possible maize yields are shown along with probability of obtaining each yield. Using
the most likely method to from an expectation, a yield of 25 quintal per ha will be selected as
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

this yield has the highest probability and is therefore the most likely to occur. However, there
is no assurance that this yield will occur in any given year but it will occur 40% of the time
over a long period.
Mathematical expectation
When either the true or subjective probability of the expected outcome is available it is
possible to calculate the mathematical expectation of yield, price, cost, income or profit. It is
given as:
E(Y) = ∑(Y1P1 + Y2P2 + Y3P3 + ….+ YnPn)
Where E(Y) is the expected yield
Y1, Y2,…, Yn are the yield under the various states of nature (wet, dry and normal
years)
P1, P2, P3,…, Pn are the respective probability of the state of nature.
Example: Let’s assume that there are three states of nature based on past experience viz., wet,
dry and normal. The probabilities of occurrence of these conditions are 0.2, 0.3 and 0.5,
respectively. Consider maize and sorghum yield in the three states of nature as in the
following table:
Table 14: Expected maize yield with varying state of nature
State of Nature Expected yield
Crop Wet years Normal years Dry years
Maize 35 25 15 24
Sorghum 15 25 20 22

The expected yield for maize is:

E(Y) = (0.2*35) + (0.5*25) + (0.5*15) = 24
The expected yield for sorghum is:
E(Y) = (0.2*20) + (0.5*30) + (0.3*30) = 22
Finally the values 24 and 22 quintals are used for planning purpose.
Decision making under risk
There are several elements or components to any decision involving risk. Here three of them
are considered.
There are alternative decisions or strategies available to the decision maker;
There are possible events that can occur, such as variation in weather and variation in price
and these factors create the risk because the actual outcome is not known at the time the
decision must be made; and
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The consequences or result of each strategy (decision) for each possible outcome (event) may
be expressed as yield, net returns or some appropriate value.
Example: Consider a fattening program or plan
Assume that a farmer plants alfalfa feed in a given hectare of land in the winter
Oxen are purchased in winter and graze on the alfalfa and sold in the spring
All oxen must be purchased and sold after fattening
Now the farmer’s problem is on deciding how many oxen to purchase. That is:
If too few oxen are purchased and the weather is good there will be excess grazing available
and opportunity for additional profit is given up.
If too many oxen are purchased and the weather is poor, there will be insufficient forage, so
that feed may have to be purchased and profit is reduced or a loss is incurred.
Let’s further assume that the farmer has decided on three choices: purchase 30, 40 or 50 oxen.
These choices are the decision strategies and the weather can be good, average and poor with
probability of 0.2, 0.5 and 0.3, respectively.

The same three weather outcomes are possible for each of the possible strategies. This creates
nine potential consequences or results to be considered and it is helpful to organize this
information with decision tree or with pay off-matrix.
Decision tree (a diagram that traces out all possible strategies/acts), potential outcome (events
and possibility) and their consequences; and is illustrated as follow:
Table 15: Decision strategies with varying state of nature for oxen fattening program
Strategy Weather outcome Probability Net returns Expected Value
Good 0.2 6000
Buy 30 Average 0.5 4000 3800
Poor 0.3 2000
Good 0.2 5800
Buy 40 Average 0.5 5600 4160
Poor 0.3 0
Good 0.2 8000
Buy 50 Average 0.5 6000 4000
Poor 0.3 2000

The expected values are the summation of the net return weighted by their probability
(example, for the buy 30, the expected value is (0.2*600) + (0.5*400) + (0.3*200) = 3800
birr).
Pay-off matrix: This contains the same information as the decision tree but is organized in
the form of table and is illustrated below.
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Table 16: Pay off matrix for oxen fattening program

Weather outcome Probability Purchase strategy
Buy 30 Buy 40 Buy 50
Good 0.2 6000 6800 800
Average 0.5 4000 5600 6000
Poor 0.3 2000 0 -2000
Minimum Value 2000 0 -2000
Maximum Value 6000 6800 8000
Expected value 3,800 4160 4000
Simple average 4,000 4133 4000

The Decision Rule

The decision rule includes the following: maximin, maximax, maximize expected value and
most likely outcome.
Maximin rule: This rule concentrates on the best possible outcome for each strategy. This
rule says that nature will always do the worst (pessimistic approach). Therefore, the strategy
with the best of the worst possible result is selected, that is, the one with the maximum of the
minimum value is selected. From the above table this rule select “buy 30” strategies as its
minimum on sequence of birr 2000 is higher than the minimum for the “buy 40 and 50”
strategy with the minimum consequence of birr 0 and 2000, respectively.
Maximax rule: This rule is just the opposite of maximum rule. That is, this rule selects the
strategy with the highest maximum value or the maximum of the maximum value. This rule
says nature will always do its best (optimistic approach). According to this rule “buy 50”
strategy will be selected since its maximum value is greater than the maximum value of the
other two strategies.
Maximize expected value: In this rule the decision is made by selecting strategy with the
highest expected value. Accordingly, this rule selects the “buy 40” strategy since it has the
highest expected value.
Most likely outcome rule: By this rule, the outcome that is most likely to occur (one with
highest probability) and then the strategy with the highest consequences for that outcome will
be chosen. Accordingly, the highest probability (0.5) and the corresponding highest
consequence (6000 birr) occur in the “buy 50 strategy”. Therefore, this rule selects “buy 50”
strategy.
The use of the different rules depends on the types of the decision maker’s attitude towards
risk and the existing financial condition of the business. There are 3 types of persons with
regard to their attitude towards risk.
Risk-averse person: Risk avoider person. Usually risk-averse person perform the one that is
sure to get with the highest probability even if the result is low. This person usually prefers to
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use maximin rule for making decision. A person/business with weak financial position mostly
prefers to use this rule.
Risk taker (prefer): This is a person who tries to achieve the maximum output under risk
condition. This person prefers to use maximax rule for decision making. A person/business
with strong financial position mostly prefers to use this rule.
Risk indifferent person: A person who doesn’t care whether risk occur or not. This person
prefers the last two decision rule to make his/her decision.
Methods of Reducing Risk and Uncertainty
The various methods which can be used to reduce risk are discussed hereunder.
Diversification: Production of two or more commodities with negative correlation in their
performance parameters may reduce income variability if all prices and yields vary.
Selection of stable enterprises: Irrigation will provide more stable crop yields than dry land
farming. Production risk can be reduced by careful selection of the enterprises with low yield
variability. This is particularly important in areas of low rainfall and unstable climate.

Crop and livestock insurance: For phenomena, which can be insured, possible magnitude of
loss is lessened through converting the chance of large loss into certain cost through insurance
arrangement.
Flexibility: Diversification is mainly a method of preventing large losses. Flexibility is a
method of preventing the sacrifice of large gains. Flexibility allows for changing plans as time
passes, additional information is obtained and ability to predict the future improves.
Spreading sales: Instead of selling the entire crop output at one time, farmers prefer to sell
part of the output at several times during the year. Spreading sales avoids selling all the crop
output at the lowest price of the year but also prevents selling at the highest price.
Continuous assessment
Quiz, test and assignment will be provided.

Summary
Risk is defined as the situation which exists when the future can be predicted with a specified
degree of probability; while in the case of uncertainty, there is no valid basis for assigning any
kind of probability to the future events. Knowledge can never be perfect so that yields and
prices of inputs and outputs cannot be predicted with accuracy. The farmers, therefore, take
decisions under conditions of risk and uncertainty. Risk can be overcome by different types of
insurance while uncertainty cannot be insured. Certain precautions that can be taken against
uncertainty include diversification, selection of enterprises, insurance, flexibility and
spreading sales. Decision rules that may be used under risk conditions include the maximax
rule, maximin rule, maximize expected value and most likely outcome rule.
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

3.5.3.8 Role of gender in Farm Business and Its Management (3 Hours)

Pre-test
– Does every member of your family participate on decisions of resources use?
– How do you rank the decision making power of all household members in your family
– Mention the types of activities normally accomplished by women and those by men
– What is the basis to separate activities done by men and those by women?
– What is gender?
In many societies farm tasks are often gender specific. For example while males plough the
land, females may sow, or females may be responsible for water fetching, while males cater
for firewood. In farm production the division of labour may be by crop, by field or by task.
Within the domestic sphere, women work for the family not only to ensure its reproduction,
but also its maintenance and survival. Three major areas where gender role matters in farm
business are briefly explained below.
Division of labour in farm production
Tasks in farm production include cultivation, sowing, weeding, fertilizer application, pesticide
application, harvesting, processing, storage and marketing. Males and females play their share
based on the gender role defined by social system and the requirements of specific tasks such
as technical specifications. For instance both may share the tasks on equal basis or each may
focus on some activities leaving others to their counterparts (e.g. Men may go fertilization
application and women may undertake weeding).
Decision-making on farm production
The production process can be broken into five components: choice of crops (cash or food
crop?), time to perform a particular task (e.g. land preparation, sowing or weeding), decision
to adopt an innovation and choice of processing and storage method. The decisions on these
farm production processes can be made by women, men or both depending on the gender role
specified by society which varies from place to place.
Decision making on resource allocation and disposal of produce
Basic farm resources were discussed earlier. A farm family member or groups with final say
determines the allocation and use of resources. The outcome of resource allocation and
produce disposal decision has a direct implication on which field crop to select; task
allocation among household members; decision whether to hire labour; sale of surplus
produce; market choice and Livestock purchase.

In summary, gender among other factors, highly influences the performance of farm business.
Involvement in the decisions on production, labour division and resources allocation drives
the incentive to accomplish farm activities and bear the responsibility for the outcome.
Further, considering gender issues will assist to better direct development projects and thus
realize project goals as efficiently as possible.

Continuous Assessment
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Assignment –students identify specific gender roles in farm business in their locality and
discuss in the class

Natural Resource and Environmental Economics (3 Hours)

Pre-test questions
- Define natural resource economics and environmental economics.
- Mention some services provided by the environment.
- Do you think that property rights have roles in resource use efficiency?
Concepts and Definitions of Natural Resource and Environmental Economics
Natural resource and environmental economics emphasizes the links between the economy
and the ecosystem. It adopts a conceptual framework that views the economy as a subsystem
of a finite and nonexpanding ecosystem that imposes biophysical limits on economic growth.
This framework is consistent with the concept of sustainable development and sustainable
resource use. Addressing the interconnections between the economic and ecological spheres
requires that natural and environmental resource issues be approached from a
multidisciplinary perspective. Natural resource and environmental economics is one of the
disciplines in this nexus. Natural resource and environmental economics as a discipline is a
relatively recent theme of Economics.
What is Natural Resource Economics? It is the study of how to best govern scarce natural
resources, especially, such as air, ground water, marine fishery that are common rather than
private properties. The sort of questions and problems to be studied in the area of natural
resources economics include production, markets, management, uses, and abuses of natural
resources such as fisheries, forests, and non-renewable resources extraction.
What is Environmental Economics? It is the study of the impact of the goods and services
produced by economy, particularly market systems of allocation, on environmental quality
and ecological integrity. The sorts of questions to be studied under environmental economics
include: externality, economics of pollution, targets and instruments for their control, and
environmental valuation.
Natural resource and environmental economics, therefore, is the application of the principles
of economics to the study of how environmental and natural resources are developed and
managed.
Important concepts in Natural Resource and Environmental Economics
Efficiency–is in terms of the missed opportunity. If it is possible to avoid wastage and make
some society beneficiary, that resource allocation is said to be inefficient. Example, in the
case of energy inefficiency, technical inefficiency, it is possible to avoid through employing
different techniques in which resource could be saved without hurting the final output. But
economics focus on allocative efficiency. Example it is possible to generate electricity from
fossil coal in a technically efficient way, but it produces pollution waste which costs society
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in terms of health care. If that cost, not paid by the electricity supplier exceed its saving from
producing electricity from coal, then it is economically inefficient. This is due to choice in
resource allocation; it is possible to produce electricity from less polluting resource. The
concern of economics here is to choose the allocation of less polluting resource so that the
society as whole will be better off.
Optimality–is related to efficiency but it is distinct from it. To understand this concept has
the following in mind:
Some society is there;
Some overall objective that this society has, in terms of which we can measure the extent to
which some resource use decision is desirable from that society’s point of view.
So, resource use decision is socially optimal if it maximizes that objective given any relevant
constraints that may be operating. A resource allocation cannot be optimal except it is
efficient. So efficiency is the necessary condition for optimality but not sufficient.
Sustainability–is about taking care of intergenerational equity. Is the optimal allocation of the
resource means sustainable? If it is not, the sustainability should be the constraint for
optimality.
Economy–Environment Interlinkage
Every economic action can have some effect on the environment, and every environmental
change can have an impact in all economic activities. By 'the economy', we refer to the
population of economic agents, the institutions they form (which include firms and
governments) and the interlinkages between agents and institutions, such as markets. By
'environment', we mean the biosphere, the 'thin skin on the earth's surface on which life
exists', the atmosphere, the geosphere (that part of the earth lying below the biosphere) and all
flora and fauna. Our definition of the environment, thus, includes life forms, energy and
material resources, the high and low atmosphere. These constituent parts of the environment
interact with each other. As an example, consider the generation of electricity. In extracting
fossil fuels to use as an energy source, we deplete the stock of such fuels in the geosphere. In
burning these fuels to release their energy, we also release carbon dioxide (CO 2) and sulphur
dioxide (SO2), both of which may produce undesirable environmental impacts that reduce
human (and, therefore, economic) well-being.
The interlinkages between the economy and the environment are summarized in Figure 4.
Here we simplify the economy into two sectors: production and consumption. Exchange of
goods, services and factors of production takes place between these two sectors. The
environment is shown here in two ways: as the three interlinked circles E 1, E2 and E3, and the
all-encompassing boundary labeled, E4. The production sector extracts energy resources (such
as oil) and material resources (such as iron ore) from the environment. These are transformed
into outputs; some useful (good and services supplied to consumers) products and some waste
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products, such as SO2. There is some recycling of resources within the production sector,
shown by the loop R1, and within the consumption sector, as shown by the loop R2.

E4: Global Life-

Support Services

Figure 4: The economy-environment interlinkage

The environment’s first role, then, is it serves as a supplier of resources. Its second role is as a
sink, or receptor, for waste products. These wastes may result directly from production, as
already mentioned, or from consumption: when an individual puts out garbage, or when they
drive to work, they are contributing to this form of waste. In some cases, wastes are
biologically and/or chemically processed by the environment. For example, organic emissions
to an estuary from a distillery are broken down by natural processes-the action of micro-
organisms into their chemical component parts. Whether this results in a harmful effect on the
estuary depends on a number of factors, including the volume of waste relative to the volume
of receiving water, the temperature of the water and its rate of replacement.
For some inputs to the environment, there are no natural processes to transform them into
harmless, or less harmful, substances. Such inputs, which are variously termed 'cumulative'
and 'conservative' pollutants, include metals such as lead and cadmium, and man-made
substances such as PCBs (polychlorinated biphenyls) and DDT (dichloro-diphenyl-trichloro-
ethane). If, in our estuary example, PCBs are discharged into the water, then they will not be
broken down by either chemical processes' (oxidation) or through biological processes by
micro-organisms.
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So far we have seen that the environment acts as a waste sink, as a partial recycling factory
for human wastes from production or consumption and as a source of energy and material
resources. The next role to be considered is that marked E 3 in Figure 4. The environment acts
as a supplier of amenity, educational and spiritual values to society. For example, people in
Europe may derive pleasure from the existence of wild life in tropical moist forests
('rainforests'), while native peoples living in these areas attach spiritual and cultural values to
them, and the flora and fauna therein. We need to make precise the sense in which such values
'count' for economists.
What this simple example shows is that using the environment for one purpose (as a supplier
of material resources) can reduce its ability to supply us with other services, such as the
ability to breath clean air. This is why in Figure 4 the three circles E1, E2 and E3 are shown as
overlapping: there are conflicts in resource use. These conflicts would include the following:
– using a mountain region as a source of minerals means its amenity value is reduced;
– using a river as a waste-disposal unit means its amenity value is reduced and that we
can no longer extract so many material resources (fish to eat) from it;
– felling a forest for its timber reduces the electricity-generating capacity of a dam,
owing to soil erosion, and reduces amenity values since the forest's inhabitants (animal
and human) are displaced or destroyed;
– preserving a wetland for its aesthetic qualities forgoes use of the drained land for
agriculture.
The environment is, thus, a scarce resource, with many conflicting demands placed on it.
Returning to Figure 4, the boundary marked E4 represents the global life-support services
provided by the environment. These include:
– Maintenance of an atmospheric composition suitable for life.
– Maintenance of temperature and climate.
– Recycling of water and nutrients.
Property Rights and Externalities
Markets and efficient property rights markets
While it is possible to achieve efficient resource use without reliance on markets, the
informational and computational requirements are very high. An alternative to a market
economy is a centrally planned economy. A centrally planned economy is a form of economic
organization in which decisions regarding what to produce, how much to produce, where to
produce, how to distribute production, and the level of resource and commodity prices are
determined by government units. Efficient use of resources in a centrally planned economy
requires information on input requirements and output possibilities of alternative production
technologies for all locations and points in time; consumers’ willingness to pay for all
commodities over time and space; and transportation, marketing and distribution requirements
and costs. Based on this information, the government units have to determine the production,
consumption and prices for all resources and commodities for all regions and time periods.
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Therefore, a centrally planned economy requires the orchestration of, literally, thousands of
economic decisions.

Purely competitive markets automatically achieve efficient resource use through the
independent profit-maximizing behavior of firms and the independent utility-maximizing
behavior of households, provided there exists an efficient set of property rights. Property
rights are institutional rules that govern and facilitate the use and exchange of resources and
commodities. Efficient property rights are a prerequisite for market transactions.
Market equilibrium price and quantities are influenced by the specification of property rights.
This is illustrated in Figure 5, which shows the market demand and supply curves for an
agricultural crop under pure competition. Under pure competition a) there is a large number of
producers and consumers; b) no single producer or consumer can influence the price received
or paid for the product; and c) there is no uncertainty regarding production technologies,
consumer preferences and prices. In Figure 5, D is the market demand curve. It has a negative
slope because buyers are willing to purchase additional units of the crop as the price of the
crop decreases, other things equal. Marginal cost (MC) is the market supply curve that is the
sum of the marginal cost curves above average variable costs for all firms producing the crop.
It is positively sloped because sellers are willing to sell more of the crop as the price
increases. The profit maximizing level of crop production is where P r = MC or is also
known as the privately efficient level of production.

Figure 5: Market Equilibrium

Privately efficient crop production (Qr) and price (Pr), and socially efficient crop
production (Qs) and price (Ps,), in a purely competitive market, D = demand; MC =
marginal cost; and MSC = marginal social.
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In selecting the profit maximizing output, firms typically do not consider environmental
damages caused by production. For example, runoff from agricultural fields carries sediment,
fertilizers and pesticides to nearby streams and lakes, which can result in water pollution.
Marginal cost excludes damages caused by water pollution. Adding the marginal
environmental damages from crop production to MC gives the marginal social cost (MSC) of
crop production. The socially efficient level of crop production is Qs where Ps = MSC.
When farmers have a right to pollute water, they ignore the environmental damages from crop
production and select the privately efficient level of crop production, which is Qr. Because
MSC > MC, Qs < Qr and Ps > Pr, production and pollution are higher and prices are lower when
producers have the right to pollute water. When producers do not have the right to pollute
water, society has the right to take action to reduce pollution damages. Suppose this action is
in the form of a tax on production. Imposition of the tax causes the MC curve to shift upward
by the amount of the tax. An increase in MC causes the profit maximizing production level to
decrease. If the tax equals the difference between MSC and MC, then the market achieves
equilibrium where P = MSC and the privately efficient level of production equals the socially
efficient level of production.
Efficient Property Rights
Property rights are efficient if they satisfy four basic properties: ownership, specificity,
transferability and enforceability. Ownership is the legal mechanism for conveying property
rights to a resource. It determines who has the legal right to use a resource. In cases where
resources are privately owned, ownership is secured by payment in an amount that is mutually
agreeable to buyer and seller. Several types of ownership are possible. At one extreme is
exclusive ownership, which is the most restrictive form of ownership. Exclusive ownership of
a resource requires that all benefits and costs associated with the ownership and use of the
resource be borne by the owner. Suppose odor from a paper mill pollutes the air in a nearby
community. If the cost of air pollution is not considered by the paper mill, then, owner
exclusivity is violated. Exclusive ownership allows the resource owner to let another party use
the resource through different mechanisms like leasing. At the other extreme of the ownership
spectrum is res nullius which means that the property belongs to no one. While exclusive
ownership allows the resource to be bought and sold, res nullius prevents it. Another form of
ownership is res communis, which refers to common or communal property that is owned
and/or managed by a group of kindred individuals, such as a tribe or clan.
Specificity of property rights refers to the bundle of rights that apply to a particular property. It
determines what can and cannot be done with the resource. Consider what happens when the
cattle owned by a rancher graze on a neighbor's land, causing damages to the land. The
neighbor's property rights are being violated if the rancher does not have permission to graze
cattle on the neighbor's land. Under this specification of property rights (lack of permission to
graze), the rancher is legally required to keep the cattle off the neighbor's land. If the
neighbor's land is designated as open range, however, then the rancher has a right to graze
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

cattle on the neighbor's land. Under this specification of property rights, the only feasible way
to keep the cattle off the neighbor's land is for the neighbor to install fencing, which is costly.
If cattle grazing are not covered by a property right, then a conflict is likely to arise between
the rancher and the neighbor. Resource conflicts can be resolved when the rights of the
rancher and the neighbor are completely specified.
An efficient property right is transferable, which allows resources to be allocated to their
highest valued use. Transferability of one or more elements in a bundle of property rights
makes possible the leasing of private land, creation of utility easements and the existence of
restrictive covenants.
Ownership, specificity and transferability of property rights are of limited value in achieving
efficient resource use without enforceability. Enforceability requires that the property right be
enforceable and enforced when there is a violation. A right that is not enforceable is of little
value.
Even when enforceability is feasible, violations can occur. Two types of violations are
possible: unintentional and intentional. An unintentional violation is one that occurs even
though best management practices are being followed. Phosphorus pollution of the lake by
nearby farms is likely to occur when there is a heavy rain on the day following application of
manure. This type of pollution is unintentional. Pollution of the lake by industrial sources
would be intentional when the industry knowingly releases an amount of phosphorus to the
lake that exceeds the standard. Industrial sources might risk paying the fine when the expected
penalty (probability of a being caught times the amount of the fine) is less than the expected
benefit of exceeding the standard (reduction in phosphorus disposal costs).
Transaction Costs
While establishment of efficient property rights is a necessary condition for efficient resource
use under pure competition, it is not costless. The costs of achieving efficient property rights
are called transaction costs. Transaction costs are usually small when only a few individuals
are involved and the conflict is minor. However, transaction costs can be high when many
parties are involved.
Resolving resource conflicts constitutes a major perennial transaction cost. Examples of
resource conflicts in the Ethiopia include competition between agricultural, access to and/or
use of public lands for grazing, timber harvesting, water supplies, recreation and endangered
species; encroachment of prime agricultural areas by urban development and others. On a
global scale, resource conflicts are caused by global warming, deforestation, ozone depletion
and loss of biological diversity. Finally, enforcement of property rights entails major costs.
Market Failure
There are three conditions under which operation of markets fails to achieve efficient resource
use:
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

– The market is not purely competitive.

– The resource is a common property or open access resource.
– There are externalities.
Each of these conditions constitutes a market failure. The failure does not mean there is
something moral1y or ethical1y wrong with the market. Rather, it implies that the prices
generated in the market do not provide firms and households with the incentives needed to
achieve social1y efficient resource use.
Common Property and Open Access Resources
Natural resources can be managed as common property or open access resources. Common
property resources are resources that are owned in common and managed for a common
purpose. Owners have exclusive rights to the property but cannot exclude one another from
using it. There may or may not be restrictions on how frequently owners may use the
resource. If frequency of use is not restricted, as in a city park, then the resource tends to be
overexploited, which results in Garrett Hardin's tragedy of the common. If frequency of use
by owners is restricted like the tribal grazing lands in African countries, overexploitation can
be avoided. Open access resources are not owned by anyone (res nullius). Thus, it is not
practical to exclude others from using them, and there is generally no incentive for an
individual to limit his or her use of the resource. An example of an open access resource is the
ocean fisheries.
Externalities
Of the three sources of market failure just described, externalities have received the most
attention in natural resource and environmental economics. An externality exists when the
activities of an acting party influence the welfare of an affected party and the acting party
does not consider how its activities affect the welfare of the affected party. The acting party is
the party engaged in the activity responsible for the externality, and the affected party is the
party whose welfare is influenced by the externality. The acting and affected party can be a
household or a firm. Hence, externalities can take place between firms, between households,
and between households and firms. If the acting party engages in an activity for the sole
purpose of harming or benefiting the affected party, then the activity does not constitute a true
externality.
Continuous assessment
Quiz and test will be provided.
Summary
Economic activity takes place within and is part of the economy and the environment which
involves the earth and its atmosphere. The services that environment provides include: serving
as a resource base, as a waste sink, Amenity service and life supporting function. Market-
based economies can automatically achieve socially efficient resource use through the
independent actions of consumers and producers. Markets do not function properly without
FARM MANAGEMENT AND ENTREPRENEURSHIP: FARM MANAGEMENT

efficient property rights. Such rights have four major attributes: exclusivity, specificity,
transferability and enforceability. Exclusivity allows the resource owner to exclude others
from using the resource. Specificity refers to the bundle of rights associated with a particular
property. Transferability allows property rights to be conveyed to another party.
Enforceability implies that property right infringements can be determined and violators can
be prosecuted. Transaction costs refer to the time and money costs of establishing property
rights. An externality occurs when the actions of an acting party have an adverse or beneficial
effect on the welfare of an affected party.

Major References
Cramer, G.L.; Jensen, C.W.; and Southgate, D.D. (1997) Agricultural Economics and
Agribusiness (7th edition). John Willy & Sons inc. New York
Halcrow, G. (1981) Eoconomics of Agriculture, International Student Edition. McGraw-Hill
international Book Company
Ronald D. Kay and William M. Edwards, 1999. Farm Management (4th edition).
WCB/McGraw Hill.
Tony Prato, 1998. Natural Resource and Environmetal Economics. Iowa State University
Press, Ames, USA.
V.T. Raju, & D.V.S. Rao (1990), Economics of Farm Production and Management, Oxiford
& IBH publishing co., New Delhi, India