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Agricultural Economics

Lecture 2

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Agricultural Economics, 3th edition By H. Evan Drummond and John W. Goodwin

© 2011, 2004 Pearson Higher Education, Inc.© 2011, 2004 Pearson Higher Education, Inc.Pearson Prentice Hall - Upper Saddle River, NJ 07458Pearson Prentice Hall - Upper Saddle River, NJ 07458

Introduction to Agricultural EconomicsIntroduction to Agricultural Economics

• Agricultural economics surveys agriculture and the food industry in its many facets and forms.

• The agricultural economist is concerned with the entire food and fiber system.– From inputs used, all the way through the production,

processing, distribution, and consumption chain.• Study of agricultural economics covers much more

than just the activities of farmers or ranchers.– Some economists deal with issues of resource

conservation, pollution control, and water management.– Others study the agribusiness sector as purchasers,

processors, and distributors of food and fiber products.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsAGRICULTURAL ECONOMICS AGRICULTURAL ECONOMICS • The objective of any scientific inquiry is to…

– Observe & describe a particular range of phenomena.– Organize those observations into recognizable patterns.– Formulate “laws” where sufficient regularity warrants.

• The laws give scientist a basis on which to make predictions.

• Economics is a social science, and social scientists must deal with the laws of human nature.– As humans are not consistent in their behavior, the laws

of the social scientist are less reliable & more open to exception than those of physical or biological scientists.

– Nevertheless, economic behavior of most persons is generally consistent, and thus, predictable to a degree.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsAGRICULTURAL ECONOMICS AGRICULTURAL ECONOMICS • Economics is that particular social science that

deals with the allocation of scarce resources among an unlimited number of competing alternative uses.

• The word “resources” describes anything tangible:– Wheat, barbed wire, hamburgers, water, labor, clean air.

• Every resource is relatively scarce, meaning the availability of every resource is insufficient tosatisfy all of its potential users.

• Scarcity creates the need for a system to allocate the available resource among some of those potential users.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsAGRICULTURAL ECONOMICS AGRICULTURAL ECONOMICS • Agricultural economics is the social science that

deals with the allocation of scarce resources among competing alternative uses found in the production, processing, distribution, and consumption of food and fiber.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsBASIS FOR ECONOMICS BASIS FOR ECONOMICS • The study of economics rests on three foundations:

– Self-interest, scarcity, and choice.

• Without scarcity, there would be no need foran allocation system.

• Choice is important, because without choicesthere is no decision to be made.– Since economics is about decision making & allocation,

without choices there would be no need for economics.

• Self-interest is what drives the consumer to seek more “stuff ” at a lower price.– It also drives the producer to produce as efficiently as

possible—all economic activity is driven by self-interest.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsBASIC ECONOMIC DECISIONS - Five IssuesBASIC ECONOMIC DECISIONS - Five Issues• Every economic system must resolve five basic

issues:– What to produce.– How to produce it.– How much to produce.– When to produce.– For whom to produce.

• These basic questions must be answered in eachsociety—they simply cannot be avoided.– Institutional & political systems of each society determine

the manner in which these decisions will be made.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsECONOMIC SYSTEMS ECONOMIC SYSTEMS • At one extreme of possible allocation mechanisms

lies the free market or price system.– Each individual producer and consumer, restricted only

by financial resources, is free to choose what, how,how much, and when to produce or consume.

• Financial resources of each consumer resolves the“for whom” question.

• At the other extreme is the command system.– All decisions are made by a central planning agency

or other administrative individual such as an absolute dictator or tribal chief.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsECONOMIC SYSTEMS - Price System ECONOMIC SYSTEMS - Price System • An advantage of the price system is consumer

sovereignty and freedom in economic decisions.– The price system is a very efficient mechanism for the

“what,” “how,” “how much,”& “when” decisions.• Its does have shortcomings, which even its most

ardent supporters recognize.– In a price system, the old adage, that the “rich get richer

and the poor get poorer,” has some validity.– There are a number of resources that a price system

cannot efficiently allocate.• Frequently called public or nonmarket goods, these

include education, national defense, and fire protection.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsECONOMIC SYSTEMS - Command System ECONOMIC SYSTEMS - Command System • Advantages of a command system are that it is

very effective in allocating public goods.– And can be quite egalitarian in “for whom” decisions.

• Disadvantages of such an allocation system are loss of individual freedom in economic decisions.– And inherent inefficiencies of central planning agencies.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsBASIC SKILLS OF AGRICULTURAL ECONOMISTSBASIC SKILLS OF AGRICULTURAL ECONOMISTS• The study of agricultural economics provides the

student with an opportunity to explore phenomena common to everyday life from the perspective of an analytical scientist.

• The role of the economist is to devise rules for making decisions in an ever-changing, uncertain economic environment.– These rules can be used to make production,

consumption, marketing, and financial decisions.

• Studying logic of these managerial rules, a student can learn to adjust decisions to changing environments in which economic activity occurs.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsEconomic ModelsEconomic Models• It is impossible for economists to explain, much

less predict all behavior—different people act differently.– As a general rule, people act in similar, predictable ways.

• An expected pattern of economic behavior is called an economic model.– The basic building block in the logic of the economist.• A model usually will include…– Some assumptions about human behavior.– Other assumptions about the institutional environment

in which a particular form of human behavior takes place.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsEconomic ModelsEconomic Models• The economist uses the model to attempt to

describe appropriate economic behavior.– Leading to the eventual achievement of some goal.

• A frequently used economic model is the “perfectly competitive firm,” with a number of assumptions about the firm & the its operating environment.– The assumption is made that the firm is so small relative

to the market that its actions will not affect the market.– Also that the firm manager attempts to maximize profits

given a particular resource endowment.

• Are the assumptions valid? • If not the results may not be appropriate.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsEconomic ModelsEconomic Models• At best, economic models approximate reality in a

manner that enhances our ability to conceptualize and simplify the real world we are examining.– Models provide the economist with an internally

consistent mechanism for conceptualizing problems.– They force the economist to reason in a systematic,

deductive manner.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsCeteris Paribus Ceteris Paribus • Ceteris paribus is a Latin phrase that roughly

translates to “everything else being equal.” – Generally any economic principle is valid only

when all other external factors remain the same.

• Use of ceteris paribus gives economics much ofthe logical rigor required in a scientific inquiry.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsOpportunity Cost Opportunity Cost • A powerful economics concept is opportunity cost.• All economic resources have value.

– Value is sometimes determined in a marketplace where the user of a resource pays the prevailing price for theuse of the resource.

– Other times, resources have economic value, butthose resources are not purchased in the open market.

• In the latter case, economists use the principle of opportunity cost to determine the economic valueof a resource.– Though there is no manifest market price of that resource.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsOpportunity Cost Opportunity Cost • Opportunity costs cannot be measured directly.

– They can only be estimated indirectly.

• The study of economics is all about economic values—costs and returns.– When available, we use market prices to determine

economic value.– When market prices are not available, we use the

concept of opportunity cost to estimate those values.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsDiminishing ReturnsDiminishing Returns• In the economics of production and consumption,

the concept of diminishing returns is central tothe process of economizing.

• The basic idea of diminishing returns is that as you increase the amount of something, ceteris paribuswill eventually increase at a decreasing rate.– Diminishing returns.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsDiminishing ReturnsDiminishing Returns• The idea of diminishing returns is expressed in

the “law of diminishing marginal utility.” – Marginal utility refers to the additional utility or

satisfaction associated with one additional unit of a good beingconsumed—ceteris paribus.

• What this law says is that the amount of total utility gained from consuming a good eventually increases at a decreasing rate.– Assuming consumption of everything else stays constant.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsMarginalityMarginality• One of the greatest contributions of economics is

the concept of marginality.– In economics, the term marginal refers to an additional

or an incremental unit of something.

• Most economic analyses deal not with the marginal value of production or consumption.– It is on the margin where economic decisions are made.

• As the consumer consumes additional units of a good, ceteris paribus, additional satisfaction orutility obtained by each unit decreases.– At any given consumption level, economists focus

on the economics of the marginal or additional unit.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsMarginalityMarginality• The relevant economic question of the consumer

should be…– Is the marginal utility associated with one additional unit

greater than the marginal cost of acquiring that unit? • Regardless of current level of satisfaction or utility,

if the marginal utility is greater than the marginal cost, the consumer can increase total utility by consuming the marginal unit.– The same basic principle applies to production as well

• As additional units of fertilizer are applied to agiven amount of land, ceteris paribus.– Incremental or marginal returns to that fertilizer decline.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsMarginalityMarginality• Using marginal analyses, we are able to determine

economic optimizing behavior.– Ignoring total costs or returns & concentrating on

marginal costs and returns, we are able to focuson the economizing process.

• From the economist’s perspective, everything happens on the margin.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsFACTS, BELIEFS, AND VALUES FACTS, BELIEFS, AND VALUES • Since economics inevitably must deal with the value system of

individuals and society, it is important to distinguish among facts, beliefs,and values.

Facts are what we know to be the case.Beliefs are what we think to be the case.

Values are what we think should be the case.

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Introduction to Agricultural EconomicsIntroduction to Agricultural EconomicsFACTS, BELIEFS, AND VALUES FACTS, BELIEFS, AND VALUES • As a social scientist, the agricultural economist studies

man’s behavior as producer and consumer. – With words to describe the behavior/environment taken from

everyday language.