• It solves the problems of how much to produce ?
• It guides in the determination of optimum input to use and optimum output to produce.
• It explains the one of the basic production relationships viz., factor- product relationship.

Most Profitable level of production

(a) How much input to use.:

• Given a goal of maximizing profit, the farmer must select from all possible input levels, the one which will result in the greatest profit.
• To determine the optimum input to use, we apply two marginal concepts viz: Marginal Value Product and Marginal Factor Cost.

i) Marginal Value Product (MVP): It is the additional income received from using an additional unit of input. It is calculated by using the following equation. Marginal Value Product = Δ Total Value Product/Δ input level

MVP = ΔY. P y/Δ X

Δ = Change

Y =Output and Py = Price/unit

ii) Marginal Input Cost (MIC) or Marginal Factor Cost (MFC): It is defined as the additional cost associated with the use of an additional unit of input.

Marginal Factor Cost = Δ Total Input Cost/Δ Input level

MFC or MIC = Δ X Px/Δ X = Δ X .Px / Δ x = Px

X input Quantity Px Price per unit of input

MFC is constant and equal to the price per unit of input. This conclusion holds provided the input price does not change with the quantity of input purchased.

Decision Rules

1. If MVP is greater than MIC, additional profit can be made by using more input.
2. If MVP is less than MIC, more profit can be made by using less input.
3. Profit maximizing or optimum input level is at the point where MVP=MFC

Py (Δ Y/Δ X) = P x Δ X/ΔX

Or, Δ Y/Δ X = Px/ P y

(b) How much output to produce (Optimum output):

• To answer this question, requires the introduction of two new marginal concepts.

i) Marginal Revenue (MR): It is defined as the additional income from selling additional unit of output. It is calculated from the following equation:

Marginal Revenue = Change in total revenue / Change in Total Physical Product

MR = Δ TR / Δ Y

MR=Δ Y.Py / Δ Y = P y

Y = output

Py = price per unit of output

Total Revenue is the same as Total Value Product. MR is constant and equal to the price per unit of output.

ii) Marginal Cost (MC): It is defined as the additional cost incurred from producing an additional unit of output. It is computed from the following equation.

Marginal Cost=Change in Total Cost / Change in Total Physical Product

MC=Δ X. P x/Δ Y

X= Quantity of input

Px= Price per unit of input.

Decision Rules:

1. If Marginal Revenue is greater than Marginal Cost, additional profit can be made by producing more output.
2. If Marginal Revenue is less than Marginal Cost, more profits can be made by producing less output.
3. The profit maximizing output level is at the point where MR=MC

Δ Y. P y/Δ Y=Δ X. Px/Δ Y

Or, Δ Y/Δ X= Px/P y