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What to Produce

A firm can produce a variety of products or output from its inputs; which products should the firm produce from its inputs or economic resources?

What product should the business produce (product-product)

.

A third decision for a manager is what should the business produce when it has several alternative products to consider.

The assumption is that the inputs can be used to produce several different products or output. The manager's decision then is which of these products should be produced with the variable input. Similar to the assumptions underlying the discussions of "how much to produce" and "how to produce," it is assumed the manager wants to produce a combination of outputs or products that maximizes profit.

  • Example:  A farmer raises livestock and produces crop but does not have quite enough labor to do both to the fullest capacity. The question then is whether the farmer should forsake some livestock production to produce more crop, or should the farmer forsake some crop production to raise more livestock.

Economic theory indicates that the business should produce the combination of products so

MPPy1/Py1 = MPPy2/Py2 or

MPPy1/MPPy2 = Py2/Py1

The assumptions underlying this economic rule include

  • one input (X) can be used to produce more than one product (e.g., y1 and y2);
  • there is a limited quantity of X available to the business;
  • the quantity of each product that will be produced by using one more unit of input will differ (i.e., MPPy1 will not equal MPPy2),
  • the market price of the outputs will differ (Py1 will not equal Py2), and
  • the cost of one unit of X will be the same regardless of which product is being produced.

Accordingly, when the ratio between the amount of y1 that can be produced from a unit of X and the Py1 (MPPy1/Py1) is equal to the ratio between the amount of y2 that can be produced from a unit of X and the Py2 (MPPy2/Py2), the business is producing the combination of the two products that maximize profit.

  • If the ratio for one product is greater than the ratio of the other product, the business would increase it profit by shifting more of the input to produce the product with the higher ratio. The manager would continue to shift the use of X between the two products until the ratios are equal.

 

An Example of Deciding “What to Produce”

The question that needs to be answered (the decision that needs to be made) is what outputs or products should a business produce.  The following example uses a simple example from production agriculture.

A farmer has $200 to invest in raising three crops.  This $200 can be used for wheat, soybean, or corn, fro example.  The farmer mentally divides the $200 of capital into $10 units (thus the farmer has 20 units of capital to allocate among the three crops/products).  The question is which crops should the farmer grow?

To answer this question, the farmer will apply the concepts of Marginal Input Cost (MIC) and Marginal Value Product MVP for each input.  In this case, the MIC is $10 for each unit of capital.  The MVPs for the crops are summarized in the following table.

Each column reflects the production function for that particular crop/product.

Unit of Capital 

MIC per unit of Capital

MVP for Crop A

MVP for Crop B

MVP for Crop C

1

$10

$24

$22

$19

2

$10

$21

$20

$18

3

$10

$17

$18

$17

4

$10

$12

$16

$16

5

$10

$6

$15

$15

6

$10

$0

$12

$14

7

$10

 

$9

$12

8

$10

 

$6

$10

9

$10

 

 

$8

10

$10

 

 

$5

11

$10

 

 

 

12

$10

 

 

 

Decision rule:  use the input to produce the product with the greatest MVP as long as the MVP exceeds the MIC.

The following table indicates which product will be produced with each unit of input.

Unit of Capital

Where is it used?

1

Crop A with MVP of $24

2

Crop B with MVP of $22

3

Crop A with MVP of $21

4

Crop B with MVP of $20

5

Crop C with MVP of $19

6 & 7

Crop B or C with MVP of $18

8 & 9

Crop A or C with MVP of $17

10 & 11

Crop B or C with MVP of $16

12 & 13

Crop B or C with MVP of $15

14

Crop C with MVP of $14

15, 16 & 17

Any Crop with MVP of $12

18

Crop C with MVP of $10

19

None of these crops because MIC is greater than any available MVP; invest remaining capital in other enterprises

20

Same as above

In this example, four units of capital went to Crop A, 6 units went to Crop B, eight units went to Crop C, and two units were used in another enterprise.  If the farmer had only $120 (12 units of capital), Crop A would receive 3 units, Crop B would receive 4 units, Crop C would receive four units, and the last unit could be used for EITHER Crop B or C because both crops offer the same MVP of $15.

 

Managers also may want to consider the economic theory that explains deciding how much to produce and how to produce.

The next page provides a summary and suggests some implications for managers.

 

 

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