2 EconomicsInternLores PDF

2
Farm management extension guide
ECONOMICS for
farm management extension
by
David Kahan
FOOD AND AGRICULTURE ORGANIZATION OF THE UNITED NATIONS

Rome 2008
First Printed: 2008
Reprint: 2013
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iii
Preface
Whether you are working for government, an NGO or

the private sector, if you are an agricultural extension
worker who is trying to assist farmers in increasing the
profitability of their farms, the material in this booklet
should be of help to you.
It introduces you to some of the concepts and

principles of economics that are relevant to smallholder
farming – particularly market-oriented farming. You will
learn the application of these economic concepts to the
day-to-day farming activities of farmers producing for the
market. You will look at some of the critical areas in which
farmers make decisions about their farm enterprises.
Through this you will gain an insight into the decisions
that farmers make and be better equipped to advise
them on how to become more market-oriented and thus
increase their profits.
This guide has been produced by the Agricultural

Management, Marketing and Finance Service of FAO
(AGSF). It is one of a planned series of guides and
other materials that look at some of the common farm
management challenges facing farmers and ways of
meeting them.
v
Contents
Preface .........................................................................iii
Acknowledgements ......................................................vi
Chapter 1
INTRODUCTION ..........................................................1
Chapter 2
KEY ECONOMIC CONCEPTS ...................................13
Chapter 3
ECONOMICS AND THE MARKET ..............................35
Chapter 4
ECONOMICS AND
FARM MANAGEMENT DECISIONS ..........................53
Chapter 5
SUMMARY .................................................................81
Glossary ......................................................................87
vi
Acknowledgements
The author would like to acknowledge the assistance of

colleagues and friends. Thanks are due to Steve Worth
for his review of the draft guide and to Andrew Shepherd
who reviewed and edited the final version, as well as
to Tom Laughlin, who managed the production process,
Michael Breece, for the design and final layout for
publication, and to Francesca Cabre-Aguilar and Martin
Hilmi for their contributions. Errors and omissions do, of
course, remain the responsibility of the author.
David Kahan
Chapter 1
Introduction
2 Economics for market-oriented farming
A small-scale farmer runs a three hectare farm. She

grows maize, a mix of beans and pumpkins, has two
dairy cows and keeps some chickens around her home.
Her farm has sustained her and her family comfortably
for a number of years. While producing for home
consumption, she has always produced a surplus which
she has sold for cash on the local market. Now that her
An example children are older, she feels the need for more cash.
of a typical She knows that it should be possible to make more
situation money from her farm.
faced by an
agricultural She recently heard on the radio that there had
extension been an increase in the demand for vegetables and
high prices could be obtained. The announcer said that
worker farmers who know how to produce tomatoes may be able
to make good profits. She wants to gain more out of her
farm. Beans have not been very successful and she is
considering introducing tomatoes as an alternative. She
wonders whether this change will increase her income.
To produce for the market will cost her money, which she
will have to pay out before she sells her produce. These
are some of the factors that she will have to take into
account before making a final decision.
If this farmer asked you for advice

about markets, demand, profits and return
on investment in tomato production,
would you be able to answer her questions?
Would you be able to give her good advice
on the management of her farm?
If not, then the contents of this guide
will be of particular use to you.
It begins with a review of farm profits,
markets, farmer goals and economics.
Introduction 3
MAIN POINTS IN CHAPTER 1
Market-oriented farming: Farm

farming for profit production
Farming for profit requires that farmers must match
grow crops or raise livestock market
that can be sold on the market. requirements
Farmers should understand markets ...
what leads to profits and what leads to losses.
Goals for farm and family

Good farm management requires Goals
clear goals.Goals give a focus for making give focus
decisions. Some important goals are to making
food security, profit maximization, risk decisions
reduction and providing education for on the farm
children.These and other goals influence
planning and decision-making on the farm.
Economics in farm management Farm

Economics as it applies to farming resources
is about the choices that are made should be
in order to obtain the most from available, used in the
often limited, farm resources. most effecient
Economics provides ways to analyse manner
and compare the profitability of crops
and livestock under different circumstances.
MARKET-ORIENTED FARMING:
FARMING FOR PROFIT
More and more farming families are finding that they

increasingly need to produce farm products that can be
sold for cash. Farming for profit requires that products
produced on the farm are sold. This is more complicated
than simply farming for food. Farming for profit requires
that the farmers grow crops or raise livestock that they
can sell on the market. It also requires that farmers
understand markets and profits. Market-oriented farmers
need to understand the kinds of products that consumers
want, the quality of the product they must produce, the
Farmers need to quantity demanded and the price that consumers are
acquire new skills willing to pay.
and techniques
in order to
farm for profit We now have a global economy where farm
products may be sold anywhere in the world. These
changes create opportunities for farmers to earn more
money and to make more profits. To take advantage of
these opportunities, farmers will need to manage their
farms in a market-oriented way. Farming for the market
requires that farmers become better decision-makers.
They must also be able to compete with other farmers.
The farmer must develop greater skills in buying and
selling, and in farm business management.
Introduction 5
GOALS FOR FARM AND FAMILY
Goals set the framework and give a focus for making

decisions. Farmers and their families have goals. In Good farm
management
many parts of the world the family household and the requires
family farm cannot be separated. Therefore, the goals of clear goals
the household and the goals of the farm often interlink.
Farmers run their farm business. They are the

decision-makers. A farmer can be a husband, a wife,
a son or a daughter; whoever takes the many day-to-
day decisions needed in farming. To ensure better farm
management decisions, farmers must have control of the
resources needed to produce a crop or livestock product.
If they are farming for the market, they will also need to
have a good understanding of that market.
Some common goals of farm families
Food security
A primary goal for every farm family
Profit maximization
Farm families need more than just food
and any cash needed
must often come from the farm
Risk reduction
Risks can create great losses in income
Social goals
The quality of family life may have a
higher priority than just making money.
Food security
Every family needs to ensure that it has sufficient,
nutritionally adequate and safe food for an active and
healthy life throughout the year. This is one of the primary
goals of every farming family, especially those whose
only source of income is the family farm.
Farmers must decide

what choice to make to ensure
food security for the family
To produce food only for the family

To produce to sell in the market
and buy food with income earned
To produce food for both
the family and to sell
Maximize profits
Farm families need more than just food. They also need
clothes, education for the children, household items and
other goods, all of which require cash. Their main source
For most farmers of cash is usually the farm; therefore they have to make
the main source profits from their farms.
of cash is usually
the farm
To make profits a farmer buys inputs, uses them
on the land to produce goods and then sells the goods in
the market. When the income from the sale of products
is greater than the cost of producing them the farmer
makes a profit. When farming for profit, farmers should
set goals to gain the most out of their farm – to maximize
profits.

Choosing between farming for food and farming
for profit is a very serious decision. How much of the
farm should be used for generating cash? Should the
whole farm be committed to producing for the market or
should some part of it be set aside to provide food for
Introduction 7
© FAO/21560/G.Bizzarri
Food for
the family
Women collecting food for the family – Ecuador comes first ...
... though to
live well the
© FAO/22632/J.Spaull
farm family
also needs to
make money ...
... which may

Selling fruit for family income – Georgia
require farmers
to change
their farming
practices.
Improved watering using a pump – Zimbabwe

the family? Farming for profit can be very risky because

there are many other farmers producing for the market.
This creates competition and requires that the farmer be
very skilful, both as a farmer and as a manager.
Risk reduction
While profit is an important goal, many farmers are more
concerned about reducing risks. Risks come in many
different ways. Rainfall may be scarce or fail, prices
for goods may fall, and pests and diseases may affect
crop yields. These are only some of the many risks that
farmers face.
While profit is
an important goal, The risks of farming can create large differences
reducing risk is in the income that the farm family earns from year to
of major concern year. An important goal among smallholder farmers,
particularly poorer farmers, is just to survive. A wish for
security is a normal motive for all people. Some farmers
see this as a more important goal than making profits. But
the goals of trying to reduce risk and to increase profit do
not have to conflict. Those farmers who generate more
profit are often better able to survive the bad years in
farming when yields and prices are low.
Social goals
Many farmers are more concerned about their quality of
life than they are about making more money. They may
be more interested in making sure that farming gives
them the time available for family, community or leisure.
Some farmers may not be interested in a particular farm
For some farmers enterprise even though they could earn high profits from it.
profit is not
the main goal
Farmers often have preferences for different enterprises.
Some may not want to raise pigs or poultry; others may
not want to keep cattle even if cattle are highly profitable.
This is often related to family traditions, culture, religion
and even social standing in the community.
Before you can effectively advise farmers about

farm management decisions, you will need to understand
the goals and motives of the farmer and the farm family. All
decisions that farmers make have to refer to their goals.
Introduction 9
Some of the questions that extension workers may

wish to ask farmers are therefore:
•• Do you want to produce all your food

requirements?
•• How important is it for you to make profits
in order to be able to buy things?
•• To what extent are you willing to take risks?
•• Do you wish more time for family, community
or leisure?
•• Are there any crops you prefer to grow
or animals you prefer to rear?
•• Are there any crops or animals that you
would not want to grow or rear?
Farmers’ preferences and goals affect the

decisions they make about their enterprises: What to
grow? How to grow? How much to grow? For whom to
grow? These goals guide their choices between different
courses of action.
Goals are about satisfaction. However, when a

farmer earns profits, this may not, by itself, satisfy family
needs. The profits earned will only provide satisfaction if
the money is used responsibly or in a way that matches Achievement of
the farmer’s goals. Very few households would be farm family goals
such as food, profit
satisfied if money earned was not used, that is to say just
or social status
saved and never spent. This idea of satisfaction usually brings satisfaction
occurs when goods and services are purchased out of
the profits made. We can conclude that the more general
goal of farmers might be to maximize satisfaction. But that
satisfaction must benefit the entire farm family. A farmer
who maximizes profit and then spends it all on beer will
not be maximizing satisfaction for the family.
You need to understand the broad range of goals

that farmers may have. This could provide you with a
better understanding of the reasons behind many of the
decisions that farmers make. For example, a decision
taken by a farmer to select a farm enterprise that
maximizes profit could result in wide variations in yields,
and thus income, from year to year.
© FAO/10173/I.Velez
When profits Enough maize to sell – Honduras
are made ...
© FAO/CFU/000649/R.Faidutti
... goods and
services can
be bought ...
... and farm

households
Goods for farm household use – Brazil
benefit. © FAO/23937/M.Bleich
A family working together – Congo

Introduction 11
Unless the farmer has money in the bank to cover

these risks, the goal of profit maximizing may not be
as sensible as selecting an enterprise that produces a
lower but more stable profit. These considerations limit
the extent to which profit is the main driving force. The
use of profit in farming, however, does have a common
purpose: it allows all of the farm family goals to be
expressed in money values. In this way better decisions
can be taken.
Various cases to consider
A farmer is continuing with an enterprise

that is losing money regularly.
The farmer needs to be aware
that this is happening.
A farmer chooses a less profitable enterprise

over one that is more profitable.
The difference in profit would indicate
the loss to the farmer because of the choice.
A farmer chooses a social goal

over maximizing profit.
Any loss of profit can be calculated
and expressed in money terms.
In each of the cases above, knowing the cost of

choices made provides the farmer with information to
assist in making a more balanced judgement. But there
is a bottom line. Market-oriented farming does require a
business approach and profit is important to bring about
a good living for the farm family. Profit generates the
capital needed to reinvest in the farm: to buy machinery
and implements, to carry out soil conservation measures
and to introduce irrigation. It also provides the purchasing
power for medical and health services, education,
recreation and food.
ECONOMICS IN FARM MANAGEMENT
Economics is about wealth, that is the use of often scarce

resources to produce and exchange goods in order to
create wealth. Farmers have limited amounts of land,
labour, money (or credit) for inputs and other resources
to use on their farms. Farm management is about making
decisions regarding use of the resources available. Wealth
is created by putting resources together. How farmers use
their resources affects how much wealth they can create.
An example of
How efficiently assessing resource utilization
farmers use their
resources affects A farm family have chickens. Should they eat the chickens
the level of or should they look after them and have a regular supply
wealth that can of eggs? If they decide to keep the chickens for their
be attained
eggs, should they eat the eggs or should they sell the
eggs? Which is the best use of their resources?
Learning about some of the key economic

concepts does help farmers make these decisions.
These principles lie at the heart of farm management
and knowledge of them is important for good decision-
making. Learning about some of the key concepts of
economics helps farmers to have greater control over the
processes that influence their wealth. It can help farmers
understand which choices or decisions will lead them to
more wealth.
Chapter 2
Key economic concepts
Factors of production
The main factors of production
are natural resources
(land, water, soil, rainfall),
labour and capital.
Farm enterprises
These are different products produced by farmers,
each of which uses inputs to produce outputs.
Farm enterprises can be divided
into three types:competitive,
supplementary and complementary.
Cost of production
Value of inputs needed to produce crops or livestock.
This chapter Variable costs apply to a specific enterprise.
Fixed costs generally apply
outlines to the farm as a whole.
the main
economic
concepts and Opportunity cost
principles that When a limited resource is used on one
apply to farm enterprise it reduces the opportunity to use
management it on another. Also, time spent on a farm
enterprise reduces the opportunity for social
or leisure activities.
Value of production
Money received from the sales of produce,
added to the value of that consumed or stored.
Key economic concepts 15
Gross margin
What an enterprise adds to total farm profits
(Gross margin =
Value of production – Variable costs).
These concepts
Farm profit and principles
Money left over after variable of economics
and fixed costs are paid. will be
elaborated on in
Net farm family income the remaining
Farm profit after taking into account chapters of
cost of family labour used to generate it. this guide
Cash flow
Difference between money received (inflows)
and money paid out (outflows).
(Although a farm may be able to make a profit,
there may be times of the year
when it runs out of cash and is then
unable to purchase inputs and materials).
Substitution
Replacing one method of production
with another that is more efficient
in terms of labour, time or money
Efficiency: return to scarce resources

The wise use of resources available to the farmer.
Risk
Weather and diseases affect farm yields.
Changes in market prices and input prices vary.
Farmers must take these and other risks into account.
FACTORS OF PRODUCTION
Factors of production are the resources needed to

produce something. The main ones are:
•• natural resources
•• labour
•• capital
Natural resources
Natural resources are what can be called “gifts of nature”.
They include land, water, soil and rainfall. These are
resources that are not the result of what is called “human
effort”.
Land. A typical farm family may own or rent some land

for cultivation. The farmer’s homestead may also have
land around it that could be used for growing food, fruit
or forage crops. Many farmers have the right to use what
is called “communal land”. This is usually land used as a
Farmers
must use the
forest or for cattle grazing.
resources
they have Water. Farmers have access to water directly from
in the best rainfall and from springs, dams, wells and rivers or from
possible ways water collected from rainfall. This water may be on the
land used by the farmer or it may be from a communal
source.
Labour
Labour is the work of farmers, their families and hired
labourers. This is human effort and it is needed on all
farms. Farmers may have three different sources of
labour: the farm family (family labour), hired labour and
labour provided through cooperation between members
of the community. A farmer may use any or all sources of
labour on the farm, depending on the situation. The total
effort from labour is made up of people, skill and time
available.
Capital
Land and labour can often be made more productive if
land is improved. Sometimes land is cleared, cultivated,
irrigated or drained. The supply of water can be increased
by the construction of dams, storage tanks and canals.
These improvements on the land require capital. Capital*
is simply a resource that is produced as a result of
human effort. Capital includes buildings, dams, roads
and machinery as well as inputs and materials. It can
be divided into two types: durable and working capital.
Durable capital is made up of items that last for a long
time, such as machinery, equipment and buildings. Capital
Working capital consists of the money used to buy stocks is essential
of inputs and materials, such as seed and fertilizer, that to operate
are generally used within a season, as well as other items and expand
a farm
of expenditure paid in advance of income earned, such
as wage bills, maintenance and repairs.
Capital is used by all farmers, but small-scale

farmers often have very little cash capital. Most of the
capital found on their farms is in-kind. This includes
livestock, tools and equipment, buildings and land
improvement measures as well as stocks of seed, fertilizer
and animal feed.
Capital is often referred to as assets.
Assets can also be divided into

CASH and PHYSICAL forms of capital
* Note that there is a difference between the concept of capital as used in economics
and the more common usage where “capital” is often used to refer to the amount of
money that people have.
FARM ENTERPRISES
Most farmers have a range of different products that

they can produce. These might include crops such as
paddy, maize, cotton and groundnuts as well as cattle,
poultry, sheep and goats. The different products are
Farm enterprises
are the products known as farm enterprises. Each farm enterprise uses
farmers produce ... inputs to produce outputs. Inputs are the things that go
into production: the use of the land, farm and family
... they require inputs ... labour, hired workers, seed for crops, feed for animals,
fertilizers, insecticides and other supplies, tools and
... the relationship
implements, draught animals and tractors. Outputs
between inputs
and outputs are the crops and livestock products themselves. They
determines what are the products of the enterprise. The relationship
farmers produce between inputs and outputs determines what the
farmer produces. Economists call this relationship the
production function.
Farm enterprises can be divided into

competitive, supplementary and complementary
Competitive enterprises
Enterprises are said to compete when they use the
same resources. For example, if a farmer doesn’t have
enough labour to harvest two different crops at the same
time, the output of one crop can only be increased if the
other is reduced.
Supplementary enterprises
Enterprises supplement one another when they use
resources that might otherwise not be used. For example,
if a farm is located in an area that has early and late rains
it may be possible to grow one crop to make use of the
early rains and a second crop that makes use of the late
rains. The resource, water, is not left unused. The two
crops do not compete for water because they require
the resource at different times of the year. These two
enterprises are supplementary.
Complementary enterprises
Enterprises complement one another when they interact
in a supportive way, such as where poultry produces
manure. The manure can be applied as a fertilizer to crop
enterprises. Similarly, poultry or animals can be fed the
crops produced. This relationship between the livestock and
crop enterprises shows that the two are complementary.
ENTERPRISE COMPARISONS
Competitive enterprises
use the “same” resources
On her three hectares of land a farmer
grows maize, beans and pumpkins which use
many of the same factors of production.
Introducing a new crop will mean that
one or more of her current enterprises
will have to be reduced or not planted at all.
These enterprises are competitive.
Supplementary enterprises
use “otherwise unused” resources
The farmer allows her cows to graze
on land she cannot use for growing crops.
She does not feed her chickens excessively
and allows them to scavenge for feed
so they do not use other food resources that
may be used profitably elsewhere on the farm.
These are supplementary enterprises.
Complementary enterprises
“support one another”
The farmer collects chicken and cow manure
to use as fertilizer on her beans and pumpkins.
She also uses maize harvest residues
and by-products to feed her chickens and cows.
These enterprises are complementary.
COST OF PRODUCTION
Cost of production refers to the value of the inputs

involved in the production of crops and livestock. For the
purposes of farm management it is useful to divide costs
into two kinds: variable costs and fixed costs.
Variable costs
Costs vary according to the size of the enterprise, the
amount of inputs used, and the yields achieved. If the
area of land under a particular crop increases or more
inputs are applied, then variable costs also increase. If
less land is planted or fewer inputs are used, the variable
Variable costs costs decrease.
apply to specific
farm enterprises
and vary with
Examples of variable costs
changes in
production
A farmer has to hire labour for weeding and harvesting.
If the farmer increases the area that needs to be weeded
or increases the number of times the land is to be weeded,
the cost of hired labour will also increase. Similarly, the
amount of labour needed for the harvest is linked to the
yield.
If a low yield is attained
the amount of hired labour
at harvest time will also be low.
If a high yield is attained

the labour costs will be higher.
The same is true of other inputs. If the farmer decides to

increase the amount of land planted to maize, the amount
of seed and fertilizer applied will increase, so increasing
the farmer’s costs.
Fixed costs
Costs which can be termed fixed usually apply to a
specific enterprise and they do not vary with changes
in production. These costs include the costs of using a
tractor, farm equipment and draught livestock as well as
payment for permanent labour.
Examples of fixed costs
A farmer has a small storeroom for fertilizer, seed,

animal feed and farm tools. Any costs associated
with the storeroom (e.g. maintaining or cleaning it)
are shared by all of the farmer’s enterprises. These
costs are not affected by production or yield. Whether
production is increased or decreased, or the yield is high
or low, the costs are fixed. It would be difficult to divide
such costs and allocate them to the farmer’s individual Fixed costs
enterprises. apply to the farm
* * * as a whole and
remain steady
as production
Concerning draught power and equipment, most of
changes
the costs of keeping a tractor, draught cattle and farm
equipment remain the same whether the item is or is
not fully used. A tractor can be used for a mix of farm
operations, cultivating a crop, transporting feed for
livestock and even transporting people to town (although
this is a very expensive form of transport). The cost
for different activities cannot be easily allocated to any
one enterprise. Portions of fixed costs, such as fuel or
hours of draught animal use, can be allocated between
enterprises but this usually requires good information,
which is often unavailable to smallholder farmers.
For the most part, fixed costs only become

important in more commercialized agriculture when
farmers have mechanized equipment. Smallholder
farmers usually have few fixed costs. Most often they
need not worry about allocating fixed costs between
enterprises. Practically all their costs are variable costs.
OPPORTUNITY COST
There is another cost that is often overlooked but is

important in economics: opportunity cost. We have
mentioned before that, because resources are limited,
when a decision is made to allocate resources something
else has to be given up. If a farmer spends money on
buying tools, he or she will have less money to spend
on other items. In all aspects of life, having one thing
often means going without another. And there is a cost to
The income giving something up.
lost by using
scarce resources
for one purpose
instead of another An example of an opportunity cost
A farmer grows maize and earns $55. If the farmer had

grown tomatoes instead of maize earnings may have
been $95*.
The opportunity cost of growing tomatoes

is the $55 that was lost (given up)
from not growing maize
In both situations the farmer would have made money,

but the point is that more money would have been made
from tomatoes than from maize.

The concept of opportunity cost can also be applied
to labour. The cost of hired labour is very easily measured
by the wage paid. But how is the time of farmers and
their families valued? It is done by deducting the value
of the time they are absent from other activities. As an
example, a farmer works part-time in town and decides
to take a day off in order to work on the farm. The farmer
* Throughout this guide the dollar ($) sign is used to indicate a monetary unit, not a
particular currency
will be giving up a day’s wages from the other job.This

cost is just as real as paying a hired labourer to do the
work. Another example concerns time available to farmers.
Where time is spent on a farm enterprise it is not available
for social or leisure activities so there is an opportunity
cost also associated with non-business activities.
There is also an opportunity cost of capital. If a

farmer allocates scarce financial resources to a farm
enterprise, is this the best use of that money? Perhaps
the farmer would have made more money by leaving
the cash in the bank and earning interest. Perhaps the
satisfaction would have been maximized by adding a
new room to the family house.
VALUE OF PRODUCTION
Once a crop has been harvested, the farmer (and

family) can do three things: sell it, consume it, or store
it. The value of production is the money received from
the sale of produce together with the value of produce
that is consumed and stored (i.e. unsold produce). It is
sometimes referred to as the “value of output”.
The value of sales is very easily measured by the

amount of money the farmer receives. This is calculated
as the quantity of production sold multiplied by the price
that the farmer receives.
Value of production sold =

Quantity sold x Sales price
As noted before, the value of production also

includes the value of unsold produce. This is produce
consumed by the farm family or stored. A convenient
method of valuing produce is by using the market price
for which the produce could have been sold. A more
Production precise way to measure the value of food produced
consumed and
crops stored
and consumed by the family is to ask: “What would we
make up part have had to pay for the food if we had not produced it?”
of the family’s However, in rural areas there is little difference between
income selling prices and buying prices and thus the sales value
can be used as a convenient approximation. Then, the
total value of production includes produce sold, produce
consumed by the farmer’s family and produce stored.
Value of production =
(Quantity sold + Quantity consumed
+ Quantity stored) x Sales price
An example of value of production
After the maize harvest a farmer had 50 bags of maize.

She sold 10 bags of maize at $5.50 each and earned
$55. She put 20 in her storage shed; 4 bags for cow feed
and chicken feed; 14 bags for her family and 2 to give to
a farmer friend.
If the farmer wanted to know the value of her maize

production, she would have to add together the bags of
maize that she sold in the market, the bags she put in
storage and the bags she gave away, and multiply the
total by the market sales price.
This would be 50 bags x $5.50 = $275

GROSS MARGIN Gross margin

of an enterprise
The gross margin for a crop or livestock product is is a measure
obtained by subtracting the variable costs from its value of what that
of production. enterprise
can add to
farm profits
Gross margin =
Value of production – Variable cost
An example of gross margin
A farmer who produces a crop worth $600

at a variable cost of $100
generates a gross margin of $500 ($600 – $100).
Calculating gross margins is essential when

deciding between different enterprises. If a farmer wants
to know whether to continue with a certain crop or grow
another, he or she could compare the gross margins of
the two crops. If a farmer changes enterprises, the fixed
costs will probably not change. But what will change
are the variable costs and value of production. Using a
gross margin will help the farmer to see if the change in
enterprise will be profitable or not.
Understanding
the basic economic
concepts discussed Using land, water and labour – Mozambique
in this chapter ...
... factors
© FAO/21202/A.Proto
of production
(land, water, soil
labour, capital) ...
... farm enterprises,

Better watering for production – Burkina Faso
cost and value
of production ...
© FAO/13846/E.Kennedy
A successful pumpkin enterprise – Tuvalu

© FAO/23030/K.Iversen
... gross margin,

farm profit and
net income ...
Intercropping for better farm profits – Ecuador
... substitution,
efficiency,
and risk ...
© FAO/12354/I.Velez
... will add to

the knowledge
needed by
families to deal
Seasonal flooding is a risk to consider – Peru
effectively with the
management of
the farm business.
© FAO/12364/F.Mattioli
Good management practices bring high yields and profits – Dominica

FARM PROFIT
Farm profit refers to the money left over after the variable
costs and the fixed costs are paid. Each enterprise has
Farm profit a gross margin, which, as noted before, is determined
needs to take by subtracting the variable costs of the enterprise from
into account the value of production. The total gross margin on a farm
both variable is the sum of the gross margins of all enterprises. But,
and fixed costs
remember, this does not include fixed costs, which still
have to be paid. The money to pay for the fixed costs
comes from the total gross margin.
Profit =
Total gross margin of all farm enterprises
– Total fixed costs
If the amount obtained by subtracting fixed costs

from the total gross margin is positive, there is a profit. If
the amount obtained is negative, there is a loss. Because
fixed costs do not vary much with changes in production,
it is almost always the case that if farmers can increase
the gross margin on their farms they will also increase
profits. Further, because the smallholder farmer usually
has few fixed costs, the total gross margin is almost the
same as total profit.
NET FARM FAMILY INCOME
Family labour is an important input for most farmers,

particularly when they are running farming systems
that are only partially or not at all mechanized. Different
enterprises require very different levels of labour input.
For example, vegetables require a much higher level of
labour input than maize. Therefore, it is unreasonable to
compare the gross margin of vegetables with the gross
margin of maize without considering the labour required.
In the calculation of the gross margin, the payment

for hired labour is already included in the variable costs.
However, in many cases, labour on small farms comes
largely from family sources. In order to meaningfully
compare different enterprises, or technologies relating to
the same enterprise, it is necessary to allocate a cost
for this family labour. Estimating the cost of such family
labour is done by valuing what it would cost to hire such It is important
labour instead of using family labour. to take into
account
the cost of
Very often, the smallholder farmer should not be
family labour
as concerned about increasing profit as about increasing
net farm family income. This is the farm profit after taking
into account the cost of family labour used to generate it.
After the farm profit is calculated, family labour costs are
deducted.
If the opportunity cost of family labour is low, the

net farm family income could be increased by using
family labour more intensively in farming operations.
Farmers often have to decide between hiring a tractor
to speed up cultivation and carrying out farm operations,
such as sowing, weeding and fertilizing manually. In a
situation where the family has limited work opportunities
and the opportunity cost of family labour is low, the gross
margins may be increased if much of the work is carried
out by the farm family, rather than by hiring a tractor.
CASH FLOW
The cash flow is the flow of money into the farm from sales
and the flow of money out of the farm through purchases.
Money received from the sale of farm produce is called
cash inflow. Money paid out for inputs and materials used
is called cash outflow. The difference between the cash
Cash inflow inflow and the cash outflow at different times of the year
and outflow is known as the net cash flow.
vary greatly
throughout
the year Farmers need to consider their likely cash flow on
a monthly or quarterly basis in order to know whether
they will have sufficient cash when it is required. If the
cash inflow is less than the cash outflow at any particular
time all cash commitments cannot be covered.
Cash flow is not the same as profitability.

Remember, profit is based on the value of production less
the variable and fixed costs. However, if the farm family
consumes a lot of the produce, it is possible that although
the farm is profitable, it may not generate enough cash to
cover its cash requirements.
In the previous example on page 25

a farmer produced crops worth $600 at a variable
cost of $100. There were no fixed costs. Based
on this information the farmer has a profit
of $500 ($600 – $100).
When we investigate further, however, we find that

the farmer only sold produce to the value of $50. The
farmer’s family consumed the rest of the produce.
Therefore the cash inflow is $50 and the cash outflow is
$100, which means that the farmer would not have the
$100 needed to cover variable costs unless the
farmer had money saved or another source of income.
SUBSTITUTION
Because there are many technical ways of producing

a crop or livestock product the farmer must choose the
method of production that is most efficient. The most
efficient method is the one that uses scarce resources
Substitution
wisely. Again, we speak of a choice a farmer must make
requires comparing
– the choice between methods of production. Given different methods
the alternatives, which is the best way of producing an of production and
enterprise? The principle of substitution can be usefully selecting the best
applied when farmers consider whether or not to use a
new technology or farm practice. As an example, farmers
have three alternatives for preparing a seed bed. They
can:
•• use hand tools

•• hire additional labour
•• use a draught animal or a small tractor
Which alternative should the farmer use? How

can the farmer assess the options wisely? The decision
depends on many factors: the size of the farm, whether
the farmer has money or needs to borrow money and
the cropping pattern. In order to make such a decision
the farmer needs to know about the factors of production
and their cost for each of the alternative methods. The
following simple principle of economics can be applied.
When substituting resources or inputs

the farmer must be certain that the savings
in the method replaced are greater than
the added cost of the new technique or practice.
Cost saved by Cost added by

giving up current greater using the new
resource than resource
input or practice input or practice
EFFICIENCY:
RETURN TO SCARCE RESOURCES
There are many ways of looking at efficiency on the farm.

One useful way is to look at efficiency from the point
of view of the factors of production: natural resources,
labour and capital. In most cases, one of these factors
will be the one that limits profits the most. This is the
most limiting factor or the effective resource constraint.
This really means that the resource is in short supply.
The effective resource constraint is used as the basis for
examining farm efficiency.
Efficiency
Efficiency is expressed in two forms: technical and
economic. Technical efficiency involves producing farm
A farm that products with the best combination of resources or inputs.
is efficiently run It is expressed as attaining the maximum level of output
is more likely
from a given level of inputs or, alternatively, a given output
to be profitable
than a farm with the use of minimum inputs. Economic efficiency
that is not measures the financial returns on resources used and
looks at the cost of using resources to produce a given
level of output. Low profitability is often traced to poor
efficiency in one or more areas of the farm business.
* * *
Efficiency and land. Land is a natural resource. If it is
the most limiting factor, the farmer has no more land to
use. If this is the case, the farmer will want to measure
efficiency in terms of land by determining the farm’s
gross margin per unit of land (e.g. hectare or acre) or
the profit per unit of land. To improve the efficiency of
the farm, the farmer should consider ways to increase
yields to try to obtain higher returns from the produce.
Efficiency and water. The most limiting factor may be

water. A farmer may consider deep ploughing, which is
good to maintain water in the soil. In order to save water
the farmer could also construct canals and transplant
vegetables on raised beds. In this way the farmer uses
less water per hectare and makes more efficient use of
this scarce resource.
Efficiency and labour. Assume that labour is the

limiting resource. This means that labour is in short
supply. When this is the case, the farmer will want to
measure efficiency in terms of labour by determining the
farm’s gross margin or profit per labour input or person-
day. To improve the efficiency of the farm, the farmer Efficiency is
concerned with
should look for ways to increase production using the the wise use of
same amount of labour, or produce the same amount the resources
using less labour. This can be done by introducing a available
labour-saving technology that reduces the amount of
time spent on farm operations.
Efficiency and capital. Capital is nearly always in short

supply and needs to be used efficiently. If capital is the
most limiting factor, the farmer will want to measure
efficiency in terms of capital by determining the farm’s
gross margin or profit per unit of capital, such as per
$100 or whatever value is most appropriate. To improve
the efficiency of the farm, the farmer would look for ways
to increase production, perhaps by investing money in
high yielding seeds (instead of ordinary seeds) or by
investing money in a more efficient technology.
RISK
One of the facts of farming is that many future events

cannot be known with complete accuracy or certainty.
This makes farming risky. Risk occurs when the outcomes
of a decision are not known in advance or cannot always
be predicted. Farmers need to make decisions that take
these risks into account*.
The most common sources of risks in farming are:
•• Production risks: crop and livestock performance

Risk exists are affected by biological processes (weather,
in many pests and diseases);
different •• Marketing or price risk: market prices vary from
forms ... year to year or in some situations daily;
•• Financial risk: when it becomes necessary to
... and with borrow money to finance the farm business;
potentially •• Institutional risk: unpredictable changes in the
devastating provision of services from support institutions;
effect •• Human and personal risk: risk to the farm
business caused by illness or a family situation.
Risk influences the amount of inputs that are used

as well as their cost. In rain fed agriculture, for example,
farmers may experience poor rains one year in five. They
will not risk using large amounts of fertilizer if there is
a possibility that the rains won’t come. Farm profits are
always uncertain. Not all factors have the same effect
on the riskiness of farm profits but all must be taken into
account. As a result of risk, farmers often have to balance
between maximizing profits and minimizing risks.
* Economists often differentiate between risk and uncertainty. Risk is associated

with events for which a probability of occurrence can be attached. For example,
the risk of no rain in a given period can be calculated, based on past rainfall
patterns. Uncertainty, on the other hand, refers to events for which no objective
way to assign a probability exists. An example is the prediction of prices. For
most practical purposes, however, the two concepts can be used interchangeably.
Chapter 3
Economics and the market
What is a market?
The place where the exchange of products
for money takes place.
Markets are made up of sellers and buyers.
Key concepts • Market • Seller • Buyer • Price •
What is marketing?
Making decisions about the marketing of farm products
is an important part of farm management.
To make these decisions, farmers need to understand
the market, how it works, how prices are determined.
Key concepts • Marketing • Decision-making • Price •

How does the market work?
Prices are determined by supply and demand.
Supply is the amount
available for sale at a certain price.
As farmers Demand is the amount
become more people are prepared to buy at a certain price.
Key concepts • Supply • Demand • Equilibrium •
market-oriented
they need to How are market prices determined?
understand how (DEMAND)
prices are The price of the product;
determined ... The price of substitutes;
Changes in tastes;
Increases in income;
Changes in population;
Future price changes;
Government policy;
Other factors affecting demand.
Key concepts • Market conditions •
• Price mechanism •
Economics and the market 37
How are market prices determined?

(SUPPLY)
The price of the product;
The conditions of supply;
Changes in the cost of production;
Change in interest of farmers;
Improved techniques;
Natural resource changes;
Government policy;
Other factors affecting supply.
... and aquire an
Key concepts • Supply conditions • awareness of
• Price mechanism • how economic
concepts and
Why do prices vary from time to time? principles relate
Changes in production and demand to marketing
at different times of the year.
Availability of competing products and inflation.
Key concepts • Inflation • Seasonality •
Why do some prices change sharply

while others do not?
The nature of the products.
Whether they are essential or non-essential.
Whether there are substitutes.
Length of time involved
in making changes in production.
Key concepts • Elasticity • Inelasticity •
Farmers can improve

the price of their products
Premium prices can be attained
if product quality is assured by better
production and post-production processes.
The organization of marketing groups
can also provide negotiating advantages.
The key concepts here are quality
and economies of scale.
ON MARKETING
What is a market?
The word “market” is used in two ways ...
First, it is a place where the exchange of products

for money takes place. Markets are made up of sellers
and buyers and their relationship influences the amount
of money received in exchange for products. Markets do
not have to be physical locations. Exchange can also
Markets
take place over the telephone and sometimes, these
are made up
of sellers days, over the Internet.
and buyers
expressing Second, a “market” represents the collective
collective demand for a product. When farmers understand the
demands market for their products, it means that they understand the
for products
product that consumers want, how much they want, what
price they are willing to pay and what qualities and other
conditions they demand. We can talk about commodity
markets, maize markets or rice markets in this way.
What is marketing?
Making decisions about the marketing of farm products
is an important part of farm management. If farmers are
to treat farming as a business they need to understand
marketing and how the market works. Marketing is a
series of exchanges linking the farmers who produce
and sell, and the consumers who buy. Buyers can take
different forms. They include:
•• Customers who buy for their own use

and their families;
•• Rural traders who sell the produce to others;
•• Processors who transform the produce and
then sell it to others;
•• Wholesalers who buy and sell to retailers;
•• Retailers who buy and sell to consumers;
•• Exporters who buy and then sell abroad.
© FAO/23934/M.Bleich
Although
many farmers
market their
produce locally ...
A local village market – Burundi
... or transport
their produce to
O.Argenti
assembly, wholesale
or retail markets ...
An assembly market – Pakistan
... more and more

the trend is
to high-value
production
© FAO/24495/D.White
destined
for sales at
supermarkets.
A speciality supermarket – Thailand

Exchange takes place when two sides agree on a

price. If they do not agree, no exchange will take place.
The exchange mechanism of selling and buying depends
on the price. Understanding how prices are set calls for
an understanding of how the market works. It also calls
for an understanding of the factors that affect supply and
demand and cause prices to change. These are all parts
of economics.
To make a profit, the farmer has to charge a high

enough price to cover more than the costs of production
and marketing. While there may be occasional price falls
that cannot be foreseen, if these costs cannot be covered
in the long run the product should not be produced.
When making plans

a farmer needs to know ...
WHAT PRICES TO EXPECT.
When selling,
a farmer needs to know ...

WHAT PRICES CAN BE OBTAINED.
HOW DOES THE MARKET WORK?
In the simplest situation farmers take their products to

markets to exchange them for money. Consumers take
their money to markets to exchange it for products. The
market sets the price at which those who want a product
When prices
(buyers) can obtain it from those who have it to sell are too high
(farmers). consumers
will not buy
the product
In a market-oriented system

price is determined by supply and demand
Supply
The amount farmers are prepared to sell.

Demand
The amount buyers are able to buy.
Market price
What both farmers and buyers
are willing to accept. When prices
are too low
producers
If supply increases but demand does not increase, may not be
the price will fall. This is often what happens in a market willing to sell
at the time of harvest, when there is an abundance of
produce for sale and prices are low. Later in the season,
when there is less for sale, the price often increases. If
demand increases but the supply does not the price is
likely to rise. Where a product is scarce consumers are
willing to pay more for it. This will push up the price. Fruits
and vegetables out of season are examples of scarce
products. When the price of a product increases, profits
tend to increase, which encourages farmers to produce
more. On the other hand, if consumers do not want the
product, its price falls and farmers make a loss. Such
a situation may lead to farmers producing less of the
product
HOW ARE MARKET PRICES DETERMINED?
As noted in the previous section, prices are determined

by supply and demand. But what does this really mean?
Supply
Normally, the higher the price of a product, the greater the
supply of that product. For example, farmers considering
producing tomatoes would be encouraged by high prices.
High prices If they do produce tomatoes and the price increases,
encourage they would be encouraged to extend the area of land
farmers to
under the crop. They would also try to grow tomatoes
grow more ...
with more or better quality inputs so that a higher yield
could be produced. The table below shows the amounts
of tomatoes that could be supplied at different prices by
all producers in the market.
Tomatoes supplied change with the price
Table 1 Price Supply

Supply ($/kg) (kg)
of tomatoes
at different 12 40 000
prices
10 32 000
8 25 000
6 20 000
4 13 000
2 7 000
= point of equilibrium
The higher the price the greater the supply

The lower the price the less the supply
Demand
The demand for a product normally rises when its price
is lower. If the market price is high, consumers reduce
their purchases. The table below shows the amount ... but high prices
also encourage
of tomatoes in demand at different prices. If tomatoes
consumers
are very expensive, consumers may substitute other to buy less
vegetables. If they are cheap, consumers will buy more.
Demand for tomatoes changes with price
Price Demand Table 2

($/kg) (kg) Demand
for tomatoes
12 3 000 at different
prices
10 9 000
8 15 000
6 20 000
4 25 000
2 35 000
= point of equilibrium
The lower the price the higher the demand

The higher the price the lower the demand
Market price
The market price is set at a point where supply and demand
are in balance. Economists call this the equilibrium price.
That is the point where the amount in demand matches
the amount supplied.
From the tables of demand and supply for tomatoes

the equilibrium price is $6 per kg
This price is the only one where there is
balance between buyers and sellers
At this price 20 000 kg of tomatoes

are both in demand and offered for sale
The equilibrium price

can also be plotted as shown below
$
(per kg)
14
Demand
12
10
8
6
4
2
Supply
0
Figure 1 0 10 20 30 40
Market price
determination Demanded and Supplied (per 000 kg)
for tomatoes
Suppose that initially the price of tomatoes is set

at $8 per kg. At that price 15 000 kg of tomatoes would
be in demand and 25 000 kg for sale. There would be an
excess supply of 10 000 kg of tomatoes over the demand.
This means that farmers would be left with a surplus that
could only be cleared once the price was reduced. As the
price falls, demand gradually expands and supply slowly
contracts until a price of $6 per kg is reached. There is
then no need for the price to fall further.
Similarly, if the initial price is $4 per kg, 25 000 kg

of tomatoes will be in demand but only 13 000 kg offered
for sale. Consumers might even form queues to buy
tomatoes. The price would then rise, giving an incentive
for farmers to plant more. At $6 per kg there is no need
for prices to rise further.
This is called the price mechanism. It indicates the

wishes of consumers and allocates productive resources
accordingly.
WHY DO PRICES CHANGE?
As we have discussed, prices change depending on

changes in supply and demand. As a result of such
changes equilibrium prices and production levels also
change. The farmer needs to recognize such changes
and adjust the farm business to them.
The following factors

influence production or supply
Seasonality of production. At peak season crops are

more abundant than they are during the off-season.
Changes resulting from climate. Supply also varies

from year to year. Changes in production frequently
occur as a result of weather (including rainfall, floods and
drought). Bad or good climatic conditions can decrease or
increase the quantity supplied. Bumper harvests usually
decrease prices, poor harvests usually increase prices.
In these cases, the level of production is not affected by
the price of the product but by climatic changes.
Supply or
Production problems. The incidence of pests, diseases production may
and other hazards, such as fire, can decrease the supply. be influenced
by other factors
Change in the cost of production. A decrease in as well as price
the cost of inputs or the introduction of more efficient
technologies would decrease the cost of production.
This makes it possible for the farmer to buy more inputs
and produce more for the same cost of production. As a
result more tomatoes could be supplied at the old price.
Conversely, an increase in the cost of labour employed
on the farm would have the opposite effect.
Improved techniques. The introduction of high yielding

varieties could increase the level of production, resulting in
a decrease in product price.
Expansion of a crop under cultivation. Farmers may

decide to plant more of a crop because of the prospect
of greater profits.
Changes in profitability of competitive products.

Changes in the profitability of competing products also
cause a change in supply. If cabbage is more profitable
than tomatoes, for example, farmers will gradually shift
towards growing cabbages. This change would lead to a
decrease in the supply of tomatoes.
For fresh produce, such as vegetables, there

are often short-term fluctuations in supply, sometimes a
result of bad weather which can affect the harvest. There
may also be transport disruptions.
The following factors

affect the demand for a product
A change in the number of consumers. Extra people

coming into a market can increase demand. Development
projects, housing developments and other programmes
often cause people to move to a new area.
A change in consumer demand. Changes may occur

Demand that make consumers demand more or less of a product
for a product at each price. In other words the level of demand could
may also be change. For example, farmers could join together to
influenced by promote their sales of tomatoes. They might advertise
factors other the good quality, freshness and availability at times of the
than price
year when tomatoes are not usually found in the market.
This may appeal to consumers, increasing demand.
An increase in income. As countries get richer there will

be a general increase in income and people will be able
to afford new products. As people become richer they
tend to reduce their consumption of staples, such as rice
and maize, and increase consumption of dairy products,
fruits and vegetables.
A change in the prices of products that are close

substitutes. In some diets spinach may be a substitute for
tomatoes. If the price of spinach decreases, consumers
may prefer to purchase it instead of tomatoes. Thus,
even though there may have been no change in the price
of tomatoes, the demand could decrease.
Availability of competing products. If a wider range

of products competing with tomatoes comes onto the
market, consumers have a wider choice. This may lead to
a lower demand for tomatoes. However, a lower demand
may lead to lower prices, which could cause demand to
increase again.
A change in taste. A promotional campaign aimed at

persuading consumers to purchase more of a product
could also increase the demand. Similarly, changes in
demand may come from changes in consumer tastes that
take place gradually as a result of changes in diet.
Safety concerns. Quickly spreading consumer fears of

contamination, as experienced in the Avian Flu epidemic,
can have an immediate effect of decreasing demand.
Expectations of future price changes or shortages.

The fear that the price of a product could rise considerably
the following week, for example, because of a planned
transport strike, would motivate people to increase their
demand and stock up. Clearly, this would not happen so
much with perishable products.
The relationship between supply and demand and

prices of products is thus extremely complex. A change
in the price of one product can affect the demand and,
in turn, the price of an entirely different product. Supply
is, however, likely to fluctuate much more than demand.
Market prices are affected more by changes in production
than by changes in demand.

Prices are also affected by what is called inflation

which is the general increase of all prices throughout
the country. Farmers cannot do anything directly about
this. High inflation means that prices rise rapidly. Inflation
affects both the price of inputs (seed, fertilizer, labour)
and the price of products. For example, a bag of fertilizer
which cost $10 last year may cost $15 a year later.
Similarly a kilogram of tomato that sold for $4 last year
may now be sold for $5. Farmers must be aware of
inflation and its impact on farm input and market prices.
CAN FARMERS SET THE PRICES

FOR THEIR PRODUCTS?
In most cases, farmers do not set their own

prices, they must accept the going price. They
are called “price-takers”. Farmers generally
grow products that are very similar to those that
other farmers grow. If a farmer were to charge
too high a price traders and consumers would
refuse to buy the product. By lowering the price,
the farmer adjusts it to the market conditions.
However, there are some situations where farmers

may be able to influence the market price. In
such situations they are called “price-makers”.
This sometimes occurs when there are only a few
farmers producing for a “niche market”. A niche
market is a highly specialized market or when
produce is produced at a specific time of the year
when premium prices can be obtained. Being
price-makers gives farmers a great advantage
when it comes to negotiating with traders
responsible for distributing their produce.
WHY DO SOME PRICES CHANGE SHARPLY

WHILE OTHERS DO NOT?
Normally, demand increases as prices fall and supply

increases as prices rise. More people are interested
in buying products that have a low price. Farmers are
interested in increasing their production to follow higher
prices.
However, the supply of some products can be

adjusted far more quickly than the supply of others. To maintain
For example, the supply of mushrooms and tomatoes profits farmers need
to understand how
can be increased or decreased quickly in response to
markets function ...
price changes. But other items such as fruit, coffee,
tea and milk take longer to adjust. If the prices of such
commodities fall, the decrease in supply does not come
about immediately. First, changes in production would
require significant changes, such as uprooting tree crops. ... and acquire the
knowledge and skills
A farmer would need to think through such changes very
necessary to respond
carefully. Second, even if the farmer were to make the to price changes
required changes, it would take a long time for overall
production to adjust.
Elasticity
Elasticity is an economic concept that can help explain
changes in product prices, supply and demand. It can
especially help to explain why changes are more significant
for some products than for others. Different products have
different elasticities.
When supply or demand change a lot in response

to a change in price, the product is said to be elastic. It
is sensitive to price changes. When supply or demand
does not change much in response to a change in price,
the product is said to be inelastic. It is insensitive to price
changes.
Salt is an example of an inelastic product. The

demand for salt would change only by a small amount
if there were a change in the price. There would have
to be a very large change to cause a noticeable change
in demand, because salt is both a very small expense
for most families and a product for which consumption
cannot be easily reduced and for which there are no
significant substitutes. On the other hand, vegetables are
generally elastic products. When prices change, supply
and demand adapt relatively rapidly.
CAN FARMERS IMPROVE THE PRICE

OF THEIR PRODUCTS?
The quality of a product influences its market price.

Consumers pay more for a product that is clean and free
The quality of dirt, insects and damage. Large eggs sell for a higher
of a product is price than small eggs. Fat animals sell for a higher price
as important as than thin ones.
supply and demand
in setting the price Farmers can improve the quality of crops and
of produce sold
livestock by using better production and post-production
practices. Using different breeds or varieties and
improving practices on the farm can increase returns.
By improving post-harvest handling practices, farmers
will ensure better quality and could obtain higher prices.
However, in order to make these improvements, it is
sometimes necessary to make special efforts that may
involve extra costs. These extra costs have to be covered
by an increase in money received for the higher quality
product. Examples are shown on the next page.
Actions farmers can take

to improve the price of their products
Improved production
Large eggs and creamier milk, for example, will bring
higher prices compared with small eggs and milk with
a lower cream content. But it is important that farmers
consider the extra costs involved in the production
change and compare them with the extra money that
improvement will bring. If the profit is higher than that
previously obtained, the extra effort will be worth it.
Organize marketing groups

Farmers acting alone to improve their prices may not
gain. A single farmer improving quality will have to sell
to the same trader as all other farmers. The trader will
probably not pay a premium as it will not be possible to
keep good quality and poor quality produce of different
farmers separate. Farmers
in groups can
often influence
However, farmers working together can often the prices of
increase their bargaining power. This helps them to deal produce sold
with buyers and negotiate contracts. Marketing groups for the better
may also be in a position to offer their members other
benefits such as better market information.
Farmers acting in groups may also be able to

improve packaging. In some countries, working together
has successfully increased prices by using a brand name
or by stressing the geographical origin of the product.
Farmers in groups can also work with retailers to ensure
that produce reaches the store quickly and can thus
command a premium for “freshness”.
Economies of scale
Scale is used to describe differences in the overall size
of farms or businesses. Economies of scale are achieved
when the cost per unit of production or output marketed
is reduced as the scale of the activity increases. Savings
(economies) can be achieved by spreading costs over
a larger scale of operation. They can also be achieved
when farmers organize themselves into groups to buy
inputs, use capital or market produce. These group

activities can bring about a cost reduction per unit of
inputs purchased or produce marketed.
Economies of scale can also come about through

specialization. As output of one product increases there
is a possibility of using more specialized management
and introducing mechanization to take the place of
labour in field operations. Increases in scale of output
allow savings to occur in the time spent on these tasks.
The following are examples of some of the

economies that can be achieved when working at a
higher level of marketing and input purchases.
•• Groups of farmers involved in marketing could

share transport arrangements to sell their
produce. This very often results in lower unit
costs. If each individual farmer were to transport
produce separately the amount of produce
transported would be smaller and per unit
transport costs would be higher than those of
the collective effort.
•• Farmers can look for ways to produce collectively.

They could share a tractor, infrastructure for
livestock production or mechanical harvesting.
•• Collective buying of inputs could also result in

economies of scale. By ordering in bulk, the
farmers would be able to buy their materials
at reduced prices and transport them more
cheaply.
Chapter 4
Economics and
farm management decisions
What decisions do farmers make?

Farmers should
use economic Farmers decide what to produce,
concepts and how much to produce
principles and how to produce.
to better
These questions are interconnected
manage their and depend on a better understanding
farm production of the relationship between inputs and outputs.
Key concept • Production function •
How do farmers select products?

Selection of enterprises is often decided
by the existing conditions on the farm.
Increasingly, this requires matching
those farm conditions
with the market opportunities.
Key concept • Comparative advantage •
How do farmers allocate resources?

The problems facing the farmer include the inputs
required to maximize profits, the technology
to select and the best way to produce.
Key concepts • Law of diminishing returns •
• Marginal product • Marginal value of production
• Marginal cost • Changes at the margin •
• Optimum level of output • Marginal analysis •
Economics and farm management decisions 55
How can farmers assess financial requirements?

By using the simple principle of cash flow,
farmers are able to assess whether or not they will
have enough money to carry out their plan or if
they are likely to be short of money at any time.
Key concepts • Cash flow • Net cash flow •
• Cumulative balance •
How should farmers cost their assets?

Once durable capital assets (e.g. farm equipment)
are purchased, resources are tied up. Costs are fixed.
Assets can be costed by understanding
depreciation and salvage value.
Key concepts • Depreciation •
• Useful life • Salvage value •
How can farmers assess whether to buy an asset?

Economic
The economic concept used to decide whether
or not to buy machinery or equipment is called
concepts and
the return on capital. Farm equipment lasts principles also
longer than a single season or year, so decisions help farmers
must be based on returns over the long term. make better long-
Key concepts • Return on capital • term investment
• Rate of return • Opportunity cost • decisions
How do farmers deal with risk?

Different strategies are needed to cope with risk.
These include using risk reducing inputs;
selecting low-risk enterprises; product diversification;
maintaining input, finance and product reserves;
contract farming; insurance; using market information.
Key concepts • Risk • Risk-reducing strategies •
WHAT DECISIONS DO FARMERS MAKE?
Farmers face a number of common problems. What

enterprises should they produce? Should their farming
system be specialized or consist of a mixture of crops
and livestock? What should they grow on what area of
land? How should they produce the enterprise and with
what methods and technologies? What combination of
resources should they use in doing so?
MANAGEMENT DECISIONS
Selecting the most profitable

combination of enterprises
Determining the most profitable
size of the farm business
Using credit wisely
Deciding on the most profitable
methods and practices
of production
Determining the most
profitable level of production
Timing production
Making marketing decisions
Determining quality of the
produce to be sold
Managing risk
There are many factors that affect the decisions

that farmers make, such as the market and the resources
available to them. There are also other, less economic,
considerations, such as the desires and expectations of
the farmer’s family and the need to balance leisure and
cultural activities with productive activities. The farmer
must take these into account when identifying:
•• the range of varieties that it is possible to grow;

•• the best market and marketing channels;
•• the most appropriate time to sell produce;
•• the best combination of enterprises to have; Farm management
•• the amount of each crop and livestock decisions depend
enterprise that should be produced; on both economic
and social factors
•• the amount of resources and inputs that
should be used to produce these products;
•• the best way of producing for the market;
•• types of farm practices and technologies
to use;
•• the ways of reducing risks.
Although the list above is long most of these decisions are

interconnected, simplifying the decisions to be made.
The four key decisions to be

made by farmers are:
What to produce?
How much to produce?
How to produce?
For which market to produce?
All of these questions

can be answered by economic principles
that look at the relationship between farm
inputs and outputs ...
... which we call the production function.

These decisions cannot be easily separated from

each other because they are all affected by the limited
resources available to the farmer. The decision to be made
between different products and their level of production
is affected by how they will be produced, which, in turn,
is influenced by how much is to be produced. This also
affects how much of any resource should be used.

The management problems facing the farmer
break down into two main areas ...
Successful
farming needs
Discovering the best way of organizing
systematic
and rational individual enterprises.
decisions
Finding the best way of fitting
the enterprises together
into the farming system.

The first problem requires the farmer to examine
the possible enterprises and decide on the most
appropriate method of production. The second requires
the farmer to see how the enterprises compete
and complement one another in their use of scarce
resources.
Farmers make decisions

through the following means
Tradition
Some farmers base their decisions on tradition. They may
rely on traditional methods of management and follow
established patterns of farming. These methods have
evolved over a long time. For example, a farmer might
decide on a cropping pattern based on a crop rotation
that is widely used.
Comparison
Some farmers base their decisions on comparison with
other farmers. For example, a farmer may apply fertilizer
at rates used by others cultivating the same crops.
Economics
Other farmers may base their decisions on economic
considerations – looking for ways to make profits.
They may look at prices of products and their costs
of production and marketing, and then calculate costs
and profit. Often these decisions are taken by farmers
without complete information. Farmers may not know
the prices and costs of products and inputs. In that case
profit may be calculated without including all the cost
items and without making a proper assessment of the
value of production. This may mean that farmers will Farming for
not maximize profits. profit requires
economic data
Farmers’ skills and knowledge of management and information
are limited. Farm records are not usually kept and
information on prices and costs is often unavailable.
Farmers also have difficulty in calculating profits and
assessing how much input to apply. Improvements in
farmers’ managerial knowledge must go hand-in-hand
with improvements in technical skills. Better knowledge
of farm management should help farmers to obtain the
type of information they need to make better decisions
and to better manage the choices that they have.
HOW DO FARMERS SELECT PRODUCTS?
Selection of enterprises is often decided by the natural

conditions of the farm. Lowland areas of Asia, for example,
have a natural advantage over upland areas for the
cultivation of rice. Upland areas with a more temperate
climate tend to be suitable for horticultural production.
Dairying has an advantage in areas close to towns and
Farmers should
cities.
identify enterprises
suited to the
natural conditions Even where there are such advantages, farmers
of their farms still face choices. For example, a lowland farmer may
have to decide between growing cereals for home
consumption or growing cash crops. Similarly, upland
farmers may have to decide between rearing livestock
and cultivating horticultural crops. Farmers often decide
by using some of the economic principles and concepts
discussed in this guide without even knowing it. Selection
of enterprises takes place through looking at supply and
demand.
Farmers must have good knowledge of their

farms, including the type of soils and their quality, water
sources and topography as well as an idea of the type
of crops that can be grown. They need to know whether
they have sufficient capital and labour to produce the
enterprises and whether they might require more labour
and machinery at particular times of the year, for example,
at harvest periods. They must also have an idea of the
gross margins that they can earn from the different
enterprises.
Farmers need to have a sense of what consumers

in the market want. What are retailers or wholesalers willing
to pay for the product? What distribution channels are
available? What is the cost of transport? What crops and
livestock enterprises can fetch high prices? Market-oriented
farming requires matching supply with the demand.
The location of the farm in relation to the

market and the transportation network also
has an important influence on enterprise
selection. It is often profitable to farm land
more intensively the closer it is to the market.
Transportation costs also influence the choice
of what to produce. The closer the farm is
to the market the cheaper it is to transport
produce. Transportation costs for products
and inputs need to be included in the gross
margin calculation of the enterprise. Box 1
Transportation
costs
Comparative advantage
There are other questions that farmers face that relate
to the selection of farm enterprises. A common decision
concerns whether to specialize in a single enterprise or
whether to diversify the farm. Farmers need to decide to
concentrate on only one or two enterprises or on a number
of enterprises. The economic principle for choosing what
to produce is called “comparative advantage”. Very
simply, this concept explains how farmers select those Farmers can apply
enterprises where profits are likely to be greatest. the concept of
comparative
Farmers often have a choice of enterprises that advantage
to select high
tend to compete with one another for land. An expansion profit enterprises
of one enterprise means a reduction in another.
Comparative advantage indicates how farmers can
decide on which plots to grow different crops. Consider
a farmer who is thinking of planting three crops, maize,
millet and tomatoes, on three plots of land that are
the same size, but which have varying soil fertility and
climate. Which crop should be selected for each plot?
The farmer needs information on yields, prices, inputs,
costs and gross margins to help make the crop selection
(see Table 3).
Table 3 shows the projected gross margin

(yield multiplied by the selling price minus the costs of
production) for the three crops when grown on each of
the three plots.
Enterprise
Plot Tomatoes Millet Maize
A 91 78 59
Table 3
B 64 67 51
Gross margin
($ per ha) C 31 20 40
Total 186 165 150
The figures in the table show that Plot A has an

absolute advantage over the other plots for all three
crops. The gross margin generated from Plot A is higher
than that of the others, perhaps because of higher yields
as a result of better soil fertility. Out of the three crops
tomatoes have the greatest advantage (i.e. the highest
gross margin). On Plot B millet generates the highest
gross margin. Plot C generates lower gross margins than
Decisions both A and B for all three crops, with maize being the
on enterprise most profitable crop.
selection
should also The farmer has a choice of specializing by growing
be based on the same crop on all three plots or choosing a crop
economics
mixture (diversifying). In this example, the size of each
plot is the same and the gross margin that can be earned
via specialization or diversification can be seen below.
Specialization
If one crop is grown on all three plots the farmer could
earn $186 from growing tomatoes, $165 from millet and
$150 from maize.
Diversification
By diversifying with a different crop planted on each of
the plots, the farmer could earn $198 from a combination
of the three crops: $91 for tomatoes from plot A; $67 for
millet from plot B; and $40 for maize from plot C. In this
case the farmer would do best to diversify. However,
prices and yields can fluctuate so unless there are

significant differences, the farmer may do best to stick with
the farming system with which he or she is comfortable.
HOW DO FARMERS ALLOCATE RESOURCES?
Farmers who want to maximize their profits should

make the best use of scarce resources such as seeds,
fertilizers, pesticides, land, labour and machinery. The
most efficient use can only be calculated if the physical
relationship between the resource inputs and the outputs
produced are expressed in economic terms. The typical
decisions that farmers have to make are: Economic
principles are used
•• What quantity of inputs should be used to determine the
to maximize farm profit? most efficient use of
resources and the
•• Which technology should be applied? best technologies
•• Which production method is best used? and methods of
production
These questions are closely related and cannot
be easily separated. Many farm decisions concern how
much of a single “factor” to use in order to maximize
profits. How much seed should be used? How much
fertilizer should be applied? How much hired labour is
required? Asking these questions is the same as asking
which level of yield per hectare or how much weight gain
per animal will give the greatest profit.
There are many farmers who still talk of the

greatest yield per hectare, the highest production per
animal, and so forth. But the greatest yield is often not
the level of production that generates the highest profit.
The farmer interested in competing in the market needs
to think about gross margins, profit, costs and returns –
not merely maximum yields.
Extension officers are trained in production

practices aimed at maximizing production.
However, advice given to a farmer that is
based only on production possibilities can
work to the farmer’s disadvantage. Farmers
need to understand the impact of production
decisions on profitability. In particular, they
need to understand the law of diminishing
Box 2 returns. Sometimes, producing less is more
Highest yield profitable than producing more.
does not always
give highest profit
Law of diminishing returns

The relationship between inputs and outputs rests on the
law of diminishing returns. This law is used to explain
how farmers determine the level of input use needed
to maximize profits. It is useful in assessing the level of
output that can be produced either from a single plot or
from the entire farm. Variable resources such as labour,
water, seed and fertilizer are applied to a fixed area of
land. The law of diminishing returns shows that beyond
a certain yield, the rate of increase in yields decreases,
The “marginal such that the additional input cost is not compensated by
concept” can additional yields.
help us to
understand
The marginal concept
“the law of
diminishing The term marginal is used often in economics. It has the
returns” same meaning as additional. It can refer to either output or
input. In both cases it can be measured in either physical
or financial terms. Thus, the marginal product per unit
of input means the addition to total production achieved
by adding one more unit of input. Similarly, the marginal
value of production means the value of the marginal, or
additional, product. It refers to the value added to the
total value of production by adding one more unit of input.
Other common marginal terms include: marginal input and
marginal cost, which refer respectively to added inputs
and the cost of an added input.

Table 4 shows an example of the marginal

product per unit of input for maize. The marginal product
(or added yield) is calculated as the difference between
different levels of total production. This appears in the
third column.
Quantity Total product Marginal product Table 4

of fertilizer of maize of maize The marginal
(bags) (bags) (bags) product for maize
when adding
0 0.5 0 different levels
1 1 0.5 of fertilizer
2 2.5 1.5
3 3.4 0.9
4 4.0 0.6
5 4.5 0.5

In this example, when no fertilizer is used, there is
little yield (total product = 0.5). When one bag of fertilizer
is applied, the total product of maize is 0.5 bag. This is
the marginal product. When the quantity of fertilizer is
increased from 1 bag to 2 bags the yield increases to 2.5
bags. This gives a marginal product of 1.5 bags of maize
(2.5 – 1.0 = 1.5).
When the amount of fertilizer is increased from 2

bags to 3 bags the total product increases to 3.4 bags. But
note here that the marginal product has decreased to 0.9
bags. The returns to the amount of fertilizer being applied
are diminishing (decreasing). As fertilizer application is
increased further, we can see that while the total product
continues to increase, the marginal product continues to
diminish.
We can see in Table 4 the effect different levels of

fertilizer have on production. It is the first step in deciding
the amount of fertilizer needed. The next step is to look at
this information in terms of value of production and costs
(for this see Table 5).
Total Total Marginal Quantity Total Marginal Gross

production value of value of of cost of cost of margin
production production fertilizer fertilizer fertilizer
(bags) ($) ($) (bags) ($) ($) ($)
(A) (B) (A – B)
0.0 10 0 0 0 0 10
1.0 20 20 1 8 8 12
2.5 50 30 2 16 8 34
3.4 68 18 3 24 8 44
4.0 80 12 4 32 8 48
4.5 90 10 5 40 8 50
4.9 98 8 6 48 8 50
5.2 104 6 7 56 8 48
Table 5 The critical question here is:

Costs and returns “How much fertilizer
for maize
should the farmer use?”
Optimum level
How much of each resource the farmer uses depends on
the cost compared with the return. The most economically
rational choice is the point of optimum level of output.
This is where the value of the marginal product is just
sufficient to cover the cost of the resource used.
In Table 5, this occurs at a level that lies between

4 and 5 bags of fertilizer (shown in bold). The gross
margin at this level of production is $50. Any application
of fertilizer below this level results in a marginal value of
production that is greater than the cost of fertilizer. This
means that the farmer would increase the gross margin
if more fertilizer were applied. With 2 bags of fertilizer,
the gross margin is $34. At fertilizer levels above 6 bags,
the gross margin begins to decrease. In this example,
however, there would be no value in applying the sixth bag
of fertilizer as it would not increase the gross margin.
So long as the marginal value of production

exceeds the extra cost, the gross margin is increased
by using more of the fertilizer input. As noted, there
comes a point when it is not profitable to apply any more

fertilizer to the crop. This is the point in the production
process where the marginal value of production equals
marginal costs. However, because prices often fluctuate,
the optimum level of output cannot usually be as easily
predicted as in this example.
Will using this resource cost me more than the

money I will receive in return? This question is applied to
many farm decisions. Will feeding poultry an additional 5 Farmers who
try to maximize
kg of feed add more to returns than to costs? Will costs
production need to
or returns increase more if the output of milk per cow is understand the
increased to 100 litres? If we add another hired labourer costs involved ...
or expand the area under cultivation, will we add more to
returns than to costs?
The practical experience of farmers closely follows

the concept of marginal analysis. Farmers who economize ... and try to
do not usually completely favour one product or resource optimize the
over another. They normally decide whether to have a use of their
resources.
little bit more of one and not quite so much of the other.
Farmers tend to apply inputs in small steps. They might
test the application of fertilizer or seeds over a number
of years, gradually trying out different combinations of
inputs and outputs before deciding on an optimum level.
As more experience is gained over the years through
demonstrations or trials an optimal allocation of fertilizer
can be reached. This often differs from recommendations
that are given by agricultural extension workers. It is up
to the farmers to test the combinations and arrive at their
own decisions as to the most profitable application.
HOW CAN FARMERS

ASSESS THEIR FINANCIAL REQUIREMENTS?
We have previously discussed gross margin as a way of

assessing the profitability of an enterprise. This indicates
how worthwhile a change in enterprise may be if planned
quantities and prices are realized. But if a new enterprise
is introduced into the farming system a cash flow analysis
also has to be prepared to assess whether the farm will
generate enough income to cover required expenditures.
As we discussed in Chapter 2, cash flow is the

Cash flow is a flow of money into the farm from sales and the flow of
useful concept money out of the farm through purchases. Cash flow
to determine calculations can help farmers assess whether they will
the availability have enough money to carry out their plan or if they are
of money at
likely to be short of money at any time. They enable the
any given time
farmer to identify the time of the year when additional
financial resources may be required.
For example, a farmer and his family know that

growing tomatoes on their farm will be profitable, but they
are not sure whether they will have enough funds to finance
the change to tomatoes. They need to find answers to a
number of questions: How much money is likely to be
generated from producing tomatoes and how much will it
cost? What enterprises will have to be reduced as a result
of introducing tomato production? When will the money be
received from sales of produce and when will money be
needed to purchase inputs? How would any shortfalls be
made up if the amount of money expected over the year
does not cover the amount needed?
To answer these questions the farm family has to

lay out planned income and expenses over the year and
assess whether they will have enough cash to cover the
costs of growing tomatoes. This is done by calculating
the cumulative cash flow (see Table 6).
Table 6 shows that over the first quarter the net

cash flow (difference between inflows and outflows)
is positive at $180. Over the next quarter the net cash
flow is negative (– $250). Assuming that the family had
no money at the beginning of the year the cumulative
balance is – $70 ($180 – $250). This shows that there
is not enough cash available to cover expenses in that
period. In quarter 3 the net cash flow is $314, again
showing that there are adequate funds. The cumulative
balance increases to $244 (– $70 + $314).
But over the next quarter the net cash flow shows
a deficit of $35. This reduces the cumulative balance for
that period to $209. The overall cash flow shows that not
enough money is available from the sale of maize, milk,
chickens and tomatoes to cover the increased expenses of
the new enterprise. The cumulative cash flow is negative in
the second quarter. The farming system does not produce
Table 6
enough cash to cover the additional expenses at certain Example of
times of the year. The proposed change is profitable but a cumulative
the family does not have cash available to finance it. cash flow
Quarter 1 Quarter 2 Quarter 3 Quarter 4

Sales of farm products
Maize 250 300
Milk 60 60
Chickens 130 Inflow
($)
Planned sale of tomatoes 60 120
Total cash inflow (A) 380 60 480 60
Purchase of inputs
Maize inputs 56
Farm inputs (livestock) 30 50 50 50
Chicken feed 20 20
Outflow
Tomato inputs 30 40 ($)
Family expenses 150 230 20 25
Total cash outflow (B) 200 310 166 95
Net cash flow (A – B) 180 - 250 314 - 35

Cumulative balance 180 -70 244 209
With a profitable enterprise but a cash flow

problem: What could the farm family do? In this example
one possibility could be to bring forward the sale of
maize in the third quarter to the second quarter. Perhaps
the family was keeping the maize in store, waiting for
a higher price later in the year. By selling earlier they
would get a lower return from maize but would be able
to overcome their cash flow problem. Alternatively, the
family could consider taking out a short-term loan.
HOW SHOULD FARMERS COST

THEIR ASSETS?
Farmers often have to make long-term decisions that,

once taken, influence the day-to-day management of
the farm. As we know, farmers are faced with decisions
Depreciation and on whether to purchase assets such as machinery,
salvage value equipment, or livestock and to plant tree crops. Once
are used to decisions are taken and money is spent, resources are
cost assets
committed and the costs become “unavoidable”. The
resources are then tied up on the farm and the assets
are regarded as a fixed cost to the farm.
After capital items such as machinery and

equipment are purchased they immediately begin to
depreciate in value. Depreciation is the loss of value of
an asset over time, either because of it being used or
because it will eventually become obsolete. This is an
© FAO/23925/M.Bleich
Investments
with long-term
consequences ...
Hand tools, watering can and wheelbarrow – Burundi

... such as
acquiring
farm tools,
machinery and
© FAO/GEWIS/07105/H.Josserand
equipment ...
... or planting
semi-permanent
or permanent
crops ...
Handheld tractor – Nepal
... must be
regarded
© FAO/21541/G.Bizzarri
as fixed cost.
A young lemon and papaya plantation – El Salvador

important factor to consider when looking at farm costs,

as eventually the item will have to be replaced. The
following example gives a fairly accurate idea of the cost
to use an item for a year.
An example of
calculating depreciation
Assume the cost of a plough is $200. It has a life of 5

years. Therefore, each year one-fifth of the cost of the
plough is taken off its value and is treated as an annual
fixed cost. This can be calculated as follows:
Depreciation = Purchase price ÷ Life of item
So, $200 ÷ 5 years = $40 per year, or the amount to be

deducted each year for five years as a fixed cost.*
As time proceeds there will be a need to replace

an asset. If a farmer buys a capital item but wishes to sell
it before the end of its life span, the value of that asset is
called the salvage value. This is the value that remains
unused. If a farmer sells the asset after two years, even
though it has a life of five years, its salvage value would
be the original price minus the cost of depreciation over
the two years.
* Although there are more complicated ways to calculate depreciation,

this is the easiest and most commonly used in farm management
HOW CAN FARMERS DECIDE

WHETHER TO BUY FARM ASSETS?
If farmers want to buy equipment, machinery or livestock

how do they decide what to do? This decision is different
from the questions raised in the previous sections. Why? Decisions on
buying assets
Machinery, farm equipment and livestock last longer than are important ...
a single season or year. Therefore the purchase of these
items requires decisions with long-term implications.
The concept that is frequently used in economics

to decide whether or not to buy items of machinery, ... they tie up
equipment or livestock is called the return on capital. This money and
is the total benefit derived from using the capital, less the determine the
farm’s future
extra costs incurred, including depreciation, maintenance profitability for
and repairs. The return on capital expresses the profit many years
expected from the investment, which is, in turn, related ahead
to the capital required to give a percentage rate of return
on the capital.
The return on capital is calculated as follows:
Rate of return =
Additional annual profit
x 100
Cost of investment
First, the amount of capital required has to be

calculated. This is simply a question of adding up
the sum required for livestock, buildings, machinery
or equipment as well as the extra working capital
required for seeds, fertilizer or other inputs. Second,
the additional profit is calculated by budgeting out the
additional income against any additional costs. As
explained before, the use of gross margins considerably
simplifies such budgeting. One must not, of course,
forget any increase in fixed costs, and costs of rent,
labour, or machinery. Included also in the additional costs

should be an allowance to cover depreciation in the capital
investment and also any additional maintenance costs.
After estimating the capital required

and the resultant profit,
the return on capital can be calculated
An example of estimating capital required
A maize farmer with two dairy cows is considering

doubling the herd to four animals. The decision calls for
a number of changes to be made on the farm. It requires
buying more animals, and involves introducing some
equipment and constructing a shed, as well as making
sure that enough fodder is grown to feed the animals.
The additional capital required

is assumed to be:
Livestock $360
Equipment $ 60
Shed $250
Working capital $100
Total additional capital required $770
The extra profit from increasing the dairy herd size has
been budgeted as follows:
Additional gross margin from milk sales $413
(Less) Maize gross margin $46

Additional labour $10
Additional maintenance costs $ 5
Depreciation of shed
and equipment (10 years) $31
– $ 92
Additional profit $321

Here, the decision to increase the number of

cows will also involve a change in the cropping pattern to
provide more fodder to feed the increase in dairy cows.
Some of the land under maize cultivation would have to
be given up. The value of the area of land to be placed
under fodder cultivation is the value of the area of maize
lost. This is the opportunity cost of the alternative use
of the land. Here the opportunity cost of the land lost to
maize has been estimated at $46 .
Box 3
Guidelines
Each capital item is normally valued for assessment
at its purchase price or cost of production.
Profit is determined by calculating

the additional income compared
with additional costs.
Additional profit that the farmer can make
as a result of this change is estimated
by calculating the increase in gross margin
of the extra head of livestock.
The additional profit is then calculated as the

increase in profit from the dairy cows minus the opportunity
cost of the land needed to grow more fodder. The overall
increase in profit is $321 ($413 – $92).
The rate of return is expressed as the increase in

profit as a percentage of the capital cost. In this example
the return is calculated at 41.6 percent. The level of return
is satisfactory and providing the figures used in the budgets
are reasonable and not over-optimistic the investment
looks worthwhile.
After calculating the rate of return, the farmer

then has to decide whether it is worthwhile to make the
investment. The anticipated rate of return on capital will
clearly need to be higher than the rate of interest if the
money has to be borrowed.
The minimum rate of return that the farmer desires

has to be assessed. The farmer needs to assess the real
cost of making the investment in the dairy enterprise.
Sometimes farmers take out loans to finance the purchase
of equipment. When they take out a loan they are usually
charged a rate of interest. The interest payment is the cost
of capital. Clearly, the rate of return must exceed the cost
of capital by quite a lot if farmers are going to take the risk
to invest.
But some farmers may decide not to take out a

loan and use their own savings instead. Even though
Farmers must
assess their
there is no cash payment of interest to be made by
“minimum the farmer, there is still a cost involved. This is the cost
rate of return” of the earnings given up by not putting money into an
before deciding alternative use. This is an opportunity cost. A farmer
if it is worthwhile might have used that very same capital in a way that
to make an could also have earned money. For example, the farmer
investment
could have kept the money in a savings deposit in the
bank where it would have earned interest.
In practice, most small-scale farmers select a

minimum rate of return in excess of 30 percent per annum.
This is quite high but reflects the fact that there are always
risks involved in going into a new venture.
Ultimately, the farmer’s decision depends on a

number of factors:
•• Is there an alternative use for the money?

•• Is the farmer interested in taking a risk?
•• Do the capital items require new skills
and training?
The farmer may expect a high rate of return to

justify taking the risk of a new enterprise and going
through the trouble of learning and developing new skills.
Alternatively, if the farmer feels that it is relatively simple
to increase the size of the dairy enterprise and to operate
the new equipment, then a lower rate of return may be
satisfactory. The decision is the farmer’s and every farmer
will have his or her preference.
HOW DO FARMERS DEAL WITH RISK?
As noted earlier, one of the facts of farming is that the

farmer faces numerous risks because many future events
cannot be known with complete accuracy or certainty.
Risk influences the amount of inputs that the farmer uses
as well as their cost. Similarly, there is uncertainty in crop
yield and product prices. As a result, farm profits are
always uncertain and this makes farm operations risky.
The more common sources of farm risk can be divided
into the five areas outlined below.
Production risk
Factors that affect the farm yields
such as pests or diseases,
poor weather, low rainfall or drought.
Marketing risk
Uncertainty about market prices,
and the supply of and demand for products.
Financial risk
Availability of funds for development,
the possible need to borrow money
and the ability to make repayment.
Institutional risk
Changes in the provision of services
from institutions that support farming,
for example banks, cooperatives,
governments or social organizations.
Human risk
Availability and productivity of farm workers
as affected by accident, illness or death,
or political or social unrest.
Some farmers try to understand risks better and

they may even make plans to reduce them when they
can. For example, in response to a production risk, a
farmer may decide to plant a drought-resistant variety
in order to reduce the risks of low rainfall. The farmer
knows that the yield from the drought resistant variety is
likely to be lower than that of a higher producing variety
but does this as a precaution of the risk of rainfall being
low.
As manager of the farm business, the farmer has

to cope with the many different types of risk. Different
ways that farmers deal with risk depend on their
personality and the extent to which they are willing to
gamble. Farmers are different, some will take more risks
than others.
The differences in the decisions that farmers take

also depend on their family and financial situation. For
example, if a farmer had financial savings and the crop
failed the family would not go hungry. The farmer can
perhaps afford to take more risk than a family with no
savings. So the farmer’s decision is complicated and
depends on many factors. In particular, the higher the
demands on the farmer for cash, the less likely he or she
will be to take a risk.
Risk-reducing strategies
Decisions on what to do vary among farmers but there are
some common ways of dealing with risk. Some of these
may require either a reduction in the level of production
or, alternatively, an increase in the costs of production
over a period of years. This often means that in order for
farmers to manage risk they may have to give up a part
of their profits in the short term.
Use risk reducing inputs. Buy inputs and materials

that better control crop diseases, pests and use of water,
and reduce animal health problems. Such inputs could
include drought-resistant varieties, pesticides, fungicides
and vaccines for animals.
Select low risk enterprises. Choose enterprises that are

more stable than others. For example, those employing
reliable crop varieties or those with well-established
channels of marketing.
Ensure system flexibility. This allows the farmer to shift

from one cropping pattern to another. For example, with
some enterprises land used can be increased or reduced
easily without affecting profitability.
Product diversification. This can increase the number

of enterprises on the farm so that if one fails, the income
from others will be sufficient to keep the farm going. Not
all enterprises are likely to fail together.
Maintain input, finance, product reserves. Farmers

can keep reserves such as money, physical inputs, final
products, food. Such reserves would help protect the
farm family from the risk of price changes. Food reserves Farmers often
also provide some security against the risk of crop failure, try to weigh
the amount
although storage losses can be a problem. of “riskiness”
when they are
Contract farming. Price uncertainty may be eliminated making plans
by making advance contracts with buyers. Farmers may
contract with suppliers to provide inputs at specified
prices and also to avoid the risk that key inputs will be
unavailable at critical times. There are, however, risks with
contract farming to be considered. For example, if a cash
crop is produced the world market price may collapse
leaving the buyer unable to honour the contract.
Collecting market information. Good information on

seasonal price variations and changes in prices over
the years can be used to plan when produce should
be marketed. The more knowledge farmers have about
price change and the past profitability of enterprises, the
better their position when they plan for the future.
Insurance. Private companies or governments may

guarantee a certain amount of money in the event of
a major catastrophe, in return for an annual premium.

Some countries will ensure against crop loss from hail or
hurricane. Farmers must give up a certain amount of their
yearly income in return for this security .
Better management practices. If farmers recognize

early on that their crops or livestock are diseased they
can respond more quickly to spray crops or inoculate
livestock. However, these precautions are likely to
increase costs and reduce profits and such actions
would need to be set against the greater security that is
gained.
Chapter 5
Summary
FINAL POINTS
As an extension worker, you have an important role

to play in supporting farmers in their marketing and
production decisions. You are in a position to guide them
away from traditional farming practices towards a more
market-oriented approach to farming.
Farmers need assistance to ensure that their

produce satisfies the consumer. This calls for improved
farm management skills so that farmers can better select
new opportunities and have an understanding of how
to deal with the market. The principles of economics as
discussed in this guide have been prepared to assist you
to understand some of the dilemmas facing farmers and
ways that these problems can be addressed. An overview
of the main economic concepts and principles follows.
•• Maximization of profit or satisfaction

•• Variable and fixed inputs
•• The margin
•• Diminishing marginal returns
•• Substitution
•• Opportunity cost
•• Efficiency: return to scarce resources
•• Comparative advantage
•• Economies of scale
•• Supply and demand
•• Elasticity
•• Farm profit
•• Net farm family income
•• Optimum level of output
•• Cash flow
•• Depreciation
•• Salvage value
•• Return on capital
•• Risk
Summary 83
Maximization of profit or satisfaction

It is generally assumed that farm businesses are planned
for the maximum profit consistent with good husbandry.
However, when objectives other than profit maximization
are considered, such as the satisfaction of family
interests, reduction of risks, or increased leisure, which
might reduce the potential profit, the costs of meeting
these objectives also need to be considered. Economic
principles should be used to indicate the best allocation
of resources for attaining the chosen objectives.
Variable and fixed inputs

The distinction of farm resources between variable and
fixed inputs underlies much of the economic thinking about
farm production. Variable inputs are those that change with
the amount of output over a given period (e.g. fertilizer,
seeds, pesticides, fuel, harvest, labour). Fixed inputs are
those that remain the same regardless of the volume
of the output actually achieved (e.g. land rent, labour
required for cultivation irrespective of final yield, livestock,
tools, machinery, buildings). The same distinction lies
between costs that vary with output and fixed costs that
are incurred irrespective of the level of output.
The margin
This is the added output, input or value (cost of product).
It is measured either in physical (production) or financial
terms. The marginal product per unit of input reflects to
the yield added to the total production by adding one more
unit of input. Similarly, the marginal value of production
refers to the value added to the total value of production
by adding one more unit of input. Other common marginal
terms include: marginal input and marginal cost, which
refer respectively to added inputs and the value of an
added input.
Diminishing marginal returns

The principle of diminishing marginal physical and
financial returns is vital to understanding farm production
economics. It is the use of the concept of diminishing
returns that determines the best level for any production
practice or activity on the farm.
Substitution
The principle of substitution applies whenever farm output
can be produced by different combinations of inputs or
different methods of production.
Opportunity cost
This principle notes that by transferring resources from
one activity to another there is a cost that is often not
measured. This is the income lost as a result of reducing
the level of output from which resources are withdrawn.
The strict definition of opportunity cost is the maximum
income that the resource(s) could have given in an
alternative use.
Efficiency: return to scarce resources

Farm efficiency is concerned with the wise use of the
resources available to the farmer. One way to look
at efficiency is from the point of view of the factors of
production (i.e. natural resources, labour and capital).
In most cases, one of these factors will be the one that
limits profits the most. This is the most limiting factor or
the effective resource constraint.
Comparative advantage
This principle refers to the distribution of physical
resources, over space. That is, the best use of land in
different locations for the production of different crops
and livestock. It suggests that for greatest efficiency
farm activities should take place in those locations where
the factors of production (climate, soils, terrain, labour
availability) provide advantages of the lowest costs
compared with other sites.
Economies of scale
Economies of scale are achieved when the cost per
unit of production or output marketed is reduced as the
scale of the activity increases. Savings (economies) can
be achieved by spreading costs over a larger scale of
operation. Economies of scale can also be achieved
among farmers when they organize themselves into
groups to buy inputs, obtain capital or market produce.
Summary 85
Supply and demand

A market exists when buyers wanting to exchange money
for goods or services are in contact with sellers wanting
to exchange products or services for money. A market
is made up of people who use, need or want a product
and who have the money to buy it. Prices are set by
producers and consumers coming together to exchange
goods and services.
Elasticity
This is an economic concept that explains changes in
product prices, supply and demand. It explains why the
prices and quantities of some products supplied and
demanded can vary more significantly than others. When
the price of a product changes, the supply and demand
for that product also change. The degree of change
in the demand and supply in response to a change in
price is called elasticity. Different products have different
elasticities.
Farm profit
Farm profit refers to the money left over after paying for
the variable and fixed costs. If the difference is positive,
that farmer is making a profit; if the difference is negative
the farmer is making a loss.
Net farm family income

Net farm family income is a concept that takes into
account the value of family labour in calculating profit.
The cost of family labour is done by valuing what it
would cost to hire that labour instead of using it in
production. After farm profit is calculated, family labour
costs are deducted.
Optimum level of output

This concept explains how much of each resource
a farmer should apply. The decision is based on
the comparison of the costs and returns. The point
of optimum level of output is where the value of the
marginal product is just sufficient to cover the cost of
the resources used.
Cash flow
Cash flow is a concept used to assess if the farmer
has sufficient money available to make changes to the
farming system. This may involve a change in farm
enterprise composition or alternatively purchasing a
capital asset, as examples. The cash flow enables the
farmer to identify the time of the year when additional
financial resources may be required. It is made up of the
flow of money that comes into the farm from sales and
the flow of money that leaves the farm through purchases
and expenditures. The net cash flow is the difference
between the cash inflows and outflows. The cash flow
can help the farmer determine the financial performance
of the farm as a whole.
Depreciation
Depreciation is a concept used to assess the loss of
value of an asset over time. This occurs as a result of
the asset being used or because it eventually becomes
obsolete. As time proceeds there will always be a need
to replace an asset.
Salvage value
Assets have a given life expectancy. The concept of
salvage value expresses the value of an asset that is
unused at the time that it is sold.
Return on capital
Return on capital is a concept used in economics to decide
whether or not to buy a fixed asset such as machinery,
equipment, an animal or establish a tree crop. These are
all long term investments. The return on capital expresses
the profit expected from the investment related to the
capital required. It is expressed as a percentage rate of
return on the cost of capital.
Risk
The concept of risk reflects the fact that future events
cannot be known with complete certainty. Risk occurs
when the outcome of a decision is not known in advance
or cannot always be predicted. These risks need to be
taken into account by farmers when making decisions.
87
Glossary
Assets Items of capital owned by the

farmer.
Capital Items produced as a result of

“human effort”.
Cash flow The flow of money into the farm

from sales and the flow of money
out of the farm through purchases.
Competitive Farm enterprises for which

enterprises the output level of one can be
increased only by decreasing the
output level of the other.
Complementary Enterprises for which increasing the

enterprises output level of one also increases
the output level of the other.
Cost of capital Payment of interest for capital

investments.
Demand The amount buyers are willing to

buy at a particular price.
Depreciation The loss of value of an asset over

time, either because it is being
used or because it will eventually
become obsolete.
Efficiency The wise use of the resources

available to the farmer.
Factors of The resources needed for

production production.
88
Farm enterprises The range of products produced

on a farm.
Farm profit The money left after the variable

costs and the fixed costs have
been paid.
Fixed costs Costs that do not vary with

changes in production.
Gross margin A measure of what the enterprise

is adding to farm profits. The gross
margin for a crop or livestock
product is obtained by subtracting
the variable costs from the value
of production.
Inputs Items that are used for production.
Investment Money used to purchase a capital

item that provides future benefits.
Labour The work of farmers, their family

and hired labourers; human effort.
Market A place where the exchange of

products for money takes place.
Market price The price that both the buyer and

the seller are willing to accept
for the product that is being
exchanged for money.
89
Marketing A process by which produce

produced by farmers reaches
consumers.
Natural “Gifts of nature”, including land,

resources water, soil and rainfall.
Net farm family The net farm income after taking

income. into account the cost of family
labour used to generate it.
Opportunity cost The income that could be received

by employing a resource in its
most profitable alternative use.
Outputs The crops and livestock produced.
Production The relationship between inputs

function and outputs.
Rate of return The increase in profit as a

percentage of the capital cost
of the investment required to
increase the profit.
Risk A situation in which more than one

possible outcome exists, some of
which may be unfavourable.
Salvage value The market value of a depreciable

asset at the time it is sold or
removed from service.
90
Supplementary Farm enterprises that use

enterprises resources that might otherwise
not be used “supplement”
one another. An example of a
supplementary enterprise is
intensive livestock such as poultry
or pig – that has no significant
demand on land as a resource.
Supply The amount that farmers are

prepared to sell at a particular
price.
Value of The money received from the sale

production of produce together with the value
of produce that is consumed and
stored.
Variable costs Costs that vary according to the

size of an enterprise and the
amount of inputs used.
Working capital Working capital consists of the

money needed to buy stocks of
inputs and materials and items of
expenditure paid in advance of
income earned.
91
Notes
92
93
94
95
96
97
The following is a list of the publications included in
the farm management extension guide series:
1
MARKET ORIENTED FARMING:
An overview
2013, 90 pp.
2
ECONOMICS for
farm management extension
2008, 90 pp.
3
MANAGING RISK in farming
2008, 107 pp.
4
FARM BUSINESS ANALYSIS
using benchmarking
2010, 142 pp.
5
ENREPRENEURSHIP
in farming
2012, 127 pp.
6
The role of the
FARM MANAGEMENT SPECIALIST
in extension
2013, 127 pp.

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2

Farm management extension guide

FOOD AND AGRICULTURE ORGANIZATION OF THE UNITED NATIONS

The designations employed and the presentation of material in this

ISBN 978-92-5-107541-8 (print)

FAO encourages the use, reproduction and dissemination of material in this

FAO information products are available on the FAO website (www.fao.org/

Whether you are working for government, an NGO or

It introduces you to some of the concepts and

This guide has been produced by the Agricultural

The author would like to acknowledge the assistance of

A small-scale farmer runs a three hectare farm. She

If this farmer asked you for advice

MAIN POINTS IN CHAPTER 1

Market-oriented farming: Farm

Goals for farm and family

Economics in farm management Farm

More and more farming families are finding that they

GOALS FOR FARM AND FAMILY

Goals set the framework and give a focus for making

Farmers run their farm business. They are the

Some common goals of farm families

Farmers must decide

To produce food only for the family

... which may

Improved watering using a pump – Zimbabwe

the family? Farming for profit can be very risky because

Before you can effectively advise farmers about

Some of the questions that extension workers may

•• Do you want to produce all your food

Farmers’ preferences and goals affect the

Goals are about satisfaction. However, when a

You need to understand the broad range of goals

... and farm

A family working together – Congo

Unless the farmer has money in the bank to cover

Various cases to consider

A farmer is continuing with an enterprise

A farmer chooses a less profitable enterprise

A farmer chooses a social goal

In each of the cases above, knowing the cost of

ECONOMICS IN FARM MANAGEMENT

Economics is about wealth, that is the use of often scarce

Learning about some of the key economic

MAIN POINTS IN CHAPTER 2

Efficiency: return to scarce resources

Factors of production are the resources needed to

Land. A typical farm family may own or rent some land

Capital is used by all farmers, but small-scale

Capital is often referred to as assets.

Assets can also be divided into

Most farmers have a range of different products that

Farm enterprises can be divided into

Cost of production refers to the value of the inputs

If a high yield is attained

The same is true of other inputs. If the farmer decides to

Examples of fixed costs

A farmer has a small storeroom for fertilizer, seed,

For the most part, fixed costs only become