When financial input is a constraint, the farm manager must prudently decide how available finance should be allocated among many possible alternatives.
Decisions are to be made on the best allocation of limited financial input among various hectares of crops, different types of livestock, and other agricultural enterprises. The equi-marginal principle provides guidelines to ensure that allocation is done in such a way that profit is maximised.
Average and Marginal Returns to Capital in Agricultural Finance
Farm financial management requires the ability to distinguish between average and marginal returns to capital. Average returns relate to the return on all the capital invested in an enterprise, while marginal returns refer to the return on an extra (added or marginal) sum of capital.
Maximising Profit on Farms with Adequate Capital
When capital is adequate, the farmer is at liberty to employ inputs up to the level where marginal revenue equals marginal cost. The quantity of input at the point of profit maximisation and the quantity of output at the profit maximisation point.
Maximising Profit on Farms with Limited Capital
If capital is limited, the concept of equi-marginal returns becomes critical. To maximise profit, the farmer with limited financial input should allocate the available capital among enterprises in accordance with the principle of equi-marginal returns.
The principle is stated as follows: A limited input (finance) should be allocated among alternative uses in such a way that the marginal value product of the last unit of input is equal in all uses.
Decision Rule for the Equi-marginal Returns Principle
The limited available financial input must be allocated among three crops sugarcane, cotton, and paddy rice using the Marginal Value Products (MVPs). The optimal allocation involves assigning three units to sugarcane and one unit each to cotton and paddy rice, respectively.
The principle of equi-marginal returns can also be stated as follows: At least N1 spent on an enterprise or factor of production should yield a marginal return exactly equal to the last N1 spent on all other enterprises or factors of production.
For example, if N1 is spent on buying fertiliser, additional feed should be purchased up to the point where the last N1 spent on feed returns the same as the last N1 spent on fertiliser.
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Opportunity Cost Principle in Agricultural Finance
Another principle closely related to equi-marginal returns is the Opportunity Cost Principle. The farm financial manager faces numerous choices regarding the use of inputs.
If an input is used in a particular production process, it cannot be used elsewhere at that time. This means the input will lose the income from its alternative use, and this forgone income is called opportunity cost.
Opportunity cost is the income that could have been earned if the input had been used in its most profitable alternative use. Alternatively, it is the value of the product not produced because the input was used for another purpose.
The concept of opportunity cost significantly influences the decision-making process of the farm manager, particularly in decisions related to input use.
In economics, opportunity cost is referred to as the real cost of an input. The real cost of an input is not its purchase price but the income it could have earned in its next best alternative use.
Application of Opportunity Cost in Enterprise Selection
Apart from input use decisions, the opportunity cost principle is a useful tool in selecting the most profitable enterprise combination. In this decision-making process, the farm financial manager must consider all enterprises suited to the farm’s situation and resource endowment.
The income from all next-best alternative enterprises is given importance, following the principle of opportunity cost, and the most profitable enterprise is selected.
This selection process is similar to the procedure followed by the principle of equi-marginal returns. Both input use decisions and the selection of the most profitable enterprises are based on the opportunity cost principle or the principle of equi-marginal returns.
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Challenges in Calculating Opportunity Cost
However, calculating the opportunity cost of capital assets presents challenges. One such challenge is determining the value of services provided by land, machinery, farm buildings, livestock, etc., in their alternative uses. Before arriving at the values of these services, determining fixed costs involves numerous complexities.
To simplify these complexities, economists and researchers have sometimes resorted to crude approximations, especially under time and data constraints.
These approximations include applying a 2 to 3 percent depreciation rate to farm structures and using an interest rate on capital equal to the return on savings or the cost of borrowed capital. As a result, the application of this principle is not as straightforward as it may appear for all types of farm financial decisions.
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