CHAPTER 11CHAPTER 11

•Input Combinations•Enterprise Combinations

Learning OutcomesLearning Outcomes1.1. Understand the concept of substitution in Understand the concept of substitution in

economics and use it decision making.economics and use it decision making.2.2. Know how to compute substitution ratio and Know how to compute substitution ratio and

price ratio for two inputs. price ratio for two inputs.3.3. Use the input substitution and price ratios Use the input substitution and price ratios

to find the least-cost combination of two to find the least-cost combination of two inputs.inputs.

4.4. Understand the characteristics of Understand the characteristics of competitive, supplementary, and competitive, supplementary, and complementary enterprises.complementary enterprises.

5.5. Use the output substitution and price ratios Use the output substitution and price ratios to find the profit-maximizing combination of to find the profit-maximizing combination of two enterprises.two enterprises.

Input CombinationsInput Combinations

Most products require two or moreinputs, and the manager may choosethe input combination or ratio to use.

The economic question is whetherone input can be substituted for another to reduce the cost.

Types of Input SubstitutionTypes of Input Substitution

• Constant rate (perfect Constant rate (perfect substitution)substitution)

• Decreasing rate (more and more Decreasing rate (more and more added to replace 1 input)added to replace 1 input)

• OR No substitutionOR No substitution

Three possible types of Three possible types of substitutionsubstitution

Input Substitution RatioInput Substitution Ratio

addedinputamtreplacedinputamt

ratioonsubstitutiinput =

Input Price RatioInput Price Ratio

replacedinputpriceaddedinputprice

ratiopriceinput =

Decision RuleDecision Rule substitution ratio = price ratio

if substitution ratio is greater than the price ratio ( SR>PR), the total cost of the feed ratio can be reduced by moving to the next lower ration in the table.

the least cost ration in this example is found by the least cost ration in this example is found by moving to ration F, where the substitution ratio is moving to ration F, where the substitution ratio is equal to the price ratio.equal to the price ratio.

SUBSTITUTION SHOULD CONTINUE UNTILSR = PR.

Choosing the least cost combinationChoosing the least cost combination Feed ration for cattle to increase weight by 2 kg per week.Feed ration for cattle to increase weight by 2 kg per week. Feed ration Hay (kg) Grain (kg) SR PRFeed ration Hay (kg) Grain (kg) SR PR A 1350 825A 1350 825 2.93 1.472.93 1.47 B 1130 900B 1130 900 2.60 1.472.60 1.47 C 935 975C 935 975 2.20 1.472.20 1.47 D 770 1050D 770 1050 1.87 1.471.87 1.47 E 630 1125 E 630 1125 1.47 1.471.47 1.47 F 520 1200F 520 1200 1.07 1.471.07 1.47 G 440 1275 G 440 1275

Price of grain: RM 0.44 per kg Price of hay: RM 0.30 per kgPrice of grain: RM 0.44 per kg Price of hay: RM 0.30 per kg

Enterprise CombinationsEnterprise Combinations

Another decision that must be madeis the combination of enterprisesto produce to maximize profits. If oneor more inputs is limited, there is anupper limit on how much can be produced.

Enterprise RelationshipsEnterprise Relationships

The first step in determining theprofit-maximizing combination ofenterprises is to determine thephysical relationship among theenterprises.

Types of RelationshipsTypes of Relationships• Competitive productCompetitive product: the production from : the production from

one enterprise can be increased only by one enterprise can be increased only by decreasing production from another decreasing production from another enterprise. enterprise.

• Supplementary productSupplementary product: more production : more production from one enterprise can be added without a from one enterprise can be added without a change in the level of the other enterprise.change in the level of the other enterprise.

• Complementary productComplementary product: as production of one : as production of one enterprise increases, production of the other enterprise increases, production of the other enterprise also increases.enterprise also increases.

Competitive EnterprisesCompetitive Enterprises

Competitive enterprises may haveconstant substitution or increasingsubstitution.

Production Possibility Curves Production Possibility Curves for Competitive Enterprisesfor Competitive Enterprises

Output Substitution RatioOutput Substitution Ratio

gainedoutputofQuantitylostoutputofQuantity

ratioonSubstituti =

Price ratioPrice ratio

lostoutputoficePrgainedoutputoficePr

ratioicePr =

Decision RuleDecision Ruleoutput substitution ratio = output price ratio

If no available combination makes theseexactly equal, get as close as possiblewithout letting the price ratio drop belowthe substitution ratio.

PROFIT IS MAXIMIZED at SR = PR, when PROFIT IS MAXIMIZED at SR = PR, when SR<PR, substitution should continue because SR<PR, substitution should continue because additional income additional income exceedsexceeds income lost i.e. income lost i.e. substitution will increase total income. substitution will increase total income.

Choosing enterprise combinationChoosing enterprise combinationSelecting a profit maximizing enterprise combination with land the fixed Selecting a profit maximizing enterprise combination with land the fixed input (the price of corn is RM 2.80/kg and the price of groundnut is RM input (the price of corn is RM 2.80/kg and the price of groundnut is RM 4.00/kg)4.00/kg)

Combination Corn (kg) Groundnut (kg) SR PRCombination Corn (kg) Groundnut (kg) SR PR

1 0 6000 1 0 6000 0.20 0.700.20 0.70 2 2000 56002 2000 5600 0.30 0.700.30 0.70 3 4000 50003 4000 5000 0.45 0.700.45 0.70 4 6000 4100 4 6000 4100 0.55 0.700.55 0.70 5 8000 30005 8000 3000 0.70 0.700.70 0.70 6 10000 16006 10000 1600 0.80 0.700.80 0.70 7 12000 07 12000 0