Tuesday, November 18, 2008

Prices and Marginal Productivity

We all know and teach that price sends signals to consumers. And we all know and teach that price sends signals to producers. To the latter group, we often talk about price signaling "what to produce," "how to produce," and "for whom to produce."

The second signal is the focus of this post. Changing prices tell producers not only what products to produce, but also what resources to use. A low price signals that those resources with low opportunity cost or a high marginal benefit/low marginal cost should be used - the concept of marginal productivity.

I used to tell my students to visualize three parcels of land. The first is very productive and very fertile. The ground seems to have a natural resistance to weeds and pests. And when the seed is sown, it naturally falls into rows and the harvest falls in nice, neat piles of its own accord. This land is productive with minimal effort and provides a decent return even when crop prices are low.

The second plot of land requires some work, some additional labor and capital resource inputs. Because of this, a return is possible, but only if prices are higher. The third plot land is a swamp, complete with alligators. Prices have to be pretty high to "drain the swamp" and still provide a return.

An article (complete with video and slide show) in today's issue of The Wall Street Journal illustrates this concept very well. The article explains how rising grain prices drew farmers in Cambodia to expand production by using less productive resources - land that had to be cleared, land that had little access to transportation or lacked irrigation. Now that prices are falling, farmers are getting the signal about "how to produce".

I think the article can also be used to discuss related issues such as role of government in providing infrastructure as a way promoting economic development; and the importance of institutions (laws and property rights) in protecting individuals and promoting growth. There are other concepts that can be developed, as well.

The idea of marginal productivity can also be extended to energy. At $4.00 a gallon for gasoline, bringing certain oil fields into production makes sense. That changes when the price of gasoline falls below $2.00 a gallon. And when we apply the idea to alternative energy sources, we can tie in the substitution effect.

I look forward to your comments.

9 comments:

Jameel said...

I think you're right, especially in today's economy. Every producer wants to have the lowest cost and the highest profit possible. The oil fields is a good example. If at $4.00 per gallon, bringing more fields online will help drive down the cost, so more consumers would be interested in the product.

Zenat said...

I also agree with Jameel. For example, if the gas prices were to go up in the near future, consumers would be in their best interest to stock up on their supply so as not to pay more when they need it. When that time comes for the prices to go high, consumers will be able to cut back on their gas consumption and gas companies would have to lower their prices once again to return to their initial profitability. To lower their gas prices, they would have to find a way to expand production by using less productive resources.

Zenat said...

I also agree with Jameel. For example, if the gas prices were to go up in the near future, consumers would be in their best interest to stock up on their supply so as not to pay more when they need it. When that time comes for the prices to go high, consumers will be able to cut back on their gas consumption and gas companies would have to lower their prices once again to return to their initial profitability. To lower their gas prices, they would have to find a way to expand production by using less productive resources.

Sherry said...

I agree with you. Marginal productivity is used for a producer to determine if he or she should increase the input in order to create a larger output. However once the maximum marginal product is reached, producers will cut down the increase of inputs because of a diminishing marginal product that begins to occur. Therefore, producers will cut back on their inputs to attempt to produce at efficient scale.

Ken said...

I really liked the way you explained the concept of marginal productivity. The example of comparing the concept to the three parcels of land was easy to comprehend and very helpful.
I agree with the posts by Jameel and Zenat -- to maximize profit is always the goal of producers. With this in mind, I further understood the reasons of producers making specific responses to price -- so they maximize profit.

Cicia said...

It's always interesting to see the applications of economics in the world around us, and the marginal productivity at work in these farms of Cambodia are easily observable. The producers, as price goes up and as they want to produce more, continue to employ increasingly less efficient resources - reflecting the law of diminishing marginal product.

For the Cambodians, I feel like they are both fortunate and unfortunate: fortunate for having this opportunity to participate in the international economic system, and to have the chance to improve their prospects, should they choose to apprehend their possibilities; but also unfortunate, because the investors care very little about the culture or the heritage of land, only about the usefulness. When price goes down again, there will be little use for these outskirted Cambodian farmlands, and though there may have been some economic growth locally, many of those tribes mentioned in the article, who traded farms for radios, will find themselves left in a difficult position.

Also, I'd just like to mention the environmental effects of these cost-minimizing methods. As we continue to plunder the land of its resources, and continue to squeeze every ounce of fertility from the soil, rather than make the long term investments of finding more yield-producing technology (which may not be as rewarding short term), we often fail to realize that increased agricultural acreage has potently negative effects, such as the desertification that we are undeniably witnessing around the world.

Anyways, I don't reject economics; on the contrary, I embrace its concepts wholly. And by the way, I realize that your blog was simply on marginal productivity, but, and I mean this as a legitimate question, not simply as rhetoric, how does economics intend to remedy these problems that it creates in maximizing profits?

Justine said...

I agree with Jameel and Zenat. Because people are naturally selfish human beings, the "invisible hand" drives us to buy things at the lowest cost possible. This also helps producers because having the lowest cost leads to more consumers and a higher profit. Now that gas prices are under $2.00, many people are buying gas much more freely. This should help lead to more profits for producers, and more money left in the pockets of consumers. Hopefully this helps lead to an improvement in the economy.

Tim Schilling said...

Jameel and Zenat:

Thank you for your comments. I think you realize this, but just to clarify, those less productive resources only stay in production for the long run if prices stay high. Is it possible that when prices drop, those sources may no longer be profitable and we would witness a mass exodus from energy exploration and production similar to what we saw in the early 1980s?

Tim Schilling said...

Cicia:

As we continue to plunder the land of its resources, and continue to squeeze every ounce of fertility from the soil, rather than make the long term investments of finding more yield-producing technology (which may not be as rewarding short term), we often fail to realize that increased agricultural acreage has potently negative effects, such as the desertification that we are undeniably witnessing around the world.

I agree with you. However, much of the technology that would produce higher yields is spurned because it can involve GMC (genetically modified crops) and/or dependence on large-scale farming (increasing productivity).

However, that is not the only technology available. But to develop the things that you and I suspect are possible will take time. And prices are signals in the short run. I believe it takes true visionaries/entrepreneurs to see the long-run.

Regardless, welcome to the blog.