Changing prices will affect a producer’s profitability. It’s important to understand the effect of prices on production and how they can be an incentive to produce more, and how falling prices could put people out of business.
Each unit of output produced can be sold; after all, that’s the point of being in business. We will assume for now that all units are sold at the same price, although in reality, this is sometimes not the case. We will also assume that all units are equally valuable, that there are no differences in quality.
The first thing we can calculate is total revenue. Revenue equals the price per unit, times the number of units. In our willow example, that’s $25 times each unit of output. Note the difference between cost and price? The price is what a consumer will pay for a product. The cost is the amount the producer must pay for the inputs to make the product. In general conversation, we sometimes mix these terms up. For example, if you buy a textbook, your parents might as you, “how much did that cost?” They are really inquiring as to the price you paid. The cost of making it has to do with the paper, ink for printing, materials for binding, and of course the capital or machinery.
Let’s add another column to our growing spreadsheet. We are assuming that willow being used for biomass sells for the price of $25/kg. We can calculate the total amount of money the producer will get if he sells the entire product. Total revenue is calculated as Price x Quantity.
Table 5-3: Production, total costs, total revenue for willow.
* highest output, ** highest cost, *** highest revenue. Permission: Courtesy of course author Hayley Hesseln, Department of Agriculture and Resource Economics, University of Saskatchewan.
Take a look at the numbers and consider the following questions. You might even write down your answers before reading ahead.
How much input do we use if we want to maximize output?
Where do we produce if we want to minimize the cost of production?
How much quantity do we produce if we want to make the most money?
To maximize output, we produce the highest output possible – 30.5 mg/ha. You will also see that this results in the greatest revenue ($762). But we have to consider cost. The total cost to produce the maximum output is $856. It’s important to take into consideration both pieces of information. Total revenue (the amount we collect from sales) minus the total cost (all the costs of production) is the amount we’re left with. This is also known as profit, or more formally in economic jargon, rent.
Looking at both costs and revenues at the same time shows us where we will be making money, and over what range of production we will be losing money. Now that we have all the information, you can see that the optimal point of production (highlighted in grey in Table 4) is 24.3 mg/ha, which requires 50 kg of fertilizer.
The total cost of production is $550 and the revenue, at a price of $25/mg is $607 resulting in a profit of $57.50.
Table 5-4: Profit = TR – TC
Optimal production requires 50 kg of fertilizer to produce 25.3 mg/ha of biomass.
The maximum profit is $57.50. Permission: Courtesy of course author Hayley Hesseln, Department of Agriculture and Resource Economics, University of Saskatchewan.
Notice that producing the maximum amount of product does not result in the maximum profit. This is not surprising because although the amount of willow produced is the highest at this point, the costs outweigh the benefits (total revenue). We can also graph the difference between costs and revenues against output, or the profit against output. It doesn’t matter which way we look at it, we will get the same answer.