“Do you know your basic economic concepts”? – ANSWERS to questions posed the previous week.

Mon, 03/10/2014 - 17:50 — Jonathan Rushton

Question 1: Correct answer is A.

The key concept covered is “opportunity cost”. Choice involves an element of sacrifice; for example if we buy more food, then we will have less money to spend on other goods. Similarly, a farmer who spends money on veterinary advice, has less money available for other inputs. Equally, a government that spends money on disease control has less available for other projects. In other words, the production or consumption of one thing involves the sacrifice of alternatives. This sacrifice of alternatives in production (or consumption) of a good is known as its “opportunity cost”. In this example, the client needs to sacrifice leisure time (assuming that she does not usually work in the evening and WEs). Valuing the time for leisure is not easy, but could be estimated on the basis of through the wage rates for unsocial hours.

Question 2: Correct answer is B.

The key concept covered here are “rational choices”. Economists often refer to rational choice principle, which is based on the assumption that individuals always make prudent and logical decisions that provide them with the greatest benefit or satisfaction. In simple terms it means weighing-up the costs and benefits of any activity, such as for example a farmer deciding what and how much to produce, a dairy farmer planning the level of feeding for the heifers, the consumption of food of unknown origin versus food of directly from a farm, a family deciding on whether to have private health insurance or using the public system. Such rational choices are commonly made by looking at the additional or marginal costs and benefits of a decision and choosing what will give the best value for money, i.e. the greatest marginal benefit relative to marginal cost. In this example, the farmer is encouraged to think a little bit about this marginal choice which is the basis of economic rational decision-making. The other answers do not include that process.

Question 3: Correct answer is C.

The key concept covered here is “productivity”, which is a measure that helps making rational decisions. The efficiency of conversion of inputs to outputs is the productivity of an activity, expressed as

Productivity = total value of outputs per unit of time/total value of inputs per unit of time

In a livestock system there are different inputs and different products. Therefore to estimate the livestock productivity it is common to convert the inputs and output to monetary values. There are other more common methods of assessing livestock productivity such as production per animal or production per hectare. What is important for an economic analysis is to identify which resources used in the production system are scarce and estimate the output per unit of this scarce resource. In this example, C is the only answer that does not have a real true denominator. A reflects liveweight meat production per kg of feed input, B reflects the amount of concentrate compared to milk produced, and D is a proxy measure for profitability compared to fixed input (labour).

Question 4: Correct answer is D.

The key concept covered here is “gross margin analysis”. The gross margin is defined as the enterprise output less the variable costs attributable to the enterprise. It is used to evaluate the economic viability of an enterprise based on actual records without taking into account fixed costs. It also does not take into account the management time given by the owner of the enterprise nor changes in an enterprise. The result is commonly expressed as output per standard unit, such as livestock units or acres. Gross margins are useful for assessing the productivity of a farm and comparing different enterprises. In this example, looking at the gross margin only (the final figure as in A, B, C) is not enough, as we need to know how it was calculated, we need to know how the output and the variable costs were calculated. Also it is important to understand the production systems under investigation, as there could be large differences in breed, feeding system (grass, concentrates, ...), etc. This information would be needed if we wanted to make an informed judgment.

Question 5: Correct answer is A.

The key concept covered here is “partial budget analysis”. Partial budgeting assesses the effect of changes in the existing system. It is designed to show the net increase or decrease in net farm income resulting from a change, as for example caused by disease. It is a useful evaluation tool in estimating the economic impact of disease. It includes the estimation of costs (=new costs and revenue foregone) and benefits (= costs saved and new revenue) due to the change and the comparison between the benefits and the costs:

COSTS

BENEFITS

(a) New costs

(b) Revenue foregone

(d) New revenue

Partial budgets are most often used for considering the use of a new input, enterprise or farm practice. Therefore, it is a useful technique to test the viability of introducing a new medication or a different animal management practice. It can also be used to evaluate the feasibility of adding a supplementary enterprise, for example the poultry or pig rearing to utilise surplus family labour. This example is about economic profitability. Before doing the partial budget analysis, the technical feasibility should already have been checked. Financial feasibility comes into play when checking the profitability of the change, i.e. whether money would need to be borrowed, how it would be borrowed and what the interest rate would be.

Question 6: The correct answer is B.

The key concept covered here is “discounting”. To compare costs and benefits that occur in different years it is necessary to convert their value into a present value. To compare costs and benefits that occur in different years it is necessary to convert their value into a present value by discounting, which requires a rate known as discount rate. This enables the comparison of the costs and benefits that occur in different time periods. Discounting is necessary, because a unit of money is considered more valuable today than in the future, a phenomenon called time preference. In other words, people rather enjoy benefits today than in the future. The discount rate does not necessarily equate to the rate of interest offered at banks, but reflects opportunity cost of capital as shown in this example. For example, if the farmer’s best option would be to put the money in a bank account, then the interest rate for these savings would apply.

Question 7: The correct answer is D.

The key concept covered here is “cost-benefit analysis”. Cost benefit analysis examines the economic profitability of a change by attempting to quantify the costs and benefits of a project in terms of common units, i.e. all aspects are valued in monetary terms. A major advantage of the approach is that it is applicable to a wide range of problems and that it provides decision-makers with an objective tool. Price effects and linkages across sectors can be included by linking benefit and cost streams to economic models that estimate the wider sector and economy impacts. The six key steps in the cost-benefit analysis are to:

Identify programme options to be assessed
Identify the additional costs (new costs, revenue foregone) and additional benefits (costs saved, new benefits) generated by the change
Determine when these additional costs and benefits occur in the future
Measure and value the costs and benefits in the same monetary unit
Calculate the present value of the additional costs and benefits using discounting and a discount rate
Compare the costs and benefits of the options identified. There are three measures of economic profitability
- Net present value = present value of additional benefits minus the present value of additional costs
- Benefit cost ratio = present value of the additional benefits divided by the present value of the additional costs
- Internal rate of return = the discount rate which turns the net present value to zero

In this example, not enough information is provided to take an informed decision, as the cost and benefit profiles are not available. This is important for example to judge the investment needed, the cash flow, and/or scale of project.

Questions posed the previous week

Question 1: A client has been advised that she needs to spend time in the evening and weekends checking if her heifers have come into oestrus. Which of the following is TRUE

a) Her time is equivalent to the leisure activities she would not be able to do
b) Time spent doing leisure activities has no monetary value and is not important in an economic analysis
c) Her time needs to be valued at the market rate for salaried time
d) One or more of the above

Key concept covered?

Question 2: A farmer has found a very cheap source of disinfectant for his cattle foot bath, you do not recognise the brand and the content labelling is not clear. Do you

a) Tell the farmer that for this type of intervention the cheapest disinfectant should be OK
b) Ask the farmer to compare the difference in cost of the disinfectants with the change in benefits from using the new disinfectant versus the old one in the footbath
c) Tell him to buy your disinfectant
d) None of the above