Farm Management

1. Farm Management Chapter 9 Cost Concepts in Economics

2. Chapter Outline • Opportunity Cost • Costs • Application of Cost Concepts • Economies of Size

3. Chapter Objectives • To explain the importance of opportunity cost and its use • To clarify the difference between short run and long run • To discuss the difference between fixed and variable costs • To identify fixed costs and show how to compute them • To show how to compute average costs • To demonstrate the use of costs in short run and long run decisions • To explore economies of size

4. Opportunity Cost • The value of a product not produced because an input was used for another purpose, or • The income that could have been received if the input had been used in its most profitable alternative use

5. Everything Has an Opportunity Cost Even if you use the input in its best possible use, there is an opportunity cost for the item you did not produce. (In this case, opportunity cost will be less than the revenue actually received.)

6. Table 9-1 Opportunity Cost of Applying Irrigation Water Among Three Uses

7. How Does Opportunity Cost Relate to the Equi-Marginal Principle? With the Equi-Marginal Principle, we are choosing to produce one product instead of another. The opportunity cost is the revenue given up from the crop not produced.

8. Opportunity Cost of Operator Time • Opportunity cost of operator's labor: What the operator could earn for that labor in best alternative use • Opportunity cost of operator's management: Difficult to estimate • Total of opportunity cost of labor and opportunity cost of management should not exceed total expected salary in best alternative job

9. Opportunity Cost of Capital The opportunity cost of capital is often set equal to what the capital could earn in a no-risk savings account. Total dollar value of the capital inputs is estimated and multiplied by the interest rate for a savings account.

10. Costs • Total Fixed Cost (TFC) • Average Fixed Cost (AFC) • Total Variable Cost (TVC) • Average Variable Cost (AVC) • Total Cost (TC) • Average Total Cost (ATC) • Marginal Cost (MC)

11. Cost Concepts These seven costs are output related. Marginal cost is the cost of producing an additional unit of output. The others are either the total or average costs for producing a given amount of output.

12. Short Run and Long Run The short run is the period of time during which the quantity of one or more production inputs is fixed and cannot be changed. The long run is the period of time in which the amount of all inputs can be changed.

13. Fixed Costs • Fixed costs exist only in the short run. • In the short run, fixed costs must be paid regardless of the amount of output produced. • Fixed costs are not under the control of the manager in the short run. .

14. Depreciation is a Fixed Cost Annual depreciation using the straight-line method is: Original Cost — Salvage Value Useful Life

15. Interest is a Fixed Cost Cost + Salvage Value Interest =  r 2 r = the interest rate

16. Other Fixed Costs Property taxes and insurance are also fixed costs. Some repairs may be fixed costs, if they are for maintenance. In practice, machinery repairs are usually counted as variable costs, while building repairs are counted as fixed.

17. Computing Total Costs • Total Fixed Cost (TFC): The sum of all fixed costs • Total Variable Cost (TVC): The sum of all variable costs • Total Cost (TC) = TVC + TFC

18. Costs

19. Costs • In buying factor inputs, the firm will incur costs • Costs are classified as: • Fixed costs – costs that are not related directly to production – rent, rates, insurance costs, admin costs. They can change but not in relation to output • Variable Costs – costs directly related to variations in output. Raw materials primarily

20. Costs • Total Cost - the sum of all costs incurred in production • TC = FC + VC • Average Cost – the cost per unit of output • AC = TC/Output • Marginal Cost – the cost of one more or one fewer units of production • MC= TCn – TCn-1 units

21. Costs • Short run – Diminishing marginal returns results from adding successive quantities of variable factors to a fixed factor • Long run – Increases in capacity can lead to increasing, decreasing or constant returns to scale

22. Revenue

23. Revenue • Total revenue – the total amount received from selling a given output • TR = P x Q • Average Revenue – the average amount received from selling each unit • AR = TR / Q • Marginal revenue – the amount received from selling one extra unit of output • MR = TRn – TR n-1 units

24. Profit

25. Profit • Profit = TR – TC • The reward for enterprise • Profits help in the process of directing resources to alternative uses in free markets • Relating price to costs helps a firm to assess profitability in production

26. Profit • Normal Profit – the minimum amount required to keep a firm in its current line of production • Abnormal or Supernormal profit – profit made over and above normal profit • Abnormal profit may exist in situations where firms have market power • Abnormal profits may indicate the existence of welfare losses • Could be taxed away without altering resource allocation

27. Profit • Sub-normal Profit – profit below normal profit • Firms may not exit the market even if sub-normal profits made if they are able to cover variable costs • Cost of exit may be high • Sub-normal profit may be temporary (or perceived as such!)

28. Profit • Assumption that firms aim to maximise profit • May not always hold true - there are other objectives • Profit maximising output would be where MC = MR

29. Added to total profit Reduces total profit by this amount Total added to profit Added to total profit Profit Why? If the firm were to produce the 104th unit, this last unit would cost more to produce than it earns in revenue (-105) this would reduce total profit and so would not be worth producing. The profit maximising output is where MR = MC Assume output is at 100 units. The MC of producing the 100th unit is 20. The MR received from selling that 100th unit is 150. The firm can add the difference of the cost and the revenue received from that 100th unit to profit (130) Cost/Revenue The process continues for each successive unit produced. Provided the MC is less than the MR it will be worth expanding output as the difference between the two is ADDED to total profit If the firm decides to produce one more unit – the 101st – the addition to total cost is now 18, the addition to total revenue is 140 – the firm will add 128 to profit. – it is worth expanding output. MC MC – The cost of producing ONE extra unit of production MR – the addition to total revenue as a result of producing one more unit of output – the price received from selling that extra unit. 150 145 140 120 40 30 20 MR 18 Output 100 101 102 103 104

30. Average and Marginal Costs • Average Fixed Cost (AFC): TFC/Output • Average Variable Cost (AVC): TVC/Output • Average Total Cost (ATC or AC): TC/Output • Marginal Cost: TC/ Output or TVC/ Output

31. A Firm’s Short-Run Costs ($) Rate of Fixed Variable Total Marginal Average Average Average Output Cost Cost Cost Cost Fixed Variable Total (FC) (VC) (TC) (MC) Cost Cost Cost (AFC) (AVC) (ATC) 0 50 0 50 --- --- --- --- 1 50 50 100 50 50 50 100 2 50 78 128 28 25 39 64 3 50 98 148 20 16.7 32.7 49.3 4 50 112 162 14 12.5 28 40.5 5 50 130 180 18 10 26 36 6 50 150 200 20 8.3 25 33.3 7 50 175 225 25 7.1 25 32.1 8 50 204 254 29 6.3 25.5 31.8 9 50 242 292 38 5.6 26.9 32.4 10 50 300 350 58 5 30 35 11 50 385 435 85 4.5 35 39.5

32. Total cost is the vertical sum of FC and VC. TC Cost ($ per year) 400 VC Variable cost increases with production and the rate varies with increasing & decreasing returns. 300 200 Fixed cost does not vary with output 100 FC 50 Output 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Cost Curves for a Firm

33. Cost Curves for a Firm Cost ($ per unit) 100 MC 75 50 ATC AVC 25 AFC Output (units/yr.) 1 0 2 3 4 5 6 7 8 9 10 11

34. The line drawn from the origin to the tangent of the variable cost curve: Its slope equals AVC The slope of a point on VC equals MC Therefore, MC = AVC at 7 units of output (point A) Cost Curves for a Firm TC P 400 VC 300 200 A 100 FC 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output

35. Unit Costs AFC falls continuously When MC < AVC or MC < ATC, AVC & ATC decrease When MC > AVC or MC > ATC, AVC & ATC increase Cost ($ per unit) 100 MC 75 50 ATC AVC 25 AFC 1 0 2 3 4 5 6 7 8 9 10 11 Output (units/yr.) Cost Curves for a Firm

36. Unit Costs MC = AVC and ATC at minimum AVC and ATC Minimum AVC occurs at a lower output than minimum ATC due to FC Cost Curves for a Firm Cost ($ per unit) 100 MC 75 50 ATC AVC 25 AFC 1 0 2 3 4 5 6 7 8 9 10 11 Output (units/yr.)

37. Things to Notice • AFC always decreases • MC may decrease at first but it eventually must increase • AVC and ATC are typically U-shaped • MC=AVC at minimum point of AVC • MC = ATC at minimum point of ATC • ATC approaches AVC from above

38. Figure 9-3 Cost curves for a diminishing marginal returns production function

39. Figure 9-4 Cost curves when marginal product is constant

40. Table 9-2 Illustration of Cost Concepts Applied to a Stocking Rate Problem

41. Graph of ATC, AVC, MC and AFC from Stocker Problem ATC MC AVC AFC

42. Application of Cost Concepts Cost concepts can be used in both short and long-run decision making.

43. Production Rules for the Short Run • If Price > ATC, produce and make a profit. • If ATC>Price>AVC produce and minimize losses. • If AVC> Price, do not produce and limit your loss to your fixed costs.

44. Logic behind These Rules Fixed costs must be paid whether you produce or not in any given year. They are therefore irrelevant to the production decision. You look at variable costs. If you can cover those, you should produce. If you can’t, you don’t produce.

45. Producing at a Loss Example Fixed Costs are $10,000. At the point where MR=MC, TVC are $8,000 and TR is $12,000. If I don’t produce, I will have a loss of _______ If I do produce, I will have a loss of _________ I should produce to minimize losses. $10,000 $6,000

46. If Losses Exceed Fixed Costs Fixed Costs are $10,000. At the point where MR=MC, TVC are $15,000 and TR is $12,000. If I don’t produce, I will have a loss of _______ If I do produce, I will have a loss of _________ I should not produce $10,000 $13,000 .

47. Figure 9-5 Illustration of short-run production decisions

48. Don’t Produce: Graphical View ATC AVC loses more than fixed cost MR = Price MC Output

49. Produce at a Loss: Graphical View ATC loses less than fixed cost AVC MR = Price MC Output

50. Produce at a Profit: Graphical View ATC per-unit profit AVC MR = Price MC Output