AAEC 2305 Fundamentals of Ag Economics

1. AAEC 2305Fundamentals of Ag Economics Chapter 4 – Continued Costs, Returns, and Profit Maximization

2. Revenue Concepts • Total Revenue (TR) – amount of money received when the producer sells the product. • TR = TPP * Py • Since firm is a price taker, firm sells each additional unit of output for same price.

3. Revenue Concepts • Average Revenue (AR) – average dollar amount received per-unit of output sold (produced) AR = TR / TPP = (TPP * Py)/TPP = Py

4. Revenue Concepts • Marginal Revenue (MR) – addition to TR from selling (producing) an additional (one more) unit of output. • MR = TR / TPP = (TPP*Py) / TPP = Py Since the firm is a price taker, Py does not  with output levels. Thus, MR always equals Py. Hence, MR and AR are graphed as a horizontal line

5. Profit Maximization:Total Revenue – Total Cost Approach •  = TR – TC • Firms will continue to expand production as long as increase in revenue is greater than increase in costs. • On the Diagram, the profit maximizing level of output is the level where the vertical difference between the TR and TC is the largest. With price of Y being $3/unit, Profits are maximized by producing 95 units (or slightly higher) of output.

6. Profit Maximization:Total Revenue – Total Cost Approach Stage I Max Profit Stage II Max Output Stage III

7. Profit Maximization:Per-Unit Output Basis • Most managers do not make decisions looking at TR and TC. Most decisions are made at the “margin.” • The output level that will maximize  is determined by comparing the amount that EACH ADDITIONAL unit of output adds to TR and TC. • Recall, Marginal Cost (MC) represents additional cost from producing an additional unit of output; and Marginal Revenue (MR) represents addition to TR from selling (producing) an additional (one more) unit of output, which is equal to the price of that output. • Thus, MC and MR can be used to determine profit maximizing level of output.

8. Determining  Max:Per-unit Output Basis • Firm will continue to expand production until added revenue received from additional unit of output sold (MR) is equal to the additional cost of producing that unit of output (MC), i.e., profit is maximized when MR = MC. With price of Y being $3/unit, Profits are maximized by producing 95 units (or slightly higher) of output.

9. Profit Maximization:Per-Unit Output Basis Stage I Max Profit Stage II Max Output Stage III

10. Implications Given price “P”, the AR and MR are given by the horizontal line at P. Profit is maximized by producing Q level of output, where MR = MC. AR = MR A P E B TR is given by the area PAQ0 D C TVC is given by the area DCQ0 TC is given by the area EBQ0 TFC is given by the area EBCD Profit is given by the area PABE 0 Q

11. Implications At P1, the firm is making profit P1 At P2, the firm is at the break-even point P2 P3 At P3, the firm continues to produce to minimize loss P4 At P4, the firm may continue to produce P5 At P5, the firm will close down 0 Q5 Q4 Q3 Q2 Q1 Thus, a profit maximizing firm will continue to produce as long as the price of the product is above the AVC.

12. Supply • Supply is a direct price and quantity relationship indicating how suppliers (producers, sellers, & mgrs) of a product respond to differing price levels. • It states what suppliers are WILLING and ABLE to supply at a given price.

13. Derivation of Supply Curves • Supply curve for the individual firm is based on the cost structure of the firm & how managers respond to alternative product prices as they attempt to maximize profits. • We discussed earlier that profit maximizing firms will shut down if the price of the product falls below the AVC. P1 Q1

14. Derivation of Supply Curves • This implies that the MC curve above AVC represents the firm’s supply curve. P1 Q1

15. Law of Supply • The Law of Supply says that the quantity of goods &/or services offered will vary DIRECTLY with the price. • Price increase will result in an increase in quantity supplied. • Price decrease will result in a decrease in quantity supplied. • The amount of increase or decrease, however, depends on the Elasticity of Supply. Price S P3 P2 P1 Q1 Q2 Q3 Output

16. Elasticity of Supply (Es) • Managers are interested in two types of supply elasticity measures: • Own-price elasticity of supply - measures the responsiveness of quantity supplied of a good to a change in the price of that good. • Cross-price elasticity of supply - measures the responsiveness of quantity supplied of a good to a change in the price of a related good.

17. Elasticity of Supply (Es) • Price Elasticity of Supply is defined as the percentage change in the quantity supplied relative to the percentage change in price. • It is a measure of responsiveness of quantity supplied to changes in price. • ES = %  QS / %  P • Or,

18. Elasticity of Supply (Es) • ES = %  QS / %  P

19. Elasticity of Supply (Es) • Interpretation • Es = 3: If the price of the product changes by 1% then the quantity supplied of the product changes by 3% • Es = 1: If the price of the product changes by 1% then the quantity supplied of the product changes by 1% • Es = 0.37: If the price of the product changes by 1% then the quantity supplied of the product changes by 0.37%

20. Elasticity of Supply (Es) • Classifications: • Inelastic supply (Es < 1): a change in price brings about a smaller change in quantity (we are less responsive to price) • Unitary Elastic supply (Es = 1): a change in price brings about an equivalent change in quantity. • Elastic supply (Es >1): a change in price brings about a relatively larger change in quantity.

21. Cross-price elasticity • Measures the effect of a change in the price of good X on the quantity supplied of Y. • ESYX = %QY / %PX • Read this as the cross-price of elasticity of supply for product Y with respect to price of product X.

22. Interpretation & Classification of Cross-price elasticity of Supply • Interpretation: • ESYX=1.5 implies that as price of X changes by 1%, the quantity supplied of Y changes by 1.5%. • Classification: • Complements in production (ESYX>0): implies that as the price of X increases, the quantity of Y supplied by the firm will increase. • Substitutes in production (ESYX <0): implies that as the price of X increases, the quantity of Y supplied by the firm will decrease.