AAEC 2305 Fundamentals of Ag Economics

1. AAEC 2305Fundamentals of Ag Economics Costs, Returns, and Profit Maximization

2. Introduction • A manager’s goal is to determine how much to produce in order to maximize profits. • In the previous section, we established Stage II is the rational stage of production, but price information (cost) is necessary to determine at which point in Stage II to produce. • Profit is affected not only by how much is produced, but also by the costs of generating that production.

3. Objective • Objective of this section is to introduce cost and revenue relationships into production to evaluate profit maximization. • Combine what we know about the physical production process with input price information to examine relationship between costs of production and level of output produced.

4. Assumptions 1) Firms seek to maximize π 2) One product, one production method 3) One variable input, all others are fixed or held constant 4) Perfect Information 5) Price taker

5. Cost Definitions • Costs of Production or Economic Costs: The payments that a firm must make to attract inputs and keep them from being used to produce other products. • Explicit Costs - Normal out of pocket costs of inputs used in production • Implicit Costs- Costs associated with inputs owned by the firm (i.e., opportunity costs - ex., land) • These may be non-cash costs, but are real costs to consider in the “economic profit” of the firm

6. Fixed vs. Variable Costs • Fixed Costs: Costs which do not vary with the level of production - These costs are associated with the fixed factors of production • Incurred regardless whether any output is produced • Length of run issues…short vs. long • Variable Costs: Costs that vary as the output level changes - These costs are associated with variable factors of production

7. Cost Relationships in Production • Costs Based on Total Output • 1) Total Fixed Costs (TFC) • 2) Total Variable Costs (TVC) • 3) Total Costs (TC) • TFC (overhead costs) - costs of inputs (implicit & explicit) that are fixed in the SR & do not change as the output level changes.

8. Cost Relationships in Production • TVC - costs of inputs (implicit & explicit) that are variable in the SR, and change as output level changes. • Calculated by summing the cost of each variable input used • TVC = (PX1X1) + (PX2X2) + . . . . + (PXnXn) • For One Variable Input: • TVC = PXX

9. Cost Relationships in Production • TC - sum of TFC & TVC • TC = TFC + TVC

10. Total Cost Curves(Assume TFC = $10 and Px = 4 X Y TFC TVC TC

11. Cost Relationships in Production • Costs Based on Per-Unit Output • 1) Average Fixed Costs (AFC) • 2) Average Variable Costs (AVC) • 3) Average Total Costs (ATC) • AFC - Average cost of fixed inputs per unit of output • AFC = TFC / Y

12. Cost Relationships in Production • AVC - Average cost of variable inputs per unit of output • AVC = TVC / Y • ATC - Average total cost per unit of output • ATC = TC / Y

13. Cost Relationships in Production • MC - Increase in total cost necessary to produce one more unit of output • MC = ΔTC / ΔY = ΔTVC / ΔY

14. Cost Curves(Assume TFC = $10 and Px = 4 X Y TFC TVC TC AFC AVC ATC MC

15. Summary of Relationships Between AFC, AVC, ATC, & MC Curves • AFC is a continuously decreasing function w/ the shape of a rectangular hyperbola • AVC & ATC curves are U-shaped (representing increasing & decreasing returns) • The vertical distance between ATC & AVC at each output level is equal to AFC

16. Summary of Relationships Between AFC, AVC, ATC, & MC Curves • MC crosses both AVC & ATC from below at their respective minimums • ATC is also referred to as Average Cost

17. Cost Curves & Production Process • The cost curves are derived directly from the production process. • Therefore, the production function can be transferred directly to the cost curves • APP & AVC and MPP & MC are mirror images of each other

18. Summary of Relationships • When MPP > APP (APP is increasing)  • MC < AVC (AVC is decreasing) • When MPP = APP (APP is max)  MC = AVC (AVC is min) • When MPP < APP (APP is decreasing)  • MC > AVC (AVC is increasing)

19. Mathematical Relationships • MC = ΔTC / Δ Y = PX / MPP • AVC = TVC / Y = PX / APP

20. Changes in Input Price • Input Price Increase • The cost of producing each output level increases - TVC & TC shift upward & left; TFC remains unchanged - AVC, AC, & MC shift upward & left • Input Price Decrease (or technological innovation increases productivity) • The cost of producing same amount of output decreases - TVC & TC shift downward & right - AVC, ATC, & MC shift downward & right