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Cost Concepts in Economics

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Cost Concepts in Economics

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    1. 1 Cost Concepts in Economics Chapter 9: Kay and Edwards

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    3. 3 Opportunity Costs The value of the product not produced because an input was used for another purpose. The income that would have been received if the input had been used in its most profitable alternative use. It denotes the real cost of using an input.

    4. 4 Short Versus Long Run The short run is a period of time sufficiently short that only some of the variables can be changed. The long run is a period of time that all variables can be changed.

    5. 5 Types of Costs Variable Costs These costs exist only if production occurs. E.g., fuel for tractor, seed, etc. Fixed Costs These cost exist whether production occurs or not. In the long-run there are no fixed costs. Can be both cash and non-cash expenses. E.g., depreciation on tractors and buildings, etc.

    6. 6 Types of Costs Cont. Sunk Costs Is an expenditure that cannot be recovered. In essence, it becomes part of fixed costs. E.g., pre-harvest costs.

    7. 7 Cost Concepts Total Fixed Costs (TFC) The summation of all fixed and sunk costs to production. Total Variable Costs (TVC) The summation of all variable costs to production. Total Costs (TC) The summation of total fixed and total variable costs. TC=TFC+TVC

    8. 8 Cost Concepts Cont. Average Fixed Costs (AFC) The total fixed costs divided by output. Average Variable Costs (AVC) The total variable costs divided by output. Average Total Costs (ATC) The total costs divided by output. The summation of average fixed costs and average variable costs, i.e., ATC=AFC+AVC.

    9. 9 Cost Concepts Cont. Marginal Costs The change in total costs divided by the change in output. ?TC/?Y The change in total variable costs divided by the change in output. ?TVC/?Y

    10. 10 Side Note on Marginal Cost How can marginal cost equal both the change in total cost divided by the change in output and the change in total variable cost divided by the change in output when variable costs are not equal to total costs? Short answer: fixed costs do not change.

    11. 11 Side Note on Marginal Cost Cont. We want to show that MC = ?TVC/?Y when TVC ? TC. We know that TC = TFC + TVC This implies that ?TC = ?(TFC + TVC) This implies that ?TC = ?TFC + ?TVC We know that ?TFC = 0 Hence, ?TC = ?TVC Divide the previous by ?Y, we obtain ?TC/?Y = ?TVC/?Y MC = ?TVC/?Y

    12. 12 Graphical Representation of Cost Concepts

    13. 13 Graphical Representation of Cost Concepts Cont.

    14. 14 Notes on Costs MC will meet AVC and ATC from below at the corresponding minimum point of each. Why? As output increases AFC goes to zero. As output increases, AVC and ATC get closer to each other.

    15. 15 Example of Cost Concepts

    16. 16 Revenue Concepts Revenue (TR) is defined as the output price (py) multiplied by the quantity (Y). Average revenue (AR) equals total revenue divided by output (Y), i.e., TR/Y, which equals py. Marginal Revenue is the change in total revenue divided by the change in output, i.e., ?TR/?Y.

    17. 17 Short-Run Decision Making In the short-run, there are many ways to choose how to produce. Maximize output. Utility maximization of the manager. Profit maximization. Profit (?) is defined as total revenue minus total cost, i.e., ? = TR – TC.

    18. 18 Short-Run Decision Making Cont. When examining output, we want to set our production level where MR = MC when MR > AVC in the short-run. If MR ? AVC, we would want to shut down. Why? If we can not set MR exactly equal to MC, we want to produce at a level where MR is as close as possible to MC, where MR > MC.

    19. 19 Intuition for Setting MR = MC Suppose MR < MC. This implies that by producing more output, you have a greater addition of cost than you do revenue. Hence you would not make the change.

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    21. 21 Why Shutdown When MR < AVC If MR < AVC, this implies that you are not bringing in enough revenue from each unit produced to cover your variable costs. Hence you could minimize your loss if you were to shutdown.

    22. 22 Why Produce When ATC > MR > AVC When MR < ATC, the company is making a loss. Why would it produce? Since the firm is making something above and beyond its variable cost, it can put some of that revenue towards fixed cost. This implies that it minimizes its loss by producing.

    23. 23 Profit Scenario Graphically

    24. 24 Loss Minimizing Graphically

    25. 25 Shutdown Decision Graphically

    26. 26 Production Rules for the Long-Run To maximize profits, the farmer should produce when selling price is greater than ATC at the production level where MC = MR. To minimize losses, the farmer should not produce when selling price is less than ATC, i.e., shutdown the business.

    27. 27 Note on Cost Concepts The producer’s supply curve is the part of the MC curve that is above the shutdown point.

    28. 28 Long-Run Average Costs The long run average cost (LRAC) curve is the envelope of the short run average cost curves when the size of the operation is allowed to increase or decrease. Note that a short run average cost curve exists for every possible farm size, as defined by the amount of fixed input available.

    29. 29 Long-Run Average Costs Cont. In a competitive market, the long run optimal production will occur at the lowest point on the LRAC, i.e., economic profits are driven to zero.

    30. 30 Size in the Long-Run A measure of size in the long run between output and costs as farm size increases (EOS) is the following: EOS = percent change in costs divided by percent change in output value

    31. 31 Size in the Long-Run Cont. If this ratio of EOS is less than one, then there are decreasing costs to expanding production, i.e., increasing returns to size. If this ratio is equal to one, then there are constant costs to expanding production, i.e., constant returns to size. If this ratio is greater than one, then there are increasing costs to expanding production, i.e., decreasing returns to size.

    32. 32 Economies of Size This exists when the LRAC is decreasing. Also known as increasing returns to size. Usually occurs because of full utilization of capital (tractors and buildings) and labor. Also occurs because of discount pricing for buying in bulk and selling price benefits for selling large quantities.

    33. 33 Diseconomies of Size This exists when the LRAC is increasing. Also known as decreasing returns to size. Usually occurs because a lack of managerial skills. Also occurs because travel time increases as farm increases. Livestock: disease control and manure disposal. Crops: geographical distance away from each other.

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