farm management chapter 9 cost concepts in economics

Farm Management

Chapter 9Cost Concepts in Economics

farm management chapter 9

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Chapter Outline

• Opportunity Cost

• Costs

• Application of Cost Concepts

• Economies of Size


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Chapter Objectives1. To explain the importance of opportunity cost and

its use2. To clarify the difference between short run and

long run3. To discuss the difference between fixed and

variable costs4. To identify fixed costs and show how to compute

them5. To show how to compute average costs6. To demonstrate the use of costs in short run and

long run decisions7. To explore economies of size


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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


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Everything Has an Opportunity Cost

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


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Table 9-1 Opportunity Cost of Applying Irrigation Water

Among Three Uses

irrigation water wheat sorghum cotton(acre inches) (100 acres) (100 acres) (100 acres

4 $1,200 $1,600 $1,8008 $800 $1,200 $1,500

12 $600 $800 $1,20016 $300 $500 $80020 $50 $200 $400

Marginal Value Products ($)


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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 revenuegiven up from the crop not produced.


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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


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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 isestimated and multiplied by the interestrate for a savings account.


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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)


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Cost Concepts

These seven costs are output related.

Marginal cost is the cost of producing anadditional unit of output. The others are either the total or average costs for producing a given amount of output.


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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 whichthe amount of all inputs can be changed.


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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.

.


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Depreciation is a Fixed Cost

Annual depreciation using the straight-line method is:

Original Cost — Salvage Value

Useful Life


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Interest is a Fixed Cost

Interest = r Cost + Salvage Value

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r = the interest rate


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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.


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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


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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


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Figure 9-1 Typical total cost curves


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Figure 9-2 Average and marginal cost curves


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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


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Figure 9-3 Cost curves for a diminishing marginal returns

production function


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Figure 9-4 Cost curves when marginal product

is constant


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Table 9-2 Illustration of Cost Concepts Applied to a

Stocking Rate Problem

Number Output MPP TFC TVC TC AFC AVC ATC MC MRof Steers Cwt Beef ($) ($) ($) ($) ($) ($) ($) ($)

0 0 *** 5,000 0 5,000 *** *** *** *** ***10 72 7.2 5,000 4,950 9,950 69.44 68.75 138.19 68.75 87.5020 148 7.6 5,000 9,900 14,900 33.78 66.89 100.68 65.13 87.5030 225 7.7 5,000 14,850 19,850 22.22 66.00 88.22 64.29 87.5040 295 7.0 5,000 19,800 24,800 16.95 67.12 84.07 70.71 87.5050 360 6.5 5,000 24,750 29,750 13.89 68.75 82.64 76.15 87.5060 420 6.0 5,000 29,700 34,700 11.90 70.71 82.62 82.50 87.5070 475 5.5 5,000 34,650 39,650 10.53 72.95 83.47 90.00 87.5080 525 5.0 5,000 39,600 44,600 9.52 75.43 84.95 99.00 87.5090 570 4.5 5,000 44,550 49,550 8.77 78.16 86.93 110.00 87.50

100 610 4.0 5,000 49,500 54,500 8.20 81.15 89.34 123.75 87.50


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

Stocking Rate Problem

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

0 100 200 300 400 500 600 700cwt beef

ATC MC

AVC

AFC


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Application of Cost Concepts

Cost concepts can be used in bothshort and long-run decision making.


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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.


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Logic behind These Rules

Fixed costs must be paid whether youproduce or not in any given year. Theyare therefore irrelevant to the productiondecision. You look at variable costs. Ifyou can cover those, you should produce.If you can’t, you don’t produce.


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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


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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

.


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Figure 9-5 Illustration of short-run production decisions


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Don’t Produce: Graphical View

MC

AVC

Output

ATC

MR = Priceloses more thanfixed cost


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Produce at a Loss: Graphical View

MC

AVC

Output

ATC

MR = Price

loses less thanfixed cost


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Produce at a Profit: Graphical View

MC

AVC

Output

ATC

MR = Price

per-unit profit


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Production Rules for the Long Run

• Price > ATC. Continue to produce at the point where MR=MC.

• Price < ATC. Stop production and sell fixed assets.


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Economies of Size

• What is the most profitable farm size?

• Can larger farms produce food and fiber more cheaply?

• Are large farms more efficient?

• Will family farms disappear and be replaced by corporate farms?

• Will farm numbers continue to fall?


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Figure 9-6Farm size in the short run


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Measuring Economies of Size

Percent Change in CostsPercent Change in Output Value

Ratio value Type of costs

< 1 Decreasing= 1 Constant> 1 Increasing


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Figure 9-7Possible size-cost relations


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Causes of Economies of Size

• Full utilization of existing resources

• Technology

• Use of specialized resources

• Decreasing input prices

• Higher output prices

• Management


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Causes of Diseconomies of Size

• Management

• Labor supervision

• Geographical dispersion

• Special problems of large livestock operations


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Figure 9-8Two possible LRAC curves


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Summary

This chapter discussed the differenteconomic costs and their use inmanagerial decision making. An analysis of costs is important for understanding and improving the profitability of a business. An understanding of costs is also necessary for analyzing economies of size.

farm management chapter 9 cost concepts in economics

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