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
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
104
103
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 Firms Short-Run Costs ()
Rate of Fixed Variable Total Marginal Average Ave
rage Average Output Cost Cost Cost Cost Fixed Var
iable 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
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
Cost Curves for a Firm

• 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)

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
Cost Curves for a Firm

• Unit Costs
• AFC falls continuously
• When MC lt AVC or MC lt ATC, AVC ATC decrease
• When MC gt AVC or MC gt ATC, AVC ATC increase

36
Cost Curves for a Firm

• 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 ( 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
• MCAVC 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 gt ATC, produce and make a profit.
• If ATCgtPricegtAVC produce and minimize losses.
• If AVCgt 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 cant, you dont produce.
45
Producing at a Loss Example
Fixed Costs are 10,000. At the point where
MRMC, TVC are 8,000 and TR is 12,000. If
I dont 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
MRMC, TVC are 15,000 and TR is 12,000. If
I dont 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
Dont 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
51
Production Rules for the Long Run

• Price gt ATC. Continue to produce at the point
  where MRMC.
• Price lt ATC. Stop production and sell fixed
  assets.

52
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?

53
Figure 9-6Farm size in the short run
54
Measuring Economies of Size
Percent Change in Costs Percent Change in
Output Value
55
Figure 9-7Possible size-cost relations
56
Causes of Economies of Size

• Full utilization of existing resources
• Technology
• Use of specialized resources
• Decreasing input prices
• Higher output prices
• Management

57
Causes of Diseconomies of Size

• Management
• Labor supervision
• Geographical dispersion
• Special problems of large livestock operations

58
Figure 9-8Two possible LRAC curves
59
Summary
This chapter discussed the different economic
costs and their use in managerial 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.