Chapter 9: Cost Concepts in Economics

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Chapter 9Cost Concepts in Economics
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Objectives

• Explain opportunity cost and its importance in
  managerial decision making
• Clarify difference between long and short run
• Discuss fixed and variable costs
• Identify fixed costs and compute them
• Compute different average costs
• Explore economies of size

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Opportunity Cost

• Opportunity cost is based on the fact that every
  input has an alternative use
• Opportunity Cost
• Value of product not produced because an input
  was used for another purpose
• Income that would have been received if the input
  had been used in its most profitable alternative
  use

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Opportunity Cost

• Ex If you produce cotton and make 1000 an acre
  and produce corn and make 700 an acre, the
  opportunity cost of producing corn is the 300
• Ex If you make 30,000 a year working for
  yourself, and could make 40,000 if you were
  employed by a company, the opportunity cost is
  the 10,000
• Ex What is the opportunity cost of owning
  capital (like a tractor)?

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Costs

• Total Fixed Costs (TFC)
• Total Variable Costs (TVC)
• Total Costs (TC)
• Average Fixed Costs (AFC)
• Average Variable Costs (AVC)
• Average Total Costs (ATC)
• Marginal Cost (MC)

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Short Run Long Run

• Short-run period of time during which the
  available quantity of one or more production
  inputs is fixed and cannot be changed
• Ex beginning of the planting season, it may be
  to late to change the cropland owned or rented
• Current production cycle is fixed as the
  available land is fixed
• Over time land may be purchased, sold, or leases
  may expire and the amount of land may increase or
  decrease

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Short Run Long Run

• Long-run period of time during which the
  quantity of all necessary inputs can be changed
• The actual length will vary depending on the
  situation and circumstances

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Fixed Costs

• Fixed Costs costs associated with owning a fixed
  input or resource
• DO NOT CHANGE AS OUTPUT CHANGES
• There are no fixed costs in the long run
• Total Fixed Costs (TFC) summation of all fixed
  costs
• Does not change with output
• DIRTI
• Depreciation (noncash expense)
• Interest on Investment (either)
• Repairs (cash expense)
• Taxes property (cash)
• Insurance (either)
• Interest is also called the opportunity cost of
  capital and is calculated as
• (Cost Salvage Value)/2 interest rate
• Ex Cost 20,000, Salvage Value 5,000 and
  interest rate is 12, the interest cost is 1,500.

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Fixed Costs

• What is the total fixed cost if depreciation is
  3,000, interest is 1,500, taxes are 25,
  repairs are 100 and insurance is 50?
• 4,675
• Total fixed costs are usually 20-25 of the
  purchase price for a depreciable asset

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Fixed Costs

• Average Fixed Costs TFC / Y
• AFC will continuously decreases as output
  increases (spreading fixed costs)

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Variable Costs

• Variable Costs can be increased or decreased by
  the manager will increase as output is increased
• Ex feed, fertilizer, seed, fuel
• Total Variable Costs (TVC) Px x
• Average Variable Costs (AVC) TVC / Y
• All cost variable costs in the long run

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Total and Marginal Costs

• Total Cost (TC) sum of TFC and TVC
• Average Total Cost (ATC) AFC AVC or TC / Y
• Marginal Cost (MC) change in TC per one unit
  change in output
• TC / Y

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Example

• Calculate the MPP, TFC, TVC, TC, AFC, AVC, ATC,
  MC, and MR
• Given TFC 4,000
• Px 395 steer
• Py 70 cwt

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Stocking Rate Example

• X (steers) Y(cwt beef)
• 0 0
• 10 72
• 20 148
• 30 225
• 40 295
• 50 360
• 60 420
• 70 475
• 80 525
• 90 570
• 100 610

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Example

• What is the profit-maximizing stocking rate for a
  pasture of fixed size?
• TFC in this example includes any annual
  opportunity cost on the land and any
  improvements, depreciation on fences and water
  facilities, and insurance
• TVC include the cost of the steer,
  transportation, health expenses, feed, and
  interest on the investment in the steer

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Example

• The size of the pasture and the amount of forage
  available are limited, thus running more and
  more steers will eventually cause the average
  weight gain per steer to decline
• This is reflected when MPP declines with more
  than 30 steers
• Total output still increases, but at a decreasing
  rate due to steers competing for available forage

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Example

• Notice TFC does not change with output
• TVC and TC are increasing with output
• The profit maximizing level depends on prices.
• When MR is 70, the profit maximizing level is 60
  steers
• What is the TR?
• What is the TC?
• What is the profit maximizing level of Profit?

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Example

• Suppose MR 64
• What is the profit maximizing level of steers?
• 50

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Cost Concepts

• Should you produce if you do not cover your fixed
  and variable costs?
• The selling price must ALWAYS be greater than of
  equal to the average variable cost to sell
• If the selling price is greater than the AVC then
  the producer covers all variable costs and
  contributes some to fixed costs
• Therefore, steers can be purchased and sold if
  they sell for less than ATC
• Eventually, you must cover all your costs

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Cost Concepts

• Production Rules SHORT-RUN
• Py gt ATC Profit! AVC lt Py lt
  ATC Min Loss!
• Py lt AVC Do not produce!
• Production Rules LONG-RUN
• Py gt ATC Profit! Py lt
  ATC Do not produce!

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Economies of Size

• What is the most profitable farm size?
• Can larger farms produce food cheaper?
• Are large farms more efficient?
• Will the number of farms continue to decline?
• DEPENDS ON COSTS PER UNIT OF OUTPUT AS FARM SIZE
  INCREASES!!!

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Size in the Long-run

• Decreasing Costs
• Constant Costs
• Increasing Costs
• Long-run average costs decline rapidly at first,
  then more slowly, eventually it may even increase
  due to diseconomies of size

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Decreasing Costs

• Economies of Size exist when LRAC decreases
• Economies come from full utilization of labor,
  machinery, and buildings
• Larger farms can afford specialized labor and
  machinery which can lower costs
• New technology
• Price discounts for large input orders
• Specialized management

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Increasing Costs

• Diseconomies of Size exist when the LRAC is
  increasing. This discourages further increases
  in farm size.
• Diseconomies come from lack of sufficient
  managerial skill for large operations
• Increased travel time to get from field to field
• Supervision of labor more difficult
• Thus, the shape of the LRAC curve depends on the
  business