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Farm Management. Chapter 9 Cost Concepts in Economics. Chapter Outline. Opportunity Cost Costs Application of Cost Concepts Economies of Size. Chapter Objectives. To explain the importance of opportunity cost and its use To clarify the difference between short run and long run

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Farm Management

Chapter 9

Cost Concepts in Economics

Chapter Outline

  • Opportunity Cost

  • Costs

  • Application of Cost Concepts

  • Economies of Size

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

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

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.)

Table 9-1 Opportunity Cost of Applying Irrigation Water Among Three Uses

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.

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

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.


  • 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)

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.

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.

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.


Depreciation is a Fixed Cost

Annual depreciation using the

straight-line method is:

Original Cost — Salvage Value

Useful Life

Interest is a Fixed Cost

Cost + Salvage Value

Interest =  r


r = the interest rate

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.

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

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

Figure 9-1 Typical total cost curves

Figure 9-2 Average and marginal cost curves

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

Figure 9-3 Cost curves for a diminishing marginal returns production function

Figure 9-4 Cost curves when marginal product is constant

Table 9-2 Illustration of Cost Concepts Applied to a Stocking Rate Problem

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





Application of Cost Concepts

Cost concepts can be used in both

short and long-run decision making.

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.

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 can’t, you don’t produce.

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.



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




Figure 9-5 Illustration of short-run production decisions

Don’t Produce: Graphical View



loses more than

fixed cost

MR = Price



Produce at a Loss: Graphical View


loses less than

fixed cost


MR = Price



Produce at a Profit: Graphical View


per-unit profit


MR = Price



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.

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?

Figure 9-6Farm size in the short run

Measuring Economies of Size

Percent Change in Costs

Percent Change in Output Value

Figure 9-7Possible size-cost relations

Causes of Economies of Size

  • Full utilization of existing resources

  • Technology

  • Use of specialized resources

  • Decreasing input prices

  • Higher output prices

  • Management

Causes of Diseconomies of Size

  • Management

  • Labor supervision

  • Geographical dispersion

  • Special problems of large livestock operations

Figure 9-8Two possible LRAC curves


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.

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