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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 l.jpg

Farm Management

Chapter 9

Cost Concepts in Economics


Chapter outline l.jpg
Chapter Outline

  • Opportunity Cost

  • Costs

  • Application of Cost Concepts

  • Economies of Size


Chapter objectives l.jpg
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 l.jpg
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 l.jpg
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 l.jpg
Table 9-1 Opportunity Cost of Applying Irrigation Water Among Three Uses


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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 revenue

given up from the crop not produced.


Opportunity cost of operator time l.jpg
Opportunity Cost of Operator Time Principle?

  • 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 l.jpg
Opportunity Cost of Capital Principle?

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.


Costs l.jpg
Costs Principle?

  • 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 l.jpg
Cost Concepts Principle?

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 l.jpg
Short Run and Long Run Principle?

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 l.jpg
Fixed Costs Principle?

  • 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 Principle?

Annual depreciation using the

straight-line method is:

Original Cost — Salvage Value

Useful Life


Interest is a fixed cost l.jpg
Interest is a Fixed Cost Principle?

Cost + Salvage Value

Interest =  r

2

r = the interest rate


Other fixed costs l.jpg
Other Fixed Costs Principle?

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 Principle?

  • 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 l.jpg
Average and Marginal Costs Principle?

  • 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 l.jpg
Figure 9-1 Principle?Typical total cost curves


Figure 9 2 average and marginal cost curves l.jpg
Figure 9-2 Principle?Average and marginal cost curves


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Things to Notice Principle?

  • 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 l.jpg
Figure 9-3 Principle?Cost curves for a diminishing marginal returns production function


Figure 9 4 cost curves when marginal product is constant l.jpg
Figure 9-4 Principle?Cost curves when marginal product is constant


Table 9 2 illustration of cost concepts applied to a stocking rate problem l.jpg
Table 9-2 Principle?Illustration of Cost Concepts Applied to a Stocking Rate Problem


Graph of atc avc mc and afc from stocker problem l.jpg
Graph of ATC, AVC, MC and AFC Principle?from Stocker Problem

ATC

MC

AVC

AFC


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Application of Cost Concepts Principle?

Cost concepts can be used in both

short and long-run decision making.


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Production Rules for the Short Run Principle?

  • 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 l.jpg
Logic behind These Rules Principle?

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 l.jpg
Producing at a Loss Example Principle?

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


If losses exceed fixed costs l.jpg
If Losses Exceed Fixed Costs Principle?

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

.


Figure 9 5 illustration of short run production decisions l.jpg
Figure 9-5 Principle?Illustration of short-run production decisions


Don t produce graphical view l.jpg
Don’t Produce: Graphical View Principle?

ATC

AVC

loses more than

fixed cost

MR = Price

MC

Output


Produce at a loss graphical view l.jpg
Produce at a Loss: Graphical View Principle?

ATC

loses less than

fixed cost

AVC

MR = Price

MC

Output


Produce at a profit graphical view l.jpg
Produce at a Profit: Graphical View Principle?

ATC

per-unit profit

AVC

MR = Price

MC

Output


Production rules for the long run l.jpg
Production Rules for the Long Run Principle?

  • 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 Principle?

  • 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 6 farm size in the short run l.jpg
Figure 9-6 Principle?Farm size in the short run


Measuring economies of size l.jpg
Measuring Economies of Size Principle?

Percent Change in Costs

Percent Change in Output Value


Figure 9 7 possible size cost relations l.jpg
Figure 9-7 Principle?Possible size-cost relations


Causes of economies of size l.jpg
Causes of Economies of Size Principle?

  • Full utilization of existing resources

  • Technology

  • Use of specialized resources

  • Decreasing input prices

  • Higher output prices

  • Management


Causes of diseconomies of size l.jpg
Causes of Diseconomies of Size Principle?

  • Management

  • Labor supervision

  • Geographical dispersion

  • Special problems of large livestock operations


Figure 9 8 two possible lrac curves l.jpg
Figure 9-8 Principle?Two possible LRAC curves


Summary l.jpg
Summary Principle?

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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