AAEC 2305 Fundamentals of Ag Economics. Chapter 4 Costs, Returns, and Profit Maximization. Introduction. A manager’s goal is to determine how much to produce in order to maximize profits.

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AAEC 2305 Fundamentals of Ag Economics

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A manager’s goal is to determine how much to produce in order to maximize profits.

In Chapter 3, we established Stage II is the rational stage of pdn, but price information (cost) is necessary to determine at which point in Stage II to produce.

Profit is affected not only by how much is produced, but also by the costs of generating that pdn.

Objective

Objective of Chapter 4 is to introduce cost and revenue relationships into production to evaluate profit maximization.

Combine what we know about the physical pdn process with input price information to examine relationship between costs of production and level of output produced.

Assumptions

1) Firms seek to maximize π

2) One product, one pdn method

3) One variable input, all others are fixed or held constant

4) Perfect Information

5) Price taker

Cost Definitions

Costs of Pdn or Economic Costs: The payments that a firm must make to attract inputs and keep them from being used to produce other products.

Explicit Costs - Normal out of pocket costs of inputs used in pdn

Implicit Costs- Costs associated with inputs owned by the firm (i.e., opportunity costs - ex., land)

Fixed vs. Variable Costs

Fixed Costs: Costs which do not vary with the level of pdn - These costs are associated with the fixed factors of pdn.

Incurred regardless whether any output is produced

Variable Costs: Costs that vary as the output level changes - These costs are associated with variable factors of pdn.

Cost Relationships in Pdn

Costs Based on Total Output

1) Total Fixed Costs (TFC)

2) Total Variable Costs (TVC)

3) Total Costs (TC)

TFC (overhead costs) - costs of inputs (implicit & explicit) that are fixed in the SR & do not change as the output level changes.

Cost Relationships in Pdn

TVC - costs of inputs (implicit & explicit) that are variable in the SR, and change as output level changes.

Calculated by summing the cost of each variable input used

TVC = (PX1X1) + (PX2X2) + . . . . + (PXnXn)

For One Variable Input:

TVC = PXX

Cost Relationships in Pdn

TC - sum of TFC & TVC

TC = TFC + TVC

Total Cost Curves(Assume TFC = $10 and Px = 4

X Y TFC TVC TC

Cost Relationships in Pdn

Costs Based on Per-Unit Output

1) Average Fixed Costs (AFC)

2) Average Variable Costs (AVC)

3) Average Total Costs (ATC)

AFC - Average cost of fixed inputs per unit of output

AFC = TFC / Y

Cost Relationships in Pdn

AVC - Average cost of variable inputs per unit of output

AVC = TVC / Y

ATC - Average total cost per unit of output

ATC = TC / Y

Cost Relationships in Pdn

MC - Increase in total cost necessary to produce one more unit of output

MC = ΔTC / ΔY = ΔTVC / ΔY

Cost Curves(Assume TFC = $10 and Px = 4

X Y TFC TVC TC AFC AVC ATC MC

Summary of Relationships Between AFC, AVC, ATC, & MC Curves

AFC is a continuously decreasing function w/ the shape of a rectangular hyperbola