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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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AAEC 2305Fundamentals of Ag Economics

Chapter 4

Costs, Returns, and Profit Maximization


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Introduction

  • 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.


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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.


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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


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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)


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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.


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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.


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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


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Cost Relationships in Pdn

  • TC - sum of TFC & TVC

    • TC = TFC + TVC


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

X Y TFC TVC TC


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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


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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


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Cost Relationships in Pdn

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

    • MC = ΔTC / ΔY = ΔTVC / ΔY


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

X Y TFC TVC TC AFC AVC ATC MC


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

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

  • AVC & ATC curves are U-shaped (representing increasing & decreasing returns)

  • The vertical distance between ATC & AVC at each output level is equal to AFC


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

  • MC crosses both AVC & ATC from below at their respective minimums

  • ATC is also referred to as Average Cost


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Cost Curves & Pdn Process

  • The cost curves are derived directly from the pdn process.

    • Therefore, the pdn function can be transferred directly to the cost curves

  • APP & AVC and MPP & MC are mirror images of each other


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Summary of Relationships

  • When MPP > APP (APP is increasing) 

  • MC < AVC (AVC is decreasing)

  • When MPP = APP (APP is max)  MC = AVC (AVC is min)

  • When MPP < APP (APP is decreasing) 

  • MC > AVC (AVC is increasing)


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Mathematical Relationships

  • MC = ΔTC / Δ Y = PX / MPP

  • AVC = TVC / Y = PX / APP


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Changes in Input Price

  • Input Price Increase

    • The cost of producing each output level increases - TVC & TC shift upward & left; TFC remains unchanged - AVC, AC, & MC shift upward & left

  • Input Price Decrease (or technological innovation increases productivity)

    • The cost of producing same amount of output decreases - TVC & TC shift downward & right - AVC, ATC, & MC shift downward & right


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