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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

AAEC 2305Fundamentals of Ag Economics

Chapter 4

Costs, Returns, and Profit Maximization

introduction
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.
objective
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
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
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 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
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 pdn8
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 pdn9
Cost Relationships in Pdn
  • TC - sum of TFC & TVC
    • TC = TFC + TVC
cost relationships in pdn11
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 pdn12
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 pdn13
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 p x 4
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
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
summary of relationships between afc avc atc mc curves16
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
cost curves pdn process
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
summary of relationships
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)
mathematical relationships
Mathematical Relationships
  • MC = ΔTC / Δ Y = PX / MPP
  • AVC = TVC / Y = PX / APP
changes in input price
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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