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.
Costs • 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 2 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
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
Table 9-2 Illustration of Cost Concepts Applied to a Stocking Rate Problem
Graph of ATC, AVC, MC and AFC from Stocker Problem ATC MC AVC AFC
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. $10,000 $6,000
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 $10,000 $13,000 .
Don’t Produce: Graphical View ATC AVC loses more than fixed cost MR = Price MC Output
Produce at a Loss: Graphical View ATC loses less than fixed cost AVC MR = Price MC Output
Produce at a Profit: Graphical View ATC per-unit profit AVC MR = Price MC Output
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?
Measuring Economies of Size Percent Change in Costs Percent Change in Output Value
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
Summary 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.