Farm Management

							  Farm Management

        Chapter 9
Cost Concepts in Economics
                  Chapter Outline

    •   Opportunity Cost
    •   Costs
    •   Application of Cost Concepts
    •   Economies of Size




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                  Chapter Objectives
1.     To explain the importance of opportunity cost and
       its use
2.     To clarify the difference between short run and
       long run
3.     To discuss the difference between fixed and
       variable costs
4.     To identify fixed costs and show how to compute
       them
5.     To show how to compute average costs
6.     To demonstrate the use of costs in short run and
       long run decisions
7.     To explore economies of size
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                  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



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     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.)




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                  Table 9-1
 Opportunity Cost of Applying Irrigation Water
             Among Three Uses

                   Marginal Value Products ($)
   irrigation water     wheat       sorghum        cotton
     (acre inches)   (100 acres)   (100 acres)   (100 acres
                   4      $1,200        $1,600         $1,800
                   8        $800        $1,200         $1,500
                  12        $600          $800         $1,200
                  16        $300          $500           $800
                  20         $50          $200           $400




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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.


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     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.
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      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.


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                  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)

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                  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.



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         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.


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                  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.



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     Depreciation is a Fixed Cost

       Annual depreciation using the
       straight-line method is:

          Original Cost — Salvage Value
                    Useful Life




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            Interest is a Fixed Cost

                  Cost + Salvage Value
Interest =                               r
                           2


   r = the interest rate



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                  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.

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            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




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     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

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                          Figure 9-1
                  Typical Total Cost Curves




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                      Figure 9-2
           Average and Marginal Cost Curves




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                  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

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                   Figure 9-3
    Cost curves when the production function
                 has no stage 1




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                      Figure 9-4
          Cost curves when marginal product
                     is constant




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                        Table 9-2
      Illustration of Cost Concepts Applied to a
                 Stocking Rate Problem
Number Output MPP         TFC      TVC       TC    AFC      AVC    ATC    MC    MR
of Steers Cwt Beef         ($)      ($)      ($)    ($)      ($)    ($)   ($)   ($)
        0         0 ***   5,000         0    5,000 ***       ***    ***   ***   ***
      10        72 7.2    5,000    4,950     9,950 69.44    68.75 138.19 68.75 87.50
      20       148 7.6    5,000    9,900    14,900 33.78    66.89 100.68 65.13 87.50
      30       225 7.7    5,000   14,850    19,850 22.22    66.00 88.22 64.29 87.50
      40       295 7.0    5,000   19,800    24,800 16.95    67.12 84.07 70.71 87.50
      50       360 6.5    5,000   24,750    29,750 13.89    68.75 82.64 76.15 87.50
      60       420 6.0    5,000   29,700    34,700 11.90    70.71 82.62 82.50 87.50
      70       475 5.5    5,000   34,650    39,650 10.53    72.95 83.47 90.00 87.50
      80       525 5.0    5,000   39,600    44,600   9.52   75.43 84.95 99.00 87.50
      90       570 4.5    5,000   44,550    49,550   8.77   78.16 86.93 110.00 87.50
     100       610 4.0    5,000   49,500    54,500   8.20   81.15 89.34 123.75 87.50


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              Graph of ATC, AVC, MC and AFC
                  from Stocker Problem

                         Stocking Rate Problem

 160.00
 140.00
 120.00            ATC                                        MC
 100.00
  80.00
  60.00                                                        AVC
  40.00
  20.00                                    AFC
   0.00
          0       100    200    300               400   500    600   700
                                      cw t beef



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    Application of Cost Concepts

      Cost concepts can be used in both
      short and long-run decision making.




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    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.


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        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.



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    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.

                                          $10,000
If I don’t produce, I will have a loss of _______

                                         $6,000
If I do produce, I will have a loss of _________

I should produce to minimize losses.



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   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.

                                          $10,000
If I don’t produce, I will have a loss of _______

                                        $13,000
If I do produce, I will have a loss of _________


          .
I should not produce

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                     Figure 9-5
  Illustration of short-run production decisions




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           Don’t Produce: Graphical View
                  ATC

           AVC


              loses more than
              fixed cost
                                   MR = Price
                  MC
                                      Output
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    Produce at a Loss: Graphical View
                  ATC
                        loses less than
           AVC          fixed cost



                                          MR = Price


                  MC
                                             Output
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    Produce at a Profit: Graphical View
                  ATC
                        per-unit profit
           AVC
                                          MR = Price



                  MC
                                            Output
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     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.




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                  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?

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                         Figure 9-6
                  Farm size in the short run




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   Measuring Economies of Size
                    Percent Change in Costs
                  Percent Change in Output Value

              Ratio value        Type of costs
                    <1            Decreasing
                    =1             Constant
                    >1            Increasing




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                          Figure 9-7
                  Possible size-cost relations




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       Causes of Economies of Size
•   Full utilization of existing resources
•   Technology
•   Use of specialized resources
•   Decreasing input prices
•   Higher output prices
•   Management


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    Causes of Diseconomies of Size
•   Management
•   Labor supervision
•   Geographical dispersion
•   Special problems of large livestock
    operations




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                         Figure 9-8
                  Two possible LRAC curves




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                  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.
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