© Mcgraw-Hill Companies, 2008 Farm Management Chapter 9 Cost Concepts in Economics

© Mcgraw-Hill Companies, 2008 Chapter Outline Opportunity Cost Fixed, Variable, and Total Costs Application of Cost Concepts Economies of Size Shape of the LRAC Curve

© Mcgraw-Hill Companies, 2008 Chapter Objectives 1.Explain the importance of opportunity cost and its use 2.Clarify the difference between short run and long run 3.Discuss the difference between fixed and variable costs 4.Identify fixed costs and show how to compute them 5.Show how to compute average costs 6.Demonstrate the use of costs in short run and long run decisions 7.Explore economies of size

© Mcgraw-Hill Companies, 2008 Opportunity Cost The income that could have been earned by selling or renting the input to someone else, or The income that could have been received if the input had been used in its most profitable alternative use

© Mcgraw-Hill Companies, 2008 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.)

© Mcgraw-Hill Companies, 2008 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

© Mcgraw-Hill Companies, 2008 Management The opportunity cost of management is difficult to estimate. The opportunity cost of labor and management cannot be greater than the total salary that could be earned at the best alternative job.

© Mcgraw-Hill Companies, 2008 Capital There are many possible uses for capital. Higher expected returns often carry higher risks. In agriculture, the opportunity cost of capital is often set equal to the interest rate on savings or the interest rate on borrowed capital. For some assets, such as land, a rental rate could be use. If assets decrease in value every year, their opportunity costs need to be decreased.

© Mcgraw-Hill Companies, 2008 Fixed, Variable, and Total 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)

© Mcgraw-Hill Companies, 2008 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.

© Mcgraw-Hill Companies, 2008 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.

© Mcgraw-Hill Companies, 2008 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..

© Mcgraw-Hill Companies, 2008 Depreciation Is a Fixed Cost Annual depreciation using the straight-line method is: Original Cost — Salvage Value Useful Life

© Mcgraw-Hill Companies, 2008 Interest Is a Fixed Cost Interest =  r Cost + Salvage Value 2 r = the interest rate

© Mcgraw-Hill Companies, 2008 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.

© Mcgraw-Hill Companies, 2008 Annual Fixed Costs for a Harvesting Machine Purchase price of $120,000, salvage value of $50,000 and a useful life of 5 years. Depreciation $14,000 Interest (8%) 6,800 Property Taxes 400 Insurance 500 Total Fixed Cost $21,700

© Mcgraw-Hill Companies, 2008 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

© Mcgraw-Hill Companies, 2008 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

© Mcgraw-Hill Companies, 2008 Figure 9-1 Typical total cost curves

© Mcgraw-Hill Companies, 2008 Figure 9-2 Average and marginal cost curves

© Mcgraw-Hill Companies, 2008 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

© Mcgraw-Hill Companies, 2008 Figure 9-3 Cost curves for a diminishing marginal returns production function

© Mcgraw-Hill Companies, 2008 Figure 9-4 Cost curves when marginal product is constant

© Mcgraw-Hill Companies, 2008 Application of Cost Concepts Table 9-1 is an example of some cost figures for a stocker-steer operation The size of pasture and amount of forage are limited Adding more steers causes declining MPP Total fixed costs = $5,000 per year Variable costs = $485 per steer

© Mcgraw-Hill Companies, 2008 Table 9-1 Illustration of Cost Concepts Applied to a Stocking Rate Problem Variable costs = $495 per steer, fixed costs = $5,000, selling price = $87.50/cwt

© Mcgraw-Hill Companies, 2008 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.

© Mcgraw-Hill Companies, 2008 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.

© Mcgraw-Hill Companies, 2008 Figure 9-5 Illustration of short-run production decisions

© Mcgraw-Hill Companies, 2008 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.

© Mcgraw-Hill Companies, 2008 Cash and Noncash Expenses Fixed costs can be either cash or noncash Depreciation is always noncash Repairs and property taxes are always cash Interest and insurance may be either cash or noncash

© Mcgraw-Hill Companies, 2008 Table 9-2 Cash and Noncash Expense Items

© Mcgraw-Hill Companies, 2008 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?

© Mcgraw-Hill Companies, 2008 Figure 9-6 Farm size in the short run

© Mcgraw-Hill Companies, 2008 Measuring Economies of Size Percent Change in Costs Percent Change in Output Value

© Mcgraw-Hill Companies, 2008 Figure 9-7 Possible size-cost relations

© Mcgraw-Hill Companies, 2008 Causes of Economies of Size Full use of existing resources Technology Engineering economies Use of specialized resources Decreasing input prices Higher output prices Management

© Mcgraw-Hill Companies, 2008 Causes of Diseconomies of Size Management Labor supervision Geographical dispersion Special problems of large livestock operations

© Mcgraw-Hill Companies, 2008 Figure 9-8 Two possible LRAC curves

© Mcgraw-Hill Companies, 2008 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.