Introduction to Agricultural and Natural Resources Production Costs and Supply FREC 150 Dr. Steven E. Hastings

Production Costs and Supply This Outline Covers the additional parts of Chapter 6 and parts of Chapter 8 in Penson et al. Major Topics – Cost Concepts – Profit – Production Costs – Maximizing Profit – Individual and Market Supply – Elasticity of Supply – Summary

Production Costs and Supply Firm and Market Supply – The final step to derive and understand the Supply Curve is to consider the cost of all inputs. Cost Concepts – Like inputs, “costs” can be looked at in a variety of way. – Explicit and Implicit Costs Explicit costs are "out-of-pocket" costs for labor, insurance, rent, etc. Implicit costs are the value of a resource that a firm or producer owns or controls; usually valued by opportunity costs.

– Opportunity costs are the value of an input it its next best alternative use. All inputs have an opportunity cost. – Length-of–Run or Planning Horizon – very short-run to ultimate long- run. – Fixed and Variable Costs – correspond to fixed and variable inputs.

Profit – Accounting Profits vs. Economic Profits – Economic Profit is total revenue minus the costs of all inputs (some valued at the price paid for them (explicit costs) and some valued at their opportunity cost (implicit costs). – Economic Profit is not the same as Accounting Profit (revenue – explicit costs). Accounting profit does not account for the opportunity costs of all inputs. – Examples: family labor on a farm, value of land owned, etc.

Costs of Production – Derived from the Production Function (TPP) and the prices of inputs. – Total Fixed Costs (TFC) - costs of inputs fixed in the short run. – Total Variable Costs (TVC) - costs of variable inputs. – Total Costs (TC) = TFC + TVC – Average Fixed Costs (AFC) = TFC / TPP - fixed costs are spread as output increases. – Average Variable Costs (AVC) = TVC / TPP - U-shaped. – Average Total Costs (ATC) = AFC + AVC or TC / TPP - U-shaped.

– Marginal Cost (MC) =  TC /  TPP or  TVC /  TPP – MC is the change in costs necessary to increase output by one unit; the MC curve crosses AVC and ATC from the bottom at their minimum points. See Table 6-3 and Figure 6-4 in the text.

Everything Depends onThe Production Function The price of a unit of Labor is $5.00 per hour.

Production Costs First, look at (2), (4) and (6). - TFC is a constant. - TVC is the units of the variable input used multiplied by the price of the variable input. - TC is TFC + TVC.

Examples from the press: – But soaring costs of feed, fertilizer and fuel -- some of which have more than tripled in the past two years … Mr. Blackburn said he lost $3,000 in 2007 and $5,000 in 2006 when all his production costs are considered. "If I didn't have a daytime job, I would have quit a while ago.“ – “I’ve never seen nothing like it in all my life, the costs of farming,” Mr. Erhman said, noting many farmers are unable to stay afloat. He noted the price of fertilizer has gone from $190 to $1,200 a ton in the last year. Prices of fuel for farming equipment have more than doubled. Ehrman said while his crops have been selling at higher prices than usual, he isn’t making any more profit than usual thanks to the prices of fuel, fertilizer and other materials.

Revenue to the Firm Revenue Curves (from Sales of the Product) – Total Revenue (TR) = P * TPP - as more output is sold at a fixed price, TR increases at a fixed rate (P). – Average Revenue (AR) = TR / TPP - the revenue received per unit of output. – Marginal Revenue (MR) =  TR /  TPP - the addition to TR from producing (and selling) and additional unit of the output.

TR, MR, AR and Price Total Revenue P=MR=AR $ $ Output $45.00

Profit Maximization – The goal of the entrepreneur is to find the level of output that maximizes profit. – Profit (PT) = Total Revenue – Total Costs = TR – TC There are two ways to look at this: – 1 - Total Revenue - Total Costs – The optimum is where TR - TC is the maximized. – No graph in this text, but…..

Total Revenue – Total Costs Total Revenue

– 2 - Marginal Revenue = Marginal Costs – In the case of a firm selling in a competitive market (price taker), P = MR = AR. – If MR > MC, then profits must be increasing. If MR < MC, then profits must be decreasing. Thus, profits are maximized where MR = MC. – Profit Maximizing Rule: a firm maximizes profit by producing at the level of output where MR = MC. – See Table 6-4 and Figure 6-5.

Graphically,

Again

Bigger Version: MC = MR = Profit Max!

Production Costs Alternative Important Prices – Break-even Price - P = AR = ATC. At this point the firm is earning no profit (breakeven) but is earning a return on all inputs comparable to other uses. – Lost Minimizing Price(s) - P = AR > AVC and P = AR < ATC. As long as a firm is covering AVC and contributing some to AFC, it should produce in the short run. If it shuts down, it will have to pay all the AFC. – Shut-down Price - P = AR < AVC. If price is less than AVC, the firm should shut-down. – See Figure 6-5 (again).

A Firm’s Short-run Supply Curve – Shows the quantity the firm will produce at alternative prices, ceteris paribus. This curve is the MC curve above the minimum AVC curve. – Things held constant in the supply curve include: the production function (technology), input prices, producer motivations, etc. – See Figure 8-1.

Production Costs (continued) A Market Supply Curve – Market supply is the various quantities of a good that all producers are willing and able to produce and offer at alternative prices in a given market during a specified time. – The market (or industry) supply schedule is the horizontal (sum of quantities) of the supply schedules for each individual producer. – See Figure 8-2.

Market Supply

– Along a supply schedule, the only variable that changes is the price and this in turn determines the quantity offered. All other factors are held constant. – Familiar terminology “a change in quantity supplied” – response to price change, ceteris paribus “a change (or shift) in supply” – response to change in technology, input prices, prices of other products, expectations, number of producers, taxes and subsidies, etc.

Price Elasticity of Supply – E s - measures the “responsiveness” of quantity supplied to a change in price. – Calculation – pick two points on a supply curve (P1, Q1 and P2, Q2). – If the price of a good goes up, do producers produce a little more or a lot more?

– E s is always positive with three designations – E s < 1 Inelastic Supply E s = 1 Unitary Supply E s > 1Elastic Supply – Supply Elasticity varies by crop and or product.

Production Costs and Supply Summary – The concept of supply is used to model and measure producer behavior in our economic system – Typical production costs and are the basis for the supply curve. Lecture Sources: Text and Miscellaneous Materials