AAEC 2305 Fundamentals of Ag Economics Chapter 4 Costs, Returns, and Profit Maximization

Introduction b A manager’s goal is to determine how much to produce in order to maximize profits. b 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. b Profit is affected not only by how much is produced, but also by the costs of generating that pdn.

Objective b Objective of Chapter 4 is to introduce cost and revenue relationships into production to evaluate profit maximization. b 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 b 1) Firms seek to maximize π b 2) One product, one pdn method b 3) One variable input, all others are fixed or held constant b 4) Perfect Information b 5) Price taker

Cost Definitions b 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 pdnExplicit 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)Implicit Costs- Costs associated with inputs owned by the firm (i.e., opportunity costs - ex., land)

Fixed vs. Variable Costs b 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 producedIncurred regardless whether any output is produced b Variable Costs: Costs that vary as the output level changes - These costs are associated with variable factors of pdn.

Cost Relationships in Pdn b Costs Based on Total Output 1) Total Fixed Costs (TFC) 1) Total Fixed Costs (TFC) 2) Total Variable Costs (TVC) 2) Total Variable Costs (TVC) 3) Total Costs (TC) 3) Total Costs (TC) b 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 Pdn b 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 usedCalculated by summing the cost of each variable input used TVC = (P X1 X 1 ) + (P X2 X 2 ) (P Xn X n ) TVC = (P X1 X 1 ) + (P X2 X 2 ) (P Xn X n ) For One Variable Input:For One Variable Input: TVC = P X X TVC = P X X

Cost Relationships in Pdn b TC - sum of TFC & TVC TC = TFC + TVC TC = TFC + TVC

Total Cost Curves (Assume TFC = $10 and P x = 4 X Y TFC TVC TC

Cost Relationships in Pdn b Costs Based on Per-Unit Output 1) Average Fixed Costs (AFC)1) Average Fixed Costs (AFC) 2) Average Variable Costs (AVC)2) Average Variable Costs (AVC) 3) Average Total Costs (ATC)3) Average Total Costs (ATC) b AFC - Average cost of fixed inputs per unit of output AFC = TFC / Y AFC = TFC / Y

Cost Relationships in Pdn b AVC - Average cost of variable inputs per unit of output AVC = TVC / Y AVC = TVC / Y b ATC - Average total cost per unit of output ATC = TC / Y ATC = TC / Y

Cost Relationships in Pdn b MC - Increase in total cost necessary to produce one more unit of output MC = ΔTC / ΔY = ΔTVC / ΔY MC = ΔTC / ΔY = ΔTVC / ΔY

Cost Curves (Assume TFC = $10 and P x = 4 X Y TFC TVC TC AFC AVC ATC MC

Summary of Relationships Between AFC, AVC, ATC, & MC Curves b AFC is a continuously decreasing function w/ the shape of a rectangular hyperbola b AVC & ATC curves are U-shaped (representing increasing & decreasing returns) b The vertical distance between ATC & AVC at each output level is equal to AFC

Summary of Relationships Between AFC, AVC, ATC, & MC Curves b MC crosses both AVC & ATC from below at their respective minimums b ATC is also referred to as Average Cost

Cost Curves & Pdn Process b The cost curves are derived directly from the pdn process. Therefore, the pdn function can be transferred directly to the cost curvesTherefore, the pdn function can be transferred directly to the cost curves b APP & AVC and MPP & MC are mirror images of each other

Summary of Relationships b When MPP > APP (APP is increasing)  MC < AVC (AVC is decreasing) MC < AVC (AVC is decreasing) b When MPP = APP (APP is max)  MC = AVC (AVC is min) b When MPP < APP (APP is decreasing)  b MC > AVC (AVC is increasing)

Mathematical Relationships b MC = ΔTC / Δ Y = P X / MPP b AVC = TVC / Y = P X / APP

Changes in Input Price b Input Price Increase The cost of producing each output level increases - TVC & TC shift upward & left; TFC remains unchanged - AVC, AC, & MC shift upward & leftThe cost of producing each output level increases - TVC & TC shift upward & left; TFC remains unchanged - AVC, AC, & MC shift upward & left b 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 & rightThe cost of producing same amount of output decreases - TVC & TC shift downward & right - AVC, ATC, & MC shift downward & right