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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.
2.
3.
4.
5.
6.
7.
Explain the importance of opportunity cost and its
use
Clarify the difference between short run and long
run
Discuss the difference between fixed and variable
costs
Identify fixed costs and show how to compute
them
Show how to compute average costs
Demonstrate the use of costs in short run and long
run decisions
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
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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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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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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.
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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.
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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)
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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.
© 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.
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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 =
2
r = the interest rate
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r
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
Interest (8%)
Property Taxes
Insurance
$14,000
6,800
400
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
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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
© Mcgraw-Hill Companies, 2008
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
© Mcgraw-Hill Companies, 2008
Figure 9-3
Cost curves for a diminishing marginal returns
production function
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Figure 9-4
Cost curves when marginal product
is constant
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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 = $485 per steer
© Mcgraw-Hill Companies, 2008
Table 9-1
Illustration of Cost Concepts Applied to a
Stocking Rate Problem
Number
of steers
0
10
20
30
40
50
60
70
80
90
100
Output
cwt beef
0
75
150
225
295
360
420
475
525
570
610
MPP
***
7.5
7.5
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
TFC
($)
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
TVC
($)
0
4,950
9,900
14,850
19,800
24,750
29,700
34,650
39,600
44,550
49,500
TC
($)
5,000
9,950
14,900
19,850
24,800
29,750
34,700
39,650
44,600
49,550
54,500
AFC
($)
***
66.67
33.33
22.22
16.95
13.89
11.90
10.53
9.52
8.77
8.20
AVC
ATC
MC
MR
($)
($)
($)
($)
***
***
***
***
66.00 132.67 66.00 87.50
66.00 99.33 66.00 87.50
66.00 88.22 66.00 87.50
67.12 84.07 70.71 87.50
68.75 82.64 76.15 87.50
70.71 82.62 82.50 87.50
72.95 83.47 90.00 87.50
75.43 84.95 99.00 87.50
78.16 86.93 110.00 87.50
81.15 89.34 123.75 87.50
Variable costs = $495 per steer,
fixed costs = $5,000,
selling price = $87.50/cwt
© Mcgraw-Hill Companies, 2008
Total
profit
(5,000)
(3,388)
(1,775)
(163)
1,013
1,750
2,050
1,913
1,338
325
(1,125)
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
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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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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
Expense item
Cash expense
Depreciation
Interest (own capital)
Interest (borrowed capital)
Value of operator labor
Wages for hired labor
Farm raised feed
Purchased feed
Owned land
Cash rented land
Seed, fertilizer, fuel, repairs
Property taxes, insurance
Noncash expense
X
X
X
X
X
X
X
X
X
X
X
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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
=1
>1
Decreasing
Constant
Increasing
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Figure 9-7
Possible size-cost relations
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Causes of Economies of Size
•
•
•
•
•
•
•
Full use of existing resources
Technology
Engineering economies
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.
© Mcgraw-Hill Companies, 2008
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