© mcgraw-hill companies, 2008 farm management chapter 9 cost concepts in economics
TRANSCRIPT
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Farm Management
Chapter 9Cost Concepts in Economics
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Chapter Outline
• Opportunity Cost
• Fixed, Variable, and Total Costs
• Application of Cost Concepts
• Economies of Size
• Shape of the LRAC Curve
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Chapter Objectives1. Explain the importance of opportunity cost and its
use2. Clarify the difference between short run and long
run3. Discuss the difference between fixed and variable
costs4. Identify fixed costs and show how to compute
them5. Show how to compute average costs6. Demonstrate the use of costs in short run and long
run decisions7. Explore economies of size
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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 opportunitycost 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 isdifficult to estimate. The opportunitycost of labor and management cannotbe greater than the total salary thatcould be earned at the best alternativejob.
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Capital
There are many possible uses for capital. Higher expected returns oftencarry higher risks. In agriculture, theopportunity cost of capital is often setequal to the interest rate on savings orthe interest rate on borrowed capital. Forsome 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 anadditional 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 whichthe 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
Interest = r Cost + Salvage Value
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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Annual Fixed Costs for a Harvesting Machine
Purchase price of $120,000, salvage valueof $50,000 and a useful life of 5 years.
Depreciation $14,000Interest (8%) 6,800Property Taxes 400Insurance 500
Total Fixed Cost $21,700
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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 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
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Table 9-1 Illustration of Cost Concepts Applied to a
Stocking Rate Problem
Variable costs = $495 per steer, fixed costs = $5,000,selling price = $87.50/cwt
Number Output MPP TFC TVC TC AFC AVC ATC MC MR Totalof steers cwt beef ($) ($) ($) ($) ($) ($) ($) ($) profit
0 0 *** 5,000 0 5,000 *** *** *** *** *** (5,000)10 75 7.5 5,000 4,950 9,950 66.67 66.00 132.67 66.00 87.50 (3,388)20 150 7.5 5,000 9,900 14,900 33.33 66.00 99.33 66.00 87.50 (1,775)30 225 7.5 5,000 14,850 19,850 22.22 66.00 88.22 66.00 87.50 (163)40 295 7.0 5,000 19,800 24,800 16.95 67.12 84.07 70.71 87.50 1,01350 360 6.5 5,000 24,750 29,750 13.89 68.75 82.64 76.15 87.50 1,75060 420 6.0 5,000 29,700 34,700 11.90 70.71 82.62 82.50 87.50 2,05070 475 5.5 5,000 34,650 39,650 10.53 72.95 83.47 90.00 87.50 1,91380 525 5.0 5,000 39,600 44,600 9.52 75.43 84.95 99.00 87.50 1,33890 570 4.5 5,000 44,550 49,550 8.77 78.16 86.93 110.00 87.50 325
100 610 4.0 5,000 49,500 54,500 8.20 81.15 89.34 123.75 87.50 (1,125)
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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 youproduce or not in any given year. Theyare therefore irrelevant to the productiondecision. You look at variable costs. Ifyou can cover those, you should produce.If you can’t, you don’t produce.
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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
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Table 9-2 Cash and Noncash Expense Items
Expense item Cash expense Noncash expense
Depreciation XInterest (own capital) XInterest (borrowed capital) XValue of operator labor XWages for hired labor XFarm raised feed XPurchased feed XOwned land XCash rented land XSeed, fertilizer, fuel, repairs XProperty taxes, insurance 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 9-6Farm size in the short run
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Measuring Economies of Size
Percent Change in CostsPercent Change in Output Value
Ratio value Type of costs
< 1 Decreasing= 1 Constant> 1 Increasing
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Figure 9-7Possible 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 9-8Two possible LRAC curves
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Summary
This chapter discussed the differenteconomic costs and their use inmanagerial 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.