AAEC 2305 Fundamentals of Ag Economics

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AGEC 220
Production Costs, Supply, Price Determination
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Introduction

• A managers goal is to determine how much to
  produce in order to maximize profits.
• Previously 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.
• Profit is affected not only by how much is
  produced, but also by the costs of generating
  that pdn.

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Objective

• Introduce cost relationships into production.
• 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.

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Assumptions

• 1) Firms seek to maximize p
• 2) One product, one pdn method
• 3) One variable input, all others are fixed or
  held constant
• 4) Perfect Information
• 5) Price taker

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Cost Definitions

• 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 pdn
• Implicit Costs - Costs associated with inputs
  owned by the firm (i.e., opportunity costs - ex.,
  land)

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Fixed vs. Variable Costs

• 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
  produced
• (Ex rent)
• Variable Costs Costs that vary as the output
  level changes - These costs are associated with
  variable factors of pdn.
• (Ex seed cost)

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Short Run vs. Long Run

• Short Run Time period in which the firm has
  both fixed variable factors of pdn, and thus
  fixed variable costs.
• Long Run Time period in which there are no
  fixed factors of pdn, only variable factors of
  pdn. Thus, the firm only incurs variable costs.

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Cost Relationships in Pdn

• Costs Based on Total Output
• 1) Total Fixed Costs (TFC)
• 2) Total Variable Costs (TVC)
• 3) Total Costs (TC)
• TFC (overhead costs) costs of inputs (implicit
  explicit) that are fixed in the SR do not
  change as the output level changes.

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Cost Relationships in Pdn

• 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 used
• TVC (PX1X1) (PX2X2) . . . .
  (PXnXn)
• For One Variable Input
• TVC PXX

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Cost Relationships in Pdn

• TC sum of TFC TVC
• TC TFC TVC

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Total Cost Curves(Assume TFC 10 and Px 4
X Y TFC TVC
TC
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Cost Relationships in Pdn

• Costs Based on Per-Unit Output
• 1) Average Fixed Costs (AFC)
• 2) Average Variable Costs (AVC)
• 3) Average Total Costs (ATC)
• 4) Marginal Cost (MC)
• AFC Average cost of fixed inputs per unit of
  output
• AFC TFC / Y

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Cost Relationships in Pdn

• AVC Average cost of variable inputs per unit of
  output
• AVC TVC / Y
• ATC Average total cost per unit of output
• ATC TC / Y

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Cost Relationships in Pdn

• MC Increase in total cost necessary to produce
  one more unit of output
• MC ?TC / ?Y ?TVC / ?Y

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Cost Curves(Assume TFC 10 and Px 4
X Y TFC TVC TC AFC AVC ATC MC
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Summary of Relationships Between AFC, AVC, ATC,
MC Curves

• AFC is a continuously decreasing function w/ the
  shape of a rectangular hyperbola
• AVC ATC curves are U-shaped (representing
  increasing decreasing returns)
• The vertical distance between ATC AVC at each
  output level is equal to AFC

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Summary of Relationships Between AFC, AVC, ATC,
MC Curves

• MC crosses both AVC ATC from below at their
  respective minimums
• ATC is also referred to as Average Cost

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Cost Curves Pdn Process

• The cost curves are derived directly from the pdn
  process.
• Therefore, the pdn function can be transferred
  directly to the cost curves
• APP AVC and MPP MC are mirror images of
  each other

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Summary of Relationships

• When MPP gt APP (APP is increasing) ?
• MC lt AVC (AVC is decreasing)
• When MPP APP (APP is max) ? MC AVC (AVC is
  min)
• When MPP lt APP (APP is decreasing) ?
• MC gt AVC (AVC is increasing)

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Mathematical Relationships

• MC ?TC / ? Y PX / MPP
• AVC TVC / Y PX / APP

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Changes in Input Price

• Input Price Increase
• The cost of producing each output level increases
  - TVC TC shift upward left TFC remains
  unchanged - AVC, AC, MC shift upward left
• 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 right

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Supply

• Supply direct price and quantity relationship
  detailing the functional relationship of how
  suppliers (producers, sellers, mgrs) of a
  product respond to differing price levels.
• It states what suppliers are WILLING and ABLE to
  supply at a given price.

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Derivation of Mkt Supply Curves

• Supply curve for the individual firm is based on
  the cost structure of the firm how mgrs respond
  to alternative product prices as they attempt to
  maximize profits.
• We discussed profit maximization decision rules
  for the individual firm and said that the MC
  above AVC represented the firm short run supply
  curve.

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Derivation of Mkt Supply Curves

• In the long run, MC curve above ATC represents
  the firms long run supply curve (remember AVC
  and ATC are the same in the long run).
• Additionally, the firms supply curve is derived
  under the assumption that the only economic
  variable changing is the goods own price. All
  other factors are assumed to remain constant.

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Derivation of Mkt Supply Curves

• The industry supply curve is the horizontal
  summation of all individual firms supply curves
  in the market.

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Example
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Example
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Law of Supply

• Law of Supply quantity of goods /or services
  offered to a mkt will vary DIRECTLY with the
  price.
• Price increase will result in an increase in
  quantity supplied.
• Price decrease will result in a decrease in
  quantity supplied.
• The amt of increase or decrease depends on the
  Elasticity of Supply.

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Elasticity of Supply (Es)

• Elasticity (in general) percentage change in the
  quantity supplied relative to the percentage
  change in price (or other economic variable) as
  we move from one point to another on the supply
  curve.
• It is a measure of responsiveness of quantity to
  changes in price (or other eco variable)

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Elasticity of Supply (Es)

• E ? Q / ? P
• Elasticity represents movement along the supply
  curve and thus elasticity is also a measure of
  the degree of slope of the supply curve.

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Elasticity of Supply (Es)

• Classifications
• Inelastic supply (Es lt 1) a change in price
  brings about a smaller change in quantity (we are
  less responsive to price)
• Unitary supply (Es 1) a change in price
  brings about an equivalent change in quantity.
• Elastic supply (Es gt1) a change in price
  brings about a relatively larger change in
  quantity.

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Elasticity of Supply (Es)

• Mgrs economists are interested in two types of
  supply elasticity measures
• Own-price elasticity of supply measures the
  responsiveness of quantity supplied of a good to
  a change in the price of that good.
• Cross-price elasticity of supply measures the
  responsiveness of quantity supplied of a good to
  a change in the price of a related good.

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Elasticity of Supply (Es)

• Es ? Qs / ? P ltorgt
• Es ((Q2-Q1) / (Q2Q1)) / ((P2-P1) / (P2P1))
• In class examples

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Cross-price elasticity

• ESY1Y2 ?QY1 / ?PY2
• ESY1Y2 ((QY12 QY11) / (QY12 QY11)) / ((PY22
  PY21) / (PY22 PY21))
• Measures the effect of a change in the price of
  good Y2 on the quantity supplied of Y1.
• Read the cross-price of elasticity of supply for
  product Y1 with respect to product Y2.

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Classification of Cross-price elasticity of
Supply

• Complements in production (ESY1Y2 gt 0) implies
  that as the price of Y2 increases, the quantity
  of Y1 supplied by the firm will also increase.
• Substitutes in production (ESY1Y2 lt 0) implies
  that as the price of Y2 increases, the quantity
  of Y1 supplied by the firm will decrease.
• In class examples

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Change in Supply versus Change in Quantity
Supplied

• Changes in quantity supplied result from changes
  in the price of the product and are movements
  along the supply curve.
• Changes in supply result from changes in
  quantity sold due to factors other than a change
  in the price of the product.

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Determinants of Industry Supply

• Qs f(own price input prices, technology,
  prices of alternative products, number of
  sellers, other factors)
• States that quantity supplied will vary with
  price as long as the supply shifters are held
  constant.