Farm Management

1
Farm Management

• Chapter 9
• Cost Concepts in Economics

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Chapter Outline

• Opportunity Cost
• Costs
• Application of Cost Concepts
• Economies of Size

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Chapter Objectives

1. To explain the importance of opportunity cost and
   its use
2. To clarify the difference between short run and
   long run
3. To discuss the difference between fixed and
   variable costs
4. To identify fixed costs and show how to compute
   them
5. To show how to compute average costs
6. To demonstrate the use of costs in short run and
   long run decisions
7. To explore economies of size

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Opportunity Cost

• The value of a product not produced because an
  input was used for another purpose, 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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Table 9-1 Opportunity Cost of Applying
Irrigation Water Among Three Uses
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How Does Opportunity Cost Relate to the
Equi-Marginal Principle?
With the Equi-Marginal Principle, we are choosing
to produce one product instead of another. The
opportunity cost is the revenue given up from
the crop not produced.
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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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Opportunity Cost of Capital
The opportunity cost of capital is often set
equal to what the capital could earn in a
no-risk savings account. Total dollar value of
the capital inputs is estimated and multiplied by
the interest rate for a savings account.
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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.
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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
Cost Salvage Value
Interest ? r
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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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
• MCAVC 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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Table 9-2 Illustration of Cost Concepts Applied
to a Stocking Rate Problem
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Graph of ATC, AVC, MC and AFC from Stocker
Problem
ATC
MC
AVC
AFC
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Application of Cost Concepts
Cost concepts can be used in both short and
long-run decision making.
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Production Rules for the Short Run

• If Price gt ATC, produce and make a profit.
• If ATCgtPricegtAVC produce and minimize losses.
• If AVCgt 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 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 cant, you dont produce.
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Producing at a Loss Example
Fixed Costs are 10,000. At the point where
MRMC, TVC are 8,000 and TR is 12,000. If
I dont produce, I will have a loss of
_______ If I do produce, I will have a loss of
_________ I should produce to minimize losses.
10,000
6,000
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If Losses Exceed Fixed Costs
Fixed Costs are 10,000. At the point where
MRMC, TVC are 15,000 and TR is 12,000. If
I dont produce, I will have a loss of
_______ If I do produce, I will have a loss of
_________ I should not produce
10,000
13,000
.
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Figure 9-5 Illustration of short-run production
decisions
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Dont Produce Graphical View
ATC
AVC
loses more than fixed cost
MR Price
MC
Output
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Produce at a Loss Graphical View
ATC
loses less than fixed cost
AVC
MR Price
MC
Output
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Produce at a Profit Graphical View
ATC
per-unit profit
AVC
MR Price
MC
Output
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Production Rules for the Long Run

• Price gt ATC. Continue to produce at the point
  where MRMC.
• Price lt ATC. Stop production and sell fixed
  assets.

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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 Costs Percent Change in
Output Value
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Figure 9-7Possible size-cost relations
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Causes of Economies of Size

• Full utilization of existing resources
• Technology
• 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 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.