1. Chapter 9 Cost Concepts in Economics
Farm Management
Chapter 9
Cost Concepts in Economics

2. Chapter Outline Opportunity Cost Costs Application of Cost Concepts
Economies of Size
farm management chapter 9

3. Chapter Objectives
To explain the importance of opportunity cost and its use
To clarify the difference between short run and long run
To discuss the difference between fixed and variable costs
To identify fixed costs and show how to compute them
To show how to compute average costs
To demonstrate the use of costs in short run and long run decisions
To explore economies of size
farm management chapter 9

4. 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
farm management chapter 9

5. 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.)
farm management chapter 9

6. Table 9-1 Opportunity Cost of Applying Irrigation Water Among Three Uses
farm management chapter 9

7. 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.
farm management chapter 9

8. 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
farm management chapter 9

9. 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.
farm management chapter 9

10. 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)
farm management chapter 9

11. 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.
farm management chapter 9

12. 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.
farm management chapter 9

13. 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. .
farm management chapter 9

14. Depreciation is a Fixed Cost
Annual depreciation using the
straight-line method is:
Original Cost — Salvage Value
Useful Life
farm management chapter 9

15. Interest is a Fixed Cost
Cost + Salvage Value
Interest =  r 2
r = the interest rate
farm management chapter 9

16. 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.
farm management chapter 9

17. 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
farm management chapter 9

18. 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
farm management chapter 9

19. Figure 9-1 Typical total cost curves
farm management chapter 9

20. Figure 9-2 Average and marginal cost curves
farm management chapter 9

21. 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
farm management chapter 9

22. Figure 9-3 Cost curves for a diminishing marginal returns production function
farm management chapter 9

23. Figure 9-4 Cost curves when marginal product is constant
farm management chapter 9

24. Table 9-2 Illustration of Cost Concepts Applied to a Stocking Rate Problem
farm management chapter 9

25. Graph of ATC, AVC, MC and AFC from Stocker Problem
farm management chapter 9

26. Application of Cost Concepts
Cost concepts can be used in both
short and long-run decision making.
farm management chapter 9

27. 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.
farm management chapter 9

28. 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.
farm management chapter 9

29. Producing at a Loss Example
Fixed Costs are $10, At the point where
MR=MC, TVC are $8,000 and TR is $12,000.
If I don’t 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
farm management chapter 9

30. If Losses Exceed Fixed Costs
Fixed Costs are $10, At the point where
MR=MC, TVC are $15,000 and TR is $12,000.
If I don’t 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 .
farm management chapter 9

31. Figure 9-5 Illustration of short-run production decisions
farm management chapter 9

32. Don’t Produce: Graphical View
ATC
AVC
loses more than
fixed cost
MR = Price MC
Output
farm management chapter 9

33. Produce at a Loss: Graphical View
ATC
loses less than
fixed cost
AVC
MR = Price MC
Output
farm management chapter 9

34. Produce at a Profit: Graphical View
ATC
per-unit profit
AVC
MR = Price MC
Output
farm management chapter 9

35. 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.
farm management chapter 9

36. 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?
farm management chapter 9

37. Figure 9-6 Farm size in the short run
farm management chapter 9

38. Measuring Economies of Size
Percent Change in Costs
Percent Change in Output Value
farm management chapter 9

39. Figure 9-7 Possible size-cost relations
farm management chapter 9

40. Causes of Economies of Size
Full utilization of existing resources
Technology
Use of specialized resources
Decreasing input prices
Higher output prices
Management
farm management chapter 9

41. Causes of Diseconomies of Size
Management
Labor supervision
Geographical dispersion
Special problems of large livestock operations
farm management chapter 9

42. Figure 9-8 Two possible LRAC curves
farm management chapter 9

43. 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.
farm management chapter 9