Cost Concepts

in Economics
(Chapter 9)

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 2
ectives
1. Explain opportunity cost and its use in
decision making.
2. Discuss the difference etween the short-run
and long-run.
3. Understand the difference etween fixed costs
and varia le costs.
4. Learn to identify and compute fixed costs and
varia le costs.
5. Learn to compute the different average costs.
6. Use fixed and varia le costs to make short-
run and long-run production decisions.
7. Discuss economies of size and how they
explain changes in farm size and profita ility.
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 2pportunity Cost
The income that would have een
received if the input had een used in its
most profita le alternative use.
The value of the product not produced
ecause an input was used for another
purpose.
An ³economic concept´ not an
³accounting concept.´

As economic decision-makers, we assume
costs include opportunity costs.
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 Costs
Total fixed costs (TFC)
Average fixed costs (AFC)
Total varia le costs (TVC)
Average varia le cost (AVC)
Total cost (TC)
Average total cost (ATC)
Marginal cost (MC)

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±hort-Run & Long-Run
³Time concepts´ rather than fixed
periods.
±hort-run:

2ne or more production input is fixed:
Increasing cropland?

2ne crop or livestock production cycle.
Long-run:

The quantity of all necessary production
inputs can e changed.

Expand or acquire additional inputs.
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 Fixed Costs
Result from owning a fixed input or resource.
Incurred even if the resource isn¶t used.
Don¶t change as the level of production changes
(in the short run).
Exist only in the short run.
Not under the control of the manager in the
short run.
The only way to avoid fixed costs is to sell the
item.

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 Fixed Costs
(DIRTI ± 5)
1. Depreciation
2. Interest Cash
3. Rent
4. Taxes (property) Noncash
5. Insurance

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Important Fixed Costs
Total fixed cost (TFC):

All costs associated with the fixed input.
Average fixed cost per unit of output:

AFC = TFC
2utput
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 Varia le Costs
Can e increased or decreased y the
manager.
Varia le costs will increase as production
increases.
Total Varia le cost (TVC) is the
summation of the individual varia le
costs.
VC = (the quantity of the input) X (the
input¶s price).

 Varia le Costs
Varia le costs exist in the short-run and
long-run:

In fact, all costs are considered to e varia le
costs in the long run.
Varia le versus Fixed, some examples:

Fertilizer is a varia le cost until it has een
purchased and applied.

La or and cash rent contracts have to e
considered fixed costs during the duration of the
contract.

Irrigation water is generally varia le, ut can
have a fixed component.
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Important Varia le Costs
Total varia le cost (TVC):

All costs associated with the varia le input.
Average varia le cost per unit of output:

AVC = TVC
2utput

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 Total Cost
The sum of total fixed costs and total
varia le costs:

TC = TFC + TVC

In the short run TC will only

increase as TVC increases.

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 Average Total Cost
Average total cost per unit of output:

AFC + AVC

ATC = TC
2utput

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 Marginal Cost
The additional cost incurred from
producing an additional unit of output:

MC = ÷ TC
÷ 2utput
MC = ÷ TVC
÷ 2utput
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Typical Total Cost Curves

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Typical Total Cost Curves
(selected attri utes)
TFC is constant and unaffected y output
level.
TVC is always increasing:

First at a decreasing rate.

Then at an increasing rate.
TC is parallel to TVC:

TC is higher than TVC y a distance equal
to TFC.

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 T2DAY¶± DETAIL±
(9-15)

Exam Num er 1:

Chaps 1, 2, 7, 8, 9, 3, and 4.
Thru next week¶s la (La 4)

Exam date = 2ct. 6 or 2ct. 8
Complete Chap. 9 today:

Into Chap 3 and 4 on Friday and next week.
Fixed costs revisited.
Questions on costs to this point??
cþ
 Fixed Costs
(DIRTI ± 5)
1. Depreciation
2. Interest Cash
3. Rent
4. Taxes (property) Noncash
5. Insurance

c„
Typical Total Cost Curves
(selected attri utes)
TFC is constant and unaffected y output
level.
TVC is always increasing:

First at a decreasing rate.

Then at an increasing rate.
TC is parallel to TVC:

TC is higher than TVC y a distance equal
to TFC.

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 Typical Average &
Marginal Cost Curves

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 Typical Average &
Marginal Cost Curves
(selected attri utes)
AFC is always declining MC is generally increasing.
at a decreasing rate. MC crosses ATC and AVC
ATC and AVC decline at at their minimum point.
first, reach a minimum, If MC is elow the average value:
then increase at higher
Average value will e
levels of output. decreasing.
If MC is a ove the average value:
The difference etween

Average value will e
ATC and AVC is equal increasing.
to AFC.

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±tocking Rate Pro lem

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 Production Rules
for the ±hort-Run

If expected selling price > minimum ATC

(which implies TR > TC):

A profit can e made.
Maximize profit y producing
where:
MR = MC
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 Production Rules
for the ±hort-Run
If expected selling price < minimum ATC
ut > minimum AVC:
(which implies TR > TVC ut < TC)

A loss cannot e avoided.

Minimize loss y producing where
MR = MC.

The loss will e etween 0 and TFC.

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 Production Rules for the
±hort-Run
If expected selling price < minimum AVC
(which implies TR < TVC):

A loss cannot e avoided.

Minimize loss y not producing.

The loss will e equal to TFC.

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±hort Run Production Decisions

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Management Myth # 2
If the crop price is low, I can
make it up in volume!
If you can¶t cover your varia le cost
per unit of output it doesn¶t matter
how much you produce. You will
never e a le to cover VC let alone
any FC.

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 Production Rules
for the Long-Run
If selling price > ATC (or TR > TC):

Continue to produce.

Maximize profit y producing where
MR = MC.

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 Production Rules
for the Long-Run
If selling price < ATC (or TR < TC):

There will e a continual loss.

±ell the fixed assets to eliminate fixed costs.

Reinvest money in a more profita le
alternative.

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 Relationship Between Costs
and Farm ±ize
What is the most profita le farm size?
Can larger farms produce more cheaply?
Are large farms more efficient?
Will family farms disappear and e
replaced y large corporate farms?
Will the num er of farms continue to
decline?
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Vow is farm size measured?
Num er of livestock.
Num er of acres.
Num er of full time workers.
Total owner equity.
Total farm assets
Farm profit.
Gross farm income.
Total revenue or sales.
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Farm ±ize in the ±hort-Run
The quantity of one or more inputs is fixed:

Usually land.
±hort-run average cost curves are typically U-
shaped.
AC increases at higher levels of production:

2ne or more limiting fixed inputs makes
additional production more and more
difficult (diminishing marginal returns?).

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Farm ±ize in the ±hort-Run

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Farm ±ize in the Long-Run
Nothing is fixed ± everything is varia le.

Manager has time to ad
ust all inputs to

the level that results in the desired farm
size.

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Relation Between 2utput and Costs
as Farm ±ize Increases
Percent change in total costs
Percent change in total output value

Three possi le results:

Ratio value Type of Costs Returns to ±ize
<1 Decreasing Increasing
=1 Constant Constant
>1 Increasing Decreasing

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Possi le ±ize-Cost Relations

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 Economies of ±ize
Increasing returns to size.
LRAC curve is decreasing.
Economies of size result from:

Full utilization of la or, machinery, uildings.

A ility to afford specialized la or and
machinery and new technology.

Price discounts for volume purchasing of inputs.

Price advantages when selling large amounts of
output.

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Long-Run Average Cost Curve
(Economies of ±ize)

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 Diseconomies of ±ize
Decreasing returns to size.
LRAC curve egins to increase.
Diseconomies of size result from:

Lack of sufficient managerial skill.

Need to hire, train, supervise, and coordinate
larger la or force.

Dispersion over a larger geographical area.

Disease control, waste disposal.

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Long-Run Average Cost Curve
(Diseconomies of size)

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 ±ummary
2pportunity costs can (and should?) e used in
udgeting and farm financial analysis.
Importance of fixed and varia le costs when
making short-run production decisions.
In the short run, production should take place only
if the expected income will exceed varia le costs.
In the long run, production should take place only
if income is high enough to pay all costs.
The relation etween cost per unit of output and
size of the usiness determines whether there are
increasing, decreasing, or constant returns to size.

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