Farm Management - Chapter 9: Cost Concepts in Economics

Farm Management - Chapter 9: Cost Concepts in Economics

Chapter Outline

• Opportunity Cost
• Cash and Noncash Expenses
• Fixed, Variable, and Total Costs
• Application of Cost Concepts
• Appendix 2

Chapter Objectives

• Explain the importance and application of opportunity cost
• Clarify the difference between short run and long run
• Discuss fixed vs variable costs
• Identify fixed costs and compute them
• Demonstrate the use of costs in decision-making for short run and long run

Opportunity Cost

• Definition: The income forfeited by not using an input in the most profitable way.
• Examples:
• Selling or renting an input to generate income.
• Using an input for lower-value output, incurring a loss of potential earnings.

Key Points on Opportunity Cost

• Even with optimal use of inputs, there are opportunity costs related to other outputs not produced.
• Opportunity cost of labor: What could be earned by the worker in the best alternative employment.

Capital

• Various uses for capital often correspond to different levels of risk and expected returns.
• In agriculture, the opportunity cost of capital may equate to the interest on savings or borrowed funds.
• For depreciating assets, the opportunity cost decreases over time.

Cash and Noncash Expenses

• Fixed costs can be either cash (e.g., repairs, property taxes) or noncash (e.g., depreciation, opportunity costs).
• Interest is considered cash if paid but an opportunity cost if no loan exists on the asset.
• Table 9-1 outlines different cash and noncash expenses.

Types of Costs

Fixed, Variable, and Total Costs

• Definitions:
• Total Fixed Cost (TFC)
• Average Fixed Cost (AFC)
• Total Variable Cost (TVC)
• Average Variable Cost (AVC)
• Total Cost (TC): TC = TFC + TVC
• Marginal Cost (MC): Cost of producing one more unit.

Short Run vs Long Run

• Short Run: At least one input is fixed. Costs that must be paid regardless of output.
• Long Run: All inputs can be adjusted.

Fixed Costs

Characteristics

• Exist only in the short run and must be paid regardless of production level.
• Not controllable in the short run.

Examples of Fixed Costs

• Interest on loans can be calculated using average value and opportunity interest rate.
• Average annual depreciation calculated:
• Formula: (Original Cost - Salvage Value) / Useful Life
• Property taxes and insurance are typically fixed costs.

Calculation Example

• For a harvesting machine:
• Purchase Price: $120,000
• Salvage Value: $50,000
• Useful Life: 5 years
• Average Value: $85,000
• Depreciation: $14,000
• Interest: $6,800
• Property Tax: $400, Insurance: $500
• Total Fixed Cost: $21,700

Total Costs

• Total Fixed Costs (TFC): Sum of all fixed costs.
• Total Variable Costs (TVC): Sum of all variable costs.
• Total Costs (TC): TFC + TVC.

Average and Marginal Costs

• Formulas:
• AFC = TFC / Output
• AVC = TVC / Output
• ATC = TC / Output
• MC = Change in TC / Change in Output

Application of Cost Concepts

• Example of a stocker-steer operation:
• Fixed costs = $10,000/year
• Variable costs = $990 per steer
• Selling price = $175/cwt

Production Rules for Short Run

• Price > ATC: Produce for profit.
• ATC > Price > AVC: Produce to minimize losses.
• AVC > Price: Do not produce, limit losses to fixed costs.

Long Run Production Rules

• Price > ATC: Continue production where MR=MC.
• Price < ATC: Stop production and liquidate fixed assets.

Cost Curves

Concepts

• Cost curves are essential for visualizing relationships between outputs and costs.
• Appendix on Cost Curves discusses how cost curves are affected by variations in production functions.

Observations from Cost Curves

• AFC decreases over output levels.
• AVC and ATC typically exhibit U-shaped tendencies.
• Marginal cost intersects AVC and ATC at minimum points.

Other Cost Curve Characteristics

• TVC increases initially at decreasing rates, eventually increasing at faster rates.
• Curves differ based on production function nature; some may not have Stage I characteristics.

Summary

• This chapter explores economic cost concepts crucial for managerial decision-making.
• Understanding costs is vital for enhancing business profitability and operational efficiency.