Farm Management

1. Farm Management Chapter 9 Cost Concepts in Economics

2. Chapter Outline • Opportunity Cost • Fixed, Variable, and Total Costs • Application of Cost Concepts • Economies of Size • Shape of the LRAC Curve

3. Chapter Objectives • Explain the importance of opportunity cost and its use • Clarify the difference between short run and long run • Discuss the difference between fixed and variable costs • Identify fixed costs and show how to compute them • Show how to compute average costs • Demonstrate the use of costs in short run and long run decisions • Explore economies of size

4. Opportunity Cost • The income that could have been earned by selling or renting the input to someone else, or • The income that could have been received if the input had been used in its most profitable alternative use

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.)

6. 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

7. Management The opportunity cost of management is difficult to estimate. The opportunity cost of labor and management cannot be greater than the total salary that could be earned at the best alternative job.

8. Capital There are many possible uses for capital. Higher expected returns often carry higher risks. In agriculture, the opportunity cost of capital is often set equal to the interest rate on savings or the interest rate on borrowed capital. For some assets, such as land, a rental rate could be use. If assets decrease in value every year, their opportunity costs need to be decreased.

9. Fixed, Variable, and Total 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)

10. 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.

11. 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.

12. 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. .

13. Depreciation is a Fixed Cost Annual depreciation using the straight-line method is: Original Cost — Salvage Value Useful Life

14. Interest is a Fixed Cost Cost + Salvage Value Interest =  r 2 r = the interest rate

15. 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.

16. Annual Fixed Costs for a Harvesting Machine Purchase price of $120,000, salvage value of $50,000 and a useful life of 5 years. Depreciation $14,000 Interest (8%) 6,800 Property Taxes 400 Insurance 500 Total Fixed Cost $21,700

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

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

19. Figure 9-1 Typical total cost curves

20. Figure 9-2 Average and marginal cost curves

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

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

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

24. Application of Cost Concepts • Table 9-1 is an example of some cost figures for a stocker-steer operation • The size of pasture and amount of forage are limited • Adding more steers causes declining MPP • Total fixed costs = $5,000 per year • Variable costs = $485 per steer

25. Table 9-1 Illustration of Cost Concepts Applied to a Stocking Rate Problem Variable costs = $495 per steer, fixed costs = $5,000, selling price = $87.50/cwt

26. 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.

27. 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.

28. Figure 9-5 Illustration of short-run production decisions

29. 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.

30. Cash and Noncash Expenses • Fixed costs can be either cash or noncash • Depreciation is always noncash • Repairs and property taxes are always cash • Interest and insurance may be either cash or noncash

31. Table 9-2 Cash and Noncash Expense Items

32. 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?

33. Figure 9-6Farm size in the short run

34. Measuring Economies of Size Percent Change in Costs Percent Change in Output Value

35. Figure 9-7Possible size-cost relations

36. Causes of Economies of Size • Full use of existing resources • Technology • Engineering economies • Use of specialized resources • Decreasing input prices • Higher output prices • Management

37. Causes of Diseconomies of Size • Management • Labor supervision • Geographical dispersion • Special problems of large livestock operations

38. Figure 9-8Two possible LRAC curves

39. Figure 9-9Costs per unit of production Insert figure 9-9 here, no title • cost per bushel of corn, (b) cost per bushel of soybeans, (c) cost per cwt of milk • Source: Iowa Farm Business Association (2005), Center fo Farm Financial Management, Minnesota (2005)

40. 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.