Cost Concepts in Economics

Chapter 9: Kay and Edwards

Agenda
     

Opportunity Cost Long Versus Short-Run Cost Concepts Revenue Concepts Production Rules in Short and Long-Run Size in Long-Run

Opportunity Costs


The value of the product not produced because an input was used for another purpose. The income that would have been received if the input had been used in its most profitable alternative use. It denotes the real cost of using an input.
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Short Versus Long Run



The short run is a period of time sufficiently short that only some of the variables can be changed. The long run is a period of time that all variables can be changed.

Types of Costs


Variable Costs
 

These costs exist only if production occurs. E.g., fuel for tractor, seed, etc. These cost exist whether production occurs or not. In the long-run there are no fixed costs. Can be both cash and non-cash expenses. E.g., depreciation on tractors and buildings, etc.

Fixed Costs
   

Types of Costs Cont.



Sunk Costs


 

Is an expenditure that cannot be recovered. In essence, it becomes part of fixed costs. E.g., pre-harvest costs.

Cost Concepts


Total Fixed Costs (TFC)



The summation of all fixed and sunk costs to production. The summation of all variable costs to production. The summation of total fixed and total variable costs. TC=TFC+TVC
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Total Variable Costs (TVC)



Total Costs (TC)



Cost Concepts Cont.



Average Fixed Costs (AFC)



The total fixed costs divided by output. The total variable costs divided by output. The total costs divided by output. The summation of average fixed costs and average variable costs, i.e., ATC=AFC+AVC.

Average Variable Costs (AVC)



Average Total Costs (ATC)

 

Cost Concepts Cont.



Marginal Costs


The change in total costs divided by the change in output.



(TC/(Y

The change in total variable costs divided by the change in output.



(TVC/(Y

Side Note on Marginal Cost



How can marginal cost equal both the change in total cost divided by the change in output and the change in total variable cost divided by the change in output when variable costs are not equal to total costs?


Short answer: fixed costs do not change.

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Side Note on Marginal Cost Cont.

        

We want to show that MC = (TVC/(Y when TVC { TC. We know that TC = TFC + TVC This implies that (TC = ((TFC + TVC) This implies that (TC = (TFC + (TVC We know that (TFC = 0 Hence, (TC = (TVC Divide the previous by (Y, we obtain (TC/(Y = (TVC/(Y MC = (TVC/(Y

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Graphical Representation of Cost Concepts

$ TC TVC

TFC

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Graphical Representation of Cost Concepts Cont.

$ MC

ATC AVC

AFC

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Notes on Costs


MC will meet AVC and ATC from below at the corresponding minimum point of each.


Why?

 

As output increases AFC goes to zero. As output increases, AVC and ATC get closer to each other.
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Example of Cost Concepts

X 10 16 20 22 26 32 40 50 62 76 Y 10 30 48 65 81 96 108 116 120 117 TFC 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 TVC 1000 1600 2000 2200 2600 3200 4000 5000 6200 7600 TC 2000 2600 3000 3200 3600 4200 5000 6000 7200 8600 AFC 100 33.33 20.83 15.38 12.35 10.42 9.26 8.62 8.33 8.55 AVC 100 53.33 41.67 33.85 32.10 33.33 37.04 43.10 51.67 64.96 ATC 200 86.67 62.50 49.23 45.45 43.75 46.30 51.72 60.00 73.51 30 22.22 11.76 25 40 66.67 125 300 -466.67
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MC

Revenue Concepts


Revenue (TR) is defined as the output price (py) multiplied by the quantity (Y). Average revenue (AR) equals total revenue divided by output (Y), i.e., TR/Y, which equals py. Marginal Revenue is the change in total revenue divided by the change in output, i.e., (TR/(Y.
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Short-Run Decision Making



In the short-run, there are many ways to choose how to produce.

  

Maximize output. Utility maximization of the manager. Profit maximization.



Profit (T) is defined as total revenue minus total cost, i.e., T = TR TC.

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Short-Run Decision Making Cont.



When examining output, we want to set our production level where MR = MC when MR > AVC in the short-run.


If MR e AVC, we would want to shut down.



Why?

If we can not set MR exactly equal to MC, we want to produce at a level where MR is as close as possible to MC, where MR > MC.
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Intuition for Setting MR = MC

 

Suppose MR < MC. This implies that by producing more output, you have a greater addition of cost than you do revenue.


Hence you would not make the change.

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Intuition for Setting MR = MC

 

Suppose MR > MC. This implies that by producing more output, you have a greater addition of revenue than you do cost.


Hence you would make the change.

You would stop increasing output at the point where the trade-off in additional revenue is just equal to the trade-off in additional costs. 20

Why Shutdown When MR < AVC



If MR < AVC, this implies that you are not bringing in enough revenue from each unit produced to cover your variable costs. Hence you could minimize your loss if you were to shutdown.

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Why Produce When ATC > MR > AVC



When MR < ATC, the company is making a loss.



Why would it produce?

Since the firm is making something above and beyond its variable cost, it can put some of that revenue towards fixed cost.


This implies that it minimizes its loss by producing.

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Profit Scenario Graphically

$ Profit MC MR = py ATC ATC AVC

AFC Yprofit

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Loss Minimizing Graphically

$ MC Loss ATC ATC MR = py AFC Yloss AVC

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Shutdown Decision Graphically

$ If we did not produce: loss = B Loss = A + B ATC ATC B AVC MC

MR = py

A Yloss

AFC

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Production Rules for the LongRun



To maximize profits, the farmer should produce when selling price is greater than ATC at the production level where MC = MR. To minimize losses, the farmer should not produce when selling price is less than ATC, i.e., shutdown the business.
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Note on Cost Concepts



The producer s supply curve is the part of the MC curve that is above the shutdown point.

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Long-Run Average Costs



The long run average cost (LRAC) curve is the envelope of the short run average cost curves when the size of the operation is allowed to increase or decrease. Note that a short run average cost curve exists for every possible farm size, as defined by the amount of fixed input available.

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Long-Run Average Costs Cont.



In a competitive market, the long run optimal production will occur at the lowest point on the LRAC, i.e., economic profits are driven to zero.

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Size in the Long-Run



A measure of size in the long run between output and costs as farm size increases (EOS) is the following:


EOS = percent change in costs divided by percent change in output value

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Size in the Long-Run Cont.



If this ratio of EOS is less than one, then there are decreasing costs to expanding production, i.e., increasing returns to size. If this ratio is equal to one, then there are constant costs to expanding production, i.e., constant returns to size. If this ratio is greater than one, then there are increasing costs to expanding production, i.e., decreasing returns to size.
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Economies of Size
  

This exists when the LRAC is decreasing. Also known as increasing returns to size. Usually occurs because of full utilization of capital (tractors and buildings) and labor. Also occurs because of discount pricing for buying in bulk and selling price benefits for selling large quantities.

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Diseconomies of Size
  

This exists when the LRAC is increasing. Also known as decreasing returns to size. Usually occurs because a lack of managerial skills. Also occurs because travel time increases as farm increases.
 

Livestock: disease control and manure disposal. Crops: geographical distance away from each other.

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