AgEc 301 Agricultural Economics I Homework Assignment 5 Due Wednesday, October 12, 2005 Please hand in via email

to mcintosh@uidaho.edu as an attachment. Note that I will be in Moscow on October 12 so homework can be handed in to me either after class on the 12th or first thing in the morning on the 13th. 1. The relevant cost for most managerial decisions is the current cost of an input. The relevant cost for computing income for taxes and stockholder reporting is the historical cost. What advantages or disadvantages do you see in using current costs for tax and stockholder reporting purposes? Theoretically, it would be preferable to use current costs for income tax calculations and for stockholder reporting. On a practical level, however, this would be nearly impossible. Estimation of current cost, based upon current market values, would be a difficult task with a great deal of room for subjectivity. This could result in many arbitrary cost designations, and the "policing" of tax returns would become a much more formidable task. On a practical basis, the use of historical costs for tax and stockholder reporting purposes has obvious advantages over the theoretically superior current costs. 2. What is the difference between marginal and incremental cost? Marginal costs are the cost effect of one-unit changes in output. Incremental cost is the cost effect associated with a given managerial decision. Incremental costs may also relate to output changes, but, if so, the output change involved is that of a relevant block (or increment) of service. 3. What is the relation between production functions and cost functions? Be sure to include in your discussion the effect of conditions in input factor markets. There is a direct relation between production and cost functions. A cost function is determined by combining a given production function with the related price functions for the inputs actually employed in production. If inputs are purchased in competitive markets so that their prices are constant irrespective of how many are purchased, the relation between production and cost functions is straightforward (see Figures 8.2, 8.3, and 8.4). With imperfect competition in input markets, the relation becomes somewhat more complex. In all cases, cost/production relations can be employed either to minimize total costs subject to an output constraint or to maximize output subject to a total cost or budget constraint.

4. Three business students (who also happened to be PETA members) are considering operating a tofu burger stand in the Dalles, Oregon, windsurfing resort area during their summer break. This is an alternative to summer employment with a local fruit cannery where they would earn $7,500 each over the three-month summer period. A fully equipped facility can be leased at a cost of $8,000 for the summer. Additional projected costs are $2,000 for insurance, and 25 per unit for materials and supplies. Their tofu burgers would be priced at $1.50 per unit. a) What is the accounting cost function for this business? The accounting cost function is: Total Accounting Cost = TCA = Fixed leasing plus insurance costs + Variable materials plus supplies costs = $8,000 + $2,000 + $0.25Q = 10,000 + $0.25Q b) What is the economic cost function for this business? The economic cost function is: Total Economic Cost = TCE = Summer employment opportunity cost + TCA = 3(7,500) + $10,000 + $0.25Q = $32,500 + $0.25Q c) What is the economic breakeven number of units for this operation? (Assume a $1.50 price and ignore interest costs associated with the timing of the lease payments.) The economic breakeven point is reached when: Q = TFC/(P AVC) Q = $32,500/($1.50 - $0.25) Q = 26,000

5. For Advanced Students (not required for full credit on the assignment, but a good problem for you to try working through) Assume that a firm produces its product in a system described in the following production function and price data: Q = 3X + 5Y + XY PX = $3 PY = $6 Here, X and Y are two variable input factors employed in the production of Q. a) What are the optimal input proportions for X and Y in this production system? Is this combination rate constant regardless of the output level? b) It is possible to express the cost function associated with the use of X and Y in the production of Q as Cost = PXX + PYY or Cost = $3X + $6Y. Use the Lagrangian technique to determine the maximum output that the firm can produce operating under a $1,000 budget constraint for X and Y. Show that the inputs used to produce that level of output meet the optimality conditions derived in Part a). c) What is the additional output that could be obtained from a marginal increase in the budget? d) Assume that the firm is interested in minimizing the cost of producing 14,777 units of output. Use the Lagrangian method to determine what optimal quantities of X and Y to employ. What will be the cost of producing that output level? How would you interpret , the Lagrangian multiplier, in this problem?