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3. COSTS (Perloff- chapter7 Blandford et al- chapter 6)

Cost

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Why Examine Costs 1. Necessary to Calculate Net Returns (Profits) 2. Used in Pricing – determines break-even price

3. Linked to supply response 4. Shut-down point Cost

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Why Examine Costs Businesses use a 2-step procedure to determine how to produce a certain amount of output efficiently: 1. technically efficient – 2. economically efficient –

• Any profit maximizing firm minimizes its cost of production for a specified amount of output. Cost

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3.1. Measuring Costs 3.1.A. Economic Costs • Economic costs consider all relevant costs • Economic costs include both explicit and implicit costs Explicit costs –

Implicit costs –

Cost

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3.1. Measuring Costs 3.1.A. Economic Costs Opportunity Costs Example. Amanda generates a profit from her own business of $40,000 from which she can draw a salary. She could have worked for another company and gotten paid $60,000. What is actual net income of Amanda’s business for economic purposes?

.

Cost

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3.1 Measuring Costs 3.1.B. Costs of Durable Inputs - Capital (land, equipment, quota etc) is a durable input -

How to allocate the initial purchase over time?

What to do if the value of capital changes over time?

Cost

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3.1 Measuring Costs 3.1.C. Sunk Costs - a past expenditure that cannot be recovered

Example. Luke buys a turnip harvester for $25,000 but it can only be used for harvesting turnips. The market for turnips slumps and the value of the harvester drops to $10,000. Opportunity costSunk cost.

Cost

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3.2 Minimizing Costs to Produce What combination of inputs to use? K

Objective?

K*

L*

Cost

L

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3.2 Minimizing Costs to Produce Technically efficient combination of inputs given by production function (isoquant for 2 inputs) Firm wants to choose economically efficient combination of inputs (minimize costs) Firms needs info on: a) b) Cost

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3.2 Minimizing Costs to Produce 3.2.A. Isocost Line Example. Cost of production with 2 inputs C = w*L + r*K where C= total cost ($) w = wage rate ($/hr) L = # of labour hours used r = rental rate of machine services ($/hr) K = # of hours of machine services Cost

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3.2 Minimizing Costs to Produce 3.2.A. Isocost Line If the budget is $100 and w=5 and K r=2.5, what is the iso-cost line? 40

How much K would be used if L=10 and budget is $100? L 20 Cost

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3.2 Minimizing Costs to Produce 3.2.A. Isocost Line K 80

What happens to isocost line if budget changes? C = w*L + r*K K= (C/r) – (w/r)* L What is the iso-cost line if budget increases from $100 to $200?

40

20

40 Cost

L 12

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3.2 Minimizing Costs to Produce 3.2.A. Isocost Line What happens to isocost line if price changes? K

Example What is the isocost line if the rental rate for capital rises from $2.5 to $4?

Slope=-2

40 Slope=-1.25 25

. Cost

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L

3.2 Minimizing Costs to Produce 3.2.B Choice of Cost Minimizing Inputs What combination of inputs will produce an output of 97 at least cost?

K

Isoquant ?K*?

Iso-cost line

Y=97 ?L*?

L Cost

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3.2 Minimizing Costs to Produce 3.2.B Choice of Cost Minimizing Inputs Would any input combination along the given iso-cost line represent the minimum cost choice?

K

?K*?

Isoquant Y=97

Iso-cost line ?L*?

L

Cost

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3.2 Minimizing Costs to Produce 3.2.B Choice of Cost Minimizing Inputs K Cost minimization is where the slope of the isoquant equals the slope of the isocost line: MPPL/MPPK = w/r

K* Y=97 L*

L Cost

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3.2 Minimizing Costs to Produce 3.2.B Choice of Cost Minimizing Inputs Cost Minimizing Approaches 1. Lowest iso-cost rule 2. Tangency rule

3. Last dollar rule Cost

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3.2 Minimizing Costs to Produce C=5*92+2.5*16 =$500

Example 1. The farmer has 60 lbs pigs that Protein she wants to market at 100 lbs (40 lbs of gain). She can feed energy which costs $5/unit or protein which costs $2.5 unit. Two protein & energy combinations are illustrated on the graph and both can result in 40 lbs of gain. Which feed ration should be used?

C=5*70+2.5*30 =$425

30

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Y=40 70

Cost

92

Energy 18

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3.2 Minimizing Costs to Produce Example 2. A bottling company uses bottling machines (K) and workers (L) to produce soft drinks. Machines cost $1000 per day and workers earn $200 per day. At the current level of production, the marginal product of the machine is an extra 200 bottles per day and the marginal product of labour is 50 more bottles per day. Is the firm producing at minimum cost? (Perloff, chp 7 Q.3.33) If it is minimizing cost, explain why?

If it is not, explain how the ratio of inputs should be changed to lower its costs.

. Cost

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3.2 Minimizing Costs to Produce Example 3. Choice of Technique in Rice Milling on Java

Cost

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3.3 Demand for Inputs • The demand for a good or service relates the use of it to its price • The demand for inputs is used to assess many policy questions – farm labour? • Impact of labour regulations (min wage, standards)

– fertilizer? • Environmental effect of raising its price

• The cost minimizing input use concepts can help us determine the use of an input as its price changes Cost

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3.3 Demand for Inputs 3.3.A Determination of Input Demand K

Wage rate

-w1/r

A K**

w1

K*

w0

What Happens to the Demand for Labour if Wage Rate Rises (w0 to w1)?

Y B

L

L

L**

L*

L

L* Cost

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3.3 Demand for Inputs 3.3.B Shifts in Input Demand • What would happen if output increased?

Wage rate

• What if the price of a substitute input fell?

w1 w0

L**

L*

L

• What if the price of a complementary input fell? Cost

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3.4. Cost Functions • A firm needs to know how its cost varies with output in order to maximize profits • Costs tend to rise with output but how? • In the short run, some of the inputs cannot be changed • In the long run, all inputs can be changed – Thus usually more costly to increase output in the short run

Cost

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3.4. Cost Functions 3.4.A. Short Run Cost Measures Fixed Costs (FC) – • production expenses that do not change regardless of the level of output.

Variable Costs (VC) – • costs of production that vary with the level of output produced

Total Cost (TC) = VC + FC

Cost

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3.4. Cost Functions 3.4.A. Short Run Cost Measures Marginal Cost (MC) • the amount by which a firm’s cost changes if the firm produces one more unit of output

Average Fixed Cost (AFC) = FC/y

Average Variable Cost (AVC) = VC/y

Average Total Cost (AC) = AFC + AVC -is the unit cost of production Cost

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3.4 Cost Functions 3.4.A Short Run Cost Measures- Example Output

TFC

TVC

0

48

0

48

1

48

25

73

3

48

66

114

4

48

82

130

5

48

100

148

6

48

120

168

7 8

48 48

141 168

189 216

9

48

198

246

10

48

230

278

11

48

272

320

12

48

321

369

2

TC

AFC

AVC

ATC

MC

94

Cost

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3.4 Cost Functions 3.4.B. Short Run Cost Curves Figure 1. Total Cost (TC), Total Variable Cost (TVC) and Total Fixed Cost (TFC) from Example in Table

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3.4 Cost Functions 3.4.B. Short Run Cost Curves Figure 2. Average Total Cost (ATC), Average Variable Cost (AVC), Average Fixed Cost (AFC) and Marginal Cost (MC)

Cost

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3.4 Cost Functions 3.4.B. Short Run Cost Curves • Graphical Representation • What units are on the axises? • What shape does AFC have? • What is the relationship between MC and AVC and ATC?

Cost

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3.4 Cost Functions 3.4.B. Short Run Cost Curves • Since output prices are assumed fixed, the production function determines the shape of a firm’s cost curves. Law of Diminishing Returns from the input side – . from the output side –

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3.4. Cost Functions 3.4.C. Long Run Cost In the long run, there are – No fixed costs – All inputs are variable, therefore all costs variable

The firm can adjust inputs that were fixed in the short run like plant size Long run average cost curve

Cost

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3.4. Cost Functions 3.4.C. Long Run Cost Below are 3 possible plant sizes with short run average cost curves for small (SRACS), medium (SRACM), and large plants (SRACL). What is the long run average cost curve (LRAC)? Cost per unit of output

SRACL

SRACS

SRACM

Cost

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Output

3.4 Cost Functions 3.4.C. Long Run Cost Choice of Technology to Minimize Cost- Example It costs $100,000 to buy a harvesting machine that uses $200 of labour per acre to harvest an acre of tomatoes. What is its TC and ATC?

It costs $300,000 to buy a harvesting machine that uses $75 of labour per acre to harvest an acre of tomatoes. What is its TC and ATC?

What is the number of acres of tomatoes at which you are indifferent between the two harvesters.

. Cost

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3.5. Economies of Size 3.5.A. Definitions Economies of size-

Diseconomies of size-

Minimum Efficient Scale

Cost

Output

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3.5. Economies of Size Typical shape of the long run average cost curve

.

Cost per unit of output

Output

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3.5. Economies of Size 3.5.B. Reasons for Economies of Size 1. Spreading of Fixed Costs 2. Specialization 3. Physical Properties 4. Buying power Cost

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3.5. Economies of Size 3.5.C. Reasons for Economies of Size 1. Labour Costs 2. Dis-incentive effects 3. Spread too thin

Cost

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Average Cost Curve- Hogs !"#$%&'()'*+&%,#&'-./0',12'.$03$0'/"4&' 500

Average cost

400

300

200

100

0 0

2000

4000

6000

8000

10000

12000

Hog quantity

' ' Cost

Source: Duvaleix-Treguer & Gaigne392012

Application: dairy cost of production (South Africa)

!"#$%&'()''

*+,$-.'-/&%-#&'+01,1&

Source: Mkhabela and Mndeme Cost 2010

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Average Cost Curve- Dairy

Source: Moschini 1988

Cost

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Average and Marginal Cost CurvesDairy

Figure 2. Estimated average and marginal cost for the Ontario dairy industry for 2006

Source: Rajsic 2011

Cost

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Application: sugar cane (South Africa)

Cost

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3.5. Economies of Size 3.5.D. Average Cost Curves in Agriculture • The long run average cost curves in agriculture tend to be Lshaped rather than U-shaped • What does it mean?

• What are the implications? . Cost

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