Lab 15 Agricultural and Resource Economics (ARE 201)

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1 Lab 15 Agricultural and Resource Economics (ARE 201) This lab assignment is worth 100 points. Unless instructed differently, you are to complete the assignment and have it to me by this Thursday at 5:00 p.m. Late lab assignments will not be accepted without prior arrangement with me. Please let me know if you need any help with this assignment. Good Luck! Purpose of Lab: This assignment will continue to examine the elasticity of demand and teach you how to evaluate renting (leasing) versus ownership decisions for capital items. You will also learn how to determine a price to charge for providing services with capital items (machinery and equipment). I. Continuation of Elasticity Assignments: In 1989, the N.C. General Assembly directed the Division of Motor Vehicles of N.C. increase the fee charged for personalized tags from $30 to $40. The increased fee was to pay for a new program; planting wildflowers along our highways. However, the total revenue received by the state from the sale of personalized tags decreased, and the wildflower program was scaled back. Assume the demand for personalized tags is linear. Why did total revenue from the sale of personalized tags fall? DMV increased the price of personalized tags in the ELASTIC section of the demand curve! This resulted in a decrease in total revenues from the sale of personalized tags. Consumers substituted regular tags for the now more expensive personalized tags. What price action, ceteris paribus, should the General Assembly have taken to increase total revenue from the sale of personalized tags? DMV should have decreased the price of personalized tags OR increased the price of regular tags by the same percentage that DMV increased personalized tags. If DMV also increased the price of regular tags by the same percentage as personalized tags, then there would have been no change in the relative price of each tag option. Thus, no real incentive for substitution.

2 2 Using past data, when the wheat harvest has fallen10 percent due to bad weather, wheat prices have increased 40 percent. What is the price elasticity of demand for wheat? -10% / 40% = -.25 Using the price elasticity computed above, how much will the quantity of wheat purchased by consumers decrease if the government raises the price of wheat by 20 percent? +20% x -.25 = -5% c. How much will the total revenue of wheat farmers change, and in what direction will this change take place given "a" and "b" above? (percent change in total revenue = (1 - Ed ) X percent change in price) (1-.25) x 20% = 15% Answer the following questions independent of "b" and "c" above. Using the price elasticity computed in "a" above, how much will the price of wheat increase if the government were to destroy 10 percent of the crop? -10% / -.25 = + 40% Using your answer to "d" above, how much will the total revenue of wheat farmers change, and in what direction will this change take place? (1 -.25) x 40% = + 30%

3 3 The price elasticity of demand for 3-inch caliper, Bradford pear trees has been estimated to be Current consumption in your market area is 25,000 trees per year. If the price of Bradford pear trees decreased from $125 to $100, what would be the percentage increase in QUANTITY DEMANDED? P 0 = 125 %Δ P = -20 P 1 = 100 %Δ Q = +50 Δ P = -25 How much, and in which direction would total revenue change? (Part b depends on correct answers for part a) Q 0 = 25,000 TR 0 = 3,125,000 Q 1 = 25,000 x(1 +.50) =37,500 TR 1 = 3,750,000 ΔTR = 625,000 II. Cost Concepts Reviewed and Summarized Length of run: The length of time period considered for a production decision affects the cost structure (concepts) of a business firm. Short run: A period of time sufficiently long to allow the firm to change its output level but not long enough to change its plant size or output capacity. One or a small number of factors can be varied but not all the factors of production. Long run: A period of time long enough for all factors to vary. Therefore all the factors of production can be varied, including plant size or output capacity. Variable input: Factor of production in which the quantity used in the production process can be varied in the short run. In the short run a factor quantity which varies directly with output from the production process.

4 4 Fixed input: Factor of production in which the quantity used in the production process CANNOT be varied in the short run. In the short run a factor quantity which does NOT vary with output from the production process. Accounting costs (explicit costs): Value of a production factor as measured by the actual physical outlay of money required to acquire the use of the factor. Opportunity cost (implicit cost): Value of a production factor as measured by the value of the benefit that is forgone by choosing to use the factor in one alternative production process rather than its next best alternative use. When making production decisions, we use opportunity cost to value production factors that do not require physical cash outlays for their acquisition and allocation to the production process. Economic cost (explicit + implicit costs): Cost which includes both accounting costs and opportunity costs. When making production decisions, relevant accounting costs and relevant opportunity costs are used in the decision making process. Therefore: Economic cost = accounting costs + opportunity costs Variable cost: A cost which varies with the level of output over a given period of time. These costs would not be incurred if the production process is not started. Costs associated with variable inputs. Important costs to consider for short run production decisions. Fixed cost: A cost that does not vary with the level of output over a given time period. These costs remain constant whether we choose to begin the production process or not. Costs associated with fixed inputs. These costs are not relevant to short run production decisions. Sunk cost: Any cost classification becomes sunk when you incurr a cost (accounting or opportunity cost) as a result of allocating a production factor to the production process. Economic decision making procedures do not recognize sunk costs as being relevant for making production decisions. Marginal cost: The change in variable costs (or total costs) associated with a one unit change in output. MC = Change in Variable Cost / Change in Q output Total variable cost: sum of all costs incurred by the firm for all variable inputs. (TVC) Total fixed cost: sum of all costs incurred by the firm for all fixed inputs. (TFC) Total cost: TVC + TFC = TC

5 5 Average variable cost: Average fixed cost: Average total cost: TVC / Qoutput = AVC TFC / Qoutput = AFC TC / Qoutput = ATC = (AVC + AFC) III. Evaluating Renting or Leasing vs. Ownership Decisions and Determining the Price to Charge for Services. This exercise will help you determine if it is in your best interest to purchase or rent (lease) a piece of equipment or machinery. It will also teach you how to determine the price that you should charge for a service. The decision to lease or own a piece of equipment or machinery depends on: 1. Ownership cost of the equipment or machinery, 2. Operating cost of the equipment or machinery, 3. Cost of leasing or renting, and 4. Number of hours you plan to use the equipment or machinery each year. These decisions are usually made by calculating the number of hours used, acres used or uses for the equipment that is required to breakeven, if the equipment is purchased. If the number of hours of use for a piece of equipment or machinery is greater than or equal to the hours required to breakeven, it is generally in your best interest to purchase the equipment or machinery. If the number of hours of use for a piece of equipment or machinery is less than the hours required to breakeven, it is generally in your best interest to lease the equipment. The number of hours of use for a piece of equipment that is required to breakeven is calculated as follows: Total Annual Ownership Cost Breakeven Hours = (Rental or Lease cost/ hour - Operating Cost / hour) Where the "rental or lease cost/ hour" is equal to the lease or rental rate per hour, plus any operating costs the person leasing or renting the equipment or machinery is responsible for. "Operating Cost/ hour" is the operating costs that you would be responsible for if you were to own this piece of equipment or machinery.

6 6 The price that you should charge for a service is a function of the cost of providing the service and the amount of money that you would like to clear from the service. The amount of money that you would like to clear from a service is often referred to as the gross margin. On an hourly basis, the price that you should charge for a service is calculated as follows: Ownership and Operating Cost per Hour Price for a Service per Hour = (1 - gross profit margin) Let's suppose that you own a landscape business. You would like to determine if it is in your best interest to rent or buy a tractor with a front-end loader. Answer the questions below based upon the following information. You may want to refer to your notebook, lecture notes, textbook, and past lab assignments. A local landscaper is trying to decide if he/she should rent or purchase a tractor with a front-end loader. He/she estimates that he/she will use the tractor/loader 75 hours per year. The current rental rate is $ per day, but our landscaper knows that he/she will only get 4 hours per day of effective use from the daily rental. Therefore, the effective hourly rental rate is $40 per hour. A new 35 hp tractor/loader will cost $17,600. The tractor/loader is estimated to last for 20 years with a salvage value of $4600. Property taxes are $1.00 per $100 of assessed value. Casualty insurance will cost $30 per $1000 of coverage. The current interest rate is 8.5 percent. Fuel and oil costs are estimated to be $3.25 per hour. The landscaper must provide fuel and oil for the rented tractor/loader. Repairs and maintenance are estimated to be $3.00 per hour. The rental agent is responsible for repairs and maintenance of the rented tractor/loader. Our landscaper would like to earn a 38.5% gross profit margin on services performed with this tractor/loader. Key Information: Rental rate is $160 per day, which does not include any operating costs When the machine is used, the average number of hours of use per day is 4 Therefore, the effective rental rate is $40 per hour Cost of the machine is $17,600 The salvage value of the machine is $4,600 Useful life of the machine is 20 years Nominal interest rate is 8.5% Property taxes are $1 per $100 of average value Hours of use for the machine is 75 hours per year Casualty insurance is $30 per $1,000 of average value The cost of fuel and oil is $3.25 per hour of operation ; repairs, and maintenance is $3.00 per hour of operation

7 7 Wage rate for an operator is $12.75 per hour to the employer Gross profit margin per hour is 38.5%. What is the annual depreciation charge for the machine? $650 / yr. What is the estimated annual interest cost on the machine? $ / yr. What is the estimated annual insurance cost on the machine? $333 /yr. What is the estimated property tax on the machine? $111/ yr. What is the estimated total annual ownership cost of the machine? $2, /yr.

8 8 What is the rental rate per operating hour of the machine? (Rental rate per hour plus any operating costs you are responsible for under the lease or rental agreement) $43.25/hr /hr = $56.00/hr What is the operating cost per hour for this equipment if you were to purchase the machine? $6.25/hr /hr = $19.00/hr. Using the break-even equation, calculate the hours of use required to break-even if purchased relative to renting or leasing? hrs/yr. Should you rent or purchase the machine? Purchase b/c 75 hrs/yr use > hrs/yr. breakeven What is the estimated ownership cost of the machine per hour? $27.17/hr What is the operating cost of the machine per hour? $6.25/hr /hr = $19.00/hr

9 9 What is the estimated ownership and operating cost of the machine per hour? $46.17 /hr. What price should you charge per hour for work done with the equipment? $75.07 /hr IV. Breakeven Acres: If the number of acres of use for a piece of equipment or machinery is greater than or equal to the acres required to breakeven, it is generally in your best interest to purchase the equipment or machinery. If the number of acres of use for a piece of equipment or machinery is less than the acres required to breakeven, it is generally in your best interest to lease the equipment. The number of acres of use for a piece of equipment that is required to breakeven is calculated as follows: Total Annual Ownership Cost Breakeven Acres = (Rental or Lease cost/ acre - Operating Cost / acre) Where the "rental or lease cost/ acre" is equal to the lease or rental rate per acre, plus any operating costs the person leasing or renting the equipment or machinery is responsible for. "Operating Cost/ acre" is the operating costs that you would be responsible for if you were to own this piece of equipment or machinery. The price that you should charge for a service is a function of the cost of providing the service and the amount of money that you would like to clear from the service. The amount of money that you would like to clear from a service is often referred to as the gross margin. On an "per acre" basis, the price that you should charge for a service is calculated as follows:

10 10 Ownership and Operating Cost per Acre Price for a Service per Acre = (1 - gross profit margin) You plant 600 acres of cotton each year. You currently have your cotton picked by a custom harvester at $50.00 per acre. You are trying to decide if you should buy a mechanical picker that costs $189,519. You estimate the annual ownership cost of the machine to be $26,047 per year. Operating costs are estimated to be $15.00 per acre harvested. SHOW ALL YOUR WORK OR NO CREDIT GIVEN!! Budget each alternative: Find the total cost of harvesting by custom service. $30,000 / yr Find the total cost of harvesting with the mechanical picker if purchased. $35,047 / yr.

11 11 Given the above cost data, what is the MINIMUM acreage of cotton for which Farmer Miller should consider purchasing his own cotton picker? In other words, find the breakeven acreage using the breakeven equation acres/yr You will need to refer to Table 1, Summary of Annual Ownership Costs, Performance Rates, and Hourly Operation Costs of Machines, 1998 Field Crop Budgets to complete this question. We want to determine how much we would charge per acre to disk a field with a 110 hp tractor (code #11) and a 16 ft. disk (code # 162) and cover ownership cost, operating cost, labor cost, and a gross profit margin of 30 percent? Use the values in the table for ownership cost and operating cost, and a labor wage rate of $8.50 per hour. Do not include labor in the operating cost of the tractor or disk. We will treat labor as a separate item. Complete the steps to solving this problem below. What is the total annual ownership costs for the tractor? $6,215.82/yr How many hours per year will the tractor be used? 500 hrs/yr What is the ownership cost for the tractor per hour? $12.43/hr What is the total operating cost per hour for the tractor? $10.73/hr

12 12 What is the total ownership cost and operating cost per hour for the tractor? $23.16/hr What is the total annual ownership cost for the disk? $1,555.93/yr How many hours per year will the disk be used? 125 hrs/yr What is the ownership cost per hour for the disk? $12.45/hr What is the total operating cost per hour for the disk? $3.56/hr What is the total ownership cost and operating cost per hour for the disk? $16.01/hr What is the performance rate (hours per acre) for the disk?.138 hours / acre What is the total ownership and operating cost per hour for the tractor and the disk combined? $39.17 / hr.

13 13 What is the total ownership and operating cost per acre for the tractor and the disk combined? $5.41 / acre What is the cost of labor per acre? $1.17 / acre How much would you charge per acre to disk a field with a 110 hp tractor (code #11) and a 16 ft. disk (code # 162) and cover ownership cost, operating cost, labor cost, and a gross profit margin of 30 percent? $9.40 / acre V. Breakeven Uses: If the number of uses for a piece of equipment or machinery is greater than or equal to the uses required to breakeven, it is generally in your best interest to purchase the equipment or machinery. If the number of uses for a piece of equipment or machinery is less than the uses required to breakeven, it is generally in your best interest to lease the equipment. The number of uses for a piece of equipment that is required to breakeven is calculated as follows: Total Annual Ownership Cost Breakeven Uses = (Rental or Lease cost/ use - Operating Cost / use) Where the "rental or lease cost/ use" is equal to the lease or rental rate per use, plus any operating costs the person leasing or renting the equipment or machinery is responsible for.

14 14 "Operating Cost/ use" is the operating costs that you would be responsible for if you were to own this piece of equipment or machinery. Presently you rent a gas pig cooker for $45 per day to cater pig pickin's. If you rent, you must purchase the gas at $12.00 per tank, and clean the cooker ($3.00) before returning it. Of course, if you buy a pig cooker, you must also buy gas and clean the cooker. You are considering the purchase of your own pig cooker for $1000. How many catered pig pickin's a year would you have to cater in order to justify owning your own cooker? SHOW ALL YOUR WORK OR NO CREDIT GIVEN!!! If you purchase a pig cooker: Depreciation = $100/yr Taxes = $5/yr Interest = $25/yr R&M = $25/yr Total purchase price of cooker is $1000, and it will last 10 years with no salvage value remaining. Taxes are $1 per $100 of average value. Insurance is $0 - the cooker will be covered by your homeowners' or tenants insurance policy at no extra cost. Assume an interest rate of 5 % Repairs and maintenance are estimated to be $25 per year whether the cooker is used or not. Therefore, consider repairs and maintenance an ownership cost. One tank of propane gas is required for each use, at $12.00 per tank Cooker cleanup is estimated to cost $3.00 per use Total = $155/yr. Annual ownership cost Rent: $60 / use Breakeven uses = 3.44 or 4 uses per year.

15 VI. Marginal Analysis Re-Visited: A restaurant has found it is able to serve more customers with additional waiters and waitresses during the lunch hour. The following table shows the relationship of waiters and waitresses to customers served per lunch hour. Determine the profit maximizing number of waiters or waitresses to hire during the lunch hour. Waiters or Total Marginal Waitresses Waitress Waitress Customers Return to Marginal Or Waiter Or Waiter per Hour Waitress or Revenue Cost/hour Cost/hour Waiter per per Hour Hour 2 _ _ _ _ _ _ Assume: Return to waiter or waitress labor = Each customer generates $1.00 net revenue above all costs (food and cost of operating restaurant) EXCEPT the cost of waitresses. This represents a $1.00 per customer return to waiter or waitress labor per hour. Control variable = number of waiters or waitresses Price of waiter or waitress = $5.00 per hour to employer (marginal cost) Compute: Total waiter or waitress cost per hour, marginal waiter or waitress cost per hour, return to waiter or waitress labor per hour, and marginal revenue per hour in the table above. (4 points) How many waitresses should be hired to maximize profits during the lunch hour? Here you are determining the profit maximizing level of input use. The economic decision rule is to continue adding waitresses or waiters until the marginal revenue per waitress or waiter hired = marginal waitress or waiter cost Waiters or Waitresses Hired: 8 Your wait staff have organized, and are collectively bargaining with you for a wage rate of $8.00 per lunch hour to the employer. How would you respond as a profit maximizing manager if you agree to pay $8.00 per hour? (HINT: How many waiters or waitresses would you now hire at this new wage rate?) Waiters or Waitresses Hired: 5

16 16 How many waitresses or waiters did you "let go?" Of the waiters and waitresses you would let go, as a manager, how would you assess their productivity level relative to the waitresses and waiters you "kept on?" Waiters or Waitresses Downsized: 3 Productivity level? Kept the most productive waiters and waitresses. Let the less productive waiters and waitresses go. In conclusion, what could you say about the affect of collective bargaining (unions) agreements that increase wage rates, ceteris paribus? Collective bargaining agreements are usually successful at raising wage rates, however, employers will typically respond to the higher wage rates by evaluating technologies or new ways to organize the business in such a way as to minimize total costs. This may mean the substitution of capital for labor, or in the case of the restaurant business used as an example here, reorganize the production process. How? Switch to self service drink stations like you have seen in the fast food industry. Switch to a buffet style food delivery system like what has occurred with firms like Golden Corral etc. These re-organizations have lead to lower labor costs for the business.