Production Function

Production is the creation of goods and services using the inputs of production. The physical
relationship between the inputs and outputs of goods and services is called production function and
expressed in mathematical form:
Q = f (X)
Where Q = output
X = inputs

Output refers to the goods and services that have been created using the production inputs.

Inputs of production refer to the factors of production which include land, labor, capital, and
entrepreneurship (see detailed discussion in Chapter I). Inputs are classified as follows:
1. Fixed inputs – They are those that remain constant regardless of the volume or quantity of
production. This means that whether you produce or not, the factors of production is
unchanged.
2. Variable inputs – These are those that vary in accordance to the volume or quantity of
production. If there is no production; then, there is no variable inputs.

The Law of Diminishing Returns

It states that when successive units of variable input is combined with a fixed input, the total
product (TP) or output (Q) will increase, but beyond some points the resulting increases in output will
become smaller and smaller.

Total Product (TP) refers to the total production or output (Q).

Marginal (Physical) Product (MP) – It is the additional output produced by employing one
additional unit of input (X) holding the level of usage of all other inputs constant.

TP Q
MP = or using Q to denote TP MP =
x x

Average (Physical) Product (AP) – It is the output produced per unit of the input

AP = TP or using Q to denote TP AP = Q
x x
Table 12. Total product (in cavans) schedule of rice production
with workers as variable input (x).

Units of Total Product (TP) Marginal Average

workers (x) or Output (Q) Product (MP) Product (AP)
0 0
1 5 5 5.0
2 15 10 7.5
3 29 14 9.7
4 44 15 11.0
5 55 11 11.0
6 61 6 10.2
7 64 3 9.1
8 64 0 8.0
9 62 -2 6.9
10 59 -3 5.9
 Three Stages of Production

The Stage 1 of the production process is characterized by an increasing AP. In Figure 25, this
occurs from the origin (0) up to x=5. The increasing AP is explained by specialization and teamwork
gained from an additional X. Moreover, at this stage the fixed input is grossly underutilized. The point
of equality between AP and MP serves as the boundary between Stages 1 and 2 of the production
process. At this of intersection (MP = AP), it is noticeable that the AP has reached its maximum value.

The Stage 2 of the production process corresponds to the range of x from 5 up to 8. The end point
of stage 2 corresponds to the point of maximum output on the TP curve. This maximum TP happens
when the MP is equal to zero (MP=0). This point serves as the boundary between stages 2 and 3 of
the production process. At this level, both MP and AP are declining.

The Stage 3 of the production process encompasses the range of x over which the total product is
declining (which corresponds to negative MP). Stage 3 occurs when x exceeds 8 where the crowding
effects overwhelm any output attributable to additional workers.

Production Isoquants and Isocost

Isoquants represent the various combinations of two inputs that can be used to produce the
same level of output.
 Figure 26. Isoquant
12
10
8
6
Labor
4
2
0
2 4 6 8 10 12 14 16
Capital

Characteristics of Isoquants
1. They slope downward to the right for those combinations of inputs that firms will want to use.
2. They do not intersect.
3. They are convex to the origin.

Isocost line contains all combinations of inputs that the same budget can purchase at constant
prices.

Provided below is an example of isoquant and isocost schedules and graphs.

Table 13. Isoquant schedules

Q = 500 Q=1000 Q=1500
Labor Capital Labor Capital Labor Capital
9 18 16 24 20 28
10 14 20 15 21 25
16 7 25 12 23 20
25 3 35 9 36 14
28 2 45 8 48 13

Budget =P16,000 Price of Labor =P500/unit Price of Capital=P400/unit

 Labor Capital
32 0
28 5
24 10
20 15
16 20
12 25
8 30
4 35
0 40

Figure 27. Isocost

35

30

25

20
Labor

15

10

0
0 5 10 15 20 25 30 35 40 45
Capital
 The point of tangency of the Isoquant and Isocost curves shows the best combination of inputs
(labor and capital) given the capital outlay of P16,000. The firm must employ 20 units of labor and 15
units of capital in its production process. The maximum output that the firm can produce is 1000
units.

Figure 28. Isoquant and Isocost

50

45

40

35

30

25
Labor
20

15

10

0
0 5 10 15 20 25 30 35 40 45

Capital
 EXERCISE 5
THEORY OF PRODUCTION

Name ________________________________Score ____________ = ___________%

Section __________ Date Submitted ____________ Professor ____________________

NO ERASURES ON ALL FINAL ANSWERS

I. Write the letters of your choice on the space provided before each number on column A.
Column A Column B

___1. Isocost line a. Optimum combination

___2. Creation of any good or service b. AP is increasing
___3. Marginal Product c. Combination of inputs to produce
___4. Point of tangency of the isoquant and same level of output
isocost curves d. Capital
II. Answer the following problems.

A. Complete the table below.

X TP AP MP
25,000 500 -
80 38,500
44,500 300
140 200
200 51,300

B. The following are the schedules of two isoquant curves.

Isoquant Schedule 1 Isoquant Schedule 2

A B A B
0 30 0 48
1 20 1 35
2 14 2 26
3 9 3 18
4 7 4 10
5 5 5 9
 6 4 6 8
7 3 7 7
8 6

Plot the two isoquant curves and label the graph properly.

Chapter 6
Theory of Cost and Profit

COST CONCEPT

Cost of production refers to the total payment by a firm to the owners of the factors of production.
 Factors of Production Factor Payment
Land Rent
Labor Wage or Salary
Capital Interest
Entrepreneurship Profit

The price of the resources is measured in terms of opportunity cost. Opportunity cost is the value of
the foregone opportunity or alternative benefits. This means that in order for a business firm to secure
the services of resources, it must pay an amount equal to what these resources can earn in other
alternative uses. For instance, a skilled worker earning P1,000 in company A has an opportunity cost
equal to P1,000. That is the worth of the skill provided by the worker. If company B wishes to hire the
services of the said skilled worker, then company B has to pay P1,000 (the opportunity cost).

Important cost concepts include:

A. Explicit vs. Implicit costs

Explicit cost – (Visible cost) It is the actual (explicit) expenditures made by the firm (that is usually
thought of as its only expenses).

Implicit cost- (Invisible cost) It is the cost of self-owned, self-employed resources frequently
overlooked in computing the expenses of the firm.

B. Short run and long run viewpoints

Short run – It is the planning period of the firm so short that some resources can be classified as
fixed while some are considered variable.

Long run – It is the planning period of the firm so long that all resources eventually become
variable.

Short Run Cost Curves

In the short run, the total costs of a firm depend on the firm’s size and on the level (or volume) of
production. The component parts of total costs (TC) are total fixed costs (TFC) and total variable
cost (TVC).

TC = TFC + TVC TFC

Fixed cost – It is the kind of cost which remains constant regardless of the level (or
volume) of production.
The summation of all the fixed costs incurred by a firm in its production is
the total fixed cost (TFC).

Variable cost – It is the kind of cost which changes in proportion to the level (or
volume) of production.
Total variable cost (TVC) is the totality of all the variable costs spent by
the firm in its production.

Using the example on input-output data in Chapter 5, the following costs (Total and Averages) are
derived. Additional assumptions are: (1) There is only one variable input (X) which costs P50
each; and (2) The fixed input values at P150, regardless of the output.
Table 15. Costs and output schedules.
X TP MP AP TVC TFC TC AVC AFC AC MC
0 0 - - 0 150 150 - - - -
1 6 6 6.0 50 150 200 8.33 25.00 33.33 8.33
2 16 10 8.0 100 150 250 6.25 9.38 15.63 5.00
3 29 13 9.7 150 150 300 5.17 5.17 10.34 3.85
4 44 15 11.0 200 150 350 4.55 3.41 7.95 3.33
5 55 11 11.0 250 150 400 4.55 2.73 7.27 4.55
6 60 5 10.0 300 150 450 5.00 2.50 7.50 10.00
7 62 2 8.9 350 150 500 5.65 2.42 8.06 25.00

TC

TVC

TFC

Average and Marginal Cost Curves

Average cost is also called unit cost. These curves show the same kind of information as the total
cost curves in a different form. The average cost curves include the average cost (AC), average
fixed cost (AFC), and average variable cost (AVC).

Average fixed cost (AFC) refers to the fixed cost per unit at various levels of output. This is
obtained by dividing the TFG by the output (Q).
TFC
AFC =
Q
Average variable cost (AVC) is the variable cost per unit at various levels of output. It is the
quotient of TVC and the output.
TVC
AVC =
Q
Average cost (AC) is the overall costs per unit of output. This can be obtained in two ways:
 TC
AC =
Q
or
AC = AFC + AVC

Marginal cost is the additional or extra cost brought about by producing one additional unit (of
output). Also, this is known as the slope of the TC. It is obtained by dividing the change in the
total cost by the change in the output.
TC
MC =
Q

MC

AC
AVC
AFC

PROFIT CONCEPT

Total and Marginal Revenue

Total Revenue (TR) is the payment for the output produced by the firm. This represents the
income of the firm. It is obtained by multiplying the price (P) and the output (Q) produced.

TR = P x Q

Marginal Revenue (MR) is the additional income of a firm obtained by producing and selling one
additional unit of product. It is also equivalent to the slope of the TR. The mathematical formula
to derive MR is as follows:
TR
MR =
Q
Table 16. Revenue schedule
MR =  TR
Units of Output (Q or TP) TR = P x Q  Q
 0 0 -
6 60 10
16 160 10
29 290 10
44 440 10
55 550 10
60 600 10
62 620 10
61 610 10
59 590 10
56 560 10

TR

MR

Profit, Loss and Breakeven

Profit maximization involves the comparison of TR and TC. The mathematical formula to derive
profit (P) is by getting the difference between total revenue (TR) and total cost (TC).
 = TR - TC

A positive difference indicates profit (>0); a negative difference means loss (<0); and when =0,
it suggests breakeven or TR is equal to TC.

Profit maximization is a point where the (positive) difference between the TR and the TC is
highest. This point corresponds to the equality of the slope of the TR (MR) and the slope of the
TC (MC).

Maximum profit : MR = MC

Using the previous data, profit is obtained and presented below:

Table 17. Revenue, cost and profit schedule

Q (or TP) TC MC TR MR Profit
0 150 0 -150
 6 200 8 60 10 -140
16 250 5 160 10 -90
29 300 4 290 10 -10
44 350 3 440 10 90
55 400 5 550 10 150
60 450 10 600 10 150
62 500 25 620 10 120
61 550 -50 610 10 60
59 600 -25 590 10 -10
56 650 -17 560 10 -90

Break-even analysis examines a firm’s output where the firm makes normal profit (zero profit).
Break-even quantity is the volume or output where all fixed costs are covered. It is determined with
the formula:

Break-even quantity = TFC__

P - AVC

Where:
TFC = Total Fixed Cost
P = Price
AVC = Average Variable Cost

The point at which neither profit nor loss is made is known as the "break-even point". It is represented
on the chart below by the intersection between Total Revenue and Total Cost curves.

Sample problem and computation of Break-even:

JP Co., produces gel pen which sells at P25.00; the variable cost per unit is P10.00 and the fixed
costs are P150,000 per year. What would be the break-even quantity?

Break-even quantity = TFC__

P - AVC

Break-even quantity = 150,000_ = 10,000 units

25 - 10
To check:

TR = TC
PxQ = TFC + AVC(Q)
25 x 10,000 = 150,000 + 10 (10,000)
250,000 = 250,000
Break-even point
 EXERCISE 6
THEORY OF COST AND PROFIT

Name ________________________________Score ____________ = ___________%

Section ___________ Date Submitted ___________ Professor ____________________

NO ERASURES ON ALL FINAL ANSWERS

I. Write the letters of your choice on the space provided before each number on column A.
Column A Column B
___1. Factor payment for land a. Marginal cost
___2. Short run cost incurred whether the b. Profit
firm operates or not c. Explicit cost
___3. Invisible cost d. Marginal revenue
___4. Cost which changes as the level of e. Implicit cost
production changes f. Variable cost
___5. Factor payment for entrepreneurship g. Rent
___6. Price x quantity h. Fixed cost
___7. TR = TC i. Break even
___8. Additional income from producing j. Total revenue
and selling one additional unit of output
___9. Cost for producing one additional unit
___10. Visible cost

II. Answer the following problems.

A. The production of commodity X entails a fixed cost of P1000 per month. Variable cost per unit is
P25. How many X must be produced in order to breakeven if the price is P30 per unit?

Answer: _____________________

B. F4 Co. produces blossoms fertilizer with annual fixed cost of P320, 000, variable cost of P22.50 per
150 pound sack and sells it for P75 per sack. How many sacks of fertilizer does F4 Co. have to sell in
order to break-even?

Answer: _____________________

C. Given the following information:

Total fixed cost = P2.50 million
Selling price per unit = P1.25
Direct raw material = P 0.25/unit
Direct labor = P 0.35/unit
Variable overhead = P 0.15
 1. How many units must be produced in order to break-even? Answer: ____________
2. How many units must be produced in order to earn profits? Answer: ____________

D. If a company produces 100,000 units of good X and spends P 1 M total fixed cost and P10 average
variable cost, how much should it sell its good to break-even? To earn profits?
Answer: ____________

E. Using the following information, complete the table below.

Price per unit = P50

Average variable cost = P40
Total Fixed cost = P 250,000

Quantity Total Revenue Total Cost Profit/ Loss

0
10,000
20,000
25,000
40,000
50,000