Antiniolos, Faie R.

BSBA 2

What is Theory of Production?

It is an effort to explain the principles by which a business firm decides how much of each
commodity that it sells (its “outputs” or “products”) it will produce, and how much of each kind of
labour, raw material, fixed capital good, etc., that it employs (its “inputs” or “factors of production”) it
will use. This theory also involves some of the most fundamental principles of economics. These include
the relationship between the prices of commodities and the prices (or wages or rents) of the productive
factors used to produce them and also the relationships between the prices of commodities and
productive factors, on the one hand, and the quantities of these commodities and productive factors
that are produced or used, on the other. (Britannica .com)

Cost of production is simply the sum of the costs of all of the various factors. It can be written:

The principles involved in selecting the cheapest combination of variable factors can be seen in
terms of a simple example. If a firm manufactures gold necklace chains in such a way that there are only
two variable factors, labor (specifically, goldsmith-hours) and gold wire, the production function for such
a firm will be y = f (x1, x2; k), in which the symbol k is included simply as a reminder that the number of
chains producible by x1 feet of gold wire and x2 goldsmith-hours depends on the amount of machinery
and other fixed capital available. Since there are only two variable factors, this production function can
be portrayed graphically in a figure known as an isoquant diagram Figure 1. In the graph, goldsmith-
hours per month are plotted horizontally and the number of feet of gold wire used per month vertically.
Each of the curved lines, called an isoquant, will then represent a certain number of necklace chains
produced. The data displayed show that 100 goldsmith-hours plus 900 feet of gold wire can produce 200
necklace chains. But there are other combinations of variable inputs that could also produce 200
necklace chains per month. If the goldsmiths work more carefully and slowly, they can produce 200
chains from 850 feet of wire; but to produce so many chains more goldsmith-hours will be required,
perhaps 130. The isoquant labelled “200” shows all the combinations of the variable inputs that will just
suffice to produce 200 chains. The other two isoquants shown are interpreted similarly. It is obvious that
many more isoquants, in principle an infinite number, could also be drawn. This diagram is a graphic
display of the relationships expressed in the production function.
What is Theory of cost and profit?

* Under the condition of competitive market, profit can be used as a performance evaluation criterion,
and profit maximization leads to efficient allocation of resources.

* Profit maximization objective has been found extremely accurate in predicting certain aspect of firm's
behaviour and trends; as such the behavior of most firms are directed towards the objective of profit
maximization.

The conventional theory of the firm defends profit maximization objective on the following grounds:

* In a competitive market only those firms survive which are able to make profit. Hence, they always try
to make it as large as possible. All other objectives are subjected to this primary objective.

* Profit maximization objective is a time-honored objective of a firm and evidence against this objective
is not conclusive or unambiguous.

* Though not perfect, profit is the most efficient and reliable measure of the efficiency of a firm.

What is Profit?

Profit reflected in reduction in liabilities, increase in assets, and/or increase in owners' equity.

What is Cost?

Cost is usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities
consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good or
service.

What is Long Run?

firms change production levels in response to (expected) economic profits or losses, and the
land, labor, capital goods and entrepreneurship vary to reach associated long-run average cost. In the
simplified case of plant capacity as the only fixed factor, a generic firm can make these changes in the
long run:

• enter an industry in response to (expected) profits

• leave an industry in response to losses

• increase its plant in response to profits

• decrease its plant in response to losses.

What is Short Run?

A generic firm already producing in an industry can make three changes in the short run as
response to reach a posited equilibrium:

• increase production

• decrease production

• shut down.
What is Short Run?

Different types of cost

Fixed cost

are expenses that do not change in proportion to the activity of a business, within the relevant
period or scale of production. For example, a retailer must pay rent and utility bills irrespective of sales.

Marginal cost

is the change in total cost that arises when the quantity produced changes by one unit. In
general terms, marginal cost at each level of production includes any additional costs required to
produce the next unit.

Total revenue is the total receipts of a firm from the sale of any given quantity of a product.

Marginal revenue

(R') is the additional revenue that will be generated by increasing product sales by 1 unit.

is the conceptual time period in which at least one factor of production is fixed in amount and others are
variable in amount. Costs that are fixed, say from existing plant size, have no impact on a firm's short-
run decisions, since only variable costs and revenues affect short-run profits. Such fixed costs raise the
associated short-run average cost of an output long-run average cost if the amount of the fixed factor is
better suited for a different output level. In the short run, a firm can raise output by increasing the
amount of the variable factor(s), say labor through overtime.

3 Different Types of Revenue

1. Cash

obviously if you can make a sale that’s revenue for your company. One example of this would be
a facility that sells monthly memberships.

2. Attention and Trust

now they’re lots of businesses that need this, like I’m going to watch channel 6 news tonight.
Well, I’m not paying them cash, I’m giving them attention and trust, in which they can figure out
how to make money.

3. Referral

Does your service or product work better when your friends use it too? Krispy Kreme uses the
revenue of referral when they open up a new location, employees start giving away thousands
of donuts. The people most likely show up for a free hot donut are those who have heard the
legend of Krispy Kreme and are delighted that the company is finally in town. These people
spread the word. They tell their friends and even bring them into a store.
What is pricing and output under pure competition?

Perfect competition is a form of market in which there are a large number of buyers and sellers
competing with each other in the purchase and sale of goods, respectively and no individual buyer or
seller has any influence over the price. Thus perfect competition is an ideal form of market structure in
which there is the greatest degree of competition.

 There are a large number of independent, relatively small sellers and buyers as compared to the
market as a whole. That is why none of them is capable of influencing the market price. Further,
buyers/sellers should not have any kind of association or union to arrive at an understanding
with regard to market demand/price or sales.
 The products sold by different sellers are homogenous and identical. There should not be any
differentiation of products by sellers by way of quality, variety, colour, design, packaging or
other selling conditions of the product. That is, from the point of view of buyers, the products of
competing sellers are completely substitutable.
 There is absolutely no restriction on entry of new firms into the industry and the existing firms
are free to leave the industry. This ensures that even in the long run the number of firms would
continue to remain large and the relative share of each firm would continue to remain
insignificant.
 Both buyers and sellers in the market have perfect knowledge about the conditions in which
they are operating. Buyers know the prices being charged by different competing sellers and
sellers know the prices that different buyers are offering.
 The distance between the location of competing sellers is not significant and therefore the price
of the product is not affected by the cost of transportation of goods. Buyers do not have to incur
noticeable transport costs if they want to switch over from one seller to another.

What is Monopoly?

A market structure characterized by a single seller, selling a unique product in the market. In a
monopoly market, the seller faces no competition, as he is the sole seller of goods with no close
substitute. Also this market make the single seller the market controller as well as the price maker. He
enjoys the power of setting the price for his goods.

Example;

You have not insured your house from any future damages. It implies that a loss will be
completely borne by you at the time of a mishappening like fire or burglary. Hence you will show extra
care and attentiveness. You will install high tech burglar alarms and hire watchmen to avoid any
unforeseen event.

But if your house is insured for its full value, then if anything happens you do not really lose anything.
Therefore, you have less incentive to protect against any mishappening. In this case, the insurance firm
bears the losses and the problem of moral hazard arises.

What is Monopolistic Competition?

 Monopolistic competition occurs when an industry has many firms offering products that are
similar but not identical.

Unlike a monopoly, these firms have little power to set curtail supply or raise prices to increase profits.

Firms in monopolistic competition typically try to differentiate their product in order to achieve
in order to capture above market returns.

Heavy advertising and marketing is common among firms in monopolistic competition and some
economists criticize this as wasteful.

A middle ground between monopoly and perfect competition (a purely theoretical state), and
combines elements of each. All firms in monopolistic competition have the same, relatively low degree
of market power; they are all price makers. In the long run, demand is highly elastic, meaning that it is
sensitive to price changes. In the short run, economic profit is positive, but it approaches zero in the long
run. Firms in monopolistic competition tend to advertise heavily.

It is also a form of competition that characterizes a number of industries that are familiar to
consumers in their day-to-day lives. Examples include restaurants, hair salons, clothing, and consumer
electronics. To illustrate the characteristics of monopolistic competition, we'll use the example of
household cleaning products. It is closely related to the business strategy of brand differentiation.

Example;

The Fast Food companies like the McDonald and Burger King who sells the burger in the market
are the most common type of example of monopolistic competition. The two companies mentioned
above sell an almost similar type of products but are not the substitute of each other.

What is Oligopoly?

It is a market structure with a small number of firms, none of which can keep the others from
having significant influence. The concentration ratio measures the market share of the largest firms. A
monopoly is one firm, a duopoly is two firms and an oligopoly is two or more firms. Oligopoly include
steel manufacturers, oil companies, railroads, tire manufacturing, grocery store chains, and wireless
carriers. The economic and legal concern is that an oligopoly can block new entrants, slow innovation,
and increase prices, all of which harm consumers.

Example;

Oligopoly abound and include the auto industry, cable television, and commercial air travel.
Oligopolistic firms are like cats in a bag.