MODULE 9: THEORY OF PRODUCTION

A. Production
 Types of Utility
B. Production and Costs
 The Behavior of Profit Maximizing Firms
 The Bases of Decisions

WEEK: 9

TIME ALLOTMENT: 3 Hours

OBJECTIVES/ LEARNING OUTCOMES:

At the end of this module, the students are expected to define production in general and
differentiate the views of the accountant and economist in relation to production analysis.

LEARNING CONTENT:

THEORY OF PRODUCTION

Introduction

We now turn to examine the behavior of firms. Firms purchase inputs to produce and sell outputs
that range from computers to string quartet performances. In other words, they demand factors of
production in input markets and supply goods and services in output markets. In this chapter, we look
inside the firm at the production process that transforms inputs into outputs.

Discussion

A. Production

Production in economics generally refers to the transformation of inputs into outputs. Inputs
are the raw materials or other productive resources used to produce final products i.e., output. In
technical terms, production means the creation of utility or creation of want-satisfying goods and
services. Any good become useful for us or satisfies our want when it is worth consumption. Thus,
a good can be made useful by adding utility. For instance, we cannot consume wheat flour raw
when we are hungry (want), unless it is turned into bread (output). This conversion of wheat flour
into bread is the process of creating utility. Utilities can be created in three ways. These are the
following:

1. By changing form or shape and size of a good. The powdery wheat flour has been changed
to slices of bread. Thus form of the good has been changed. Likewise, a carpenter giving
shape of a chair to a piece of wood or a chef turning a lump of dough into delicious pizzas,
are the examples of changing shape or size of a good/s and thereby creating utility.
2. Using the scarce goods and services in proper time when they are most required. Government
maintains a buffer stock so that during the time of crisis, it releases food grains in the market
to meet the demand.
3. By transferring a good from one place to another where its use is worthwhile. Sand transferred
from river side to construction site increases its utility.
 Thus, production is the process of adding utility to a good through form utility, place utility
and time utility.

 Types of Utility
1. Form Utility
Changing the form of natural resources i.e. converting the raw material into items
possessing utility.
For example, changing the form of a log of wood into a table or changing the form of
iron into a machine.

2. Place utility
Changing the place of resources from the place where they are of little or no use to
another place where they are of greater use.

3. Time Utility
Making available materials at times when they are not normally available. For
example, harvested food grains are stored for use till next harvest. Canning of
seasonal fruits is undertaken to make them available during off season.
B. Production and Costs
The reason that an entrepreneur assumes the risk of starting a business is to earn profits.
The fundamental assumption in the theory of production is that a rational owner of a business will
seek to maximize the profits (or minimize the losses) from the operation of his business. However,
before anything can be said about profits we must first understand costs and revenues. This chapter
will develop the basic concepts of production costs.

An economist's view of costs includes both explicit and implicit costs. Explicit costs are
accounting costs, and implicit costs are the opportunity costs of an allocation of resources (i.e.,
business decisions). Accountants subtract total cost from total revenue and arrive a total accounting
profits.

Profit = Total revenue - Total cost

An economist, however, would include in the total costs of the firm the profits that could have
been made in the next best business opportunity (e.g., the opportunity cost). Therefore, there is a
significant difference in how accountants' and economists' view profits B economic profits versus
accounting profits.

Total revenue is the amount received from the sale of the product; it is equal to the number
of units sold (q) times the price received per unit (P). Total cost is less straightforward to define.
We define total cost here to include (1) out-of-pocket costs and (2) opportunity cost of all inputs or
factors of production. Out-of-pocket costs are sometimes referred to as explicit costs or accounting
costs. These refer to costs as an accountant would calculate them. Economic costs include the
opportunity cost of every input. These opportunity costs are often referred to as implicit costs. The
term profit will from here on refer to economic profit. So whenever we say profit = total revenue -
total cost, what we really mean is

Economic profit = Total revenue - Total economic cost

An economist, however, would include in the total costs of the firm the profits that could have
been made in the next best business opportunity (e.g., the opportunity cost). Therefore, there is a
significant difference in how accountants' and economists' view profits B economic profits versus
accounting profits.

For the purposes of economic analysis, a normal profit includes the cost of the lost opportunity
of the next best alternative allocation of the firm=s resources. In a purely competitive world, a
business should be able to cover their costs of production and the opportunity cost of the next best
alternative (and nothing more in the long-run). In an accounting sense there is no benchmark to
determine whether the resource allocation was wise. Instead various financial ratios are used to
determine how the firm has done with respect to similarly situated companies.

 The Behavior of Profit Maximizing Firms

Private business firms are set apart from other producers, such as households and
government, by their purpose. A firm exists when a person or a group of people decides
to produce a good or service to meet a perceived demand. Firms engage in production—
that is, they transform inputs into outputs—because they can sell their products for more
than it costs to produce them.
 All firms must make several basic decisions to achieve what we assume to be their
primary objective— maximum profits. The three decisions that all firms must make
include:
1. How much output to supply (quantity of product)
2. How to produce that output (which production technique/technology to use)
3. How much of each input to demand

The first and last choices are linked by the second choice. Once a firm has decided
how much to produce, the choice of a production method determines the firm’s input
requirements. If a sweater company decides to produce 5,000 sweaters this month, it
knows how many production workers it will need, how much electricity it will use, how
much raw yarn to purchase, and how many sewing machines to run.

Similarly, given a technique of production, any set of input quantities determines

the amount of output that can be produced. Certainly, the number of machines and
workers employed in a sweater mill determines how many sweaters can be produced.

Changing the technology of production will change the relationship between input
and output quantities. An apple orchard that uses expensive equipment to raise pickers
up into the trees will harvest more fruit with fewer workers in a given period of time than
an orchard in which pickers use simple ladders. It is also possible that two different
technologies can produce the same quantity of output. For example, a fully computerized
textile mill with only a few workers running the machines may produce the same number
of sweaters as a mill with no sophisticated machines but many workers. A profit-
maximizing firm chooses the technology that minimizes its costs for a given level of
output.

In this chapter, all firms in a given industry produce the same exact product and we
are concerned solely with production. In later chapters, these three basic decisions will be
expanded to include the setting of prices and the determination of product quality.

 The Bases of Decisions

As we said earlier, a firm’s three fundamental decisions are made with the objective
of maximizing profits. Because profits equal total revenues minus total costs, each firm
needs to know how much it costs to produce its product and how much its product can be
sold for.

To know how much it costs to produce a good or service, a firm needs to know
something about the production techniques that are available and about the prices of the
inputs required. To estimate how much it will cost to operate a gas station, for instance,
a firm needs to know equipment needs, number of workers, kind of building, and so on.
The firm also needs to know the going wage rates for mechanics and unskilled laborers,
the cost of gas pumps, interest rates, the rents per square foot of land on high-traffic
corners, and the wholesale price of gasoline. Of course, the firm also needs to know how
much it can sell gasoline and repair services for.

In the language of economics, a firm needs to know three things:

1. The market price of output
2. The techniques of production that are available
3. The prices of inputs
 Output price determines potential revenues. The techniques available tell me how
much of each input I need, and input prices tell me how much they will cost. Together the
available production techniques and the prices of inputs determine costs.

The rest of this chapter and the next chapter focus on costs of production. We begin
at the heart of the firm, with the production process. Faced with a set of input prices,
firms must decide on the best, or optimal, method of production (Figure 7.2). The optimal
method of production is the one that minimizes cost. With cost determined and the market
price of output known, a firm will make a final judgment about the quantity of product to
produce and the quantity of each input to demand.

Summary

This module is an introduction to the theory of production necessary to understand the behavior
of the firms, how firms acquire materials put into production to create output.

REFERENCES:

1. Pagoso, C., Dinio, R., Villasis, G. (2006). Introductory Microeconomics (Third Edition). Rex Book
Store, Manila, Philippines.
2. Kapoor, K.C., Soni J.C., Achrya, P.K., Riba, M., Riddi, A. (2016). Economic Theory. Vikas
Publishing House PVT.LTD

Congratulations on finishing Module 9! Keep up the good work.

Prepared: Reviewed/Approved:

JUVIELYN R. RAMOS AIZA P. RUMAUAC, CPA

Instructor Program Head, Accountancy and Business Administration