Wk7 / Theory of Production All things being equal, the company could have earned

₱10 more per unit if they had produced shorts instead of t-

WHAT IS ECONOMIC PROFIT? shirts. Therefore, (-₱10) is considered economic loss.

An economic profit or loss is the difference between the THEORY OF PRODUCTION

revenue received from the sale of an output and the costs
The theory of production examines the relationship
of all inputs used, as well as any opportunity costs. In
between the factors of production (land, labor, capital,
calculating economic profit, opportunity costs are
entrepreneur) and the out of goods and services. This is
deducted from revenues earned.
based on “short run” or period of production to change
Profit describes the financial benefit realized when the amount of variable input, labor. The “long run” is a
revenue generated from a business activity exceeds the period of production that is long enough for producers to
expenses, costs and taxes involved. adjust various inputs to analyze the best mix of the factors
of production.
Accounting profit measures actual inflows versus outflows
and is part of the required financial transparency of the  The theory of production deals with the relationship
company between the factors of production and the output of
goods and services.
Economic profit on the other hand, is not recorded on a
 The law variable proportions can explain how
company’s financial statement, nor is it required to be
increasing units of a single input will cause the output
disclosed to regulators, investors or financial institutions.
to vary.
The calculation for economic profit in general can vary by
THE LAW OF DIMINISHING MARGINAL RETURNS
scenarios:
In this example we are looking for the relationship between
Economic profit = revenues - explicit costs - opportunity
inputs and outputs.
costs
When a pizza company hired more workers what happens
EXAMPLES OF ECONOMIC PROFIT
to the number of pizza they can produce?
Juan start up business costs ₱100,000 and during the first
# Workers # Pizza Marginal
year of operation, the business earned revenue ₱120,000. Increases
(Input) (Output) Product
This results in an accounting profit ₱20,000. However, if Juan because of
had stayed at his previous job, he would have made 0 0 - Specialization
₱45,000. Economic profit is equal to:
1 5 15 With which
₱120,000.00 - ₱100,000.00 - ₱45,000.00 = - ₱25,000.00 worker does the
2 15 10
This calculations only considers the first year of business. If law of
after the first year, costs decrease to ₱10,000.00 then 3 20 5 diminishing
economic profit outlook would improve for future years. marginal returns
4 22 2 begin?
WHAT IS NORMAL PROFIT?
5 22 0
It may be viewed in conjunction with economic profit.
6 18 -4
Normal profit occurs when the difference between
company’s total revenue and combined explicit and
implicit costs are equal to zero (0).
Quantity of Labor
Normal profit and economic profit are economic
considerations.

❏ Gross profit is the focus in this scenario and company

would subtract the opportunity cost per unit:

Economic profit = revenue per unit - COGS per unit - unit

opportunity cost

If the company generates ₱100 per unit from selling t-shirts

with ₱50 cost per unit, gross profit for t-shirt is ₱50. However,
if they could potentially produce shorts with revenue of
₱100 and costs of ₱40 then an opportunity cost of ₱10.

₱100 - ₱50 - ₱60 = ₱10

Economies of scale (Long run production) - refers to the CALCULATING MARGINAL COST OF PRODUCTION
cost advantages a company gains with increase
 Production cost includes every expenses associated
production. Total cost can be higher but average cost is
with making a good or service.
lower.
 Fixed cost include overhead expenses such as salaries,
Advantage of economies of scale rent and utility cost, etc.
 Variable cost are directly related to and those that
Cost advantages that can occur when a company
vary with production levels such as cost of materials
increases their scale production and becomes more
used in production.
efficient, resulting in a decreased cost per unit.
For example, the total cost of producing 100 units of good
The amount a company should produce does not just look
is ₱200. The total cost of producing 101 units is ₱204. The
on cost but also on consumer demand.
average cost of producing 100 units is ₱2 or ₱200 / ₱100.
However, the marginal cost for producing unit 101 is ₱4 or
(₱204 - ₱200) / (101 - 100).

Optimum Production
Long run
average costs At some point, if the company reaches its optimum
increasing production level, the point at which producing any more
units would increase the per unit production cost. The
additional production causes fixed and variable costs to
increase.

Marginal Revenue
WHAT ARE DISECONOMY OF SCALE?
Measures the change in the revenue when one additional
 It happens when a company grows so large that the unit of product sold.
costs per unit increase. It takes place when economies
of scale no longer function for a firm. With this principle, Can marginal revenue increase?
rather than experiencing continued decreasing costs, Marginal revenue increases whenever the revenue
a firm sees an increase in costs when output is received from producing one additional unit of a good
increased. faster than its marginal cost of production. It means that
 It can involves internal to an operation or external there are profit opportunities if production expands.
conditions beyond a firm’s control.
 It may result from technical issues in a production
process, organizational management issues, or
resources constraints on productive inputs.

DISECONOMY OF SCALE EXAMPLE

The owner of car distributor hires store manager and

delegates’ decision-making to each one of their store
managers. Having several stores and different managers
for each location can cause different decisions to be
made at one store than at another store.

One store manager may be efficient at making decisions

that are in the best interest of the owner and the company
overall while another store manager may make decisions
that have a positive impact on their individual store but not
on the company.

MARGINAL REVENUE AND MARGINAL COST PRODUCTION

 Economic measures used to determine the amount of

output and the price per unit of a product that will
maximize profits
 According to economic theory, a firm should expand
production until the point where marginal costs is equal
to marginal revenue.