Basic Microeconomics

Instructor: Lea B. Morenes

Lesson 7- Production

A firm (or producer or business) combines inputs of labor, capital, land, and raw or finished
component materials to produce outputs. If the firm is successful, the outputs are more valuable
than the inputs.

Production is the process (or processes) a firm uses to transform inputs (e.g., labor, capital, raw
materials) into outputs, i.e. the goods or services the firm wishes to sell.

Economists divide factors of production into several categories:

1. Natural Resources (Land and Raw Materials)

2. Labor – When we talk about production, labor means human effort, both physical and
mental.
3. Capital – When economists uses the term capital, they do not mean financial capital (money);
rather, they mean physical capital, the machines, equipment, and buildings that one uses to
produce the product.
4. Technology – Technology refers to the process or processes for producing the product.
5. Entrepreneurship – Production involves many decisions and much knowledge.Ultimately, it is
the entrepreneur, the person who creates the business, whose idea it is to combine the
inputs to produce the outputs.

Fixed inputs are those that can’t easily be increased or decreased in a short period of time. In the
pizza example, the building is a fixed input. The restaurant owner signs a lease and is stuck in the
building until the lease expires. Fixed inputs define the firm’s maximum output capacity.

Variable inputs are those that can easily be increased or decreased in a short period of time.

Each business, regardless of size or complexity, tries to earn a profit:

Profit=Total Revenue – Total Cost

Total revenue is the income the firm generates from selling its products. We calculate it by
multiplying the price of the product times the quantity of output sold:

Total Revenue=Price × Quantity

Total cost is what the firm pays for producing and selling its products. Recall that production
involves the firm converting

inputs to outputs. Each of those inputs has a cost to the firm. The sum of all those costs is total cost.

Average total cost (sometimes referred to simply as average cost) - is the cost on average of
producing a given quantity.

Average totalTotal
cost Cost
=
Quantity of output
Average variable cost we divide variable cost by quantity of output.

Variable Cost
Average variable cost =
Quantity of output

Average total and variable costs measure the average costs of producing some quantity of output.

Two types of cost:

Explicit costs are out-of-pocket costs, that is, actual payments. Wages that a firm pays its
employees or rent that a firm pays for its office are explicit costs.

Implicit costs are more subtle, but just as important. They represent the opportunity cost of using
resources that the firm already owns. Often for small businesses, they are resources that the
owners contribute. For example, working in the business while not earning a formal salary, or using
the ground floor of a home as a retail store are both implicit costs.

These two definitions of cost are important for distinguishing between two conceptions of profit,
accounting profit, and economic profit.

Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference
between cash brought in and cash paid out.

Economic profit is total revenue minus total cost, including both explicit and implicit costs. The
difference is important because even though a business pays income taxes based on its accounting
profit, whether or not it is economically successful depends on its economic profit.