The Theories of Production 2.

Input – Input case

• Combination of two inputs that will minimize cost if the output
• It is assumed that the firm or producer, which is the subject level is fixed, given the prices of the inputs
of the study, is a maximizer of output, and eventually, of • Combination of two inputs that will produce the highest output
profit if the cost outlay is fixed, given the prices of the inputs.
• Input- Output Relationship
• Output – Output The Isoquant - Isocost Approach
• Input-input Relationship The Isoquant
• Is a curve that shows combination of two inputs that will
1. Input – Output Relationship yield the same level of output
• In this relationship, it is assume that there is only one
variable input Characteristics of Isoquant:
• How the output will behave with changes in the use of
1. Downward sloping
variable input
2. Convex to the origin
THE PRODUCTION FUNCTION
3. Isoquants do not intersect
• Production function - physical relationship between inputs
used in the production and the output or product produced.

The Law of Diminishing Return

• if the input of one resource is increased by equal increments

per unit of time while the quantities of other inputs are held
constant, there will be some point beyond which the marginal
physical product of the variable resource will decrease

Marginal Product (MP)

• Change inn TP/Change in the quantity of variable input

X
∆𝑇𝑃
∆𝑋1
• Average product (AP)
𝑇𝑃
𝑋1
The Stages of Production

Stage 1

- Is characterized by increasing average product of the variable

input X1 which implies the increasing efficiency of the variable
input. The total product also increases at this stage as more units
of X1 are use

Stage 2

- Is characterized by decreasing average product and decreasing The Isocost

marginal product. As larger quantities of the variable X1 are used,
the efficiency of X1 decreases. The total product however • A line that shows the combinations of two inputs that a
continues to increase. firm can afford, given the firms cost outlay and the prices
of the two inputs
Stage 3
𝐶𝑜𝑠𝑡 𝑜𝑢𝑡𝑙𝑎𝑦 (𝐶𝑂)
- The use of large quantities of X1 further decreases the average 𝑋−𝑖 =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑋1
product of X1. The marginal product is negative and total product
is decreasing. The efficiency of the input decreases. 𝐶𝑂
𝑌−𝑖 =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑋2
What is the relevant stage of production? Why?
EXAMPLE: The cost outlay of a firm is PhP 15,000/mo, while the
Best level of input use
prices of X1 and X2 are Php 300 and PhP 250 per unit,
• level of input where the value of the marginal product (VMP) respectively. Construct an isocost
is equal to the price of input (P) or where VMP=P
• it can be determined using the formula.
• VMP= Marginal Product x price of the output

The Least Cost Combination

• It can represent the combination of inputs that will give the

highest output for a given cost outlay and prices of the inputs
• It can give combination of inputs that will require the lowest cost
outlay for a given level of output and the prices of the inputs
 Best output mix

• The output combination that will maximize the firm’s TR

given its limited inputs

The Expansion Path

• Shows the different combinations of two output that will

maximize TR, given different input levels while holding the
prices of the outputs constant.

The Expansion Path

• Shows the combination of two inputs that the firm should choose
if its CO changes while the prices of inputs remain the same.

3. The Output - Output Case of Production

• Assumes that the firm can produce two kinds of output from a
given set of inputs.
• The firm’s objective is thus, to find the output combination that
will maximize its total revenue
• The isoresource curve (The product transformation curve) Time Comparison in Decision Making
• Shows the maximum combinations of two outputs that a
Discounting vs. Compounding
firm can produce given its available resources

• Characteristics: Discounting
1. Downward sloping
• is the process of bringing a future value to its present
2. Concave to the origin
value
3. Non intersecting
𝑉𝑛
𝑉𝑜 =
(1 + 𝑖)𝑛
Where: Vo - present value

Vn - future value

i - interest rate

n – number years in the period

Compounding

• is the process of bringing a present value to its future

value
• The isorevenue line • Vn = Vo (1 + i) n
• Shows combination of two outputs that will give the same • The present and future values can also be determine using
level of total revenue, given the prices of the outputs the discounting factor (DF) and compounding factor (CF);
1
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑇𝑅) • Vo = Vn x DF where: 𝐷𝐹 = (1+𝑖)𝑛
𝑋−𝑖 =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌1 • Vn = Vo x CF CF = (1 + i) n

𝑇𝑅
𝑌−𝑖 =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌2
Time value of money

• it recognizes that values received earlier are worth more

EXAMPLE: The prices of Y1 and Y2 are PhP 3,000 per unit and Php than values received later (Gittinger, 1982)
2,000 per unit respectively, and the highest TR that can be
generated is Php 300,000 per unit time. Establish the isorevenue Why does the value of money change?
line.
• Consumption
• Investment
• Risk and uncertainty
• In general, the value of money decreases through time

Incorporating the time dimension of money in decision making

• Interest – the price paid for the use of money or

capital

Reasons why borrowers should pay interest

• If we lend money we put off the use of that amount for our
own purpose today
• We forego the opportunity to use the money purpose, for some
productive whereas the borrower gains form the money, it is
only fair that we should be compensated for the foregone
income through the payment of interest
Valuing the Future

Future value - refers to the value of an amount in the

• b.2. Perpetual Payments
future, or after sometime has elapsed.
• b.2.1. To determine perpetual periodic payments
• Vo - refers to the present value 𝑎
𝑉𝑜 =
• Vn - refers to the future value (1 + 𝑖)𝑡 − 1
• a - is either an annual or periodic payment b.2.2. To determine perpetual annual payments
𝑎
• i - is the interest rate, expressed in decimal 𝑉𝑜 =
𝑖
• n - is the number of years in the interest bearing period for single
sums, or the number of payments for a series of payments

• t - is the number of years in a period for periodic payments COST AND SUPPLY

Costs of Production

Interest Formulas • refer to the total payments that a firm has to make for the
inputs of production to be able to place good and/service in
Kinds of payments the market.
a. Single sum- money that is received or paid only once
b. Series of payments - if you pay or receive money every year The Concept of Costs
(annual) or every so many years (periodic)
• b.1. terminable - making the payments terminable or finite Alternative Cost Principle
• b.2. perpetual - have no definite end
• When resources are efficiently allocated in the production of
Single sum goods and services, an increase in the production of one
• in finding for the future value of a single sum, the basic product, say Product A, will result in a decrease in the
compounding formulae can be use; quantity produced of the other product, say Product B This
• Vn = Vo (1 + i) n will happen since in order to produce more A, resources that
• Vn = Vo x CF are used to produce Product B will be used to increase the
production of Product A so there is some quantity of Product
• b. Series of payments series of payments is either terminable or B that will be sacrificed in order to increase the production of
perpetual Product A This situation exemplifies the alternative cost
• b.1. To determine the future value of series of terminable principle or the opportunity cost principle
periodic payments made at the end of the period

(1+𝑖)𝑛𝑡 − 1 Explicit and Implicit Cost

• 𝑉𝑛 = 𝑎 [ (1+𝑖)𝑡 ]
−1 • Explicit Costs - are payments for hired resources
• n - number of payments for a series of payments • Implicit Costs - are the costs of firm’s owned resources that
• t - is the number of years in a period for periodic payments
are used in the production
• b.2. To determine series of terminable annual payments Short run Costs Curves
made at the end of each year
• Fixed Costs - are costs incurred in production that do not
(1 + 𝑖) − 1𝑛 change even if the quantity produced or output is changed
𝑉𝑛 = 𝑎 [ ] • Variable Costs - are costs that directly relate to the quantity
𝑖 of output.
• Total Costs - of production for a given quantity of output can
be determined by adding the fixed costs and variable costs
for that given output

Valuing the Present

Present Value

• refers to the value of an amount of money today, when no

time has elapsed yet.

a. Single sum
𝑉𝑛
𝑉𝑂 =
(1 + 𝑖)𝑛
𝑉𝑜 = 𝑉𝑛 × 𝐷𝐹
• b.1. Terminable Payments
Per Unit Costs Curves
• b.1.1. To determine the present value of series of terminable
annual payments • provide the same kind of information as the total costs.
(1 + 𝑖)𝑛 − 1 However, they come in a different form;
𝑉𝑜 = 𝑎 [ ] • Average Fixed Costs (AFC) - are the fixed costs per unit of
𝑖 (1 + 𝑖)𝑛 product at various levels of output

𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 (𝐹𝐶)

• b.1.2. To determine the present value of series of terminable 𝐴𝐹𝐶 =
payments made t years apart (periodic payments) 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 (𝑞)
[(1 + 𝑖)𝑛𝑡 − 1] • Average Variable Costs (AVC) - are the variable costs per unit
𝑉𝑜 = 𝑎 product at various level of output
⌊{(1 + 𝑖)𝑡 −1}⌋(1 + 𝑖)^𝑛𝑡] 𝑉𝐶
𝐴𝑉𝐶 =
𝑞
• Average Costs (AC) – it can be obtained by dividing total costs
(TC) by the quantity of output
𝑇𝐶
𝐴𝐶 =
𝑞
• Marginal Costs (MC) -is the incremental costs of producing one
more unit of a product
∆𝑇𝐶
𝑀𝐶 =
∆𝑞
Revenue
• refers to the income derived from a given source. It can be
express in Total, Average or Marginal.
A. Total Revenue (TR) = Price per unit (P) x Quantity of
product sold (Q)
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑇𝑅)
B. 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝐴𝑅) = 𝑂𝑢𝑡𝑝𝑢𝑡 (𝑄)
∆ 𝑖𝑛 𝑇𝑅
C. 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑀𝑅) = ∆ 𝑖𝑛 𝑄

Profit Maximization

• Profit (π) of a given level of output can be defined as the

difference between TR derived from the output and Total Costs
of producing that output.
• π = TR TC
• The rule of determining the output that will maximize profit (or
minimize loss) is that the revenue from the additional unit of
output is equal to the cost of producing it. In other words,
profit is maximized if MR is equal to MC

Principles of Rational Decision-making

The Marginal Principle

• The marginal principles involves the comparison of the

additional gain with the additional costs
• Marginal analysis can also be applied in the production,
specifically with respect input-output, input-input, and
output-output decisions
• Optimum use of one variable input
• Optimum combination of two variable inputs
• Optimum output decisions

Optimum use of one variable input (Input-output decision)

• The guide for determining the best level of inputs use is

VMP=Pi
• VMP = MP x price per piece
• MP = future output-past output

Optimum combination of two variable inputs

Decision criteria

𝐶𝑂 = (𝑃𝑋1)(𝑄𝑋1) + (𝑃𝑋2)(𝑄𝑋2)
𝑀𝑃𝑋1 𝑃𝑋1
=
𝑀𝑃𝑋2 𝑃𝑋2
Optimum output decisions

• MR = MC; marginal output is where the additional cost of

producing the output is equal to the additional revenue it
will generate.
• The marginal output, is the smallest size of output that
will be produced

Comparative advantage

• The principle of comparative advantage explains why

nations, both rich and poor, trade The principle states
that “to maximize profits, one should produce those
things, considering yields, costs, and returns, from which
the percentage return above cost is greatest”