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Chapter Five

Production
and Cost

Production
 Economic activity, which combines the
four factors of production to form
output that will give direct satisfaction
to consumers.
 It includes material goods or any
services.
 Is the process of converting inputs into
outputs.

Inputs
Commodities and services that
are used to produce goods and
services.
Generally classified into three
broad categories:

Land

Labor

Capital

Technology: Labor Intensive or
Capital Intensive
Technology is the production
process employed by firms in
creating goods and services.

Labor Intensive
 Philippines
 Vietnam
 China
 Other developing countries

Capital Intensive
 Germany
 Japan
 Korea
 United States of America

Short Run versus Long Run
Production Inputs:
 Fixed Inputs- any resources the quantity
of which cannot be readily be changed
when market conditions indicate that a
change in output is desirable.
 Variable Inputs- any economic resources
the quantity of which can be easily
changed in reaction to changes in output
level

Production Function
 Functional relationship between
quantities of inputs used in production
and outputs to be produced.
 Specifies the maximum output that
can be produced with a given quantity
of inputs.

Total, Average, and
Marginal Products
Three Important Production
Concepts:
Total Products- refers to the total
output produced after utilizing the
fixed and variable inputs in the
production process.

 Fixed Inputs- components of
production which do not
change.
 Variable Inputs- changeable
resources in the production.
 Marginal Product- “extra” or
“additional”.

Extra output produced by 1
additional unit of that input while
other inputs are held constant.

MP=

MP=

Average Product- final concept
in the production process.

AP=

Input
(Labor)e

Hypothetical Production
Schedule of T-shirts
TL

MP

AP

0

0

0

0

1

8

8

8

2

20

12

10

3

37

17

12

4

57

20

14

5

72

15

14

6

80

8

13

7

85

5

12

8

88

3

11

9

86

-2

10

10

82

-4

8

The table shows
the total amount
of t-shirts that
can be produced
for different
inputs of labor
when other
inputs and the
state of
technical
knowledge are
held constant.

Total, Marginal, and Average Products
100

80

60
TP
MP

40

AP

20

0
0

1

2

3

4

5

6

7

8

9

10

-20

It shows that the total product increases at a decreasing rate while marginal and average
products first increases, reach their maximum and thereafter decline.

Law of Diminishing Returns
“This law holds that we will get less extra output
when we add additional doses of an input while holding
other inputs fixed. In other words, the marginal
product of each unit of input will decline as the
amount of that input increases, holding all other
inputs constant. ”

For example:
When more sewers are added to sew t-shirts using a
single sewing machine, the sewing machine gets more
crowded so that the marginal product of the additional
sewer declines.
In fact, in our example the 10th sewer added
contributes less than all the other sewers since his
marginal product is negative 4 units of t-shirts.

What does this imply?
It simply tells us that as more and
more variable inputs are used to a fixed
input the contribution of the extra unit
of variable input added declines.

What lesson can we derive from the
Law of Diminishing Returns?
It shows us that it would be absurd for
a company to have workers beyond the
point of negative returns or even to
approach that point. However, we would
certainly want to keep hiring workers
who yielded increasing returns. And if
company found it profitable to increase
output still further, it would keep hiring
workers even though their returns were
diminishing.

Increasing Marginal Returns
It happens when the marginal product
of an additional worker exceeds the
marginal product of the previous worker.
We can also say that there is increasing
marginal returns when a small number
of workers employed and arise from
increased specialization and division of
labor in the production.

For example:
If you as manager of a garments factory employ
just on worker, that person that you have employed
must learn all the aspects on making a t-shirt, cutting
the cloth, making the pattern, sewing the cloth,
putting the buttons, ironing the shirt, packaging,
delivering, etc. That single person must perform all
these tasks.
If you hire a second person, the two workers you
have can now specialize in different aspects of the
production process. As results two marginal product of
the second worker is greater than the marginal product
of the first worker. In this case marginal product is
increasing. Most production processes experience
increasing marginal returns initially.

Decreasing Marginal Returns
It occurs when the marginal product of
an additional worker is less than the
marginal product of the previous worker
hired to do the same task. Decreasing
marginal returns arise from the fact that
more and more workers use the same
equipment and work space. Thus, as more
and more workers are employed, there is
less and less production for the
additional worker to do.

For example:
If you hire the fifth worker, output
increases( MP=15) but not as much as it did
when you hired your fourth worker (MP=20).
In this case the first four workers exhaust
all the possible gains from specialization
and the division of labor. By hiring the
fifth worker, he produces more t-shirts, but
the sewing machine is being operated
closer to its limits. Sometimes the fifth
worker has nothing to do because the
machine is utilized by the other workers.

Hiring yet another sewer continues to
increase output but by successively
smaller amounts until you hire the
eighth sewer at which point total product
stops rising. Add a ninth worker and the
workplace is so crowded that your
workers get in each other’s way and total
product falls.

Return to Scale
Diminishing returns (also called law of
diminishing returns) states that in all
productive processes, adding more of one factor
of production, while holding all others
constant ("ceteris paribus"), will at some point
yield lower incremental per-unit returns, and
marginal products refer to the response of
output to an increase of a single input when all
other inputs are held constant.

Returns to scale and economies of scale are
related but different terms that describe what
happens as the scale of production increases in
the long run, when all input levels including
physical capital usage are variable (chosen by the
firm). The term returns to scale arises in the
context of a firm's production function. It
explains the behavior of the rate of increase in
output (production) relative to the associated
increase in the inputs (the factors of production)
in the long run. In the long run all factors of
production are variable and subject to change due
to a given increase in size (scale).

Three important cases
should be distinguished:
 Increasing returns- to scale occurs
when a firm increases its inputs, and a
more-than-proportionate increase in
production results.

For example:
In year one a firm employs 200
workers, uses 50 machines, and produces
1,000 products. In year two it employs
400 workers, uses 100 machines (inputs
doubled), and produces 2,500 products
(output more than doubled).

Decreasing Returns to Scale

Decreasing returns to scale is
closely associated with diseconomies
of scale (the upward part of the longrun average total curve).
 Decreasing returns to scale happens
when the firm's output rises
proportionately less than its inputs
rise.

For example:
In year one, a firm employs 200
workers, uses 50 machines, and produces
1,000 products. In year two it employs
400 workers, uses 100 machines (inputs
doubled), and produces 1,500 products
(output less than doubled).

Decreasing Returns to Scale
When input prices remain constant,
decreasing returns to scale results in
increasing long-run average costs
(diseconomies of scale). An organization
may become too big, thus creating too
many layers of management, too many
departments, and too much red tape.
This leads to a lack of communications,
inefficiency, delays in decision-making,
and inefficient production.

Constant Returns to Scale
Constant returns to scale occurs
when the firm's output rises
proportionate to the increase in inputs.

Problem:
In the example above, after doubling
the inputs in year one, what would
output have to be in year two for the
firm to experience constant returns to
scale?

Solution:
2,000 products. At 2,000 products,
the output doubles. Because the
inputs double, the increase in
production is proportionate. By
definition, this equates to constant
returns to scale

Theory of Cost
Cost refers to all expenses acquired
during the economic activity or the
production of goods and services. It
includes expenditures incurred for the
utilization of the various factors of
production in the creation of goods.

The equation that every business
person knows better than anything else
in the world is:

Sales – Costs = Profit
or
Total Revenue – Total Costs = Profit

The Firm’s Goal
A firm is a collection of
resources that is transformed into
products demanded by consumers.
Knowing the firm’s goals allows
the manager to make effective
decisions.

Goals that the firm might
pursue:

Economic Objectives
 market share
 profit margin
 return on investment
 technological advancement
 customer satisfaction
 shareholder value
• Noneconomic Objectives
 workplace environment
 product quality
 service to community

Limits to Firm Size
Tradeoff between external
transactions and the cost of internal
operations.

What are the Accounting Cost
and Profit?
Accountings Cost- an accounting cost
pertains to money a business spends to
acquire materials for resale or inclusion
in its production cycle.
Accounting profit- is equal to total
revenues minus accounting costs. This
number also goes by the names “net
profit,” “accounting income,” “business
profit” and “net income.

Opportunity Cost
The value of most appealing
alternative that is not chosen is called
opportunity cost.

Opportunities:
-To work all day and makes
money
-To take the day off and to go to
a movie

Explicit and Implicit Cost
Explicit Cost- payment to nonowners of a firm for their resources.
Implicit Cost- opportunity costs of
using resources owned by the
firm.

Economic Profit

A firm’s economic profit equals total revenue
minus total cost.
Total revenue is the amount received from the sale
of the product. It is the price of the output
multiplied by the quantity sold.
Total cost is the sum of the explicit cost and
implicit costs and is the opportunity cost of
production.
Because one of the firm’s implicit costs is normal
profit, the return to the entrepreneur equals
normal profit plus economic profit.
If a firm incurs an economic loss, the
entrepreneur receives less than normal profit.

Fixed Cost
 Fixed cost overhead or supplementary cost
are those expenses which are spent for the
use of fixed factors of production.
 Fixed costs stay the same no matter how
much output changes.
 Fixed cost are sometimes call sunk costs
because once we have obligated ourselves to
pay them, that money has been sunk into
our business firm. Fixed costs are the
firm’s overhead.

Examples:
Rent, interest, and expenses on
machines, depreciation, and
salary/wages of employees under
guaranteed contract. These expenses
do not change regardless of a change
in quantity of output produced.

Variable Cost
• Variable costs or prime or operating costs,
on the other hand, are those expenses which
change as a consequences of a change in
quantity of output produced.
• Variable costs are those costs which are
incurred on variable costs are those costs
which are incurred on variable factor inputs.
These include expenses on labor inputs, raw
materials, electricity, fuel etc,.

Total Fixed Cost, Total Variable Cost,
and Total Cost
Total fixed cost(TFC) – consist of cost
that do not vary as output varies and
that must be paid even if output is zero.
These are payments that the firm must
make in the short run, regardless of the
level of output. This implies that even if
a firm does not produce any output, still
it must pay rent, property taxes, etc.

Total variables cost(TVC) – as a firm
expands from zero, total variable cost is
added to total fixed cost.
- consist of costs that are zero when
output is zero and vary as output
increases(decreases). These costs relate
to the cost of variable inputs.

Examples:



Wages for daily workers
Raw materials
Electricity
Fuel consumption

Given total fixed cost and total
variable cost, the firm can calculate
total cost(TC). Total cost is the sum
of total fixed cost and total variable
cost at each level of output. Thus,

TC = TFC + TVC

Graphical illustration of the short
run cost schedule

Short Run Cost Schedule (in peso)

Short Run FC, VC and LC Curves

The figure illustrates the relationship of total cost to total variable cost and total fixed cost.

Short Run MC, AFV, AVC, ATC Curves

The figure show s the relationship of marginal cost to average fixed cost, average
variable cost, and average total cost.

 The curve is derived by plotting the data from
the short run cost schedule of the table.
 Marginal Cost (MC) curve decreases during the
initial stage of production, reaches a
minimum, and then increases gradually as
more outputs are produced.
 MC also intersects both the average variable
cost (AVC) curve and the average total cost
(ATC) curve at the minimum point on each of
this cost curve.
 The average fixed cost (AFC) declines
continuously as output expands.
 AFC is also the difference between ATC and
AVC curves at any quantity of output.

The decision to operate or shut down
Firm has two options:
-operate
-shut down
•If it operates, it will produce the output that will
take provide the highest possible profit to the firm,
if it is losing money, it will operate at that output
at which losses are minimized.
•If the firm shut downs, it ‘s OUTPUT is ZERO.
Shutting down however DOES NOT IMPLY ZERO
TOTAL COSTS.

Examples:
Table in Short run cost
at output 0 there is a FC (100) therefore is a TC of
100
Why can a firm not go out of the business in the short
run?
-Because it still has FIXED COST.

Suppose a firm has fixed cost of 5M,
variable cost of 6M, and a total
revenue of 7M. What does it do in
the short run? As we have noted, it
has a choice either to operate or
shut down.
If you are the owner of the business
what would you do?

Whatever you do, you will lose money.
If you operate:
FC+VC=TC
5M+6M= 11M
Total Revenue- Cost= Profit or Loss
7M-11M= -4M
Your loss is 4M. Definitely it is not good for you as the
owner of the business.

If you shut down:
Since you still have fixed cost of 5M certainly you still have to pay
for them. Your VC will be ZERO, Sales will be ZERO.
If you shut down you produce nothing.
FC+ VC= TC
5M+0= TC
Total Revenue-Cost= Profit or Loss
TC= 5M
0-5M= -5M
Your loss is 5M by shutting down.
What do you do now? Shut down and loss 5M or operate and loss 4M?
What you do is operate, it is better to lose 4M than to lose 5M.

Summary:
Firm will operate in the short run when:
 Total Revenue EXCEEDS Variable
Cost
Firm will shut down in the short run
when:
 Total Revenue is LESS THAN Variable
Cost