CHAPTER V

THE THEORY OF FIRM:

PRODUCTION AND COST
PRODUCTION
-Production refers to any economic activity, which combines the fours of production
(land, labor, capital and entrepreneurship)

INPUT
- these are commodities and services that are used to produce goods and services
(Samuelson and Nordhaus 2005). Inputs are largely classified into three principal
categories: land, labor, and capital.

OUTPUT
- quantity of goods or services produced in a given time period, by a firm, industry, or co
whether consumed or used for further production.
Technology: labor intensive or capital intensive

- Technology is the production process employed by firms in creating goods

and services

- Technology can be classified into two broad categories: Labor-intensive and

capital-intensive

Labor-intensive technology
- utilizes more labor resources than capital resources.

capital-intensive technology
- utilizes more capital resources than labor resources
in production process.
 SHORT RUN VERSUS LONG RUN
Short run
- is a period of time so short that there is only FIXED INPUT, therefore
changes in output level must be accomplished exclusively by the use of
VARIABLE INPUTS.
IsIsany
anyresource
economic resource
quantity of the quantity
which cannotofreadily
which be
can
be easily
change changed
when marketin conditions
reaction toindicate
changes in output
that a
level.
change in output is desirable
Long run
- is a period of time so long that all inputs are considered variable. The
long run is therefore known as the PLANNING HORIZON.
THE PRODUCTION FUNCTION

Is the functional relationship

between quantities of inputs
used in production and output
to be produced.
 PRODUCTION POSSIBILITY CURVE
In order to see a firm efficiently producing its goods and services, we have to understand
the production possibility curve or the Production Possibilty Frontier (PPF)

The PPF curve which shows the combination of two or

more goods and services that can be produced by
making efficient use of all the available factor
resources or the factors of production.

6
 Figure 5.1 : Production Possibility Curve

Wheat
Production Possibility Curve
A F
B

C
D

Cotton
Point A, B, and C on the production possibility curve show the combination of goods that can
be produced with the efficient utilization of resources.
TOTAL, AVERAGE, AND MARGINAL
PRODUCTS

Total products
refers to the total output produced
after utilizing the and variable inputs in the
process
 Figure 5.2 : Production Possibility Curve

Wheat

A
F
B

C
D When there is an increase in
the capacity of the firms production
such as technology improvement
or more endownment from natural
resources such as discovery of more
gold or silver, the PPC shifts outward.

Cotton
 MP= ∆TP
∆I L
AP= TP
MP= TP2 – TP1 I
I2 – I1

10
 FIGURE 5.1
HYPOTHETICAL PRODUCTION SCHEDULE OF T-SHIRTS
Input(Labor) TP 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 if T-shirts that can be produced for different inputs of labor
when other inputs and the state of technical knowledge are held constant. From total product,
we can derive important production concepts like the marginal and average products.
 Marginal product
is the extra output by 1 additional unit of
that input while other inputs are held constant
 Average product
Equals the total product divided by
total units of input used
GRAPICAL PRESENTATION OF TP, MP, AND AP

TP

The figure shows the

total, marginal, and average
product. Total product
increase as a decreasing rate
while marginal and average
AP product first increase, reach
MP their maximum and thereafter
decline
OUTPUT AND REVENUE OF THE FIRM
Output is the amount of a good
produced; revenue is the amount of
income made from sales minus
all business expenses.
TOTAL REVENUE FORMULA

Total revenue = Price(P) x Quantity(Q)

 TABLE 5.2
PRODUCTION AND REVENUE SCHEDULE OF T-SHIRTS

Input Q MPP Price Total Marginal

(Labor) Revenue Revenue
Product
0 0 0 10 0 0
1 8 8 10 80 80
2 20 12 10 200 120 The table shows the marginal
revenue product which helps in the
3 37 17 10 370 170 marginal analysis in studying the
effects of variable inputs (Labor). As
4 57 20 10 570 200 Labor increase, the revenue
decrease at a certain point by each
5 72 15 10 720 150
additional unit
6 80 8 10 800 80
7 85 5 10 850 50
8 88 3 10 880 30
9 86 -2 10 860 -20
10 82 -4 10 820 -40
THE LAW OF DIMINISHING RETURNS
used to refer to a point at which the level of
profits or benefits gained is less than the
amount of money or energy invested.

“the law of Diminishing Returns holds that we will get less

and less extra output we add additional doses of an input
while holding other inputs.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. (
Samuelson and Nordhaus 2005.109)
INCREASE MARGINAL
RETURNS
Increase marginal returns happen
when the marginal product of an
additional worker exceeds the
marginal product of the previous
worker.
 DECREASING MARGINAL
RETURNS
Decreasing marginal returns occurs
when the marginal product of an
additional worker is less than the marginal
product of the previous worker.
RETURN TO SCALE
Diminishing returns and marginal product
refer to the response of output to an increase
of a single input when all other inputs are
held constant.
Three important cases should be distinguished
in return to scale
1. Constant Returns To Scale

Indicates a case where a change in all inputs leads to a proportional

change in output.

2. Increasing Returns To Scale (also called economies of scale)

Happen when an increase of all outputs leads to a more than-

proportional increase in the level of output.

3. Decreasing Return To Scale

Occurs when a balanced increase in all outputs lead to a less-than-
proportional increase in total output.
THE THEORY OF COST
Cost refers to the all expenses acquired during
the economic activity or the production of
goods or services.
The equation that every business person knows better than
anything else in the world is:

Sales – Cast = Profit or

Total Revenue – Total Cost = Profit
THE FIRM’S GOAL
the goal of the firm is always described as
"maximization of shareholders' wealth". Profit
Maximization - is always used as a goal of the
firm in microeconomics.
 The goal of the owners of the firm is to maximize the
return on their capital investment—to maximize profit
 Profit is revenue less cost-- defined as opportunity cost
 Explicit and implicit costs
 Normal profit and economic profit
ACCOUNTING COST AND PROFIT
Accounting cost is the recorded cost of an
activity. An accounting cost is recorded in
the ledgers of a business, so the cost appears in
an entity's financial statements.

Accounting profit is the monetary costs a firm

pays out and the revenue a firm receives. It is the
bookkeeping profit, and it is higher than
economic profit. Accounting profit = total
monetary revenue- total costs.
 OPPORTUNITY COST
the opportunity cost, also known as alternative
cost, of making a particular choice is the value
of the most valuable choice out of those that
were not taken.
EXPLICIT AND IMPLICIT
COSTS
Explicit costs are payments to non-owners
of a firm for their resource ( Tucker 2008)

Implicit costs are the opportunity costs of

using resources owner by the firm.
ECONOMIC
PROFIT
It is the price of the output
multiplied the quantity sold.
FIXED COSTS AND VARIABLE COST
Fixed costs or overhead or supplementary cost are those
expenses which are spent by the use od fixed factors of
production

Variable cost or prime operating costs, are those expenses

which change as consequence of a change in quantity of
output produced
TOTAL FIXED COST, TOTAL VARIABLE
COST AND TOTAL COST
Cost are divided into two basic categories – total fixed cost and
total variable cost

Total Fixed Cost (TFC) consist of costs that do not vary as

output varies and that must be paid even if output is zero.

Total Variable Cost (TVC) consist of cost that zero when

output is zero and vary as output increases(decreases). These
cost relate to the cost of variable inputs.
Total cost
Is the sum of total fixed cost and total variable cost

TC = TFC + TVC
 Table 5.3
SHORT RUN COST SCHEDULE ( IN PESO)

Q FC VC TC MC AFC AVC ATC

0 100 0 100 ---- ---- ---- ----
The table illustrates a hypothetical
1 100 40 140 40 100 40 140 short run cost schedule. The
2 100 68 168 28 50 34 84 quantity of output is shown on
column 1, while column 2, 3 and 4
3 100 90 190 22 33 30 63
shows the FC, VC, and TC.
4 100 115 215 25 25 29 54 Column 5 indicates the MC while
column 6, 7 and 8 are the AFC ,
5 100 148 248 33 20 30 50
AVC and ATC, respectively.
6 100 195 295 47 17 33 49
7 100 260 360 65 14 37 51
8 100 350 450 90 13 44 56
9 100 460 560 110 11 51 62
10 100 600 700 140 10 60 70
 AVERAGE COSTS: AVERAGE FIXED
COST, AVERAGE VARIABLE COST AND
AVERAGE TOTAL COST
Average fixed cost
is total fixed cost divided by the quantity of output method.
You will note that as output increases, average fixed cost falls continuesly

AFC= FC / Q
Average variable cost
is total variable cost divided by the quantity of output produced.
Usually it declines for a while as output increases, but eventually it levels off
and then begins to rise more outputs are produced.

AVC = VC / Q
Average Total Cost
is total cost divided by the quantity of
output produced. It is also the sum of the average
fixed cost and average variable cost.

ATC = TC / Q or
ATC = AFC = AVC
MARGINAL COST
Marginal cost (MC) is the cost of
producing one additional unit
output
MC = ∆TC
∆Q
= TC2 – TC1
Q2 – Q1
GRAPHICAL ILLUSTRATION OF THE
SHORT RUN COST SCHEDULE
In order to appreciate the cost concepts that we
have discussed, it is better if we illustrate them
graphically through cost curve
 Figure 5.4: Short Run FC, VC, and TC Curves

TC
VC

The figure illustrates the

relationship of total cost
FC to total variable cost
and total fixed cost

38
Figure 5.5: Short Run MC, AFC, AVC, ATC Curve

MC

ATC
AFC
This figure shows the relationship of
marginal cost to average fixed cost,
average variable cost and average
AFC total cost
THE CONCEPT OF PROFIT MAXIMIZATION

PROFIT MAXIMIZATION
profit maximization is the short run or
long run process by which a firm may
determine the price, input, and output
levels that lead to the greatest profit.

Profit is simply define as the difference that

arises when a firm’s total revenue is
greater that its total cost.
 There are several approaches of this problem. The total
revenue-total cost (TR-TC) method relies on the fact that
profit equals revenue minus cost, that is:

Profit = TR - TC
On the other hand, the marginal revenue-marginal cost (MR-MC)
method is based on the fact that the total profit in a perfectly
competitive market reaches its maximum profit where marginal
revenue equals marginal cost, that is

MR=MC
We have earlier introduce that concept marginal cost. Marginal revenue is a
parallel concept. Using both concepts, we will be able to find the output at
which a firm maximizes its profit and to calculate that profit.

If your firm sold four cell phones worth of P3,200, calculate your total revenue.
The answer is of course P12,80. Why? Because total revenue is price times
total quantity of output sold, or we can say;

TR = (P) (TQs)
 Table 5.4
Cost and revenue schedule

Output Price(₱) TR(₱) MR(₱) TC(₱) ATC(₱) MC(₱) TPr(₱)

1 500 500 500 100 100 ----- -500

2 500 1000 500 1500 750 500 -500

3 500 1500 500 1800 600 300 -300

4 500 2000 500 2000 500 200 0

5 500 2500 500 2300 460 300 200

6 500 3000 500 2850 475 550 150

7 500 3500 500 3710 530 860 -210

The table depicts the cost and the revenue schedule of a hypothetical firm selling T-shirts.
The last column shows the total profit (TPr) that the firm obtains after selling outputs of T-shirts.
The output at which the firm maximizes its total profit is five (TPr = P200)
 Figure 5.6 Hypothetical D, MR, MC and ATC Curves

MC

a
ATC
D, MR

The figure illustrate the relationship between cost, average

total cost, and marginal revenue. A firm will maximize its profits or
minimize its loss at output where MC = MR.