Theory of production

•The process of
transforming both fixed
and variable inputs into
finished goods and
services.
Production Function
• Inputs
• Outputs
• Fixed factor- remains constant
regardless of the volume of
production
• Variable inputs- can be changed
 FACTORS OF PRODUCTION
1. Land—to economists land
includes all natural
resources– “gift of nature”
that used in production
process, arable land, forests
etc.
2. Capital— (or capital goods or
investment goods) includes all
manufactured aids used in
producing consumer goods ad
services.
•The process of producing and
purchasing capital goods is
known as investment.
3. Entrepreneurial ability- a
special human resource, distinct
from labor. The entrepreneur
performs:
•Takes the initiative
•Makes the strategic business
decisions
•Innovator
•Risk bearer
4. Labor- is a broad term
for all physical and mental
talents of individuals
available and usable in
producing goods and
services.
WHAT ARE COSTS?
• According to the Law of Supply:
▫ Firms are willing to produce
and sell a greater quantity of a
good when the price of the good
is high.
▫ This results in a supply curve
that slopes upward.
WHAT ARE COSTS?
• The Firm’s
Objective
▫ The economic
goal of the
firm is to
maximize
profits.
 Total Revenue, Total Cost,
and Profit
• Total Revenue
▫ The amount a firm receives for
the sale of its output.
• Total Cost
▫ The market value of the inputs a
firm uses in production.
 Total Revenue, Total Cost,
and Profit
•Profit is the firm’s total
revenue minus its total cost.

•Profit = Total revenue - Total

cost
 Costs as Opportunity Costs
• A firm’s cost of production includes all the
opportunity costs of making its output of goods
and services.

• Explicit and Implicit Costs

▫ A firm’s cost of production include explicit
costs and implicit costs.
 Explicit costs are input costs that require a direct
outlay of money by the firm.
 Implicit costs are input costs that do not require an
outlay of money by the firm.
 Economic Profit versus
Accounting Profit
• Economists measure a firm’s
economic profit as total revenue
minus total cost, including both
explicit and implicit costs.
• Accountants measure the accounting
profit as the firm’s total revenue
minus only the firm’s explicit costs.
Economic Profit versus Accounting
Profit
• When total revenue exceeds both
explicit and implicit costs, the firm
earns economic profit.

• Economic profit is smaller than

accounting profit.
 Figure 1 Economists versus Accountants
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

© 2007 Thomson South-West

 PRODUCTION AND COSTS

• The Production Function

▫ The production function shows
the relationship between
quantity of inputs used to make
a good and the quantity of
output of that good.
The Production Function
• Marginal Product
▫ The marginal product of any
input in the production process
is the increase in output that
arises from an additional unit of
that input.
Table 1 A Production Function and
Total Cost: Hungry Helen’s Cookie
Factory

© 2007 Thomson South-West

 The Production Function
•

▫ Example: As more and more workers

are hired at a firm, each additional
worker contributes less and less to
production because the firm has a
limited amount of equipment.
 Figure 2 Hungry Helen’s Production
Function
Quantity of output

160

120

80

40

0
0 2 4 5 7
Number of Workers Hired
© 2007 Thomson South-West
 The Production Function
• Diminishing Marginal Product
▫ The slope of the production
function measures the marginal
product of an input, such as a
worker.
▫ When the marginal product
declines, the production function
becomes flatter.
From the Production Function to
the Total-Cost Curve
• The relationship between the
quantity a firm can produce and
its costs determines pricing
decisions.
• The total-cost curve shows this
relationship graphically.
Elasticity
• Is a measure of a variable's sensitivity to a
change in another variable.
• In business and economics, elasticity
refers the degree to which individuals,
consumers or producers change their
demand or the amount supplied in
response to price or income changes. It is
predominantly used to assess the change
in consumer demand as a result of a
change in a good or service's price.
Formula:
% change in quantity demanded
% change in price
Types of Elasticity
• Price elasticity of demand (PED),
which measures the
responsiveness of the quantity
demanded to a change in price.
PED can be measured over a price
range, called arc elasticity, or at
one point, called point elasticity.
•Income elasticity of demand
(YED), which measures the
responsiveness of thequantity
demanded to a change in
consumer incomes.
•Cross elasticity of demand
(XED), which measures the
responsiveness of thequantity
demanded of one good, good
X, to a change in the price of
another good, good Y.
PED can be:
• Less than one, which means PED
is inelastic.
• Greater than one, which is elastic.
• Zero (0), which is perfectly
inelastic.
• Infinite (∞), which is perfectly
elastic.
• There are three extreme cases of PED.
• Perfectly elastic, where only one price can be
charged.
• Perfectly inelastic, where only one quantity
will be purchased.
• Unitary elasticity, where all the possible
price and quantity combinations are of the same
value. The resultant curve is called a rectangular
hyperbola.
Types of Business Firms
● There are about 24 million business firms in United
States—each of them falls into one of three legal
categories
1. Sole Proprietorship
 A firm owned by a single individual
2. Partnership
 A firm owned and usually operated by several
individuals who share in the profits and bear
personal responsibility for any losses
3. Corporation
 Owned by those who buy shares of stock and whose
liability is limited to the amount of their investment
in the firm
 Ownership is divided among those who buy shares
of stock
 Each share of stock entitles its owner to a share of
the corporation’s profit
 Forms of Business Organization

Percent of Firms Percent of Total Sales

Corporations 20%

Partnerships 7%

Corporations 90%

Sole
Proprietorship
s 73%
Partnerships 4%

Sole
Proprietorship
s 6% 3
0
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