Topic 4: PRODUCTION & COST FUNCTION

The Presenters

BETTY B. ROSALINA T. LILIBETH M. MARIA LOURDES

ESPLANA REYES NAZARIO D. MORALES
Part 1:
Production Function,
Basic Concepts and
Curves, One variable
Input and Returns to
Scale
- BETTY B. ESPLANA
 What is a Production?
 Any activity which create value is production.
 In other words, it is transformation of inputs (such as
capital, equipment, labor, land and etc.) into outputs such
as goods or services.
 In economics, the technical law, relating inputs to outputs,
has been given the name as PRODUCTION FUNCTION.
Production Function
refers to the functional relationship between physical inputs and physical
outputs of commodity
 Production Function
 A production function may be written as follows:

Q = f ( N, L, C, E……)
Where:
Q = output (total product)
N (Land) ; L (Labor); C (Capital) and E (Entrepreneurship), …..
Are inputs
Inputs of Production
Factors of production are broadly classified as:

1. Land
Anything which is gift of nature and not
the result of human effort, e.g. soil, water,
forests, minerals, Owner of land is called
landlord. Reward of land is called as rent.
Physical or mental effort of human
beings that undertakes the production
process.
Inputs of Production

2. Labor
Labor is supplied by the workers. Labor can be skilled as
well as unskilled, physical or intellectual. Reward/price of
labor is called as wages/ salary.
Inputs of Production
3. Capital
Wealth which is used for
further production as
machine/
equipment/intermediary
good. It is outcome of human
efforts meaning capital is
man-made, Reward of capital
is called as interest.
4. Entrepreneurship/ Inputs of Production
Organization
The ability and action
to take risk of
collecting,
coordinating, and
utilizing all the factors
of production for the
purpose of uncertain
economic gains. Owner
of enterprise is
entrepreneur. Reward
of entrepreneurship is
called as profit.
Concept of Time Time can categorize as under:
1. Market Period or Very Short Period is a period
Alfred Marshal during which all factors of' production and hence
cost remains fixed. As such, outputs as well as
introduced the supply also remain fixed.
element of time 2. Short run a period so brief that the amount of at
in production least one input is fixed. Thus we have both fixed
as well as variable factors
decision 3. Long Run is a period of time sufficient enough
for all inputs (or factors of production), to be
variable as far as an individual firm is concerned.
Take Note: The length of time necessary for all
inputs to be variable may differ according to the
nature of the industry and the structure of a firm.
Types of Production Function
Before analyzing the types of production-function it will be useful to understand the
meaning of following important terms

Factors of production are broadly classified into two categories i.e. fixed and variable
factors:
1. Fixed Factors. The factor inputs which cannot be varied in the short-period.
Examples of Fixed Factors are : Plant, machinery, heavy equipment, factory
building, land etc.
2. Variable Factors - The factor inputs which can easily be varied, in the short-
period Examples of variable factors are : labor, raw material, power, fuel etc.
The distinction between fixed factors and variable factors appears only in the short-
period. In the long-run, all the factors of production become variable factors.
 Types of Production Function
• Inputs kept constant, ONE INPUT is
varied
Short Run • LAW OF VARIABLE PROPORTION

• Varying all inputs

Long Run • LAW OF RETURNS TO SCALE
LAW OF VARIABLE
PROPORTIONS
It states that as the
quantity of one
factor is increased,
keeping the other
factors fixed, the
marginal product of
that factor will
eventually decline.
This means that up
to the use
 Returns to a Variable Factor in the Short-Run:
 In the short-run we study the behavior of
output as more and more units of a variable
factor (labor) are applied to a given quantity
of a fixed factor
 Three concepts bear relevance in this
context, viz., total product (TP), average
product (AP) and marginal product (MP).
Here Q is total product. It refers to the total
amount produced by all the factors employed
in a fixed time period. AP is output per unit of
input. It is calculated by dividing TP by the
amount of the variable factor, e.g., labour (L).
Three stages of the production process in the short-run:
(1) In the first stage, when additional units of labor
are employed, TP increases more than proportionately
and MP also increases. This is the stage of increasing
return to the variable factor (labor).

(2) In the second stage TP increases no doubt, but

not proportionately. In other words, the rate of
increase of TP falls. This means that MP diminishes.
This is the stage of diminishing return to the variable
factor (labor). This is perhaps the most important
stage of the production process in the short run.

(3) In the third stage, TP itself diminishes and the MP

is negative. This is the stage of negative return to the
variable factor (labor).
LAW OF RETURNS TO
SCALE
It explains the behavior
of output in response
to a proportional and
simultaneous change
in inputs. Increasing
inputs proportionately
and simultaneously is,
in fact, an expansion of
the scale of production.
 Returns to Scale:
Returns to Variable Factors in the Long Run:
 All factors are variable in the long run we may find that returns to
scale increase decrease or remain constant.
 The law of diminishing returns deals with short-run situations in
which some factors of production are fixed in supply. However, in
the long run, it is possible to vary the use of all factors of production
employed.
 This means that in the long run it is possible to change the scale of
activities (operation) of a firm.
Table 6.2: Returns to Scale
 As the size of the firm increases from 2 workers
and 1 machine to 6 workers and 3 machines, it
experiences increasing returns to scale (output
increase more than proportionately).

 A change in scale from 6 people and 3

machines to 8 people and 4 machines yields
constant returns to scale (size and output
change by the same percen­tage). Any further
growth in the size of the firm yields decreasing
returns to scale because output increases less
than proportionately.
 Increasing Returns to Scale:
 A situation of increasing returns to scale can be attributed to two considerations
indivisibilities of some factors and advantages of specialization.
1. Indivisibilities: The inability to divide certain factor units into smaller units without
either complete loss of usefulness in production or partial loss in efficiency results in
a relatively low output per unit of input when operations are conducted on a very
small scale.
2. Specialization: The other and closely related cause of increasing returns to scale is
the advantage offered by specialization. In a very small business, employees must
perform a wide variety of tasks. As the size of enterprise increases, each employee
can be used in a relatively specialized job, with a consequent increase in output per
worker.
 Constant Returns to Scale:
Constant returns to scale are relevant only for time periods in
which adjustment of all factors is possible. If a firm doubles output in
a short period with a fixed physical plant which was previously
utilized to normal optimum capacity, returns per unit of the variable
factors will decline because of the operation of the Law of
Diminishing Returns.
 Decreasing Returns to Scale:
 Decreasing returns to scale for the firm itself are usually attributed
to increased problems and complexities of large-scale
management.
 Continued increases in entre­preneurial activity beyond a certain
point encounter more and more serious problems and difficulties.
 There are two major determinants of
increasing returns to scale:
1. Indivisibilities: A large firm can afford to employ large and specialized machinery.
Moreover, the firm has large output to fully occupy the machine for a long period of
time and, therefore, it can be operated efficiently. Indeed some machines are indivisible
in the sense that they are only efficient if they are large in size, for example, blast
furnaces.
2. The Principle of Increased Dimensions: Large machines sometimes lead to fall in costs
per unit of output. This is because a large machine can cater for a much larger output.
But this may involve only a slightly greater cost.
For example, a double-decker bus can carry twice number of passengers as a single
decker at the same total fixed cost. Moreover, only the same labor is required. A large oil
tanker can carry twice as much oil as a smaller tanker but needs only a few more workers
to operate it. This is called the economy of increased dimensions.
Part 2:
Theory of Costs
- ROSALINA T. REYES
 What is meant by the Theory of Cost?

 The theory of cost definition states that the costs of a

business highly determine its supply and spendings.
 The modern theory of cost in Economics looks into the
concepts of cost, short-run total and average cost, long-run
cost along with economy scales. 
 The cost function varies concerning factors such as
operation scale, output size, price of production, and more.
Types of Costs

1. Accounting Costs / Explicit Costs:

The cost of production including employee salaries,
raw material cost, fuel costs, rent expenses and all
the payments made to the suppliers from the
accounting costs.
 Types of Costs
2. Economic Costs / Implicit Costs:
 According to the modern theory of cost in economics, the
investment return amount of a businessman, the amount
that could have been earned but not paid to an
entrepreneur and monetary rewards for all estates owned
by the businessman form the economic costs.
 These costs include accounting costs and the money also
returned which the owner could have earned from elsewhere
apart from the business.
 Types of Costs

3. Outlay Costs: These are the recorded account costs

or actual expenditure spent on wages, rent, raw
materials and more.
4. Opportunity Costs: These are the missed
opportunity costs. They are not recorded in the
account books but show the cost of sacrificed or
rejected policies.
 Types of Costs
5. Direct / Traceable Costs: These costs are easily pointed out
or identified expenditures such as manufacturing costs. Such
costs cater to specific operations or goods.
6. Indirect / Non-Traceable Costs: These costs are not related
directly or identifiable to any operation or service. Costs
such as electric power or water supply are some examples
because these expenses vary with output. They generally have
a functional relationship with production.
 Types of Costs
7. Fixed Costs: Such costs do not vary with output and are fixed
expenditure of the company. For example, taxes, rent,
interests are all fixed costs as they do not vary within a
constant capacity. Any company cannot avoid these costs.
8. Variable Costs: These costs vary with output. For example,
salaries of the employee, raw material costs all fall under
variable costs. These directly depend on the fixed amount of
resources.
 Fixed Costs
These costs are those that remain unchanged as the output level of the firm
changes. It does not matter what level of output the firm produces (even zero
output makes no difference), any cost which is a fixed cost will remain the
same. Common examples of fixed costs are as follows:
Examples of fixed costs
1. Rent
2. Interest on loans
3. Insurance
4. Depreciation
Fixed costs can be represented graphically, and this would
appear as follows:
 Variable Costs
Any cost which varies directly with the level of output would be classified as a
variable cost. Varying directly means that the total variable cost will be
dependent on the level of output. Common examples of variable costs are as
follows:
Examples of fixed costs
1. Direct labor
2. Raw materials and components
3. Packaging costs
4. Heating and lighting
Variable costs can be represented on a graph and this would
appear as follows:
 Calculating costs

Figure 3 Short-run average cost curve Figure 4 Long-run average cost curve
 Comparing Short Run and Long Run Costs

• A company tries to increase its output

by changing only the variable factors
Short Run such as raw materials or labor.
• The fixed variables remain untouched

• The company can change any factor to

obtain desirable outputs as per their
Long Run interests.
• Ultimately all these factors result in cost
Summary
Remember, a standard marginal and average cost curve
diagram should look like this:

Figure 5 Marginal and average cost

Figure 6 Marginal cost, average cost, average fixed cost and
average variable cost
Relationship between Total Cost, Total Fixed Cost
and Total Variable Cost of a Business.

Total Costs (TC)

= Total Fixed Cost (TFC) + Total Variable Cost (TVC)

FIXED COST  VARIABLE COST 

• refers to a cost that does not change
with an increase or decrease in the
number of goods or services produced
or sold.
• are expenses that have to be paid by a
company, independent of any specific
business activities.
• is a corporate expense that changes in
proportion to how much a company
produces or sells.
• increase or decrease depending on a
company's production or sales volume
—they rise as production increases and
fall as production decreases.
 Theory of Cost in Economics

 The modern theory of cost in Economics also specifies

economies of scale where an increased production
decreases the cost per unit of production.
 The returns to scale first increase, then stabilize for
some time and then decrease.
 Let's take a look at the different types of economies—

1. Technical: Technical economies include investment in machinery

and more efficient capital equipment to increase production
efficiency.

2. Effective Management: When an organization increases operation,

they need a better division of labor into various sub-departments for
efficient management.

3. Commercial: A large amount of components and raw materials is

needed with increased production. Hence raw material costs
decrease. The advertisement cost for a unit of production also falls,
which increases.
 Let's take a look at the different types of economies—

4. Finance: With a raised Finance, any company becomes popular.

Their banking securities increase and Finance is raised at a
much lower cost.
5. Risk Management: As the firm becomes more diverse, risk-
taking factors also increase.
Part 3:
Theory of Firms
Costs, Revenues and Objectives

- LILIBETH M. NAZARIO
Theory of the Firm
 Profit
 Difference between Revenue and Cost

Profit = Total Revenues – Total Costs

Within economics you will meet:
1. Normal profit - is that level of profit which is
just sufficient to keep the firm in its present
use. Normal profit is assumed to be an element
of the Average Total Cost (ATC) curve.
2. Supernormal profit (or abnormal profit)- this is
any profit made in excess of normal profit.
The definitions of supernormal and normal profit mean that profit on a diagram drawn by an economist shows
supernormal profit only. Normal profit is included as an element of the ATC curve and arises where ATC = AR.

Figure 3 Firm in perfect competition - supernormal profit

The definitions of supernormal and normal profit mean that profit on a diagram drawn by an economist shows
supernormal profit only. Normal profit is included as an element of the ATC curve and arises where ATC = AR.

Figure 4 Monopoly - supernormal profit

 This has to be compared with the accountant's definition
of profit.

Accounting profit
The difference between revenue from sales and the
costs incurred in making these sales, regardless of
any credits given or taken.

Accountants deal in facts. They do not get involved

with concepts such as normal profit
 Why do firms try to make a profit?
Profit has many uses:
1. It is the return to the entrepreneur.
2. It is a source of funds for development
3. It is a motivator.

Profit is a driving force within business. It is an incentive to

invest for investors. It lies behind all cost reduction exercises,
as the aim of cost reduction is profit maximization.
 Revenue
The amount received from the sale of goods or services
1. Total revenue (TR) - all the revenue earned by the business.
2. Average revenue (AR) - total revenue divided by number
sold.
3. Marginal revenue (MR) - the increase in total revenue as the
result of one more sale. This is not necessarily the same as
the price. It is only the same as price, if price remains
constant.
Total Revenue = Price x Quantity
Revenue curves vary depending on whether price is constant at all levels of
output (as in the case of a firm which is a price-taker) or falls as output
increases (as in the case of a firm who is a price-setter). Look at Figures 1
and 2 below to see the difference this makes to the shape of the average /
marginal revenue and total revenue curves:

Figure 1 Revenue curves –

constant price (price-
taker)
Revenue curves vary depending on whether price is constant at all levels of
output (as in the case of a firm which is a price-taker) or falls as output
increases (as in the case of a firm who is a price-setter). Look at Figures 1
and 2 below to see the difference this makes to the shape of the average /
marginal revenue and total revenue curves:

Figure 2 Revenue curves -

falling price (price-setter)
 Total Cost is the sum of all costs – fixed, variable
and semi-fixed
 Fixed Costs – do NOT depend on quantity
produced- Rent, Rates, Insurance, etc.
 Variable Costs –vary directly with the amount
produced – raw materials
 Semi–Fixed Costs - may vary with output but
not directly – some types of labor, energy costs
 1. Profit Maximization
2. Multiple Objectives
OBJECTIVES 3. Growth Maximization
OF FIRMS 4. Sales Maximization
5. Output Maximization
6. Security Profits
7. Satisfaction Maximization
 In the conventional theory of the
firm, the principal objective of a
business firm is profit
Profit maximization. Under the
Maximization assumptions of given tastes and
technology, price and output of a
given product under perfect
competition are determined with
the sole objective of maximizing
profits
 The basis of the difference between
the objectives of the neo-classical
firm and the modern corporation
arises from the fact that the profit
Multiple
maximization objective relates to the
Objectives entrepreneurial behavior while
modem corporations are motivated
by different objectives because of the
separate roles of shareholders and
managers. In the latter, shareholders
have practically no influence over the
actions of the managers.
 Robin Marris in his book The
Economic Theory of ‘Managerial’
Capitalism (1964) has developed a
Growth dynamic balanced growth
Maximization maximizing theory of the firm. He
concentrates on the proposition
that modern big firms are managed
by managers and the shareholders
are the owners who decide about
the management of the firms.
 Baumol’s findings of oligopoly firms
in America reveal that they follow
the sales maximization objective.
Sales According to Baumol, with the
Maximization separation of ownership and
control in modern corporations,
managers seek prestige and
higher salaries by trying to expand
company sales even at the
expense of profits.
 Milton Kafolgis suggests output
maximization as the objective of a
business firm. According to him,
“The performance of firms
Output frequently is measured directly in
Maximization terms of physical output with
revenue occupying a secondary
position.” Thus Kafolgis prefers
output maximization both to profit
maximization and revenue
maximization as the objective of a
firm.
 Rothschild has put forward the
view that the firm is motivated
not by profit maximization but
Security by the desire for security
Profits profits. In his words, “There is
another motive which is
probably of a similar order of
magnitude as the desire for
maximum profits, the desire
for security profits.”
 Scitovsky favors maximization of
satisfaction in preference to the
profit-maximization objective of the
firm. He is concerned with
Satisfaction managerial effort and the distaste
Maximization that managers have for work.
According to him an entrepreneur
would maximize profits only if his
choice between more income and
more leisure is independent of his
income. In other words, the supply
of entrepreneurship should have
zero income elasticity.
Part 4:
Profit Maximization &
Competitive Firm
- MARIA LOURDES D. MORALES
 1. Perfectly Competitive Markets
2. Profit Maximization
3. Marginal Revenue, Marginal Cost,
and Profit Maximization
Outline 4. Choosing Output in the Short-Run
Perfectly Competitive Markets
The model of perfect competition can be used to
study a variety of markets

Basic assumptions of Perfectly Competitive Markets

1. Price taking
2. Product homogeneity
3. Free entry and exit
Price Taking
 The individual firm sells a very small share of the total
market output and, therefore, cannot influence market
price.
 Each firm takes market price as given – price taker
 The individual consumer buys too small a share of industry
output to have any impact on market price.
Product Homogeneity
 The products of all firms are perfect substitutes.
 Product quality is relatively similar as well as other product
characteristics
 Agricultural products, oil, copper, iron, lumber
 Heterogeneous products, such as brand names, can charge
higher prices because they are perceived as better
Free Entry and Exit
 When there are no special costs that make it difficult for a
firm to enter (or exit) an industry
 Buyers can easily switch from one supplier to another.
 Suppliers can easily enter or exit a market.
 Pharmaceutical companies not perfectly competitive because
of the large costs of R&D required
When are Markets Competitive
 Few real products are perfectly competitive
 Many markets are, however, highly competitive
 No rule of thumb to determine whether a market is close to
perfectly competitive
Profit Maximization
Do firms maximize profits?
Managers in firms may be concerned with other objectives:
1. Revenue maximization
2. Revenue growth
3. Dividend maximization
4. Short-run profit maximization (due to bonus or promotion
incentive)
Profit Maximization
 Implications of non-profit objective
1. Over the long-run investors would not support the
company
2. Without profits, survival unlikely in competitive industries

 Managers have constrained freedom to pursue goals other

than long-run profit maximization
Marginal Revenue, Marginal Cost, and Profit Maximization

We can study profit maximizing output for any firm whether

perfectly competitive or not

Profit = Total Revenue - Total Cost

If q is output of the firm, then total revenue is price of the

good times quantity

Total Revenue (R) = Pq

Marginal Revenue, Marginal Cost, and Profit Maximization

Costs of production depends on output

Total Cost (C) = Cq
Profit for the firm, is difference between revenue and costs
 Marginal Revenue, Marginal Cost, and Profit Maximization
• Firm selects output to maximize the difference
between revenue and cost
• We can graph the total revenue and total cost
curves to show maximizing profits for the firm
• Distance between revenues and costs show
profits
• Revenue is curved showing that a firm can only
sell more if it lowers its price
• Slope in revenue curve is the marginal revenue
• Slope of total cost curve is marginal cost
Profit Maximization – Short Run
• Profit is maximized at
the point at which an
additional increment
to output leaves
profit unchanged
 The Competitive Firm
• Price taker – market price and output determined from
total market demand and supply
• Market output (Q) and firm output (q)
• Market demand (D) and firm demand (d)
• Demand curve faced by an individual firm is a horizontal
line
• Firm’s sales have no effect on market price
• Demand curve faced by whole market is downward sloping
The Competitive Firm
The competitive firm’s demand

• Individual producer sells all

units for $4 regardless of that
producer’s level of output.
• MR = P with the horizontal
demand curve
• For a perfectly competitive
firm, profit maximizing output
occurs when
 Choosing Output: Short Run
• We will combine revenue and
costs with demand to determine
profit maximizing output
decisions.
• In the short run, capital is fixed
and firm must choose levels of
variable inputs to maximize
profits.
• We can look at the graph of MR,
MC, ATC and AVC to determine
profits
A Competitive Firm – Positive Profits
A Competitive Firm – Losses
 Summary of Production Decisions
 Profit is maximized when MC = MR
 If P > ATC the firm is making profits.
 If P < ATC the firm is making losses
Thank you

QUESTIONS?