The Theory of

Firm: Production
Microeconomics
 Production
Production refers to any economic activity, which combines the four
factors of production to form an output that will give direct
satisfaction to consumers.

Material Service
goods s

Satisfaction
 Inputs and Outputs

Land
Capital
Final Goods
Labor
Entrepreneurship
Intermediate
goods
 The Production Function
Production function – is the functional relationship
between quantities of inputs used in production and
outputs to be produced. It specifies the maximum output
that can be produced with a given quantity of inputs given
the existing technology of a firm. (Samuelson and Nordhaus
2005).
𝑂𝑢𝑡𝑝𝑢𝑡=𝑓 (𝐿𝑎𝑛𝑑, 𝐿𝑎𝑏𝑜𝑟 ,𝐶𝑎𝑝𝑖𝑡𝑎𝑙)
 Production Possibility Curve
Production Possibility Curve
or Frontier is a 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.
Technology: Labor Intensive or Capital Intensive

Technology refers to the production process employed by firms in

creating goods and services. It is the body of knowledge applied to
how goods are produced (Tucker 2008).

Labor Intensive – utilizes more labor resources than capital

resources. (ex. Philippines, China)
Capital Intensive – utilizes more capital resources than labor
resources in the production process. (Germany, Japan)
 Short Run vs. Long Run
Economists partition production decisions based on the ability to
vary the quantity of inputs or economic resources used in the
production of a good or service such as raw materials, labor,
machineries, equipment, etc.

Production inputs:
• Fixed inputs – resources that cannot readily be changed when
market conditions indicate that a change in output is desirable.
• Variable inputs – resources that can easily changed in reaction
to change in output level.
 Short Run vs. Long Run
Short run – a period of time so short that there is at least one fixed
input, therefore changes in the output level must be accomplished
exclusively by changes in the use of variable inputs.

Long run – a period of time so long that all inputs are considered
variable. It is also known as planning horizon.
 Total, Average and Marginal Products
Input
Total products – total output produced TP MP AP
(Labor)
after utilizing the fixed and variable inputs
in the production process. 0 0 0 0
Marginal products – is the extra output 1 8 8 8
produced by 1 additional unit of that input 2 20 12 10
while other inputs are held constant.
3 37 17 12
Average product – total product divided
by total units of input used. 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
 Total, Average and Marginal Products
100
88 86
85
80 82
80
72

60 57

TP
40 37 MP
AP
20 20
20 17 15
12 12 14 14 13 12
10 11 10
8 8 8
5 3
0 -2
0 -4
0 2 4 6 8 10 12

-20
 Output and Revenue of the Firm
As firms aim to increase profit, a consideration of its employed
factors of production must also be reviewed. A firm needs to weigh
the cost against benefit of acquiring each unit of factor in order for
them to know up to when they will increase their inputs as long as
it is profitable to do so.

Marginal Revenue Product (MRP) – is the change in revenue

resulting from the output produced by one additional unit of the
variable input.
Marginal Physical Product (MPP) – is the change in the quantity
of output divided by the change in the quantity of the factor input.
Output and Revenue of the Firm
Marginal
Input Total
Q MP Price Revenue
(Labor) Revenue
Product
0 0 0 10 0 0
1 8 8 10 80 80
2 20 12 10 200 120
3 37 17 10 370 170
4 57 20 10 570 200
5 72 15 10 720 150
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
The Law of Diminishing Returns claims that we will get
less and less extra output when we increase all additional
doses of an input while holding other inputs fixed.

Increasing Marginal Returns happen when the marginal

product of an additional worker exceeds the marginal
product of the previous worker.
Decreasing Marginal Returns occur when the marginal
product of an additional worker is less than the marginal
product of the previous worker hired to do the same task.
Returns to Scale
Constant returns to scale – indicate a case where
a change in all inputs leads to a proportional
change in output.

Increasing returns to scale (economies of scale)

– happens when an increase in all inputs leads to a
more-than-proportional increase in the level of
output.

Decreasing returns to scale – occur when a

balanced increase in all inputs leads to a less-than-
proportional increase in total output.
 Points to Remember
• The law of diminishing returns states that as you
place in additional input while all other inputs
are fixed, the output lessens.
• Input refers to resources used in production and
output refers to products or merchandises.
• Two types of inputs: fixed and variable.
• The production function refers to the greatest
amount of output that can be created given the
exact number of inputs.
• In a short run production, a firm adjusts only its
variable input whereas in a long run production,
all inputs are variable.
The Cost of
Production
Microeconomics
 What is firm’s profit?
Total Revenue – the amount of firm receives for the sale of its output.
Total Cost – the market value of the inputs a firm uses in production.

Profit- total revenue minus total cost

 Total Cost
When economists speak of a firm’s cost of production,
they include all the opportunity costs of making its output
of goods and services.

• Explicit cost – input costs that require an outlay of

money by the firm.
• Implicit cost – input costs that do not require an outlay
of money by the firm

Total cost is the sum of explicit and implicit cost

 Profit
Economic Profit - total cost includes both explicit and implicit costs

Accounting Profit – usually larger than economic profit

Economists vs. Accountants
 The Various Measures of Cost
• Fixed costs do not vary with the quantity of output produced
• Variable costs vary with the quantity of output produce
• Total Cost = Fixed cost + Variable cost

• Average Fixed cost – fixed cost divided by the quantity of

output
• Average Variable cost – variable cost divided by the quantity
of output
• Average Total cost – total cost divided by the quantity of
output
• Marginal cost – the increase in total cost that arises from an
extra unit of production
The Various Measures of Cost
The Various Measures of Cost
 The Various Measures of Cost
• Rising marginal cost curve – because of diminishing marginal
product

• U-shaped average total cost curve

• ATC =AVC + AFC
• AFV always declines as output rises
• AVC typically rises as output increases
• The bottom of the U-shape – at quantity that minimizes
average total cost
Average total cost and Marginal cost
• How much does it cost to make the typical cup of
coffee?
• How much does it cost to increase production of
coffee by 1 cup?

• Average total cost tells us the cost of a typical unit

of output if total cost is divided evenly over all the
units produced.
• Marginal cost tells us the increase in total cost that
arises from producing an additional unit of output.
 Average total cost and Marginal cost
Efficient scale – quantity of output that minimizes
ATC

Relationship between MC and ATC

• When MC < ATC : average total cost is falling
• When MC > ATC : average total cost is rising
The marginal cost curve crosses the average total
cost curve at its minimum.
Cost Curves for a Typical Firm
Average Total Cost in Short & Long runs
Average Total Cost in Short & Long runs
Economies of Scale - long-run average total cost falls as the
quantity of output increases
Increasing specialization among workers

Constant returns to scale – long-run average total cost stays

the same as the quantity of output changes

Diseconomies of scale – long-run total cost rises as the

quantity of output increases
Increasing coordination problems
 Summary
• The goal of firms is to maximize profit, which equals total revenue minus
total cost
• When analyzing a firm’s behavior, it is important to include all the opportunity
costs of production (explicit and implicit)
• A firm’s total costs can be divided into fixed costs and variable costs.
• From a firm’s total cost, two related measures of cost derived. Average total
cost and Marginal cost.
• Marginal cost curve always crosses the average total cost curve at minimum
average total cost.
• Many costs are fixed in the short run but variable in the long run. As a result,
when the firm changes its level of production, average total cost may rise
more in the short run than in the long run.
Firms in Competitive
Market
Microeconomics
 Competitive Market
Competitive market sometimes called a perfectly
competitive market has the following characteristics:
1. There are many buyers and many sellers in the
market.
2. The goods offered by the various sellers are
largely the same.
3. Firms can freely enter or exit the market.

Firms in competitive market tries to maximize profit.

 Competitive market
Average revenue – total revenue divided by the quantity
sold
Marginal revenue – change in total revenue from an
additional unit sold

• For all types of firms, average revenue equals the

price of the good.
• For competitive firms, marginal revenue equals the
price of the good. (total revenue is P x Q and P is fixed
for a competitive firm. Therefore when Q rises by 1
unit, total revenue rises by P dollars.)
Total, Average, and Marginal Revenue for a Competitive Firm
 Profit Maximization
Produce quantity where total revenue minus
total cost is greatest
Compare marginal revenue with marginal cost
If MR > MC increase production
If MR < MC decrease production
Maximize profit where MR=MC
Profit Maximization: Numerical Example
Profit Maximization for a Competitive Firm
Marginal cost curve
Determines the quantity of the
good the firm is willing to
supply at any price. (Supply
curve)

An increase in the price from P1

to P2 leads to an increase in the
firm’s profit-maximizing
quantity from Q1 to Q2. Because
the marginal-cost curve shows
the quantity supplied by the
firm at any given price, it is the
firm’s supply curve.
 The Firm’s Short-Run Decision to Shut Down
A shutdown refers to a short-run decision not to
produce anything during a specific period of time
because of current market conditions.
A firm that shuts down temporarily still has to pay its
fixed costs.
Sunk- cost – a cost that has already committed and
cannot be recovered. It should be ignored when making
decisions

Firm’s decision: shutdown if

TR < VC or P < AVC
The Firm’s Short-Run Decision to Shut Down
 Firm’s Long-run Decision to Exit or Enter a Market

Exit refers to a long-run decision to leave the market. A

firm that exits the market does not have to pay any
costs at all, fixed or variable.

Exit the market if TR < TC or P < ATC

Enter the market if TR > TC or P > ATC
Firm’s Long-run Decision to Exit or Enter a Market
Measuring Profit
 Measuring Profit
Profit = TR – TC
We can rewrite this
definition by multiplying
and dividing the right side
by Q:
Profit = (TR/Q – TC/Q) x Q
Note that TR/Q is average
revenue, which is the price,
P, and TC/Q is average total
cost ATC. Therefore,
Profit = (P-ATC) x Q
Ex. Firm’s output is 5.75
units
Price is 500 and ATC is 465
Profit=(500-465) x 5.75
Profit = 201.25
Firm’s output is 5.25 units
Price is 400 and ATC is 456
Profit=(400-456) x 5.25
Profit = -294
Thank you!