LESSON 6

Theories of Production and Cost

Learning Objectives:
At the end of the lesson, students are able to:

1. Explain the concept of a production function

2. Distinguish between a variable input and a fixed input, the short run
period and the long run period.

3. Compute for the different measures of output such as the total

product, average product, and the marginal products;

4. State the law of diminishing marginal returns and how this is

reflected in the three stages of production in the short run;

5. Differentiate between economic cost and accounting cost, implicit

and explicit cost;

6. Compute for the different measures of cost such as total fixed

cost, total variable cost, total cost, average fixed cost, average
variable cost, average total cost, and marginal cost;

7. Compute for economic profit and determine the most profitable level
of output using the TR-TC approach and the MR-MC approach.

Theory of Production

Resources (inputs) are needed to produce output. Without resources,

a firm cannot produce a product or service.

Time/Period involved in production of output:

1, Short Run Period (SR) – a period that allows a producer to change
the quantity of some inputs but not enough for the producer to change the
quantity of those inputs that are difficult to change.
2. Long Run Period (LR) – a period that is long enough to enable the
producer to change the quantity of all inputs.
 Variable Input or Variable Factor – an input or factor whose quantity
can be easily increased or decreased by a producer.

Fixed input or Fixed factor – an input whose quantity is difficult to

increase or decrease.

In the SR period, the producer combines variable factors and fixed

factors to produce output while LR period the producer combines factors that
ae all variable.

Output can be measured by the following:

1. Total product (TP)
2. Average product (AP)
3. Marginal product (MP)

Total Product (TP) is simply the total amount of output produced with
the use of the inputs.

Average Product (AP) is the output produced by each unit of a

variable input ; AP = TP / Quantity of the variable input.

Marginal Product (MP) – measures the change in the quantity of total

output ( which can be an increase or a decrease) that is brought about by
each additional unit of the variable input.

MP = Δ TP / ΔQ = (TP1 - TP2 ) / ( Q2 - Q1)

In the SR period, it is labor as the variable factor, the AP and MP of the

variable input is usually the AP and MP of labor.
The AP of labor measures the amount of output produced by each
laborer, it therefor measures labor productivity.
The MP of labor, on the other hand, shows the increase or decrease in
output that results from the employment of an additional worker.
Law of Diminishing marginal Returns
States that the extra output produced by the additional variable input
will eventually decrease as more of it is combined with fixed inputs.

The law of diminishing marginal returns can be further understood by

an explanation of the three stages that production has to go through the SR
period. These stages are the stage of increasing marginal returns, the stage
of diminishing marginal returns, and the stage of negative marginal returns.

Example:
Hypothetical Production Schedule in Short Run
Number of TP of Labor AP of Labor MP of Labor
(No. of Chairs ( No. of
Workers /week) (No. of chairs/week) Chairs/week)
0 0 - -
1 10 10 10
2 25 12.5 15
3 42 13 17
4 60 15 18
5 76 15.2 16
6 83 13.8 7
7 85 12.1 2
8 85 10.6 0
9 82 9.1 -3
10 77 7.7 -5

If the labor is the variable factor , the rest are fixed factors; the quantity
of fixed factors is no longer included in the table since the quantity is constant.
The table shows the total production , as well as the average and
additional productions of chairs per week. When there are 8 workers, the total
number of chairs produced is a maximum of 85 chairs so that each of the 8
workers produces 10.6 chairs which is lower than the AP when there have
been only 3 workers.
The MP of the 8 workers is zero which means that this additional
worker did not add any chair to the total production compared with the three
workers who added 17 chairs.
The MP indicates the rate at which output changes such that if the MP
is positive and is increasing, the TP is increasing at a faster rate.
 If the MP is still positive , but decreasing, the TP still continues to
increase but at a slower rate.
If the MP is zero, the TP reaches its maximum and when the MP
becomes negative and continues to decrease, the TP starts to fall.
The stage of diminishing marginal returns starts when the MP starts to
fall until it reaches zero, thus, the TP still increases but at a decreasing rate
until it reaches its maximum level.
The stage of negative returns starts when the MP becomes negative ,
resulting in a decline in TP.
The stage of increasing returns starts when the MP is positive and is
increasing.

Theory of Cost
The cost of production is the sum of the payments for the use of the
inputs.
The cost of production in economic perspective differs from the
accounting perspective. Economic cost includes implicit and explicit cost
while Accounting cost includes only the explicit cost.

Implicit Cost is a cost that does not involve actual payment since the
inputs are owned by the producer. It is considered by the economist as part of
the cost of production.
Explicit Cost is a cost that involves actual payment since this is a
payment for the use of an input that is not owned by the producer. In such
case, the producer pays somebody else for the use of the input.
Example: wages can be implicit or explicit cost.
Rental payment is an explicit cost if you pay for it. Implicit cost if
you are the owner for it.

Cost are classified into:

1. Fixed Cost
2. Variable Cost
 Fixed Cost is a payment for the use of a fixed input and since the
quantity of a fixed input does not change, so will its payment. Example : rental
payment and interest on loans.

Variable Cost is a payment for a variable input and since the quantity
of the variable input changes with the quantity of output, its payment also
changes.
In the SR period, the cost of production is the sum of fixed cost and
variable cost since in this period , fixed and variable inputs are used to
produce output.

Other Measures of Cost that are important to the Producer :

1. Average Fixed Cost = Total Fixed Cost per unit of Output

AFC = TFC / Q

2. Average Variable Cost = Total Variable Cost per unit of Output

AVC = TVC/ Q

3. Average Total Cost = Total Cost per unit of Output

ATC = TC/ Q or ATC = AFC + AVC

4. Marginal Cost = Change in total cost per unit Change in

output

MC = Δ TC / ΔQ = (TC2 - TC1) / ( Q2 – Q1)

Example:
Given:
Averag Margina
Quantity Total
Total Total Average Average e l
Variabl
of Cost
Fixed e Fixed Variable Total Cost
Output Cost Cost   Cost Cost Cost  
   
0 4,200 0 4,200  
1 4,200 2,050 6,250 4,200 2,050 6,250 2,050
2 4,200 3,850 8,050 2,100 1,925 4,025 1,800
3,516.6
3 10,550
4,200 6,350 1,400 2,116.67 7 2,500

To illustrate how the different costs are computed:

TC = TFC + TVC = 4,200 + 3,850 = 8,050

AFC = TFC/Q = 4,200 / 2 = 2100

AVC = TVC / Q = 3,850 /2 = 1,925

ATC = TC / Q = 8050 / 2 = 4,025 or

ATC = AFC + AVC = 2,100 + 1,925 = 4,025

MC = ATC / ΔQ = (TC2 - TC1) / Q2 – Q1

= (8,050 – 6,250) / 2 - 1 = 1,800

Total Revenue and Economic Profit

Economic Profits are different from the revenues earned by firms

from the sale of output.
Total Revenue is price per unit of a good multiplied by the quantity
bought of the good.
Economic profit is the difference between the TR and TC
 Revenues earned by the firm can be measured by the following:

TR = Price per unit of output x quantity of output bought

AR = Total revenue per unit of output = TR /Q

MR = Δ TR / ΔQ = ( TR2 - TR1 ) / (ΔQ2 - ΔQ1)

Approaches in Profit Determination

The maximum profit for the firm can be determined by using data on a
firm’s TR and TC or using marginal analysis that makes use of the firm’s data
on MR and MC.
Whether the firm realizes economic profit ( π ) or incurs economic
losses ( -π ) will depend upon the relationship of the firm’s TR and TC.

TR, TC, and Economic Profit ( π )

Relationship of Positive or Negative
Remark
TR & TC Economic Profit
   
Firm gains
TR > TC π > 0 , positive economic
  profit
     
TR = TC π = 0 Firm does not gain
economic growth
 
but
it earns normal
  profit
  which isan implicit
  cost and is therefore
    a part of TC
   
Firm incurs
TR < TC
π < 0 economic
  losses
     
 If economic profit is the different maximum profit between TR and TC ,
then maximum profit would be the biggest difference between TR and TC.

The output level that the firm would produce should be that which will
give it the biggest profit.

MR, MC, and Marginal Profit

Relationship of Value of Mπ,

Remark
MR and MC Positive or Negative
     
MR > MC Mπ > 0 , positive Total economic
  profit increases
     
Total economic
MR = MC
Mπ = 0 profit
  stops increasing; it
  reaches its
  maximum
   
     
MR < MC Mπ < 0 , negative Total economic
    profit decreases

Recap:

A production function is a mathematical expression that shows the

dependent relationship between the amount of output that is produced by a
given set of inputs.

Production goes through two time periods the short run (SR) and the
long run (LR) periods. In the SR period, the firm combines fixed and variable
inputs while in the LR period, the firm combines inputs that are all variable.

The three stages of production are the stage of increasing marginal

returns, where the MP increases; the stage of diminishing marginal returns,
where the MP starts to fall until it reaches zero, and lastly, the stage of
negative returns, where MP becomes negative.

Costs are incurred every time production is undertaken. These cost

costs are the payments for resources or inputs used in production.
 Economic cost differs from accounting cost; the former includes implicit
and explicit costs while accounting includes only explicit.

In the SR period, the firm incurs fixed and variable costs. There are
other measures of cost such as the AFC, AVC, ATC and MC.

The firm sells the produced goods and receives revenue from the sale
of these goods. There are measures of revenue such as TR, AR, and MR.

The firm’s goal is to maximize economic profit. Based on the TR and

TC, the maximum economic profit is earned if TR exceeds TC by the biggest
amount. According to marginal analysis , the maximum profit is earned when
MR = MC since it is at this point that marginal profit becomes zero.

Answer the following:

1. Solve for the firm’s total cost if it incurs an average fixed cost of 50
pesos and a total variable cost of Php 20,000 in producing 1,000 units
of output.

2. If the firm sells the 1,000 units of output at 100 pesos per unit, solve for
the firm’s total revenue.

3. Solve for the total economic profit earned by the firm based on your
answer in no. 1 and 2.

4. Suppose the firm’s total cost increase to Php120,000 when the output
increases from 1,000 units to 1,100 units; solve for the firm’s marginal
cost.