THEORY OF THE FIRM:

PRODUCTION, COSTS AND PROFITS

PRODUCTION
3.1 THE PRODUCTION
CONCEPT
 Production is the process of transforming two
(2) or more inputs into one (1) or more product
or output.
 also called the creation of utility.
 Production inputs/factors of production include:

land, labor, capital and entrepreneurship which

also
 fixed factor vs. variable factor
PRODUCTION PROCESS

PRODUCTION PRODUCTIO PRODUCTION

INPUTS N PROCESS OUTPUTS

Finished
Manufacturing
LAND Products
Assembly
LABOR Semi-
Processing
CAPITAL processed
Service
MANAGEMENT products
Operation
Services
PRODUCTION PROCESS…
 Manufacturing – production activity where
raw materials are transformed into finished
products.
 Assembly- refers to the making of semi-
processed products into finished products.
 Processing –refers to the transformation of
raw materials or other semi-processed items
into other semi-processed products.
PLANNING PERIODS IN PRODUCTION
 Planning Period – refer to the circumstances
surrounding the production process and resource
utilization and technology.
A. Short run(SR)- this period refers to a production
environment which is short enough to allow variability
and flexibility in resource utilization and technology.
 the use of at least one input or resource cannot be
changed. Ex. land
B. Long run(LR)- It is the planning period long enough to
allow the producer to vary all the resources either in
quantity or quality as desired.
FIXED VS. VARIABLE INPUTS

A.) Fixed input- refers to an input, the

quantity of which does not vary with the
level of output.
Ex. Land area, tools and Equipment

B.) Variable input- It is also an input, the

quantity of which varies with the level of
output.
 3.2 THE PRODUCTION FUNCTION
 Production function deals with the physical relationship
between the output and the combination of different inputs
used in the production process at any given level of
technology per unit of time, leaving other inputs used
constant and prices of output and input aside.

 This relationship is always subject to the “Law of

Diminishing Marginal Productivity”
Q=f(L,/K,…N)
 Where: Q= output or total product
L= labor input
K= capital input
N = other inputs
f= function relating output and inputs
 USES OF PRODUCTION FUNCTION

 How to obtain Maximum output

 Helps the producers to determine
whether employing variable inputs /costs
are profitable
 Highly useful in longrun decisions
 Least cost combination of inputs and to
produce an output
 A. SHORT RUN PRODUCTION
FUNCTION
 The short run production production
assumes there is at least one fixed
factor input. Mathematically :
 Q = f ( K/L)
 Where:
 Q = output level
 K = Variable input
 L = fixed input
THE ELEMENTS OF THE PRODUCTION FUNCTION

A.) Total product (TP) or Q- the amount of

output produced over any given period of
time when the variable input is combine
with other fixed inputs.
Q = f (K/L)
 Reflects the efficiency of the fixed input.
ELEMENTS OF PRODUCTION FUNCTION
B.) Marginal product (MP) - measure of the increase
or decrease in the output that results from the use
of the additional unit of the variable input.

 MPP = change in output = ∆ Y

change in input ∆X

C.) Average Product (AP) - a variable input is a ratio of

the total product to the total amount of the variable
input used.
 APP = output = Y
input X
TABLE 8. HYPOTHETICAL PRODUCTION FUNCTION FOR
CORN
Bags of TPP APP MPP
Fertilizer
0 0 0 -
1 9 9 9
2 27 13.5 18
3 50 16.67 23
4 70 17.5 20
5 85 17 15
6 96 16 11
7 101 14.43 5
8 101 12.63 0
9 95 10.56 -6
10 85 8.5 -10
SHAPES OF TPP, APP, AND MPP CURVES
(THREE STAGES OF PRODUCTION )
 THE STAGES OF PRODUCTION AND
THEIR CHARACTERISTICS
 Stage I- goes from the origin to the point where
the APP is maximum.
 The total product curve is increasing as well as
the average and marginal product.
 The TPP is a reflection of the efficiency of the
fixed resource and the APP is a reflection of
the efficiency of the variable resources,
therefore we can say that in Stage I, both the
efficiency of the fixed and variable resources
are increasing. This implies that the use of
both resources yields increase in total output.
 THE STAGES OF PRODUCTION…
 Stage II- is characterized by the point where
the APP is maximum up to the point where
the MP is equal to zero.
 The APP is already declining in stage II but
the MPP is still positive which implies that
the use of the additional variable input is
still contributing to the total production of
firm.
 A rational decision maker continues to
increase the variable input used to attain
maximum output.
 THE STAGES OF PRODUCTION…
 Stage III- covers the range over which the
MPP is negative.
 It will be unwise for the firm to continue
producing in this stage because it could
decrease total output by using more of the
variable input.
 In stage III, both the efficiencies of the
fixed and the variable resources are
already declining which means that the
use of both should be stopped to minimize
losses.
 What is Inflection Point ?
 An inflection point is a point on the graph
of a function at which the concavity
changes. Points of inflection can occur
where the second derivative is zero.
 An Inflection Point is where a curve
changes from Concave
upward to Concave downward (or vice
versa) Concave upward is when the
slope increases:Concave downward is
when the slope decreases:
RELATIONSHIP OF APP,
TPP, AND MPP
 At the point where the MPP curve is
above APP curve, APP is increasing.
 MPP=APP, APP is at its highest point.
 MPP is less than the APP, APP is falling.
 When TPP is increasing at an increasing
rate, MPP and APP are increasing
 TPP is at its inflection point MPP is
maximum
 TPP is at its maximum, MPP is zero.
 TPP is falling, the MPP is negative or less
LAW OF DIMINISHING MARGINAL
PRODUCTIVITY OR LAW OF VARIABLE
PROPORTIONS
 states that “when the total output is
increased due to the use of additional
units of variable input while the
quantities of other inputs are held at a
fixed, the rate of increase in the total
output after some point will become
smaller and smaller”.
3.3 COST OF PRODUCTION
 Production Cost measures the
value of inputs used over a period of
time to produce goods and services.
 Economic Cost vs accounting Cost
ECONOMIC COST…
 Opportunity cost- is the cost concept relevant in
economic analysis. Opportunity cost is defined
as the value of the resource in its next best
alternative use.
 Explicit costs- are the actual costs incurred in
production of goods and services. These are the
considered as the “out of the pocket” or cash
expenses of the firm.
 Implicit costs- are those costs which are
incurred in production and which are part of the
self-employed, self-owned resources by the
firm.
SHORT RUN COSTS OF THE FIRM
 A.Variable costs – are the costs
incurred by the firm for all variable
inputs the value of which varies with
the level of output.

 B. Fixed costs- are the costs incurred

by the firm for all fixed inputs. The
value of these does not vary with the
level of output.
THE COSTS CURVES OF THE
FIRM
1. The total cost curves
A. Total variable costs (TVC)- total
obligations of the firm on all variable
inputs used in the production process.
B. Total fixed costs (TFC)- total
obligations of the firm for all fixed
inputs used in production.
C. Total costs (TC)- the sum of the total
variable costs and the total fixed costs.
TC=TVC+TFC
 TABLE 9. HYPOTHETICAL TOTAL COST
OF CORN PRODUCTION
Bags of fertilizer Output of corn Total fixed cost Total variable Total costs
cost
0 0 1000 0 1000
1 9 1000 600 1600
2 27 1000 1200 2200
3 50 1000 1800 2800
4 70 1000 2400 3400
5 85 1000 3000 4000
6 96 1000 3600 4600
7 101 1000 4200 5200
8 101 1000 4800 5800
9 95 1000 5600 6600
10 85 1000 6000 7000
2. THE PER UNIT COST CURVES
 A. Average variable cost (AVC)- is the ratio
of the total variable costs to the total
product. AVC=TVC/Q
B. Average fixed cost (AFC)- the ratio of the
total fixed cost to the total output.
AFC=TFC/Q
C. Marginal cost (MC)- refers to the
additional cost incurred by the firm for every
additional unit of output produced.
MC=ΔTC
ΔQ
RELATIONSHIP BETWEEN THE PRODUCTION
FUNCTIONS AND THE COST FUNCTIONS
 The production function when known can
be used along with fixed cost and input
price to derive all the cost functions. The
cost functions include both the production
function and the fixed and variable cost of
production.
 Cost curves usually are expressed that
output or yield is an independent variable.
3.4 PROFIT MAXIMIZATION/LOSS
MINIMIZATION: CASE OF PERFECT
COMPETITION
Characteristics of perfectly competitive market
(PCM) model: A review
 A.) Many small buyers and sellers, each one
buyer or seller cannot influence the market price;
thus the firm is a price taker.
 B.) There is free entry and exit in the industry.
 C.) Homogeneous product.
 D.) Perfect mobility of goods, services and
resources.
 E.) Perfect information or knowledge of the
market.
 PROFIT CAN BE VIEWED AS:
 Economic profit- is the excess of the total
revenue over all the costs of production
which include both the explicit and the
implicit costs of all other resources used
by the firm.
 Financial profit (Accountant’s point of
view) in gross income- total cash expenses.
APPROACHES IN PROFIT DETERMINATION AND
CONDITIONS FOR PROFIT MAXIMIZATION

 1. Total approach- the maximum profit is

determined by getting the maximum
positive difference between the total
revenue and the total costs.
Profit or π= TR-TC
 Where TR= price of good times the quantity
sold or TR=PxQ
TC=TFC+TVC
Hypothetical data of the firms total cost, total
revenue, and profit (Py=P100/unit, Px= P600/unit and
TFC = P1000)
Bags of Output of Total Total Cost Profit
Fertilizer corn (Y) Revenue (TC)
(X) (TR)
0 0 0 1000 -1000
1 9 900 1600 -700
2 27 2700 2200 500
3 50 5000 2800 2200
4 70 7000 3400 3600
5 85 8500 4000 4500
6 96 9600 4600 5000
7 101 10100 5200 4900
8 101 10100 5800 4300
9 95 9500 6400 3100
10 85 8500 7000 1500
RULE FOR PROFIT MAXIMIZATION:

 If TR>TC= the firm obtain

profit
 If TR<TC= the firm incurs a
loss
 If TR=TC= the firm
experiences break even
 2. Marginal approach- this approach uses the
concepts of marginal revenue (MR) and marginal
costs (MC). Profit is maximized when MR=MC. The
profit maximizing condition under this market is
P=MR=MC.

 Marginal revenue (MR)- refers to the additional

revenue or sales for every additional unit of good sold.
MR=ΔTR
ΔQ
 Marginal cost (MC)- as defined earlier;
MC=ΔTC
ΔQ