Production and

Cost

Production•Refers to any economic activity,which combines the four factorsof production to form an outputthat will give direct satisfactionto consumers

• The process of converting inputs into outputs

Categories of Inputs• Land (natural resources) includes

those above and under the earthlike forest products and mineralores.• Labor is the mental and physical

ability used in the production ofgoods and services.•Capital resources are the goods that

are used in the production of otherother goods and services likemachines, equipments, buildings,buildings, etc.

Short Run vs Long Run

•Short-run is the period of time so short thatthere is at least one fixed input thereforechanges in the output level must beaccomplished exclusively by changes in the useuse of variable outputs.•Long-run is a period of time so long that allinputs are considered variable.

The Production Function

•The functional relationship betweenquantities of inputs used in productionand outputs to be produced.

•In order to produce a t-shirt, itsproduction function may appear asfollows:

etc.) Buttons,Thread, Sewer, Machine,Sewing (Fabrics, fO shirtt

Production Concepts•Total Product refers to the total output

produced after utilizing the fixed andvariable inputs in the production process.process.

-Fixed inputs are components ofproduction which do not change,like machineries and equipment.-Variable inputs are the changeableresources in the production, such asraw materials and number oflaborers.

•Marginal Product of an input is the extraoutput produced by 1 additional unit ofof that input while other inputs are heldheld constant.

•Average Product equals total productdivided by total units of input used.

1ΔI

ΔTPMP

12

12

LL II

TPTPMP

1I

TPAP

Production Schedule of T-shirts

Input (Labor) TP MP AP

0 0

1 8

2 20

3 37

4 57

5 72

6 80

7 85

8 88

9 86

10 82

Production Schedule of T-shirtsInput (Labor) TP MP AP

0 0 0 0

1 8 8 8

2 20 12 10

3 37 17 12

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, Marginal, and Average Products

-20

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8 9 10

Series 1

Series 2

Series 3

Law of Diminishing Returns

The Law ofDiminishing Returnsholds that we will getless and less extraoutput when we addadditional doses of aninput while holdingother inputs fixed.

Increasing marginal returns happen whenthe marginal product of an additionalworker exceeds the marginal product ofof the previous worker.

Input (Labor) TP MP AP

1 8 8 8

2 20 12 10

3 37 17 12

4 57 20 14

5 72 15 14

Decreasing marginal returns occur whenthe marginal product of an additionalworker is less than the marginal productproduct of the previous worker hired to dodo the same task.

Input (Labor) TP MP AP

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

Returns to Scale

Constant returns toscale indicates acase where a changechange in all inputsinputs leads to aproportional changein output.

Increasing returns to scale (alsocalled economies of scale) happenhappen when an increase in allinputs leads to a more-than-proportional increase in the levellevel of output

Decreasing returns toscale occur when abalanced increase in allinputs leads to a less-than-proportionalincrease in total output.

The Firm’s GoalOf course, the basic goal of a firm is tomaximize its profit. A firm that doesnot seek to maximize profit is eithereliminated or absorbed by firms that doseek that goal.

Sales – Costs = ProfitOr

Total Revenue- Total Costs = ProfitTotal cost

refers to all expenses acquired during theeconomic activity or the production of goods orservices.

Total revenue is the amount received from the sale of the product.price of the output X Quantity sold

In 2010, the total revenue of your t- shirtscompany from the sale of souvenir shirts wasP150,000. Your firm paid P20,000 for fabric,P22,000 for wages of the sewers you hired, andP3,000 in interest to the bank from your loan. Theaccountant of your firm said that the depreciationof your firm’s sewing machines during the sameperiod was P10,000.

Profit = Total Revenue – Total Costs

= 150,000 – (20,000+ 22,000+ 3,000+10,000)

= 150,000 – 55,000

Profit = P95,000

Explicit costs are payments to non- ownersof a firm for their resources such as laborlabor or the use of a building.

Examples:- wages paid to labor- rental charges for a plant or office

building- the cost of electricity and phone

bills- the cost of raw materials

Implicit costs are the opportunity costs of using resources owned by the firm.firm.

Example:- Using a vacant room ofyour house to be youroffice you forego anopportunity of renting itout to others.

Fixed CostAlso called overhead or

supplementary cost, are those expensesare spent for the use of fixed factors ofproduction.

Fixed costs stay the same no matter how much changes.

Fixed costs are sometimes call sunkcosts because once we have obligatedourselves to pay them, that money hasbeen sunk into our business firm.

Variable CostVariable costs or prime or

operating costs are those expenseschange as a consequence of a changequantity of output produced.

In case of reduction in production,there should be a correspondingdecrease in variable costs to maintainproduction efficiency.

However, some costs can havea component or part that is fixedand part that is variable.

Two Basic Categories of Cost

1. Total Fixed Cost (TFC) - consists ofcost that do not vary as output variesand that must be paid even if output iszero. Even if a firm does not produce anyoutput, still it must pay rent, propertytaxes, etc.

2. Total Variable Cost (TVC) -consists of costs that are zero whenoutput is zero and vary as outputincreases (decreases)

Given total fixed cost and total variable cost, the firm can

calculate total cost (TC). Total the sum of total fixed cost and total variable cost at each level of output.

Thus,

TC = TFC + TVC

Average Fixed Cost

𝑨𝑭𝑪 =𝑭𝑪

𝑸

Average Variable Cost

𝑨𝑽𝑪 =𝑽𝑪

𝑸

Average Total Cost

𝑨𝑻𝑪 =𝑻𝑪

𝑸

or

𝑨𝑻𝑪 = 𝑨𝑭𝑪 + 𝑨𝑽𝑪

Marginal Cost

Marginal Cost (MC) is the cost of producingone additional unit of output. It is the changechange in total cost when one additional unitunit of output is produced.

Equation

𝑴𝑪 =∆𝑻𝑪

∆𝑸

or

𝑴𝑪 =∆𝑻𝑽𝑪

∆𝑸

Short Run Cost ScheduleQ FC VC TC MC AFC AVC ATC

0 100 0 100 - - - -

1 100 40

2 100 78

3 100 90

4 100 211

5 100 248

6 100 300

7 100 260

8 100 355

Q FC VC TC MC AFC AVC ATC

0 100 0 100 - - - -

1 100 40 140 40 100 40 140

2 100 78 178 38 50 39 89

3 100 90 190 12 33 30 63

4 100 111 211 21 25 28 53

5 100 148 248 37 20 30 50

6 100 200 300 52 17 33 50

7 100 260 360 60 14 37 51

8 100 355 454 94 13 13 26

Relationship of TVC and TFC

0

50

100

150

200

250

300

350

400

450

500

1 2 3 4 5 6 7 8 9

FC VC TC

Relationship of MC to AFC, AVC, & ATC

0

20

40

60

80

100

120

140

160

1 2 3 4 5 6 7 8

MC AFC AVC ATC

In summary, in the short run a firm hastwo options: operate or shut down. Itoperates when total revenue exceeds variablecosts. But when variable costs are greaterthan total revenue, it shuts down.