NOTRE DAME OF SALAMAN COLLEGE

Founded in 1965 by the Oblates

Owned by the Archdiocese of Cotabato
Managed by the Diocesan Clergy of Cotabato (DCC)

“Service for the Love of God through Mary”

(B.E.S.T)

MICROECONOMICS
BSBA 2 (2nd Semester)
Instructress: Ms. ARCHIE MAE QUINTO
Week5-Week 8
Chapter 4: THEORY OF CONSUMPTION
Objectives
At the end of the chapter, the student is expected to:
 Identify the different factors that affect utility and consumption behavior;
 Explain Maslow’s Hierarchy of Needs;
 Distinguish the relationship of income to substitution effects;
 Plot using the graph indifference curve with given data on food and clothing consumption; and
 Construct a table using own hierarchy of budget schedule and illustrate it via graph.
Terms to Remember
Budget line – contains infinite points of combinations of commodity items that the same budget can buy at given price
Convergence – often referred to as “catch-up effect” in economics
Income effect – potential increase in the consumption of two commodities
Indifference curve -a useful tool for analyzing consumption behavior on utility theory
Isocost line – shows all combinations of inputs, which cost the same total amount
Marginal rate of substitution (MRS)-rate at which a consumer is ready to give up one good in exchange for another good
while maintaining the same level of utility
Marginal utility (MU)-additional satisfaction derived from consumption of additional goods and services; also defined as
the utility or dissatisfaction from the last unit of consumption
Maslow’s Theory of Motivation – diagram that explains why people are driven by particular needs at particular times
Optimum combination – implies that a consumer can increase the level of satisfaction, despite a fixed income, by altering
the consumption mix
Paradox value – discusses why absolute necessities in life (1.e., water) are cheaper as compared to luxuries in life (i.e.,
diamonds)
Reference groups - groups that have a direct or indirect influence on person’s attitudes or behaviors
Substitution effect – an idea that when price increases or income decreases, consumers will replace expensive items with
cheaper alternatives
Total utility (TU) – total amount of satisfaction derived from consuming foods and services
Utility – satisfaction derived from the consumption of a commodity
Introduction
This chapter revolves around the fundamental concept of utility or satisfaction to explain consumption and demand
behavior in the short term. Graphs and tables lend support as tools of understanding and analysis. In addition, the chapter
illustrates the simple dynamics of these tools which can serve as a starting point in understanding long-term consumption
behavior.
UTILITY AND BEHAVIORAL FACTORS
Utility is defined as the satisfaction derived from the consumption of a commodity which determines consumption and
demand behavior. As such, it is the foundation of consumer’s behavior.
Figure 24 presents the underlying cultural, social, personal, and psychological factors that affect utility and consumption
behavior. Inter-factor combinations filter different patterns of consumption behavior down the line. Different consumption
behaviors can stem from, say, variations within the cultural structure in combination with the cross sections of the other
interlocking structures. In addition, the psychological factors reflect Maslow’s Hierarchy of Needs as influenced by the
said inter-factor combinations.

Figure 24: Model of Factors Influencing Behavior

Cultural Factors
Cultural factors exert the broadest and deepest influence on consumer behavior. Culture is one of the most fundamental
determinants of a person’s wants and behaviors while lower creatures are largely governed by instinct, human behavior is
generally learned. A child growing up in society learns basic set of values, perceptions, preferences, and behaviors
through the process of socialization involving the family and other key institutions.
For example, some people have preference for the music of Bach or Mozart, while others would go crazy for Justin
Bieber; toilet paper may be a common thing for the urban dwellers but could be a rare commodity for the people who live
in the mountain.
Social Factors
A consumer’s behavior is also influenced by social factors such as the consumer’s reference groups, family, and social
roles and statuses.
Reference groups are those groups that have a direct or indirect influence on person’s attitudes or behaviors. A teenager
may buy shoes that are in accordance to the taste of his peer group, while a more matured person would prefer more
durable or conservative shoes.
Personal Factors
Buyer’s decisions are also influenced by personal outward characteristics such as the buyer’s age and life cycle,
occupation, economic circumstances, lifestyle, personality, and self-concept.

Figure 25: Maslow’s Hierarchy of Needs

Psychological Factors
Person’s purchases are also influenced by psychological factors: motivation, perception, learning, beliefs, and attitudes.
Maslow’s Theory of Motivation. Abraham Maslow sought to explain why people are driven by particular needs at
particular times. Maslow’s hierarchy of needs consist the biological needs, safety needs, social needs, esteem needs, and
self-actualization.
Perception can be defined as the process by which an individual selects, organizes, and interprets information to create
meaningful picture of the world. Learning, on the other hand, describes changes in an individual’s behavior arising from
experience.
A belief is a descriptive thought that a person holds about something, while an attitude describes a person’s enduring
favorable and unfavorable cognitive evaluations, emotional feelings, and action tendencies toward some object or ideas.
To sum up, a consumer will buy a particular product, given an optimum budget, if he thinks and believes that this product
will give him the best value or utility.

THE UTILITY FUNCTION

Utility is the technical term for satisfaction. There is a functional relationship between utility and consumption as the need
for the latter arises.
Total utility (TU) – the total amount of satisfaction derived from consuming foods and services.
Marginal utility (MU) – the additional satisfaction derived from consumption of additional goods and services.
This functional relationship assumes two forms and is quantitatively defined as follows:

TU (Total Utility) = Function of Q (Consumption)

MU = Λ (TU) (Satisfaction from an additional unit of consumption)
ΛQ
Where:
Λ = change
Table 9
Utility Schedule
Consumption Total Utility Marginal Utility
1 7 7
2 13 6
3 18 5
4 22 4
5 25 3
6 27 2
7 28 1
8 28 0
9 27 1
10 25 -2
11 22 -3
12 18 -4
13 13 -5
14 7 -6
15 0 -7

CONSUMPTON
The Indifference Curve
The indifference curve, together with the Isocost in the next section, is a useful tool for analyzing consumption behavior
on the utility theory. An indifference curve contains varying combinations in the consumption of commodities that yield
the same level of total utility. It illustrates this property by assuming two commodity items, which are shown in Table 10
and Figure 27 for food and clothing.
The points along the indifference curve correspond to the different combinations of consumption of food and clothing that
yield the same level of their aggregate utility: between any points to another along the curve, an inverse relationship exists
between the commodity units, inasmuch as the utility foregone by consuming less of one is regained by consuming more
of the other. It is the equality between utility gained and utility foregone that holds the total utility level from both
commodity items constant.
Between any two points along the indifference curve, the ratio between utility gained and utility foregone is always equal
to 1 and therefore constant. However, this 1s not true for the corresponding substitution between the commodity items.
The marginal rate of substitution (MRS) of food (Y-axis) to clothing (X-axis) in Table 10 is measured as follows, which is
simply how much food one has to give up to consume an additional unit of clothing:
MRS =ΛFood Consumption
ΛClothing Consumption
Where:
Λ = change
Food Consumption Clothing Consumption Marginal Rate of
Substitution
56 1 -
46 2 (10)
37 3 (9)
29 4 (8)
22 5 (7)
16 6 (6)
11 7 (5)
8 8 (4)
5 9 (3)
3 10 (2)
2 11 (1)
Assume a continuous increase in clothing consumption and a decrease in food consumption. The MU of Clothing (ΛUtil)
while decreases its marginal consumption or reciprocal (ΛConsumption ) increases due to the Law of Diminishing
Returns. On the other hand, the MU of food consumption increases while the reciprocal decreases due to the opposite
influence of this law as consumption declines. Therefore, for every unit of utility foregone and then regained by
continuously decreasing food consumption and increasing clothing consumption, respectively, the following relationship
should hold true:
more positive (ΛClothing consumption is increasing)
less negative (ΛFood consumption is decreasing)

Therefore:
(MRS)= (ΛFood)
(ΛClothing)
Table 10 and Figure 27 illustrate the foregoing relationship through the slope of the indifference curve. The change in
food consumption diminishes for every additional unit of clothing consumed.

The Law of Diminishing Marginal Utility and the Shape of the Curve
The shape of the indifference curve is convex to the graph’s point of origin due to The Law of Diminishing Returns. To
maintain overall satisfaction, one only has to give up less of a good with an increasing marginal utility (MU) to be
regained by more consumption of another with a decreasing MU.
Hierarchy of Indifference Curves
As already mentioned, an indifference curve corresponds to a certain level of utility. Therefore, changing the consumption
levels of commodities at every point of combination along the curve leads to another indifference curve and utility level.
There is a hierarchy consisting of infinite indifference curves as there are infinite levels of utility.
In Figure 28, all points from curve I1 rise to curve I2 as the consumption levels of food and clothing increase, and the
opposite is true with a downward shift in the curve. The shift in the indifference curve follows the direction of the upward
sloping line from the point of origin of the graph indicating the consistency of varying the quantity levels of both
commodity items for all the points of combination along the curve. Hence, no curve intersects another curve. Moreover,
an indifference curve can be drawn from any point on the graph as there are infinite levels of utility.
However, it should be noted that the level of consumption and corresponding indifference curve vary in direct proportion
with the level of utility only up to a certain extent. Beyond this limit, the utility level declines despite the increase of
overall consumption and a higher indifference curve due to the Law of Diminishing Marginal Utility.

The Budget Line and the Optimum Combination

What is the optimum or best combination of consumption of the commodities within a budgetary limit? The answer to this
question lies in the relationship between the indifference curve which represents what the consumer likes, and the budget
line which limits affordability.
The Budget Line
A budget line contains infinite points of combinations of the commodity items that the same budget can buy at given
prices. The aforementioned statement is quantitatively expressed as follows, assuming food and clothing as the
commodities being purchased:
B = (Pf) (Qr) + (Pc) (Qc)
Max Qf =B maximum for f (food)
Max Qc = B maximum for c (clothing)
Where:
B = given budget
Qr = quantity of food
Qc = quantity of clothing
Thus, budget (B) is the total expenditure per food (f) and clothing (c).
An inversely proportional relationship exists between the two commodities along the budget line given the budget and
prices as constant. Figure 29 and Table 11 present a hierarchy of budget items where a directly proportional relationship
exists between the levels of the budget line and the overall purchase quantities of the commodity items. The point along
every budget line that coincides with the straight line drawn from the point of origin of the graph represents the same ratio
of combination between the commodity units as Table 11 also illustrates. The difference between these points lies in the
purchase quantities of the budget the lines. Thus, a bigger budget leads to a greater purchasing power and a higher budget
line.

Budget = P500 Budget = P1, 000 Budget = P1, 500

Food Clothing Food Food Clothing
10 0 20 0 40 0
8 1 16 2 32 4
* * *
6 2 12 4 24 8
4 3 8 6 16 12
2 4 4 8 8 16
0 5 0 10 0 20
*Price of Food = P50
*Price of Clothing = P100
*Rate of Substitution of Food to Clothing = 2
Finally, the budget lines have two important properties. One property is the constant rate of substitution between the
commodity variables from any point to another along the budget line. The marginal rate of substitution (MRS) assuming
the examples given, is measured in absolute terms (i.e., disregarding the negative sign) as follows:
Note: The percentage change in the budget is the same as the corresponding change in the quantity of each commodity for
the same combination. For example, a ratio of combination equals to 3 (see figures with asterisk) yields 6 units of food
and 2 units of clothing when the budget is P500. They increase by 100% to 12 units and 4 units, respectively, when the
budget likewise increases by 100% to P1, 000.

MRS = ΛFood Units Purchased

ΛClothing Units Purchased

The ratio is simply how much of the food purchase one has to give up to buy an additional unit of clothing. This
additional unit entails an additional expenditure equal to its price, which is shifted from the expenditure for food. The
consumption of food foregone in shifting this amount to buy an additional unit of clothing is the alternative meaning of
the said rate of substitution and is expressed as follows:
MRS= Price of Clothing
Price of Food
Since these prices are constant, the aforementioned ratio and hence the marginal rate of substitution (MRS) between the
commodities are likewise constant at any point of combination along the budget line. In Table 11, the marginal rate of
substitution of food to clothing is equal to 2.
The other property exhibits the budget lines as parallel to one another in the hierarchy. Any budget line, which
corresponds to a budget level, exhibits the same marginal rate of substitution (MRS) between the commodities as long as
their prices and hence their price ratios are constant. This consistency should therefore bring the budget lines as parallel to
one another in the hierarchy where their levels vary in direct proportion to the size of the budget.
The Optimum Combination
The quantities of the commodities at any point along a budget line indicate purchasing capacity. This point, together with
the said purchase quantities, coincides with that of an indifference curve and hence meets the latter’s budget requirement.
Simply put, the consumer can afford to have that much satisfaction.
Figure 30 shows three of the infinite indifference curves that are strategically within the purchasing power of the budget
line.

B. Indifference curve I, is attainable at either points of intersection (B and C) with the budget line as on any curve I3. On
the other hand, I3 is attainable at the point where it is tangent to the budget line (point A). Furthermore, no indifference
curve about I3 is attainable with the same budget in the absence of any point of coincidence.
The question now is, “Which of the points along the budget line corresponds to an indifference curve that yields the
maximum satisfaction?” The budget yields the maximum level of satisfaction at the point where it is tangent (point A) to
indifference curve l3. This is the highest indifference curve corresponding to the highest level of satisfaction that the
budget can afford.
The concept of optimum combination implies that a consumer can increase the level of satisfaction, despite a fixed
income, by altering the consumption mix. For example, consumers minimize their consumption of luxurious items in
favor of the more basic ones during an economic crisis. This is inasmuch as the utility gained by consuming more of the
latter outweighs the former, thus minimizing the decrease in real income and the level of satisfaction. Furthermore, the
aforementioned concept also helps make correct social decisions. For example, a government project may be better off
than generating income and employment among the lower income groups as it contributes to a better mix of social
benefits. This is inasmuch as every peso of income generates greater marginal satisfaction among the lower income
groups, thus increasing aggregate welfare.
DYNAMICS
The world is not static and so is consumption which can change due to the consumer or the goods themselves.
Prices can change to make goods relatively cheap or costly. Figure 31 shows that the budget line B, is relatively steep as
the same budget can now buy more of cheaper food but less of more costly clothing (higher marginal rate of substitution
or MRS) from the initial consumption mix at point A along budget line B. The consumer then adjusts to point B to
maximize satisfaction by buying what is cheaper in exchange for what is more costly. Originally, consuming less food and
more clothing at point A is now beyond the budget B,. The consumer is worse off either as the same budget can only buy
less of more costly clothes if only to maintain the food consumption at point A.
Relative preference can also change the consumption mix as Figure 32 illustrates.
Indifference curve (I2) is now steep relative to I1 as the consumer shifts preference from food to clothing. The MRS of I 2 is
higher as the consumer is now willing to give up more food in exchange for clothing which has become more valuable.
This change of relative preference can happen in the real world when corporate advertising deceives consumers with new
designs that appeal to vanity. Thus, the consumer adjusts to point B to buy more of additionally more satisfying clothing
in exchange for food.

Every additional peso spent should yield the highest marginal utility possible. It therefore follows that the consumer tends
to spend more on the commodity that gives this advantage. If this commodity is sugar, the consumer spends more for it
but only up to the point where the utility gained from the last peso spent is exactly the same as in any other commodity.
This equality is inevitable since the marginal utility of sugar should decline as more of it is consumed. The same process
continues up to the last peso of the budget with the other commodities having their turns in yielding the said utility
advantage for marginal spending.
A condition where the utility gained from the last peso spent on each commodity is not the same as in any other
commodity reflects the aforementioned process. Assume an inequality where the marginal utility of sugar is less than that
of butter. The consumer can increase his level of satisfaction by consuming more butter and less sugar as the utility gained
from the former outweighs the utility foregone from the latter. The net effect, of course, is a net increase in satisfaction
but the process of trading off sugar for more butter stops at the point where the marginal utility from the last peso spent on
one is the same as on the other. This is inasmuch as the utility gained for butter declines as more of it is consumed, while
the utility foregone for sugar increases as less of it is consumed.
The ultimate result is a condition of equality and maximum satisfaction where the utility gained or marginal utility from
the last peso spent on one commodity is the same as in any other commodity. This can be restated quantitatively as
follows:
MU of Commodity Y = MU of Commodity X
Price of Commodity Y Price of Commodity X

This is the optimum condition at the equilibrium point of the indifference curve and the budget line where their marginal
rates of substitution (MRS) are equal. Along a budget line, how much the consumer additionally spends on one good is
alternatively the same as the other, given a fixed budget. Along an indifference curve, the utility gained by consuming
more of one good equals utility foregone by consuming less of the other. It follows that the additional peso spent on one
yields the same utility as the other.
Furthermore, the principle can be a tool to explain shifts in consumption mix due to changes in relative prices and
preferences as can be seen in Figure 31 and Figure 32.The consumer in Figure 31 additionally spends more on cheaper
food with more purchasing power in exchange for more costly clothing (points A to B) to create a net increase in
satisfaction. Likewise, the consumer additionally spends on products that are more satisfying than the others. But
substitution is not indefinite and only up to the equimarginal condition due to the Law of Diminishing Returns. Going
beyond this optimum point makes additional spending on the same products now less satisfying than the others, making
the consumer worse off.
INCOME AND SUBSTITUTION EFFECTS
How does consumer equilibrium change with the price of a commodity item? Assume two close substitutes such as Coke
and Pepsi where the price of the latter is assumed to decrease. With the change in price, Coke shares in the potential
increase in the consumption of Pepsi. The potential increase in the consumption of both commodities, if realized, is called
income effect. However, the consumer is not only content to realize this effect as the new condition allows optimization
by substituting more Pepsi for Coke. This potential substitution, if realized, is called substitution effect.

Substitution effect results in a net gain in satisfaction since an additional peso is better spent on cheaper and more units of
Pepsi instead of the more costly units of Coke. In particular, a decrease in the price of Pepsi means more consumption,
hence more satisfaction from every last peso spent in Pepsi. In effect, the marginal utility advantage of consuming more
Pepsi instead of Coke leads the consumers to substitute the former for latter until the equi-marginal condition is fully met.

UTILITY AND DEMAND

Derivation of the Demand Curve
There is a potential consumption for a certain commodity item given its market price and the income of its potential
consumers. This potential consumption is also called demand which is the quantity that the consumers are willing to buy.
Moreover, as to how much of the given income is allocated for the product depends on the influences of the other non-
price factors of demand such as population, taste or preference, and speculation. Therefore, the potential demand for a
product at varying price levels and given a certain degree of influence of the non-price factors determines its demand
curve.
Consumer Surplus
The peso value that the consumer pays for a certain volume of a commodity is less than the peso value of the benefit from
its consumption. This means that the utility units foregone in paying for the commodity item is less than the utility units
gained from its consumption. The net benefit from the exchange is called consumer surplus or additional purchasing
power.

Consumer surplus is an indicator of social welfare and can help make correct social decisions. For example, a substantial
decrease in this surplus indicates the negative impact of an increase in price on consumers’ welfare. This price increase
leaves the consumer with more expenditure for the product, and consequently less surplus spending for other products.

The Paradox Value

The paradox value is the answer to the question that troubled Adam Smith in the 18 th century, whose book, “The Wealth
of Nation,” marked the beginning of Modern Economics. The question is, “How is it that water, which is so useful, that
life is impossible without it, has such a low price, while diamonds which are not quite necessary have such a high price?”
The answer to this question lies in the equilibrium theory of supply and demand, as well as the theory of marginal utility.
Despite its importance, the price of water 18 low as consumers are only willing to pay less for its abundance and low level
of marginal utility. However, the opposite is true for diamond which is scarce. The foregoing leads to the distinction
between Value Use and Value in Exchange. In the words of Paul Samuelson, a noted educator in Modern Economics,
“The total utility of water does not determine its price or demand.
 Chapter 5: THEORY OF PRODUCTION
Objectives
At the end of the chapter, the student is expected to:
 Describe the concept of Law of Diminishing Returns;
 2. Explain ways to improve production;
 3. Show how productivity is measured via formula,
 4. Construct own graph for Production Function using data given on Table 13, and
 5. Point out successful business in the Philippines that uses resource efficiency.
Terms to Remember
Economic efficiency-profitable improvement in overall resource efficiency
Isocost curve – defines the cost and budgetary limits of production
Isoquant- represents what can be produced; also known as product indifference curve
Isoquant-Isocost model – illustrates more dynamically how different plant sizes and resource combinations determine
different levels of resource efficiency and plant capacity
Marginal product – product due to the additional or last unit of the variable resource input
Marginal rate of substitution-defined as how much of one resource is given up in order to use an additional unit of the
other, given a fixed capacity
Production – basically means act of manufacturing a product
Productivity – the efficiency and therefore the power of inputs to produce
Resource mix or combination- defined as how much of one resource is used per unit of the other
Returns to scale – measure how output changes relatively to resource inputs in the long run and indicate how overall
resource efficiency changes with plant size

PRODUCTION FUNCTION
Plant size and the efficiency of its resources (land, labor, and capital) determine plant capacity (maximum output).
Resources are fixed in the short run, which is generally described as a period when conditions have not changed yet. But
as plant size and resource efficiency change in the long run, so is production capacity. In addition, material inputs change
with output regardless of the time frame, i.e., within fixed or changing plant capacity.
Description
Alternative plant sizes and resource combinations (choices) determine different levels of resource efficiency and
production capacities in the long run. The production function only illustrates one side of this combination but drives
home the fundamental concept of diminishing returns. As a practical model and tool of analysis, its one-variable-resource
assumption basically reflects on the dynamics of a multi-resource condition.
In particular, the production function in Table 12 and Figure 37 illustrates how variations in a certain resource (e.g., labor)
change the total product (TP) or output, assuming the other resource (e.g., capital) to be fixed. Product or output is seen
from the point of view of the variable resource, which is labor in the example, though the virtual outcome of both
resources. The purpose is to show how alternative resource combinations alter resource efficiency and output.
In the same figure, the TP or output rises with more labor inputs in the first two stages but eventually declines in the last
stage. The marginal product influences this trend and is defined as the product due to the additional or last unit of the
variable resource input and measured as follows:
MP = ΛQ
ΛI
Where:
MP = Marginal Product or Output Qp = Total Product or Output
I = Resource Input A = Change
Table 12
Production Function
Labor (Man Total Marginal Product Average Product Stage
Hours) Product/Output (Units) (Units)
1 5 5 5 Stage 1
2 10 5 5
3 16 6 5.3
4 21 5 5.2 Stage 2
5 24 3 4.5
6 24 0 4
7 21 -3 3 Stage 3
8 16 -5 2
9 10 -6 1.1
10 5 -5 0.5
11 2 -3 0.2 Stage4
12 0 -2 0
For example in Table 12, the 2 nd unit of labor yields an additional output of 5, which is actually the MP of using 2 units of
the resources. In turn, this additional product (MP) increases TP from 5 to 10 because of that 2 nd or last unit of labor. But
the 7th unit of labor has a negative product or an MP of -3, which decreases TP from 24 to 21.
At Stage 1, every additional input of labor churns out a bigger chunk with a higher MP to accelerate the TP. At Stage 2,
additional input churns out a smaller chunk with a lower MP to still increase but decelerates TP. MP continues to decline
to negative levels at Stage 3 where additional labor input has negative returns and decreases TP.
Lastly, average product (AP) is output per unit of the variable resource input and measured as follows:
AP = Q
I
In Figure 37, AP follows the trend of MP following the law of averages. In other words, a change in MP causes the AP
ratio to change in the same direction. The decline in TP at the last stage obviously decreases AP but only to the level of
zero. There is no such thing as a negative output, although a negative MP simply means a decrease in output.
The Law of Diminishing Returns
The production function shows that stretching the use of variable resources against the limits of fixed resources decreases
additional product (MP). This is the Law of Diminishing Returns, which is basically due to the limits of a fixed plant size.
In Figure 37, the use of more labor inputs beyond Stage 1 strains the fixed input of capital and makes both resource
complements less efficient. Furthermore, having too much of one resource and too little of another can even result in a
resource imbalance that decreases production capacity with a negative MP at Stage 3.
Stretching resource use to the point of imbalance or overusing breeds counterproductive conditions which directly cause
diminishing or even negative returns. The saying, Too many cooks spoil the broth” applies to production.
Suppose you have a small party at home for which you hired a temporary cook in addition to your regular cook.
Obviously, two cooks are better than one which technically means that TP increases with more resource inputs. But more
cooks now begin to overuse the same kitchen facility and breed counterproductive conditions like confusion, delays, and
mishandling of utensils. As a result, the additional cook is not as efficient as the regular cook when the latter does the
regular kitchen chores alone. Technically, this means that the MP decreases despite the increase in TP. Neither is every
cook as efficient as any one of them when doing the regular kitchen chores alone with the decrease in their AP.
Finally, what would happen if nine additional cooks were hired for the party? Perhaps, the said counterproductive
conditions would be so impinging on work that no cook can do the job unless with a bigger kitchen facility. Technically,
this is the condition of Stage 3 where output decreases despite more resource inputs.
The Lessons of Diminishing Returns
The Law of Diminishing Returns has two important lessons. First, the size of a resource, given the rest as fixed, should
not go beyond its product-maximizing point. This means that the maximum labor inputs in Figure 37 should only
correspond to the end of Stage 2 where output is maximized to determine plant capacity. Beyond this stage, resource
imbalance and diminishing returns are at their worst as production capacity (maximum output) decreases with a bigger but
overtaxed plant.
Therefore, the other lesson is that plant capacity can only increase with more of all resources unless technology changes.
Figure 38 shows that all the points of TP the move upward and rightward to form the higher production function curve
TP2. As both capital and labor increase, so is plant capacity from points A and B. From these two lessons can be drawn
the third that resources are basically complementary. Differently put, a resource is as indispensable as any other in
production.
The Isoquant-Isocost Model
This model illustrates more dynamically how different plant sizes and resource combinations determine different levels of
resource efficiency and plant capacity. As a dynamic tool of analysis, it also factors in the cost and budgetary limits of
production.
THE ISOQUANT
Theoretically, there are infinite combinations of resource inputs which determine the same plant capacity (maximum
output).In a two-variable resource system, these combinations form the product indifference curve or isoquant. Figure 39
and Table 13 present an isoquant with capital and labor as resource inputs. Between one point and another along the
curve, an inverse relationship exists between one resource and the other as the capacity foregone, by using less of one, is
regained by using more of the other (see arrows). It is the equality between capacity foregone and gained that holds
production capacity constant regardless of resource combination.
But resource input foregone is not necessarily equal to resource input gained to maintain plant capacity and their rates of
substitution are not even constant along the curve. Their marginal rates of substitution (MRS) are defined as how much of
one resource is given up in order to use an additional unit of the other, given a fixed capacity. To use the isoquant in
Figure 39, the MRS of capital (K) to labor (L) is measured as follows:
MRS = ΛY axis
ΛX axis
MRS = ΛK
ΛL
Where additionally:
Λ = Change

Table 13 shows that less and less of capital inputs (K) are given up in order to use an additional unit of labor L) as MRS
decreases down the line. In Figure 39, the shortening length of the downward pointing arrows represents K given up,
while the rightward pointing arrows represent additional1 L used. Thus, the shortening vertical arrow decreases its ratio to
the horizontal arrow, which is actually the trend of the MRS as L substitutes K. In addition, this trend shapes the isoquant
as convex to the graph’s point of origin.
The lsoquant and Diminishing Returns
The Law of Diminishing Returns influences the behavior of the marginal rate off substitution (MRS) as the latter shapes
the isoquant.
In the same example below, marginal product of labor decreases from more use, while that of capital increases from less
use with the opposite effect of diminishing returns. It follows that more labor inputs (L) are needed to produce an
additional unit of outputs as the inverse of its marginal product increases. But less capital inputs (K) are only given up to
reduce output by the same unit as the inverse of its marginal product decreases. To go back to their MRS formula, more
and more labor
Is used (ΛL) to regain the same output foregone by giving up less and less of capital inputs (ΛK). Thus, the MRS ratio
decreases as labor is substituted for capital. Clearly, less capital is given up in exchange for more and more of labor as the
former becomes more efficient from less use while the latter becomes less efficient from more use. To stress the point, an
efficient resource cannot be given up in exchange for an inefficient one to maintain output.
Table 13
Isoquant
Labor Input Capital Input Marginal Rate of Substitution
Λ Capital/ ΛLabor
1 30 -
2 26 4
3 22.5 3.5
4 10.5 3
5 17 2.5
6 15 2
7 13 1.5
8 12 1
9 12 0.5
10 12 0

Hierarchy of lsoquants
A hierarchy of isoquants is an array of isoquants which corresponds to different levels of resource inputs and plant
capacity.
In Figure 40, all the points of Q move upward to form the higher isoquant Q2 as more capital and labor combined increase
plant capacity. This overall change is actually the upward and rightward shifts in the production function curve in Figure
40 where all resources increase plant size and capacity.
In addition, there is an infinite number of isoquants as there are infinite levels of plant capacity in the hierarchy. This
means that any point in the graph is a resource combination of an isoquant. The isoquants shown in the graph are just two
of the infinite numbers in the hierarchy.

Again, the assumption of infinity serves to highlight relevant tendencies in reality. For example, technological research
can explore the possibility of designing a plan that is neither too small nor too big for a certain market size.
The Isocost Curve and Its Hierarchy
Theoretically, there are infinite combinations of production resources that a given budget can buy. In a two-variable
resource system, these combinations form the isocost curve. Figure 41 based on 7able 14 illustrates the isocost curve with
capital and labor as resource inputs. Between one point and another along the curve, one resource is given up in exchange
for the other because of a fixed budget.
The same figure and table show that each budget is split between the resources at varying purchase combinations. But as
resource prices and their ratio are constant, so is the marginal rate of substitution down the curve. Marginal rate of
substitution (MRS) is defined as how much of one resource should be given up in order to buy an additional unit of the
other, given a fixed budget. The MRS of capital (K) to labor (L) in the example is computed as follows:
MRS = ΛY axis
ΛX axis
MRS = ΛK
ΛL
Alternatively, the MRS of capital to labor is equal to the inverse of its given price ratio. Given a fixed budget, the cost
(price) of buying an additional unit of labor (L) is the capital input (K) given up for the price of labor. Thus, MRS is the
capital input (K) that the price of a unit of labor (L) could otherwise buy or: Price of L
Price of K
Likewise, there is a hierarchy of isocost curves which corresponds to different budget and cost levels. Table 14 shows that
the purchase of both capital and labor increases proportionally with the budget for every combination. Therefore, a bigger
budget forms a higher isocost curve in Figure 41 but with the same marginal rate of substitution (MRS) because of
constant prices and their ratio. Rather, volume and cost spell the difference between the isocost curves in the hierarchy.
Lastly, there is also an infinite number of isocost curves as there are infinite budget levels in the hierarchy. As in the
isoquant map, any point in the graph is a purchase combination of resource inputs of a budget and its isocost curve. The
curves in Figure 41 are among the infinite number in the hierarchy.
The Isoquant-Isocost Combination
The isoquant curve represents what can be produced, while the isocost curve defines the cost and budgetary limits of
production. The optimum resource combination for a given plant capacity is a least-cost condition.
Table 14
Isocost and Its Hierarchy
Budget = P10, 000 Budget = P20, 000
Capital Labor Capital Labor
5 0 10 0
4 4 8 8
3 8 6 16
2 12 4 24
1 16 2 32
0 20 0 40
Price of Capital = P2, 000
Price of Labor = P500
Marginal Rate of Substitution (Capital/Labor) = 0.25

In Figure 42, the budget of the isocost curve B 2 meets an alternative resource need of isoquant Qi at point B or C or
where the two curves meet. In other words, a budget can purchase a certain resource combination to build up a certain
plant capacity. Since the number of intersecting isocost curves is infinite, different resource combinations along isoquant
Q1 require different budget use of more capital and leas labor at point B should correspond to a lower isoquant and
production level because of the underlying Law of Diminishing Returns. From the equi-marginal condition at point A, a
higher marginal product (MP) is given up from less use of labor in exchange for a lower one from more use of capital at
point B. The result is a net decrease in production as labor becomes more efficient relative to capital. To go back to the
Law of Diminishing Returns, more use of capital from point A goes beyond the limits of a fixed labor input and makes
both resources inefficient as they complement each other. The result is Stage 3 of the production function where output
decreases despite more resource inputs because of diminishing returns.
Change in Resource Mix
Resource mix or combination is defined as how much of one resource is used per unit of the other. Optimum combination
changes with relative resource price and efficiency.
Figure 43 illustrates how a variation in relative resource prices can change the optimum resource combination from point
A. The isocost curve becomes steeper from B 1 to B2 as labor becomes more costly while capital cheapens. Initially, output
decreases because only less of more costly labor inputs can complement the same capital inputs with the same budget. In
the figure, point A is beyond budget B2. But finally, the same budget buys more of cheaper capital instead of more costly
labor to maintain output with the new optimum combination at point B. Any other combination along B2 corresponds to a
lower isoquant and creates a resource imbalance that diminishes returns and decreases production.

On the other hand, Figure 44 illustrates how a variation in relative resource efficiency can also change the optimum
resource combination. The new isoquant Q tends to be flat as less of more efficient capital inputs can only be given up in
exchange for more of less efficient labor lower MRS). Maintaining resource combination with more or less efficient labor
at point A now corresponds to a lower output level. An isoquant through point A is lower than Q 2 which is the new Q1
with more efficient capital on inputs. The new optimum combination is at point B where the same budget buys more of
more efficient capital instead of less efficient labor to maximize output.
In conclusion, optimum resource combination favors the use of cheaper and more efficient inputs to maximize production.
This explains why industrialized countries use capital-intensive technology to solve their problem of scarce and expensive
labor resources. The same principle explains why developing countries use labor-intensive technology to take comparative
advantage of their abundant and cheap labor.
PRODUCTIVITY
This section discusses the dynamics of resource efficiency as it affects production. Succeeding chapters will also highlight
its impact on firm’s competitiveness and survival.
Concepts
Productivity is the efficiency and therefore the power of inputs to produce. This section confines discussions to resource
inputs which are basic to production. Productivity is measured as output per unit of input which is illustrated below.
Productivity = Q
I
Where:
Q = Output
I = Input
The foregoing, which is average productivity, is the efficiency of inputs taken as a whole and is measured as their average
output (as in the above formula). On the other hand, marginal productivity is the efficiency of additional inputs and it is
measured as their marginal output which is also illustrated below.
Marginal Productivity= ΛQ
ΛL
Where additionally:
Λ = Change
In the production function in Figure 37, the average product (AP) of labor measures its average efficiency, while marginal
product (MP) measures its marginal efficiency.
Advantages
Productivity improvement means more output per unit of input as the increase in the efficiency ratio indicates. It also
means less input for output as the decrease in the ratio’s inverse indicates.
Therefore, efficiency is not a matter of size. A bigger plant is not necessarily more efficient than its smaller counterparts.
To use a simple analogy, a class may best the rest in a school fund drive by the sheer number of soliciting members. But
the most efficient class has the biggest amount solicited by every member which reflects on individual initiative.
However, productivity is not an end but a means to compete and survive in the free market. In Figure 37, plant use is most
efficient at the turning points of the MP and AP curves, 1.e., before diminishing returns. However, the limited output at
these points does not necessarily make production more competitive and profitable. Instead, an overall improvement in
resource efficiency is economically viable but only when additional output is also more than proportionate to the
additional cost of efficiency. Overall, efficiency improvement shifts the TP, MP, and AP curves upward in Figure 37. If
economically viable, the said improvement does not only increase scale but also reduces unit cost to improve
competitiveness and profit.
The profitable improvement in overall resource efficiency in the foregoing is categorized as an increase in economic
efficiency. This form of efficiency is measured as output per monetary unit of input with the latter expressed as monetary
cost in the basic productivity ratio. Therefore, economic efficiency balances or reconciles the effects of two other types of
productivity. Technical efficiency capitalizes on the output, while cost efficiency gives emphasis to the cost of inputs.
Usually, output and cost are conflicting to attain economic efficiency. Thus, the technical efficiency of a machine is not
necessarily profitable if it is too costly. To strike a balance, 1t8 additional monetary returns should outstrip its cost.
However, technological advancement can optimize both output and cost to readily fit the picture of economic efficiency.
For example, computers have become more powerful and cheaper to do more work at lower cost.
RELATIVE RESOURCE EFFICIENCY
Production resources are complementary not only in function but also in efficiency. A better machine also enables its
operator to work faster or the other way around. Resources do not become more internally efficient at the same time, but
every improvement contributes to the overall productivity picture.
In addition, the time lag between productivity improvements can alter the optimum combination of resources. For
example, replacing old machines with modern and more efficient ones improves work and shifts the TP, AP, and MP
upward. But plant expansion (long run) favors the use of more efficient capital than less efficient labor. The shift is
economically efficient since every peso of labor given up, which is additionally spent for capital, yields a net increase in
output.
Basic Ways to Improve Resource Efficiency
How much a plant overall efficiency can be improved to increase output depends on the amount of wasted resources and
time that could otherwise be used productively. But to reiterate, technical efficiency is only economically viable when it is
also profitable,1e., its returns outweigh the cost of efficiency.
One way to improve the plants over a resource efficiency or productivity is to change the nature of the resource through
innovation. One example is work specialization, which concentrates on job requirements instead of diffusing efficiency.
Thus, worker in a car assembly plant does more tightening bolts than with other jobs like mounting wheels. Another
example is the advancement in hardware technology for the electronic information industry. Hardware such as computers
has become cheaper and more powerful as more intelligence substitutes physical mass or matter. Smaller and cheaper
microchips can now do more work at lower cost because of the wonders of human intelligence. In both examples, the
same resources have more power to produce because of internal efficiency.
Another way to improve resource efficiency is to change the external condition of resources such as the organization of
work. A simple example is increasing the number of customers served in a drug retail outlet by temporarily reassigning
resources to augment the sales group during peak hours. This set-up minimizes imbalances in work distribution and labor
idle time.
Another external change that can improve resource efficiency is a more balanced resource combination. Increasing the
size of constraining resources also makes the constrained resources more efficient and minimizes diminishing returns. For
example, investment in an irrigation system (capital) enables the rice farmer to plant and harvest three times a year with
the same land area. But without irrigation, capital is at a minimum and land is only productive once a year.
Still another way to improve plant overall resource efficiency is by using resource saving technology. For example,
computers have become more powerful and cost efficient and resource combination in industrialized economies favors
their use to save on scarce and costly labor resources.
To illustrate the foregoing, the isocost curve in Figure 45 becomes steeper from B 1, to B2, as the same budget can buy
more of cheaper capital. On the other hand, the isoquant Q flattens to Q (lower MRS), as only less of the increasingly
efficient capital is given up to use an additional unit of labor to maintain plant capacity.
Maintaining combination at point A with more efficient and cheaper capital requires a smaller budget below isocost curve
B, as a smaller capacity. But optimum resource combination is now at point B despite the same budget at Ba with cheaper
and more efficient capital in exchange for labor to increase capacity to Q 3.

Returns to Scale and Productivity

Returns to scale measures how output changes relative to resource inputs in the long run and indicate how overall resource
efficiency changes with plant size. Plant expansion either conditions or stifles resource efficiency depending on plant size
and condition. Returns to scale are measured as follows:
R = % (ΛQ)
% (ΛI)
Where:
R = Returns to Scale
Q= Output
I = Resource Input
Λ = Change
% = Percentage
Resource efficiency increases when R is greater than 1 because Q increases faster than I. The opposite is true when R is
less than one.
To capture the effect of plant expansion on resource efficiency, the measure assumes constant percentage use of plant
capacity and excludes the distorting effect of diminishing returns. Otherwise, the measure can misrepresent, say, a decline
in plant efficiency from overusing resources due to diminishing returns to scale.
Therefore, the measure of R truly reflects the relation between size and efficiency only when the degree of plant use is
constant. Assume a simple case of plant expansion with no effect on efficiency yet with constant returns to scale, this
expansion is like enlarging your photo with the same body proportions. Therefore, output increases proportionally with
resource inputs in the production function for the same capacity use. In Figure 46, all the points of TP, move upward to
form the new production function TP,. full use of plant capacity, for example, results in the same output-input ratio at
point B2 as at B1, following the proportion line. The same is true at the threshold of diminishing returns at points A, and
A2. Average product (AP) and therefore overall resource efficiency remain the same despite plant expansion. R has a
value of 1 with proportional increases in plant size and capacity.
But underusing the bigger plant capacity at point A 2 in the foregoing distorts the meaning of R with the opposite effect of
diminishing returns. R is now less than 1 with a lower average product (AP) (B, to Ag) not because of returns to scale but
because of less efficient rate of plant use.

Table 15 summarizes the different stages of plant expansion in relation to overall resource efficiency. The first stage has
increasing returns to scale with R greater than 1. Output increases faster than resource inputs as the latter becomes more
and more efficient. The second stage has constant returns to scale with R equals to 1. Output increases as fast as resource
inputs as the efficiency of resource inputs is constant. The third stage has decreasing returns to scale with R less than 1.
This time, output lags behind resource inputs as the latter becomes less and less efficient. The last stage has negative
returns to scale with R that is less than zero or negative. At this stage, output decreases despite plant expansion as
resources become more and more inefficient.
Table 15
Returns to Scale
Returns to Scale Returns Marginal Productivity Average Productivity
R = %(ΛQ) /%(ΛI) ΛOutput / ΛInput Output / Input
Greater than 1 Increasing Increases Increases
Equal to 1 Constant Constant Constant
Less than 1 Decreasing Decrease Decreases
Less than Zero or Decreasing and Negative Decreases
Negative Negative

Reasons for Returns to Scale

The early part of plant expansion conditions resource specialization and division of labor which increase returns to scale.
This stage is characterized by the efficiency of size or economics of scale. In a small plant, a resource may be assigned
different functions because no job is extensive enough to be its monopoly. But large-scale production enables resources to
concentrate on job requirements instead of diffusing efficiency. For example, a worker in a big garment factory is more
efficient sewing hemlines than sewing the whole dress.
However, further expansion breeds the problem of control and decreases returns to scale. This stage is characterized by
the decreasing efficiency or even the inefficiency of size, which is also called diseconomies of scale. The reason is that the
problem of control makes coordination and directing difficult because of delays, decision lapses, or even inaction.
One factor that affects decision-making and control is communication. The longer time it takes to process and transmit
information through long organizational channels causes delays in decision-making and control. On the other hand,
miscommunication due to the growing complexity of information distorts decisions and control. Installing electrical lines
in the wrong places in a building construction project is an example of a wrong decision. To reset the lines according to
specification still results in cost inefficiency because of job duplication.
The problem of decision-making and control also stems from the difficulty of monitoring and handling large volume of
complex information that requires decisions. For one, a large organization has more management levels and the higher the
level, the more abstract is the management’s view on organizational problems. Failure to detect the critical factors lurking
behind this abstraction simply leads to impractical decisions and loss of control. On the other hand, the volume and
complexity of information may be too much for management to handle, which can lead to managerial paralysis and even
loss of control.
Put differently, decision-making and control also depend on the manner of transmittal, receipt, interpretation, and
absorption of relevant information. But they break down to inefficiency when information becomes as large and complex
as the expanding organization, given the same structure and technology.
Overcoming Decreasing and Negative Returns
In the real world, size is not a handicap after all when innovations are made to overcome the causes of decreasing and
negative returns. In Figure 47, innovation shifts the long-run production curve upward from Q 1 to Q2 and churns out
bigger additions to output from point A to point C instead of to point B without innovation. As a result, negative returns
from expansion after point D are postponed until a bigger plant is built at point E. It follows that continuous innovation
indefinitely increases returns and postpones negative returns.
Advances in information technology can solve the once insurmountable problems of communication and control in large
organizations. The fast processing and transmittal, as well as the efficient storage of large volume of complex information
make technology an indispensable tool of management decision-making. For example, the efficient management
information system in a manufacturing company can immediately update inventory control with a few strokes on the
computer keyboard to detect warehouse pilferage. Therefrom, management immediately takes corrective action to prevent
further losses and cost inefficiency.

However, innovation also applies to organizational structure and culture and not only to its physical aspect. They are
called the “hard and “soft” of the organization, respectively.
A current trend in structural innovation is decentralization toward self-managed teams. This set-up enables top
management to concentrate on long-term decisions and planning in response to its broad perspective of organizational
problems. On the other hand, the subordinates are left to effectively solve specific and immediate problems that they see
on their level. In contrast, top management in a traditional organization (centralized) blindly solves the problems that the
subordinates are supposed to solve and neglects the broad concerns of long-range planning. Therefore, matching problem
and decision perspectives promotes effective management and efficiency.
Corresponding the foregoing structural innovation is the chopping off of big organizations into smaller but autonomous
and manageable parts. Self-managed teams are most efficient in these decentralized units where the scope of decision-
making is more focused and communication is more fluid.
Finally, the general trend in corporate culture is toward a people-oriented organization. This culture reconciles
organizational and individual goals to create a synergy beneficial to both sides. It is the force behind the drive to survive
and excel in this competitive world. The culture of team work in a self-managed team is an example because it satisfies
both the individual’s need for autonomy and the organizational goal of efficiency. However, a people-oriented culture is
not developed until people believe in the philosophy after many years of practice and results. The philosophy is not only
confined to fulfillment of material wants but also of higher needs such as creativity and dignity. In the final analysis,
developing this culture in the organization is management as if people mattered.
 Chapter 6 THE THEORY OF COST AND PROFIT
Objectives
At the end of this chapter, the student is
Expected to:
 1.Describe the concept of the theory of cost and profit in economics;
 2. Distinguish fixed and variable costs;
 3. Compute total cost based on total fixed cost and total variable cost;
 4. Differentiate opportunity and imputed cost; and
 5. Discuss how to compute profit.
Terms to Remember
Assets - a resource that has economic value owned by individual or a company
Cost - value of money that has been used up to produce something
Entrepreneur – one who introduces new things and uses this innovations for the betterment of the economy
Imputed cost – cost that is implied but not included in financial report or accounting record
Inventories-a detailed list or report in one’s possession
Opportunity cost - deals on how much more (less) one gains in giving up alternatives to benefit from a choice
Revenues- also known as income; total amount received by the company for the goods or services sold
Introduction
The producer in this chapter is presented as one whose objective is profit maximization. To attain this objective, the
producer equipped with explicit concepts in order decision. Moreover, these concepts help in understanding market
behavior as discussed in the succeeding chapters.
The framework of discussion is the concept of business, which defines cost and profit. This definition serves to identify
the components of cost-output as well as revenue- output relationships, which in turn lead to the concept of maximum
profit.
GENERAL CONCEPT
From the point of view of an entrepreneur, a business or firm exists to reward entrepreneurial efforts. To render this
reward, the firm undergoes a production process the outcome of which serves the consumers or buyers. Production
embraces the whole process of making the product available to consumer, which therefore includes the final process of
distribution.’ In so doing, the firm pays a price by using its stock of assets and the value foregone is called cost. At the end
of the said process, the firm earns revenues through the sale of goods or services. The positive net effect or the difference
between revenue and cost is called profit and accrues as said reward to the entrepreneur.
Hence, profit is a creation of entrepreneurship. With the revenue earned, the firm can recover what it foregoes in the
process of production and the excess is simply the profit created. To retain this profit is to increase the firm’s stock of
assets. Conversely, the negative difference between revenue and cost results in a loss which erodes this stock of assets.
Cost Concepts
A firm maintains a stock of assets that it can use for production.
Two Classifications of Assets
1. Real assets machineries, buildings, materials, and supplies
2. Monetary assets – forms of money and near money, part of which the firm transforms into real assets through
purchases or acquisitions
The firm incurs cost by using these assets for production. It should be noted that expenditure does not constitute a
transformation of an asset from one form to another but rather the giving up of values for the production process.
Hence, a firm incurs cost not in the paying for the acquisition of real assets but rather in their use. Likewise, the use of
resources in the production of unsold goods is not considered cost as the meaning of production covers a broader
perspective. The resources used are simply transformed into these unsold goods which become part of the firm’s stock of
assets called inventories. On the other hand, the depletion of monetary assets only constitutes cost when used as payments
for the utilization of other resources, such as labor, as well as for the other obligations of the firms, such as some forms of
taxes.
Table 16
XYZ Company Income Statement for the Year Ended December 2005
(a hypothetical example)
Sales P6, 997, 500
Less Cost of Goods Sold
Raw Materials Used (Variable) P4, 006, 829
Direct Labor (Fixed) 359, 632
Factory Overhead (Fixed) 403, 077 4, 769, 538
Gross Profit P2, 227, 962
Less Operating Expenses
Other Salaries and Wages (Fixed) P789, 478
Rent (Fixed) 20, 880
Gasoline and Oil (Fixed) 37, 671
Repairs and Maintenance (Fixed) 49, 465
Utilities (Partly Fixed) 24, 874
Office Supplies 9, 955
Indirect Taxes (Variable) 25, 345
Direct Taxes (Fixed) 5, 806
Insurance Expenses (Fixed) 39, 992
Depreciation Expense (Fixed) 3, 059
 Miscellaneous (Partly Fixed) 5, 007 1, 011, 532
Net Income from Operation 1, 216, 430
Less Other Items
Interest Expense 41, 078
Net Profit P1, 175, 532
Less Other Opportunity Costs
Alternative Employment Earnings P28, 603
Alternative Money Earnings of Owner’s Money 763, 888 792, 491
Net Profit with Opportunity Cost P382, 861

Table 16 presents a simple statement of east and profit. The reasons for the inclusion of the types of cost are discussed in
the succeeding sections.
Opportunity Cost
As a concept, opportunity cost is the foregone opportunity of choosing an alternative. The difference between the
opportunity gained from the alternative and its opportunity cost is the net gain (loss) from said choice. Simply put, it is
how much more (less) one gains in giving up alternatives to benefit from a choice. Ideally, the concept should help us
change decisions for the best. In the real world however, it should at least, help us make better decisions. In business, the
use of stock of assets for production is opportunity cost since such assets could have been used for something else. Also
included as opportunity cost are the owner’s foregone earnings, which are what they could earn alternatively. One
example is the interest income that owner’s money could have earned from money market placement. Another example is
the employment income the entrepreneur lost by not working somewhere else.
Table 16 matches business gross income (sales) with opportunity cost in the forms of business cost (goods or operation)
and foregone earnings of owner’s money and entrepreneurial activity. The business earns the net amount of P1, 175,532
by using the current asset stock and entrepreneurial skill. However, it gave up P792, 491 as foregone earnings of
investment funds and entrepreneurial activity to earn P382, 861 more, which is a better choice.
In a broader perspective, cost is the foregone opportunity of the stakeholders in the business, such as the
owner(s)/stockholders, creditors, employees, and suppliers. The net is also theirs as they forego opportunities to gain of
production (net of opportunity cost) earn more. The opposite is true when the business incurs losses.
Imputed Cost
The business is a separate entity as it rewards its stakeholders. Therefore, it should pay any use of resources and other
assets to determine gains (losses) even before making the best investment choice. But accounting records exclude uses
which involve no cash outlay which is cost, nonetheless. These uses should have assigned values called imputed cost. One
example is the imputed salary of the entrepreneur who doubles as the general manager of the business. Other examples are
imputed rent for the use of personal properties for production and the interest income for the opportunity of using owner’s
money. Incidentally, accounting records impute depreciation charges to the use of fixed assets.
Since the said uses have alternative uses, their imputed costs should approximate their opportunity costs. Therefore, all
imputed costs are opportunity costs although it is not necessary true the other way around.
Cost Output Relationship in the Short Run
Given a certain level of optimum input and maximum output, cost-output relationship assumes different forms. These are
the short-run cost functions since plant size and capacity are fixed. Table 17 presents the different forms of this cost-
output relationship and serves as a reference in the succeeding discussions.
Fixed and Variable Costs
Total cost (TC) has two basic components, namely: fixed cost and variable cost. Total fixed cost (TFC) does not vary with
output; whereas, total variable cost (TVC) varies in direct proportion. The following equation illustrates:
TC = TFC + TVC
Where:
TC = Total Cost
TFC Total Fixed Cost
TVC = “Total Variable Cost
The items presented in the income statement in Table 16 are classified into fixed and variable costs. Depreciation, salaries,
and wages fall under fixed cost although the utilization of the corresponding resources varies with output. Depreciation of
fixed assets is something difficult to measure and is expressed in monetary terms although imputed with a fixed amount.
On the other hand, a business is not flexible to vary its labor inputs in the short run and hence maintains a maximum work
force size, the remuneration of which is likewise in the form of fixed cost. Furthermore, other cost items like supplies and
utility expenses are partly classified as variable as they also consist of direct inputs of production and marketing; whereas,
the rest are classified as fixed, being supportive or indirect inputs.
Figure 48 illustrates the functional relationship between output and each of the aforementioned cost concepts (i.e., TC,
TFC, and TVC) from Table 17. TFC assumes Horizontal line since it does not vary with output. Moreover, the TC and
TVC curves are parallel as the difference between them at any level of output is the constant value of total fixed cost
(TFC) since:
TFC = TC- TVC
Table 17
Cost-Output Relationship in the Short Run
Quantit Total Total Total Average Average Average Margina Total Total
y Fixed Variable Cost Fixed Variabl Total l Cost Revenu Profit
Cost Cost Cost e Cost Cost (MC) e When When
(TFC) (TVC) (AFC) (AVC) (ATC) Price is Price is
P9.5 P9.5
1 40 5 45 40 5 45 5 9.5 -35.5
2 40 8.5 48.5 20 4.25 24.25 3.5 19 -29.5
3 40 11 51 13.33 3.66 17 2.5 28.5 -22.5
4 40 13 53 10 3.25 13.25 2 38 -15
5 40 15 55 8 3 11 2 47.5 -7.5
6 40 17.5 57.5 6.67 2.92 9.58 2.5 57 -0.5
7 40 21 61 5.71 3 8.71 3.5 66.5 5.5
8 40 26 66 5 3.25 8.25 5 76 10
9 40 33 73 4.44 3.67 8.11 7 85.5 12.5
10 40 42.5 82.5 4 4.25 8.25 9.5 95 12.5
11 40 55 96 3.64 5 8.64 12.5 104.5 9.5
12 40 71 111 3.33 5.92 9.25 16 114 3
13 40 91 131 3.08 7 10.08 20 123.5 -7.5
14 40 115.5 155.5 2.86 8.25 11.11 24.5 133 -22.5
15 40 145 185 2.67 9.67 12.3 29.5 142.5 -42.5

Marginal Cost
The following are the marginal cost concepts with the equations that define them:
MC = ʌTC = ʌTC
ʌQ ʌQ
MVC = ʌTVC
ʌQ
Therefore: MC = MVC since TFC is constant and TVC is the only component that causes TC to change.
Where:
MC = Marginal Cost or change in Total Cost
MVC = Marginal Variable Cost or Change in Total Variable Cost
Q= Quantity of output
ʌC = Infinitesimal change or a unit change that is infinitely small
Figure 49 presents the MOC curve in relation to the TC and TVC curves based on Table 17. The symbol for change
carries a positive sign if the variable increases and a negative sign if the variable decreases. However, MC or MVC
always carries a positive sign, which means that total cost (TC) increases with output. Moreover, MC or MVC is also the
cost of the additional or last unit of output. For example, the table shows that MC or MVC is P2, which is the increase in
TC or TVC when output level increases from three to four units. This marginal level is simply the cost of the 4 th or last
unit when producing four units of output.
To further illustrate the derivation of the MC curve from the TC curve, point J along the MC curve in Figure 49 registers a
value equals to 30 when output is equal to 10 units. On the other hand, the corresponding change in the TC or TVC curve
in producing the 10th unit along the same point is likewise equal to 30. In addition, the behavior of the MC curve
determines the shape of the TC curve from its point of origin, the MC curve initially declines causing the increase in TC
for every additional unit of output to diminish.
Marginal Output (MO) = Change in Total Product
Change in Input
Therefore:
Marginal Input (MI) = Change in Input
Change in Total Product
Eventually, the MC curve increases causing TC to accelerate instead. The lowest point of the MC curve corresponds to the
turning point of the TC curve. The same behavior is also true of the TVC curve since MC is equal to MVC.
On the other hand, the MC values corresponding to all the units of a certain output level sum up to TVC. Referring again
to figure 49, the output level equals to 10 units corresponds to a TVC value equals to 155. This value is also represented
by the shaded portion under the MC curve representing the MC values from the 1 st to the 10th unit of output. Hence, the
alternative expressions of the TC and TVC functions are as follows:
TC = Σ (MC) + TFC
TVC = Σ (MC)
Where: Σ is the symbol for summation. Finally, the MC curve exhibits a decreasing and then increasing pattern as output
increases due to the same pattern of marginal input in the production function. Recalling Chapter 5, marginal input is
simply the inverse of marginal product with the opposite pattern of change.
Initially, total cost (TC) increases at a slower pace since less and less is added to it with a decrease in marginal cost (MC).
This implies that production becomes more and more efficient before the threshold of diminishing returns as the cost of
producing an additional unit of output decreases. Eventually, production becomes less and less efficient, thus increasing
the cost of producing an additional unit of output with the increase in MC and faster increase in TC. It should be noted at
this point that the production function influences the behavior of the MC curve through the cost of the variable inputs
related to resource use (e.g., electricity and fuel).
Average Cost
Average cost is cost per unit of output which assumes the following terms:
ATC = TC
Q
AFC= TFC
Q
AVC =TVC
Q
Where:
ATC = Average Total Cost or Cost per Unit of Output
TC = Total Cost
Q = Quantity of Output
AFC = Average Fixed Cost or Fixed Cost per Unit of Output
TFC = Total Fixed Cost
AVC = Average Variable Cost or Variable Cost per Unit of Output
TVC = Total Variable Cost
ATC = TFC + TVC
Q Q
ATC = AFC + AVC
Figure 50 illustrates the three forms of average cost based on Table 17. The ATC curve is above its AFC and AVC
components. The ATC curve decreases with its components to point I where output is equal to 10. But beyond this point,
it increases as AVC increases faster than AFC decreases. The ATC curve is bell-shaped upside down due to production
efficiency factors as explained in the next section.

Finally TC, TVC, and TFC can be derived from ATC, AVC, and AFC, respectively by simply multiplying the latter by
(output).
TC = (ATC) (Q)
TVC = (AVC) (Q)
TFC = (AFC) (Q)
Assuming the quantity level to be Qb in Figure 51, TC, TFC, and TVC are represented respectively by the shaded
rectangular areas bounded by average cost and output.
Ca and Qb
Cb and Qb
Cc and Qb
The lowest point of an average cost curve (i.e., ATC or AVC) corresponds to the output level between the phases where it
registers decreasing and then increasing trends from the point of origin of the graph.
It should be noted, however, that the points at which MC intersects the ATC and AVC curves differ.
Unit Cost and Production Efficiency
Abstracting from Figure 50, the average total cost (ATC) curve exhibits a decreasing and then increasing pattern as output
increases. The general decrease in ATC means production becomes more and more efficient in the use of resources
because of two factors. First, the increase in the marginal product (MP) and productivity in the production function
(Chapter 5) decreases the marginal cost (MOC) and average variable cost (AVC) in Figure 54. Second, more use of a
fixed plant size spreads out fixed cost (FC) to more output, thus decreasing idle capacity and average fixed cost (AFC). In
figure 50, ATC decreases due to the same change in its AVC and AFC components. This pattern continues up to point I
despite an increase in AVC. The decrease in AFC outweighs the increase in AVC, causing the ATC to continuously
decrease, thus making a unit of output cheaper to produce.
Eventually, production becomes less and less efficient with the offsetting effect of the increase in MC and AVC due to the
Law of Diminishing Returns. Figure 52 shows that beyond point I, the increase in AVC out-weighs the decrease in AFC,
making a unit of output costlier to produce.
The most efficient plant use is at point I, which is the lowest point of the ATC curve. Producing before this point means
under-using fixed resources, and increasing use toward point I means increasing efficiency of their use due to decreasing
idle capacity. On the other hand, producing beyond this point means overutilization and less efficient use of resources
(diminishing returns).
This contrast explains why, for example, electricity rate in the provinces is higher than that in Metro Manila. The basic
assumption is that an electricity-producing plant and its installations are not highly divisible. As such, a small provincial
plant might be relatively large to serve a limited market in a sparsely populated area as compared to a big plant to serve
the big demand of a densely populated metropolis. In effect, a provincial plant may be underutilized as in point B in
Figure 52 with a higher per unit cost of output thus a higher rate. However, the plant in Metro Manila is either optimally
utilized as in point I or slightly over utilized as in point J having a lower cost per unit of output, and thus a lower rate.
Therefore, the behavior of MC and AC, i.e., within a fixed plant size, reflects resource utilization and efficiency in the
context of diminishing returns.
Cost Output Relationship in the Long Run
The overall level of the ATC curve varies as plant size expands in the long run due to changing returns to scale and plant
efficiency. As a reference, assume plant expansion with constant returns to scale and no change in plant efficiency. In
Figure 51, the average cost remains the same at the same rate of plant use as at points A 1 and A2 despite plant expansion
from AVC0 to AVC1. Plant efficiency (output/input) and input efficiency (input/output) which influence average cost are
constant due to constant returns to scale. Maintaining AVC despite plant expansion is likened to enlarging one’s photo
without distorting body proportions. But the average cost curve is lower (AVC,) as returns to scale increase with higher
plant efficiency and lower (input/output) ratio. The opposite is true as returns to scale decrease at AVC 3.
The long curve in Figure 55 is the trend of the short-run ATC curve as plant size expands in the long run. Increasing
returns to scale account for its initial decline, while decreasing returns cause it to increase eventually. The most efficient
plant is ATC and operating it most efficiently at point E makes production most efficient in the long run (shown in Figure
56).
As already mentioned in Chapter 5, size conditions efficiency but becomes a liability with more expansion in the absence
of innovation. While big firms can be more cost efficient and price competitive than small firms, decreasing returns can
catch up with complacency. Reconstructing the long-run average cost curve in Figure 55, continuing innovation can
prolong the stage of increasing returns and postpone the decline of production and cost efficiencies due to decreasing
returns.
Average and Marginal Cost Curves
Referring again to Figure 53, the MC curve intersects the ATC and AVC curves at their lowest levels. An increase in MC
increases cost faster than output to slow down the decline in ATC and AVC until it meets them at their lowest points.
Therefrom, continued increase in MC leads the two curves upward as it now costs more to produce a unit of output due to
diminishing returns.
PROFIT CONCEPT
Total and Marginal Revenues
The following are the concepts of revenue output relationship with the equations that define them:
TR = PQ
AR = TR = PQ (whether price is constant or not)
Q P
MR = ʌTR
ʌQ
MR = ʌ(PQ) (if price is not constant)
ʌQ
MR = (ʌQ)P = P (if price is constant)
ʌQ
Where:
TR = Total Revenue
AR = Average Revenue or Revenue
Per Unit of Output
MR = Marginal Revenue or Revenue, or per Additional Unit of Output
P = Price
Q = Quantity
A = Infinitesimal change
Figure 57 illustrates the aforementioned concepts assuming constant price at any level of output. Change carries a positive
sign if the variable increases and a negative sign if the variable declines. However, MR always carries a positive sign
since revenue increases with output. Moreover, MR is also the revenue from the additional or last unit of output. For
example, the figure shows that MR is “a” which is the increase in TR when its level increases from Q 1 to Q2. This level of
MR is also the revenue from Qzth or last unit of output.
The TR curve increases at a constant rate with every additional unit of output, implying that the resulting additional
revenue (MR) is equal to price (AR) since the latter is constant at any level of output. To restate, the following is equal
and constant, assuming constant price at any level of output.
MR = P = AR
Maximum Profit and the Marginal Approach
This section presents the concept of maximizing profit in the short run (fixed plant size), and for simplicity, assumes a
constant price at any level of output.
Profit is defined as Total Revenue (TR) Less Total Cost (TC) with Total Variable Cost
(TVC) and Total Fixed Cost (TFC) as the latter’s components. The profit function is alternatively expressed as follows:
Profit = TR- (TFC + TVC)
= (TR-TVC) - TFC
Since TR and TVC are the sums of their marginal values (MR and MC) and TFC is fixed, the profit function is further
expressed as follows:
Profit = Σ (MR – MC) + TFC
= Σ (MR – MC) – TFC
So long as MR is greater than MC, producing more increases profit through (TR – TVC) in equation 1 or Σ(MR – MC) in
equation 2. In Figure 58, profit is maximized or loss is minimized, depending on the value of TFC, at the point where the
MC equals MR. Beyond this point, producing more decreases profit through the same component of the profit function
since MC has now increased beyond MR. Diminishing Returns and decreasing efficiency of plant use catch up with profit
as it is more costly to produce an additional unit of output beyond product price.
Average profit is profit per unit of output, which is equal to total profit divided by Q (output). Therefore, total profit is
equal to average profit multiplied by Q (output). Figure 59 illustrates maximum profit as the area bounded by (P-C-E)
representing average profit and Q representing output. At no point is profit maximized except at point E where MR is
already equal to MC.
In addition, change in price can change the level of output and maximum profit. As an example in Figure 60, price
increases from P1 to P2 resulting in more production and profit. There is now more latitude for price to outrun
diminishing returns and increasing unit cost to increase output and maximize profit. The opposite is true when price
decreases. Thus, the MC curve is the supply curve of production.
Finally, the anatomy of profit is an eye opener to the reasons behind low profit levels and their downside. A decrease in
profit may be due to prices of variable inputs that increase faster than product price. In which case, (TR – TVC) may not
be much to cover TFC and create a big profit margin. Behind low profit level may be price, which may not also be much
to create the margin that pays for fixed cost. Still another possible reason is fixed cost itself as it may tend to erode the
(TR-TVC) margin and profit. In other words, the profit function is the starting point of profit analysis.
Shifts in the Supply Curve
As already mentioned, the marginal cost curve is the supply curve of the firm. Shifts and movements along the MC curve
are therefore associated with supply factors, which have something to do with cost and profit.
Price and Number of Sellers
The volume that a seller is willing to sell at a certain price level is his maximum profit output or supply. Raising the price
level from P1 to P2 in Figure 60 shifts the MR curve upward and stretches the maximum profit point to Q 2 (point B). This
is inasmuch as a higher price level yields more additional profit [Σ(MR -MC)] with more output but only up to the point
before the increasing MC curve begins to erode total profit. In figure 60, the summation of additional profit Σ(MR -MC)]
is now represented by areas A and B. Therefore, total profit (TP) likewise increases assuming the same fixed cost (FC).
To restate the profit equation:
Profit = Σ (MR – MC) - TFC
The opposite can be said when the price level drops.
On the other hand, an increase in the number of sellers means the multiplication of aggregate output at more or less the
same price level. To emphasize this concept, assume that sellers are homogeneous in size and cost behavior. In Figure 61,
the industry would produce Qi at price P, if there was only one seller with marginal cost curve MC. However, the entry of
another seller doubles industry output to Q2 for the same price, marginal cost, and average cost levels, which are P 1 and
Y1 and Y0, respectively. This is also true for the other levels with the same underlying conditions of cost and profit. Thus,
the new cost curves are MC2 and AC2. The opposite can be said with a decrease in the number of sellers.

Productivity and Technology

As discussed in Chapter 5, an increase/decrease in the overall productivity level due to technological change
expands/limits production capacity. This is due to an increase/decrease in the capacity to produce per unit of input as
reflected in the marginal and average products. In effect, the cost of producing an additional unit of output
decreases/increases due to the changing efficiency of production.
In reconstructing Figure 59, an improvement in the overall productivity level shifts the marginal cost (MC) and average
total cost (ATC) curves downward. This shift indicates less variable cost per unit of output as well as a bigger production
capacity with longer ATC curve.
However, the AFC curve also shifts downward to further decrease ATC when productivity improves due to resource-
saving technology. Going back to Chapter 5, such technological change (e.g., computers) requires less resource to
maintain output, thus decreasing TFC and AFC. In the case of capital spending to improve the productivity of other
resources (e.g., irrigation to improve crop yield), the decrease in AC depends on how much productivity is gained in
relation to additional cost of capital, which increases TFC. If TFC outpaced output to increase AFC, AC would only
decrease with the
Offsetting effect of a decrease in AVC as a component. On the other hand, if output increases faster than TFC, AFC
decreases with AVC and AC.
Cost of Production
An increase in the prices of variable inputs increases the MC, TVC, AVC;, and ATC. This increase in cost is not
associated with plant expansion and therefore cost changes but not maximum output. Going back to Figure 53, the AVC
curve will shift upward only because of the same shift in the MC and AVC curves. There is no rightward shift whatsoever
since maximum output is constant in the absence of plant expansion. Also, going back to Figure 59, the increase in MC
will decrease profit by shrinking (TR- TVC) which pays for TFC.
Japan as a Giant in Car Manufacturing: A Reading
Today, Japan as a world economic superpower is totally different from where she was right after the Second World War
more than 68 years ago. She has rebuilt her economy from the ashes of that war to be a key player in the world economy.
Armed with a national drive to grow beyond the limits of her natural resources and the sophisticated technology that she
has developed through the years, she has extended her economic activities and influence to the rest of the world. She has
become a dominant producer of final products in the world using the latter’s resources and raw products, thus getting a
lion’s share from the fruits of production. She is in almost all sophisticated lines of business from the manufacture of cars,
computers, and ships, to banking and trading. What she earns she reinvests to produce more and add value to world
production? This explains her huge foreign exchange surplus from the surplus of goods and services (both factor and non-
factor) that she exports to almost all parts of the world.
One of the key industries that has led her to be where she is today is the car industry. Japanese car producers have invaded
even the once indomitable U.S. market getting thirty percent (30%) of the pie and pushing aside even the Big Three
among the American car manufacturers. Yet, the latter can hardly penetrate the Japanese market accounting for only one
percent (1%) of the demand. During the 1992 visit of President George Bush to Japan, to push for a freer trade with the
tiger of Asia, members of his delegation suggested to their Japanese counterparts that Japan’s trade surplus is a result of
her protectionist attitude toward foreign products. She exports more but imports less. However, the Japanese differently
view the surplus as a logical consequence of producing quality, designed for consumers taste and sold at the most
competitive prices.
There is truth in the protectionist issue. According to Kim Woo-Choong, Daewoo Head, South Korea’s second largest
industrial group, “Every country has trouble selling to Japan. It is much harder selling to the Japanese than to the
Americans.” There is also truth in the Japanese productivity credo. According to Lee laccoca, head of Chrysler, a giant
among the American car manufacturers, “Only 15% of the problem is access to their market. The other 85% is their
exports. They have the capacity to build 14 million cars a year in a market for 7 million. The Europeans won’t let them.
What are they going to do? Send them to the U.S. that’s what.”
Both sides are correct but the hidden fact is that protectionism enhances efficiency to multiply production. Japanese car
manufacturers prefer to use their surplus earnings, mostly from exports, to buy more steel and reinvest in their overseas
plants. Thus, they create the multiplier effect of increasing scale and efficiency. Generally, Japanese prefer to do this
rather than spend their huge foreign exchange surplus to satisfy local consumption. Thus, it is not surprising that dividend
payout in Japanese corporations is only thirty percent (30%) in contrast to fifty four percent (54%) in the U.S. and sixty-
six percent (66%) in Britain.
In the final analysis, the secret of their economic success is an even more basic formula. Japanese spend less and save
more and therefore invest and produce more. In contrast, many countries that she has beaten in the economic race spend
more, save less and therefore produce less. As aptly described in the feature article of the February10, 1992 issue of the
Fortune Magazine, “As Japan’s major trading partners look to the east, they see a mercantilist samurai whose successive
swings of the sword hack many Jobs and the wealth of other nations.”

The Shutdown Price

The output level where MR is equal to MC yields the maximum profit or minimum loss if price is greater than the average
variable cost (AVC), or total revenue (TR) is greater than total variable cost (TVC).
Consider again the profit equations:
P = (TR-TVC) – TFC
=Σ (MR- MC)- TFC
If price is less than AVC, then TR is also less than TVC. Therefore, total loss is equal to TFC and the amount of TVC that
TR cannot recover. The negative difference between TR and TVC is at a minimum at the output level where MR is equal
to MC as shown in figure 62. As the output level increases up to the optimum point (point of intersection), the first shaded
area where MC is greater than MR is bigger than the succeeding area where MR is greater than MC. The latter represents
the positive amount that minimizes the loss created when MC is greater than MR.
However, minimizing the negative difference between TR and TVC does not necessarily lead to a minimum of total loss.
Production at any output level results in a loss equals to the said difference and TFC; whereas, a shutdown or no-
production decision incurs no more than the minimum level of total loss equals to TFC alone. Hence, the firm is better off
when not producing if the total revenue (TR) is still inadequate to cover total variable cost (TVC) or simply the average
variable cost (AVC) is still greater than price.
Finally, the no-production or shutdown decision may apply during periods of low prices and demand as it minimizes
losses while waiting for the boom period in the market.
 NOTRE DAME OF SALAMAN COLLEGE
Founded in 1965 by the Oblates
Owned by the Archdiocese of Cotabato
Managed by the Diocesan Clergy of Cotabato (DCC)

“Service for the Love of God through Mary”

(B.E.S.T)

General Instruction: Read given activity and follow the instruction as given. Not following of instruction would mean invalidity
of the output. Attach this page to your submission.
I. Discussion Questions: Answer the given question below. Write your answer on a separate sheet of paper.

1. What is the root cause of the company’s lack volume and niche? Explain
2. How can the company solve the aforementioned crucial problems by more exposure in the international
market? How can it catch up with competitors?

II. Computation: Complete the column of MRS for this production isoquant.

Labor Input Capital input MRS

1 37.00
2 43.00
4 36.00
6 17.75
7 9.25
9 21.00
10 16.5
11 15.75
14 3.00
16 12.00

III. Complete the table below. Assume the following prices of Good Y and the quantities purchased at these
prices. The total fixed cost of the firm is ₱56,000 and the cost of direct materials is ₱50.80 per unit and that of
direct labor is ₱51.10 per unit.
Price Quantity Purchased TR TVC TC Profit
5.50 0
5.00 10,000
4.50 20,000
4.00 60,000
3.50 90,000
3.00 150,000
2.50 180,000
2.00 200,000

1. Which is the best price? Justify

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2. Plot the TR and TC curves. Identify the point of maximum profit. You can write your answer below or
you can use graphing paper.