MODULE 5 and 6 BASIC MICROECONOMICS

Session Topic: Theory of Production and Cost

Learning Outcomes:
1. Distinguish between the concepts of total product, marginal product, and average product
2. Describe the concept of diminishing returns
Key Points
Marginal Diminishing Production Variable Cost Fixed cost
product returns

Core Content
Introduction
The theory of production is an analysis of output-input relationship. As such, discussions
touch on the relation of output to the size, combination and efficiency of resources. In turn, this
output function serves as a tool in analyzing cost-output relationship. The fundamental concepts
in this chapter are the Law of Diminishing Returns which explains the output function in different
resource conditions
.
In-text Activities
Production Function
PRODUCTION refers to any economic activity, which combines the four factors of production to
form an output which will give direct satisfaction to the consumer.
Theory of Production
An increase in the quantity of factor inputs will lead to an increase in output. The theory of
production is the study of how the output level changes as the quantity of factor inputs changes.
To increase output, firms need to employ more factor inputs which will lead to an increase in
costs.
Inputs are commodities and services that are used to produce goods and services.
Outputs are useful goods and services that result from the production process.
In economics, we distinguish between two types of factor inputs:
Variable Input
Variable factor inputs are those whose quantities can be changed in response to changes in
output. Examples include electrical power consumption, transportation services, and most raw
material inputs.
Fixed Input
A fixed factor of production is one whose quantity cannot readily be changed. Examples include
major pieces of equipment or suitable factory space
Short-Run
The short run is the time period during which at least one of the factor inputs used in the
production process is fixed.
Long-Run
The long run is the time period after which all the factor inputs used in the production process are
variable
Short-Run vs Long-Run
Consider the example of a hockey stick manufacturer. A company in that industry will need the
following to manufacture its sticks:
Raw materials such as lumber Labor Machinery A factory
It might be time-consuming to add equipment. Whether new equipment will be considered a
variable input will depend on how long it would take to buy and install the equipment and to train
workers to use it. Adding an extra factory, on the other hand, is certainly not something that could
be done in a short period of time, so this would be the fixed input.

The short run is the period in which a company can increase production by adding more raw
materials and more labor but not another factory. Conversely, the long run is the period in which

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all inputs are variable, including factory space, meaning that there are no fixed factors or
constraints preventing an increase in production output.
In the long run, if a firm wants to increase output, not only can it employ more labor, it can also
employ more capital whose quantity is fixed in the short run.
Productivity refers to the amount of output a firm can get from the resources it employs
Total Product
Single-input production are sometimes called total product. Shows how total output depends on
the level of input
I (L) TP

0 0

6 20

12 96

18 162

24 192

30 150

Marginal Product of an input is the extra output produced by one additional unit of input.
MP = TP / I
Marginal Product
I (L) TP MP

0 0 0

6 30 5

12 96 11

18 162 11

24 192 5

30 150 -7

Average Product is the average amount of output per unit of input (labor).
AP = TP/I

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 I (L) TP AP (units)

0 0 0

6 30 5

12 96 8

18 162 9

24 192 8

30 150 5

I (L) TP MP AP

0 0 0 0

6 30 5 5

12 96 11 8

18 162 11 9

24 192 5 8

30 150 -7 5

Increasing Marginal Returns to Labor

An increase in the quantity of labor increases total output at an increasing rate
Diminishing Marginal Returns to Labor
An increase in the quantity of labor still increases total output but at a decreasing rate
Diminishing Total Returns to Labor
An increase in the quantity of labor decreases total output

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Law of Diminishing Marginal Returns
Holds that we will get less and less extra output when we add additional amount of input while
holding other inputs fixed.

Theory of Cost
Cost refers to all expenses acquired during the economic activity or the production of goods and
services.
Sales – Cost = Profit or
Total Revenue – Total Cost
Fixed Cost are costs that are spent for the use of fixed factors of production. These expenses do
not change regardless of a change in quantity of output produced.
Variable Cost are expenses which change as a consequence of a change in quantity of output
produced. Examples are labor and raw materials.

Total Cost
Fixed Cost + Variable Cost = Total Cost
Marginal Cost is the additional cost of one unit of product.

Output Variable Cost Fixed Cost Total Cost Marginal Cost

0 0 ₱10 ₱10 -

1 ₱10 ₱10 ₱20 ₱10

2 ₱17 ₱10 ₱27 ₱7

3 ₱25 ₱10 ₱35 ₱8

4 ₱40 ₱10 ₱50 ₱15

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 5 ₱60 ₱10 ₱70 ₱20

6 ₱110 ₱10 ₱120 ₱50

Per unit Cost

Calculate the following:

1. ATC of 6 units
2. AFC of 2 units
3. AVC of 4 units
4. ATC of 1 unit
5. AVC of 5 units
6. AFC of 5 units
Output Variable Cost Fixed Cost Total Cost Marginal Cost

0 0 ₱10 ₱10 -

1 ₱10 ₱10 ₱20 ₱10

2 ₱17 ₱10 ₱27 ₱7

3 ₱25 ₱10 ₱35 ₱8

4 ₱40 ₱10 ₱50 ₱15

5 ₱60 ₱10 ₱70 ₱20

6 ₱110 ₱10 ₱120 ₱5

AVC AFC ATC

- - -

₱10 ₱10 ₱20

₱8.5 ₱5 ₱13.5

₱8.33 ₱3.33 ₱11.66

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 ₱10 ₱2.5 ₱12.5

₱12 ₱2 ₱14

₱18.33 ₱1.67 ₱20

The Isoquant-Isocost Model

 An isoquant shows all combination of factors that produce a certain output
 An isocost show all combinations of factors that cost the same amount.
 Isocosts and isoquants can show the optimal combination of factors of production to
produce the maximum output at minimum cost.

In this diagram, the isoquant shows all the combinations of labour and capital that can
produce a total output (Total Physical Product TPP) of 4,000. In the above isoquant, this
could be

 20 capital and 18 labour or (more capital intensive)

 9 capital and 35 labour. (more labour intensive
An isoquant is usually shaped concave because of the law of diminishing returns. With
fixed capital employing extra workers gives a declining increase in the marginal product
(MP)
Marginal rate of factor substitution

The marginal rate of substitution is the amount of one factor (e.g. K) that can be replaced
by one factor (e.g. L). If 2 units of capital could be replaced with one-factor labour, the
MRS would be 2

Summary
 Marginal cost of production is the cost of producing one additional unit of
 output.
 Most firms face diminishing marginal returns (and, therefore, increasing
 marginal costs) after some level of output.

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  Fixed costs do not vary with production levels. Variable costs do.
 The short run is the time over which fixed costs are fixed. The long run is
 any length of time greater than the short run.

LEARNING ASSESSMENT : Introduction to Economic Theory

Name:_______________________________ Professor:____________________
Year and Section:_____________________ Rating:_______________________
A. Complete the table. Show the solution.
Labor input TP MP AP

1 6.00
2 9.00
3 14.00
4 17.00
5 22.00
6 27.00
7 29.00
8 25.00
9 16.50
10 10.00
11 6.00
12 3.00
13 1.00
14 0.00

B. Complete the table 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 16.50
11 15.75
14 3.00
16 12.00

References Refer to the references listed in the syllabus of the subje

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