MODULE 2

Chapter 4: THEORY OF CONSUMPTION

Objectives
At the end of the chapter you will be able to:
1. Identify the different factors that affect utility and consumption behavior;
2. Explain Maslow’s Hierarchy of Needs;
3. Distinguish the relationship of income to substitution effects;
4. Plot using the graph indifference curve with given data on food and clothing
consumption; and
5. Construct a table using own hierarchy of budget schedule and illustrate it via graph.

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 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.
 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 common thing for the urban
dwellers but could be a rare commodity for the people who live in the mountain.
*Maslow’s Hierarchy of Needs – a theory is psychology, proposed by Abraham Maslow,
which is often portrayed in the shape of a pyramid, with the largest and most fundamental
levels of needs at the bottom, and the need for self-actualization at the top.
Most human societies exhibit social hierarchy. More frequently, stratification takes
the form of social classes. Social classes show distinct product and brand references. For
instance, komiks tend to be the reading material for the lower income classes, while
magazines and newspapers are preferred by the middle and higher income classes.
Values of individuals or peoples are highly influenced by cultural environment. An
American or a Western child is exposed to the values of achievement and success, progress
material comfort, efficiency, and practically. A Filipino child, on the other hand, is exposed to
the values of hiya, paki-kisama, social acceptance, and smooth inter-personal relationships.

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.
Members of the buyer’s family can exercise a strong influence on the buyer’s
behavior. From the parents, a person acquires an orientation toward religion, economics,
personal ambitions, and love. Husband-wife involvement in purchases varies widely by
product category. Husbands are more dominant in the purchase of insurance and cars, while
wives are more dominant in the purchases of washing machines and kitchenware.
A person’s position in each group can be defined in terms of role and status. A role
consists of the activities a person is expected to perform according to the person around him
or her. Each role carries a status reflecting the general esteem accorded to it by society.
The kind of clothing that a person wears reflects his perspective roles and statuses. A
company president, for example, will tend to drive a Mercedes Benz, wear expensive
clothes, and eat in posh restaurant.
 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.
People change the goods and services they buy over their lifetime. Young single
people have different consumption needs from retirees; newly married couples buy different
kinds of furniture compared to older married couples.
A person’s occupation has an influence the goods and services he buys. A company
president will buy expensive clothes, while a blue-collar worker will buy work clothes.
A person’s lifestyle and economic condition will affect the goods and services he
buys. The traditionalists would buy the usual good as opposed to those people who would
like to experiment; the sports-minded type of person would prefer different kinds of goods
as opposed to those who are homebody type.
A person’s personality and self-concept will also influence his buying behavior.

PHYSCOLOGICAL 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 consists the
biological need, safety needs, social needs, esteem needs and self-actualization needs
(figure 25). Based on the theory, a person will try to satisfy the most important needs first.
When a person succeeds in satisfying an important need, he will be motivated to satisfy the
next most important need.

For example, a starving man (need 1) will not take an interest in going to a bar (need 3) nor
in buying luxury car (need 4). However, as each important need is satisfied, the next most
important need will come into play.
 A motivated person is ready to act. How the motivated person acts is influenced by his
perception and learning of the situation. Two people may act quite differently because their
perception and learning of situation may be different.
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.
Through perception and learning, people acquire their beliefs and attitudes. These, in
turn, influence their buying behavior. If a consumer perceives and believes that Coke is the
best soft drink, he will buy Coke. 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 towards some object or
ideas.
To sum up, a consumer will buy a particular product, given and 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 quantitively defined as follows:
TU (Total Utility) = Function of Q
(Consumption)
∆(TU )
MU = (Satisfaction from an additional unit of consumption)
∆Q
where:
∆ = 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

Table 9 and Figure 26 illustrate the aforementioned concepts with the consumption of
water as an example. The symbol for change carriers a positive sign when the variable
increases and a negative sign if the variable decreases. As the consumption level increases, a
positive marginal utility (MU) increases total utility (TU), while the opposite is true when MU
is negative. Moreover, marginal utility is also defined as the utility or dissatisfaction from the
last unit of consumption, depending on whether MU carries a positive or negative sign. For
example, the table shows that MU is 2, which is the increase in TU when consumption
increases from 5 to 6 units. This level of MU is simply the utility of the 6th or last unit of
consumption.

But how does the behavior of the MU curve influence the behavior of the TU curve and
the level of maximum satisfaction? Looking back on Table 9 and Figure 26, an additional unit
of consumption registers a positive change, and therefore an increase in TU so long as MU is
positive. Eventually, the TU curve registers a negative change, and therefore a decline where
MU is negative. The consumer is only willing to consume up to the point of maximum
satisfaction from where an additional unit of consumption no longer yields additional
satisfaction. Beyond this point, the additional dissatisfaction (negative MU) that the
consumer begins to incur simply decreases total utility (TU) or satisfaction.
Stating the concepts in concrete terms, the first glass of water is more satisfying than
the second, although two glasses of water are more satisfying than one. One is willing to
consume more glasses of water so long as one gains additional and therefore more
satisfaction, but only up to the point where an additional glass is no longer satisfying.
Beyond this point, an additional glass of water becomes more and more dissatisfying leading
to a lower level of satisfaction from all the glasses of water consumed.
However, consumers behave differently with the same consumption of a good due to
the varying influence of cultural, social, personal, and psychological factors. Consumers who
are very difficult to please would have their TU curve sharply skewed to the right (facing the
graph) if we will reconstruct Figure 26. It takes more of additionally less satisfying units of
consumption MU to add up and maximize satisfaction (Point G/H). In contrast, consumers
who are very easy to please would have their TU curve sharply skewed to the left, as it only
takes less of additionally more satisfying consumption units to multiply satisfaction to the
fullest.
In conclusion, the diminishing MU causes TU to decline eventually, for which reason,
maximum consumption is only up to the point of maximum utility.

CONSUMPTION
The Indifference Curve
The indifferent curve, together with 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 point to another along the curve, an inverse relationship exists between the
commodity units, inasmuch as the utility foregone by consuming less of one 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 ration between utility gained
and utility foregone is always equal to 1 and therefore constant. However, this is 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:
∆ FOOD CONSUMPTION
MRS =
∆ CLOTHING CONSUMPTION
where:
∆ = change

Table 10
Indifference Schedule
FOOD CONSUMPTION CLOTHING MARGINAL RATE OF
CONSUMPTION SUBSTITUION
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

∆ Util
consumption. Thu MU of clothing (∆ Consumption )
decreases while its marginal
∆ Consumption
consumption or reciprocal ( ∆ Util ) increases due to the law of Diminishing
Return. 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 the true:
more positive (∆clothing consumption is increasing)
less negative (∆ food consumption is decreasing)
Therefore:
( ∆ Food )↓
(MRS) ↓ =
(∆ Clothing)↑
 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 decreasing MU. This practically means that one becomes increasingly reluctant
to give up a good (food, for example) that becomes scarcer and additionally more valuable
(higher MU), in exchange for another (clothing) that becomes more abundant and
additionally less satisfying (lower MU).
At the extreme, no one is willing to give up a valuable good in exchange for a worth
less one.
In practical terms, one is willing to forego less and less of one good in exchange for
more and more of another as the former becomes relatively scarce and more valuable and
the latter becomes relatively abundant and less valuable.

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 the 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 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) (Qf) + (Pc) (Qc)
B
max Qf = maximum for f (food)
Pc
B
max Qc = maximum for c (clothing)
Pc

where:
B = Given budget
Qr = Quantity of food
Qc = Quantity of Clothing
Thus, budget (B) is 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 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 lines. Thus, a bigger
budget leads to a greater purchasing power and a higher budget line

Table 11
Hierarchy of Budget Schedules
BUDGET = ₱500 BUDGET = ₱1,000 BUDGET = ₱1,500
Food Clothing Food Clothing 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 1 20

*Price of food = ₱50

*Price of clothing = ₱100
*Rate of substitution = 2
Finally, the budget lines have two important properties. One property is 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 ₱500. They increase by 100% by 12 units and 4 units, respectively, when the budget
likewise increases by 100% to ₱1,000.
 ∆ Food Units Purchased
MRS = ( ∆ ClothingUnits 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 of food. This 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:
Price of Clothing
MRS =
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 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 I₂ is attainable at either points
of intersection (B and C) with the budget line as on any curve I. 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 I₃. 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 for 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.
CASE STUDY
Demand for the Big Mac on the Rise
(NYSE: MCD)
McDonald’s (NYSE: MCD) has bucked the global recession in February as both global
and U.S. same store sales rose. The company, which operates more than 32,000 McDonald’s
restaurants in over 100 countries, reported February comparable sales results on March 9
that showed global sales rising 1.4% year over year even as Feb. 2008 included an extra day
due to leap year. Excluding the extra, sales grew 5.4%.
U.S. sales climbed 2.8%, or 6.8% if you exclude the extra calendar day in 2008. Asia/
Pacific, Middle East, and Africa rose 0.7%, or 4.1% U.S. gained on the back of the chicken
line-up, the core menu, especially the Quarter Pounder, and the popularity of its breakfasts.
Europe’s growth was led by U.K. and Russia but was partially offset by a slower Germany.
Australia continued to be strong in the Asia/Pacific region. China saw weaker sales, primarily
due to celebration of Chinese New Year during the month, when in 2008, it was celebrated a
month earlier January. Despite sales growth in the first two months of the quarter,
McDonald’s still warned on March 9 that volatile foreign currency exchange rates and
commodity costs would pressure revenue and margins in the first quarter.
Foreign currencies have been especially weak in Eastern Europe, which the company
said will negatively impact the first quarter results by at least 7 cents to 9 cents per share if
rates remain at current levels. McDonald’s did not provide any actual numbers on the impact
of commodity costs but said that commodity pressures are expected to have a greater
impact on results in the first half of the year.
Overall, McDonald’s has positioned itself well to ride out global recession and even
grow its customer base and grow earnings. With the expanded value menu and healthier
menu options now being offered, more people these days than ever before are looking for a
cheap lunch option and McDonald’s offers family families trying to spend less during the
recession but still have night out an alternative to the more expensive dinner out at a local
restaurant or chain restaurant like Apple bee’s. I suspect this will be just a temporary trend
and as the economy improves, families will revert to their old routines and start to frequent
the local and cloth chain restaurants more. However, McDonald’s will retain many of these
new customers who will continue to come back for a quick meal at a value.
The stock is trading with a forward P/E of about $12.50. MCD can be played as a long
term and short buy. Today, MCD is trading at $51.50, the current trading range it is stuck in
for March is $50.50-54. I would get $55.50 as a short-term (1-3 months) trading target. This
is a 61.8% move from the recent March low of $50.44 to the March high of $59.25,and is
also 50% retracement from the March low to the January high of $63.87. I would set a
trailing stop of 4-5% once $55.50 is hit. And I would use $62.50 as long-term (6months +)
trading target. Once that level is hit, I would implement a trailing stop at $58.75.

Source: http://www.istockanalyst.com
 Sentiment Beat
March 17, 2009

Questions:
1. Illustrate and explain the changing demand for Big Mac using the indifference curve
and budget line.
2. In this case study, what do you think are the factors affecting the increased demand
for Big Mac? What about the competitor food chains? How do you think they are
affected by this increased sales for McDonald’s?
3. Do you consider the demand for Big Mac elastic or inelastic? Explain.
SUMMARY
Utility and Beneficial Factors
1.Cultural
 Culture
 Subculture
 Social Class
2. Social
 Reference Groups
 Family Roles and Statuses
3.Personal
 Age and life-cycle stage
 Economic circumstances
 Personality and self-concept
4.Physchological
 Motivation
 Perception
 Learning
 Beliefs and attitude
Maslow’s Hierarchy of Needs
1. Biological and psychological needs
2. Safety needs
3. Belongingness and love needs
4. Esteem needs
5. Self-actualization
 CHAPTER 5: THEORY OF PRODUCTION

Objectives
At the end of the chapter you will be able to:
1. Describe the concept of law 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.

INTRODUCTION
The theory of production is an analysis of output-input relationship. As such
discussions touch on the relation of the output to the size, combination, and efficiency of
resources. In turn, this output function serves as a tool in analyzing cost-output relationship
in the next chapter. The fundamental concepts in this chapter are the Law of Diminishing
Returns and returns to scale, which explain the output function in different resource
conditions.

PRODUCTION FUNCTION
Plant size and the efficiency of its resources (land, labor, and capital) determine plant
capacity (maximum output). Resources are fixed in the shirt 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, ie., within fixed or changing plant capacity.

DESCRIPTION
Alternative plant sizes and resource combination (choices) determine different levels
of resources 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-resources
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 resources (e.g., labor) change the total product (TP) or output, as
summing the other resource (e.g., capital) to be fixed. Product or output is seen from the
point of view of the variable resource which, 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 followers:
∆Q
MP = ∆I

where:
MP = Marginal Product or Output
Qp = Total Product or Output
I = Resource Input
∆ = Change
For example, in Table 12, the 2nd unit of labor yields an additional output of 5, which
is actually the MP of using 2 units of the resource. In turn, this additional product (MP)
increase TP from 5 to 10 because of that 2nd or last unit of labor. But the 7th unit of labor has
a negative product or an MP of – 3, which decrease TP from 24 to 21.

Table 12
Production Function
LABOR TOTAL MARGINAL AVERAGE STAGE
(MAN HOURS) PRODUCT/OUTPUT PRODUCTS PRODUCTS
(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 STAGE 4
11 2 -3 0.2
12 0 -2 0
 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 decelerate 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
per unit of the variable resource input and measured as follows:
Q
AP = I

In Figure 37, AP follows the trend of MP following the law of averages. In other
words, a change in MP following the law of averages. In other words, a change in MP (
∆Q Q
∆I
¿ causes the AP ratio ( I )
to change in the same direction. The decline in TP at
the last stage obviously decreases AP but only to 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 fixed plant size. In Figure 37, the
use of more labor inputs beyond Stage 1 strains the fixed input of capital and makes both
resources complements less efficient. Furthermore, having too much of one resource and
too little of another can event 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 counter-
productive 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 you 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
productive the same kitchen facility and breed counter-productive 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 decrease 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 not 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 production capacity (maximum point)
decrease 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 TP₁ move
upward and rightward to form the higher production function curve TP₂. As both capital and
labor increases, so is plant capacity from point A and B. from these two lessons can be
drawn the third that resources are basically complementary. Differently put, a resource is an
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 an infinite combinations of resource inputs which determine the
same plant capacity (maximum output). In a two-variable resource system, these
combinations from 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 as the capacity forgone, 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
isoquant in Figure 39, the MRS of capital (K) to labor (L) is measured as follows:
∆ Y axis
MRS = ∆ X axis

∆K
MRS = ∆ L

where additionally:
∆ = Change
Table 13 shows that less and less of capital inputs (K) are given up in order to use 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 additional 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.
 Table 13
Isocost and its Hierarchy
MARGINAL
LABOR CAPITAL RATE OF
INPUT INPUT SUBSTITUTION
∆ CAPITAL/ ∆
LABOR
1 30 -
2 26 4
3 22.5 3.5
4 10.5 3
5 17 2.5
6 15 3
7 13 1.5
8 12 1
9 12 0.5
10 12 0

THE ISOQUANT AND DIMINISHING RETURNS

The Law of Diminishing Returns influence the marginal rate of substitution (MRS) as
the latter shapes of isoquant.
∆Q
In the same example below, marginal product of labor decreases from more
∆L
∆Q
use, while that of capital increases from less use with the opposite effect of
∆K
diminishing returns. It follows that more labor inputs (L) are needed to produce an
∆L
additional unit of outputs as the inverse of its marginal product increases. But less
∆Q
capital inputs (K) are only given up to reduce output by the same unit as the inverse of its
∆K ∆K
marginal product decreases. To go back to their MRS formula, decreases. To
∆Q ∆Q
∆K
go back to their MRS formula , more and more labor is used (∆L) to regain the same
∆L
output foregone by giving up less and less of capital (∆K). 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 with more use. To stress the point, an efficient resource cannot be given up in
exchange for an inefficient one to maintain output.

HIERARCHY OF ISOQUANTS
 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 Q₁ 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 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
number 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 plant 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 resources system, these combinations form the isocost
curve. Figure 41 based on Table 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 the table show that each budget is split between the resources at
varying 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 fixed budget. The MRS of capital (K) to labor (L) in the example is computed as follows:

∆ Y axis
MRS = ∆ X axis
 ∆K
MRS = ∆L
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
∆K
input (K) given up for the price of labor or . Thus, MRS is the capital input (K) that
∆L
the price of a unit of labor (L) could otherwise buy or:
Pr ice of L
Price of K
Likewise, there is a hierarchy of isocost 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 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.

Table 14
Isocost and its Hierarchy
BUDGET = ₱ 10,000 BUDGET = ₱ 20,000
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 = ₱2,000
PRICE OF LABOR = ₱500
MARGINAL RATE OF SUBSTITUTION (CAPITAL/LABOR) = 0.25
 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.
In Figure 42, the budget of the isocost curve B₂ meets an alternative resource need of
isoquant Q₁ 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 and cost levels. The least cost or optimum combination
is at point A where the isoquant is tangent to the lowest isocost curve that meets its
production requirement (B₁) is less than enough for the production requirement of the
isoquant.
The optimum resource combination follows the principle of the equi-marginal condition
of consumer’s behavior. At the optimum point A, the last peso spent on one resource yields
the same marginal product as on the other resource. Marginally, one resource is as efficient
as the other, and there is no relative inefficiency between them.
In Figure 42, different resource combination along the isocost curve B₁ correspond to
different isoquants and production capacities (isoquants below Q₁). The optimum purchase
combination is at point A since the given isocost curve corresponds (tangent) to the highest
isoquant and level of production capacity that it’s budget (B₁) can buy. In other word, a
budget has one resource combination that maximize output.
In the foregoing optimum condition, one resource is as marginally efficient as the other.
Therefore, any deviation from the optimum point results in a resource imbalance that
diminishes returns and decreases production capacity. In the same figure, the use of more
capital and less 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.
 PRODUCTIVITY
This section discusses the dynamics of resource efficiency as it affects production.
Succeeding chapter will also highlight its impact on firm’s competitiveness and survival

Concepts
Productivity is the efficiency and therefore 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.
Q
Productivity =
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 its measured as their marginal
output which is also illustrated below:
∆Q
Marginal Productivity =
∆I
where additionally:
∆ = Change
In the production 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
Q
in the efficiency ratio indicates. It also means less input for output as the decrease in
I
I
the ratio’s inverse indicates.
Q
Therefore, efficiency is not a matter of size. A bigger plant is not necessarily
more efficient than its smaller counterparts. To use a simply 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, i.e., before diminishing returns. However, the limited output at these points does not
necessarily make production more competitive and profitable. Instead, an over all
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 latter expressed as monetary cost in the basic
Q
productivity ratio . therefore, economic efficiency balances or reconciles the effects of
I
the 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, its
additional monetary returns should outstrip its cost. However, technological advancement can
optimize both output and cost readily fit the picture of economic efficiency. For example, computers
have become more powerful and cheaper to do more work at lower cost.
CASE STUDY
The Rational behind Attempts of MG Rover Alliances
This essay explores the rationale behind MG Rover’s attempt to forge alliances. It begins
with a brief history of the brand because in order to understand the rationale for alliances,
you must understand where the company found itself at the start of the new millennium.
The Rover brand emerged over a century age and provided high-quality cars to the
middle classes. Rover was then assimilated into the nationalized British Leyland in the mid-
1960’s. However, this was, in hindsight, seen as a failure as it starved the brand of
investment and seriously harmed its reputation for quality. In 1982, the group was spun off
and a recent strategic alliance with Honda was giving them access to Honda’s engineering
expertise and produced some excellent results. However, the group was then sold to British
Aerospace in 1988 which in turn sold it to BMW in 1994. This ended the alliance with Honda.
Within a year, Rover was within BMW circles called “the English patient” as they
believed they had bought a sick car company. The production and labor facilities were seen
as antiquated and the model range was in urgent need of updating. BMW preserved and
invested billions of pounds in revamping the whole operation to try to modernize it. They
finally gave up 2000 when the drain on BMW’s resources was threatening their own balance
sheet. The company was sold to a group of private investors, the Phoenix Consortium, for a
nominal sum. This newly formed entity was named the MG Rover group. This group had,
however, lost two key niche brands along the way – the Mini and the Land Rover. MG Rover
had +, in effect, been picked clean of key satellite brand and what was left was a company
with essentially three models: the Rover 24, 45, 75. The very problems is faced at this
juncture were the reasons it attempted to forge alliances over the next five years with other
firms including Proton, Tata, China Brilliance, and SCIA. These reasons included:

Lack of Production Volume

MG Rover lacked any serious production capacity. The top five car producers all
manufactured over three million units a year each in 2003. In comparison, MG Rover’s
production of 107,000 units in 2003 was almost derisory. The key to success in the
automobile industry is either volume or a successful niche product. With volume, you get
economies of scale which can carry the high costs of developing a new model. MG Rover’s
107,000 cars alone could not justify new models. Without new models, sales fell. The
attempt to forge an alliance was an attempt to escape from this vicious circle. The attempted
collaboration with Chinese firms was an attempt to rapidly scale up production in a single
market with huge potential. Equally, the Chinese were eager to acquire a “Western” brand
and technology.

Lack of R&D Capacity

 When the BMW sold the Land Rover brand to Ford, the Research and Development
(R&D) facility at Gaydon also went with it. This deprived Rover of most of its R&D capability
which is vital in today’s car market where constant innovation is the key to success.
Combined with its lack of production volume, MG River lacked any ability to perform serious
innovative research itself. The joint ventures with Honda and BMW had shown what MG
Rover was capable of but without deep pockets, it was stuck in a time warp.

Poor Model Range

This is obviously linked to the lack of R&A+D but exposes deeper strategic problems
within MG Rover. Even when BMW owned Rover, the only new model it launched was the
Rover 75 – an executive saloon. Yet the growing segments in the market were the super
mini, the Sport Utility Vehicle, and the MPV. MG Rover had little or nothing in these
segments. Ironically, MG Rover had, under BMW, drastically improved its quality of the range
it had. However, the result of this model gap, was that it was hemorrhaging market share in
its only real market: the UK. In 1990, it had 13.62% of market share in the UK, by 2004, it
was down to 2.99%. MG Rover simply did not have the full range of models to keep
attracting younger customers. An alliance was needed to flesh out their model range. In
hindsight, now it can be seen that the strategic alliance with Honda was probably Rover’s
access to the UK market and Rover would have gotten access to their R&D and a wider
product range. They had jointly developed five models before the break-up of their alliance.
It is clear that Rover was probably seeking what it already had with Honda.

Lack of International Markets

MG Rover was essentially and English company. The only internationally recognizable
brands it possessed were Mini and Land Rover. When these were gone, it was tied to
vagaries of the UK economy and could never achieve the global economies of the scale that,
for example, Toyota or VW had. This weakness repeatedly hindered Rover over its history.
Because when it did have good models like Montego, Maestro, and Metro, it simply did not
have the distribution network to sell them internationally to gain volume and higher
marginal profits. The alliance with BMW gave it a renewed potential for accessing the
European market and beyond but when BMW was gone, Rover was back to square one. It
needed alliances to rectify this and help it to expand graphically. However, established world
markets were oversupplied and the real place it could turn to was developing markets. Rover
still had the technological experience which was marketable in this regions – this is why
China drew interest. China had the mass market that would allow it to scale up production in
a low labor cost economy – it seemed an ideal solution to Rover’s problems.

Negative Publicity
It is worth noting that the weaker MG ROVER became, the lower its sales went. The
public did not want to buy a brand that might not exist next year. A successful alliance may
well have stemmed this effect and even turned it. MG Rover imprimatur of another
successful company. The only period when their image was really improving was when BMW
owned it and its prestige and technology rubbed off – but even this was not enough to
support sales.
Lack of Cash
This real issue at the core of MG Rover’s problems from the moment it broke from BMW
was cash. Without a rich parent pumping money into the company, it was consuming its own
capital to cover the day-today losses it was making. By 2003, it had even sold its main
production plant, Longbridge, for 45 million pounds and was leasing it back . In 2001, it had
sought investment from China Brilliance in order to fund new models but this eventually fell
through. Again in 2004, Rover and the Shanghai Automotive Industry Corporation (SAIC)
were courting but the consummation never took place. SAIC was just not willing to pour in
the cash necessary. Their logic was incredibly sound: if BMW cash and technology could not
turn Rover around, could anyone do it? The Chinese also realized that they knew more
about their own markets than Rover did and all they were really after were Rover’s models
and technology: not a potential money pit. In the end, all that was bought by the Nanjing
Group was the right to the MG Rover’s models and technology for 67 million pounds. Later,
the Longbridge plant was physically stripped of the machinery and this was shipped to
China.
It must be asked if the real rational for a search for alliances may really have been a
quest for someone to finally buy any value that was left within MG Rover. The men behind
Phoenix Trust were not new to the industry; they must have known the situation MG Rover
was in.
In the final analysis, when MG Rover split with BMW, it was too big to be a niche market
player and too small to be the global player it wanted to be. It needed to forge alliances to
rectify these problems. It needed technology, a new model range, and a brand-boosting
connection with another firm. But most of all, it needed cash.

Source: Hayat Akbar, May 9, 2010,

under the Creative Commons
Attribution-ShareAlike License

Questions:
1. What are the reasons for MG Rover’s diseconomies of scale?
2. Explain how innovation and a good research and development capacity could have
saved MG Rover?

SUMMARY
Two Concepts in Theory of Production
1. Law of Diminishing Returns states the use of variable resources against
the limits of fixed resources or describes the tendency at some point
for each succeeding addition to output to become smaller as the firms
add succession units of variable to some fixed imputs.
Two Lessons:
a. Size of a resource, given the rest as fixed, should not go beyond its
product-maximizing point.
b. Plant capacity can only increase with more resources combined unless
technology changes.
2. Returns to scale measure how output changes relative to resource
inputs in the long run and indicate how overall resource efficiency
changes with plant size.
Economies of scale cost advantages that a business can use by
expanding their scale of production.
Diseconomies of scale occur when business grows so large that cost of
unit go up and are characterized by the decreasing efficiency or even
efficiency of size.
Basic Ways to Improve Resource Efficiency
1. Change the nature of resource through innovation
2. Advancement in hardware technology for the electronic information
industry
3. Change external condition of resources
4. More balanced resource combination
5. Using resource-saving technology

CHAPTER 6: THE THEORY OF COST AND PROFIT

Objectives
At the end of the chapter you will be able 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.

INTRODUCTION
The producer in this chapter is presented as one whose objective is profit maximation.
To attain this objective, the producer is equipped with explicit concepts in order to arrive at
a more refined and rational 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
relationship, which in turn lead to the concept of maximum profit.

GENERAL CONCEPT
From a 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. To retain this profit is to
increase the firm’s stock of assets. Conversely, the negative difference between revenue and
cost result in a loss which erodes this stock.

CAST CONCEPTS
A firm maintain a stock of assets that it can use for production.
TWO CLASSIFICATION OF ASSETS
1. Real assets – machineries, buildings, materials, and supplies.
*thus a buy and sell business is also involved in production which is the service of bringing supplies from the
source to the users

2. Monetary assets – forms of money and near money, part of which the firm transform
into real assets through purchases or acquisitions.
The firm incurs cost by using theses 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 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 meaning of the production covers a broader perspective. The resources used 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 form of taxes.

OPPURTUNITY COST
As a concept, opportunity cost is the foregone opportunity of choosing 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 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
owner’s money could have earned from money market placement. Another example is the
employment income the entrepreneur lost by not working somewhere else.

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 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.

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

Table 17
Cost-Output Relationship in the Short Run
TOTAL TOTAL TOTAL AVERAGE AVERAGE AVERAGE MARGINAL TOTAL TOTAL
QUANTITY FIXED VARIABLE COST FIXED VARIABLE TOTAL COST REVENUE PROFIT
COST COST (TC) COST COST COST WHEN WHEN
(TFC) (TVC) (AFC) (ATC) PRICE IS PRICE
₱9.5 IS ₱9.5
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 2.29 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 5.92 9.25 16 114 3
12 40 71 111 3.33 5.92 9.52 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 1313 -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 equations that define them:
∆ TC ∆ TC
MC = ∆Q
= ∆Q
∆ TVC
MVC = ∆Q
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
∆C = Infinitesimal change or a unit change that is infinitely small

AVERAGE COST
Average cost is cost per unit of output which assumes the following term:

where:
ATC = Average Total Coat 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 Unit of Output
TVC = Total Variable Cost
TFC TVC
ATC = Q
+ Q

ATC = AFC + AVC

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 = (AFC0 (Q)
 PROFIT CONCEPT
TOTAL AND MARGINAL REVENUES
The following are the concepts of revenue output relationship with the equations the
define them:
TR = PQ
TR PQ
AR = = (whether price is constant or not)
Q P
∆ TR
MR =
∆Q
∆(PQ )
MR = (if price is not constant)
∆Q
(∆ Q) P
MR = = (if price to constant)
∆Q
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
∆ = Infinitesimal change

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 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 = ∑ (MR – MC) + TFC
= ∑ (MR – MC) – TFC
 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
decrease/increase 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 a longer ATC
curve.

CASE STUDY
Ford to Shutdown Australian Production by 2016
The Ford Motor Company has decided to wind down production in Australia after 85
years. The carmaker says the closure of two years. The carmaker says the closure of two
plants and the loss of 1,200 jobs are because losses and the small market.
 “Manufacturing is not viable for Ford in Australia for the long term,” said Chief
Executive of Ford Australia Bob Graziano. “Our locally made products continue to be
unprofitable, while our imported products continue to be profitable.”
Analysts estimate the company has approximately $580 million in losses in the last
fiscal year, and profit fell by 72 percent. Ford’s decision in Australia follows effort to also
close shop in Europe.
Graziano told reporters, Australian production was no longer sustainable as it was
double the costs of Europe and quadruple the cost in Asia. The average hourly
manufacturing salary in Australia in 2011 was $46.29, slightly lower than in US and Japan
and nearly 75 percent higher than Brazil, according to US Department of Labor data.
This could be a warning for other foreign automakers – Toyota and General Motors –
which both currently plan to keep operations running.
The Australian government already highly subsidizes the car industry through a $5.4
billion fund, $34 million of which is allocated to Ford Australia.
Two plants in Melbourne and Geelong in the state of Victoria will be closed by
2016, giving workers 3 years notice, and offering a government rescue support package of
$39 million.
Australia’s auto industry directly employs 45,000 people across the country and
another 250,00 indirectly, accordingly to the Federation of Automotive Products
Manufacturers.
Australia’s population in 2012 was 22.8 million, a small market to sustain both local
production and sales.
Car registrations in Australia decreased 93,423 in April of 2013, down 531 from
March, indicating a drop in sales.
Metals and plastics industries, two of Australia’s core, are expected to feel the
impact of the plant closure.
There has been a speculation that the carbon tax is a driving factor behind Ford’s
decision to halt production.
Victoria Premier Denis Napthine, though confident recovery, blames the carbon
tax for hiking up production and manufacturing costs. The government has proposed to
ditch the tax this coming December, but will not likely alter Ford’s decision to pack up and
leave for cheaper labor and more profitable production.

Source: www.rt.com. free to share and reprint license: http://rt.com/legal-disclaimer/.

May 23, 2013, 09:50 p.m.
Questions:
1. What is the effect of the decline of Ford Australia’s productivity on its cost
efficiency, production, and profit? Illustrate.
2. How does it affect Ford Australia’s suppliers, particularly the metals and plastics
industries? Illustrate.
3. How does the average hourly manufacturing salary in Australia affect cost
efficiency? How does the average hourly manufacturing salary in Asia and nearby
countries impact Ford’s decision to halt production?
4. Do you agree that carbon tax is the key factor behind Ford Australia’s decision to
stop production? Do you think Ford will still close even without the carbon tax?
Explain.
5. Explain and illustrate that profit could be maintained if the tax burden were simply
passed on to the consumers in the form of higher price. How will this affect sales?

Summary

Assets Cost Profit

Two classifications of  Opportunity cost  Tr = PQ (Price,
Assets – one gains in Quality)
 Real assets – giving up  Maximum Profit
machineries, alternatives to  Profit = TF – (TFC
buildings, benefit from a + TVC) = (TR –
materials, and choice TVC) – TFC
supplies.  Imputed cost –  MR must be
 Monetary – cost that is greater than MC.
forms of money implied but not  Average Profit:
and near money, included in AP = TP/Q
part of which the financial report
firm transforms or accounting
into real assets  Cost-output
through relationship
purchases or a. Total Fix Cost
acquisitions (TFC) does not
vary with
output
b. Total Variable
Cost (TVC)
varies with
output