EM_ReadMat (Laissez Faire/Law of Supply and Demand/Production Function & Profit Maximization)

Laissez-Faire Doctrine
Commonly known as the ‘let-alone-policy’ or referred to by some as none other than the ‘free
enterprise’ concept, the ‘laissez-faire doctrine’, states that the government should not interfere with the
economy. Adam Smith, the originator proposed that there is what he termed as the “Invisible Hand”
which takes care of the economy. Some authorities in the field believe this to be the interplay of
demand and supply forces. So, let alone or leave the economy to fend for itself and it will survive. This
is the usual sentiment of the so-called “laissez-faire” advocates (who are likewise Adam Smith
advocates). If the government is to intervene or interfere, it must only be in terms of the maintenance
of peace and order. It is implied that the government should let the private enterprise alone which
means that businesses should have the freedom to enter into any activity in competition with other
market competitors and as a result to either suffer the losses or gain the rewards. This doctrine offering
governmental interference in economic affairs beyond the minimum necessary for the maintenance of
peace and property rights was followed by vacancy in governments in the 18 th century. But before full
laissez-faire was achieved, the tide turned the other way.

Law of Demand and Supply

Economics is both a science and an art. It is a science because it is based on a body of information
and knowledge systematically organized and on principles derived from this knowledge by careful
observation, classification and analysis. Its application is an art.
A good example of this is through the basic law of Economics: The Law of Demand and Supply. The
law itself is science and its application for the advantage of the consumer is an art. It is an art because it
deals with the ways and procedures or the technique of producing material goods and services.
The Law of Demand and Supply are actually two (2) separate laws but are so interrelated, one is
discussed with the other. The Law of Demand states that as the price of a commodity increases,
quantity demanded of that commodity decreases ceteris paribus (all other things equal or constant) and
if the price of a commodity decreases, quantity demanded increases ceteris paribus. There is an inverse
relationship between price and quantity demanded. On the other hand, the Law of Supply states that as
the price of a commodity increases, quantity supplied also increases ceteris paribus and as the price of
the commodity decreases, quantity supplied also decreases ceteris paribus. This now shows there is a
direct relationship between price and quantity supplied. (Note: Without the phrase “ceteris paribus”
the statements are erroneous and the mathematical relationships argumentative.
In other words, price is directly proportional to supply and inversely related to demand. (Note: If
you state it this way, there is no need for the phrase, “ceteris paribus”)
In the Law of Demand and Supply, the point of intersection is the equilibrium point which signifies
that both the seller/producer and the buyer/consumer have agreed to exchange at that specific price
and quantity. Algebraically presented, the Law of Demand and Supply is presented as:
Q = f (P)
read as quantity is a function of price.
 This Photo by Unknown Author is licensed under CC BY-NC

(Using the graph, a discussion of demand and supply curves follow showing the intersection or the
equilibrium point as well as the areas of shortage and surplus.

For the discussion on the difference between change in quantity demanded/quantity supplied
(movement) and change in demand/supply (shift), the graphs which follow will be utilized.
 This Photo by Unknown Author is licensed under CC BY

To summarize, the change in quantity demanded or change in quantity supplied occurs along the same
demand curve or supply curve (either to the left or right) and this is called a movement. And what
causes the change if you recall the Law of Demand and Supply? Price, of course. Such that any change
occurring in price (being the independent variable), the quantity (whether supply or demand) will be
affected (being the dependent variable).
As for the change in demand or supply, it is called a shift. A shift happens when there is a transfer
to a new demand curve or new supply curve (whether to the left or to the right). And what causes the
change in demand or supply? The determinants of demand are income, population, tastes and
preferences, price expectations, prices of related goods. On the other hand, technology, cost of
production, number of sellers, weather, as well as taxes and subsidies are the determinants of supply.
(Note: The significance of the phrase, ceteris paribus can be re-emphasized here. Meaning, the
determinants of demand or supply are constant and are not considered as factors that will affect
demand or supply in the market).

Production Function
Defined as the technical relationship showing the maximum amount of output capable of being
produced by each and every set of specified factors of production or factor inputs. The quantity of
output of the goods depends on the quantities of the input X1 (labor), X2 (machinery), X3 (raw
materials) form the equation where
P = f (X1+X2+X3+…Xn)

and, where X1, X2, X3, … Xn are inputs.

Thus, a production function affirms that the maximum output of a technologically-determined
production process is a mathematical function of input factors of production. And considering the set of
all technically feasible combinations of output and inputs, only the combinations containing a maximum
output for a specified set of inputs would constitute the production function. It is important to note also
that a production function deals with the specification of the minimum input requirements needed to
produce designated quantities of output, given available technology. Lastly, keep in mind that the
production function describes technology, not economic behavior and so, the main goal of the producer
is to maximize his profits and that he utilizes his technology towards efficient production.

Profit Maximization
Since the goal of the producer is to maximize his profits, one (1) approach that may be used is the
MC=MR approach where MC is the Marginal Cost (or the difference, or increment, between total costs
at a higher and a lower level of output, divided by the number of units produced)) and MR is the
Marginal Revenue (or the difference between total revenue from sales at two different levels of output
divided by the quantity of goods produced). And in order to arrive at this profit maximization equation,
the following formulas (both on the cost side and revenue side in production) have to be considered:

Cost Side
 Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)
 Average Fixed Cost (AFC) = FC/Q
 Average Variable Cost (AVC) = VC/Q
 Average Total Cost (ATC) or Average Cost (AC) = AFC+AVC or AC/Q
(Note: it is suggested that you use the second formula for class uniformity)
 Marginal Cost (MC) = Present TC minus Previous TC/ Present Q minus Previous Q
(or the Difference in Total Costs divided by Difference in Quantities)
Revenue Side
 Total Revenue (TR) = P × Q (or Price multiplied to Quantity)
 Average Revenue (AR) = TR÷ Q (TR divided by Q) = Price (P)
 Marginal Revenue (MR) = Present TR minus Previous TR/Present Q minus Previous Q
(or Difference in Total Revenues divided by the Difference in Quantities
Note: Once you have the MC and the MR per level you can now evaluate if the producer attained profit
maximization based on the three (3) expected outcomes: MC ¿ MR; MC ¿ MR or MC = MR