Production and Cost Theory – focus on the supply side of the market.

- How the producers make choices – and how these choices affect the market.

Theory of Firms – states that firms exist for the purpose of profit maximization – individuals put up
businesses because they want to earn profit, at the same time they want to maximize their profit (and
for them to be able to do it, they have to understand the concept Production Theory and Cost Theory)

Production Function – mathematical expression that shows the technical relationship between the
firms’ input and output.

Output = f (inputs)

Output – dependent variable

Input – independent variable

Anything that will happen to your input will affect your output.

Input – refers to your factors of production such as land, labor, capital, and entrepreneurship.

2 kinds of Input (Fixed and Variable)

Fixed Input – inputs whose quantity is not changed by the firm, regardless of its reason.

- Inputs which do not vary throughout the production process, we cannot easily decrease or
increase the number of our fixed input during the production process.
- Ex. You have 1hec land, during the production of your palay, you cannot easily increase the
amount of your land because it’s too costly on your part to buy another hectare of land during
the production process, therefore, land can be considered as a fixed input.
- Ex. Capital – assets, machineries, or other tools that can directly produce goods and services. –
we cannot easily increase or decrease the number of inputs.

Variable Input – inputs whose quantities can really be changed like labor and raw materials.

- Referring to the inputs that vary throughout the production process, we can easily increase or
decrease the number of our variable input.
- Ex. Planting Palay – when you realize that one farmer is not enough to fill your land, therefore
you can hire more farmers. – therefore, we can say that labor can be considered as variable
inputs.

Production Period – refers to how firms adjust their inputs which may also depend on the available
money to pay for inputs such as land, labor, capital, and entrepreneurship.

- Refers to the adjustment of the firm from using fixed input to variable input.
- When we say production period, we are not referring to the duration of time of the production
process, instead, we are referring to the adjustment of the firm from using fixed input to
variable input.
- We can say that a firm is on a long-run period, but it’s been on the business for only 10 years.
- We can also say that the firm is already 20 years in the business but still on the short-run period.
3 types of Production Period

Very Short – Run Period or the Immediate Period – the firm uses fixed input and only uses fixed input in
producing goods and services.

Short – Run Period – the firm gradually adjusts from using fixed input to variable input.

Long – Run Period – the firm only uses variable input.

Production table – is used to further understand the production theory, stages of production, and the
law of the diminishing marginal return.

- Let’s say you have 1 hectare of land, and 1 hectare of land is considered as fixed input – as you
may notice, throughout the production process, it is only 1 hectare. And let’s use labor as
variable input, throughout the production process, we increase the number of farmers.
- Always remember that when we say Marginal Product, that is the output produced by the last
worker wherein we have the formula – MP = TP/L – MP = TP2- TP1/L2-L1
- We have the formula for the average product – AP = TP/Labor

Marginal Product – what did the last worker contribute. Is he more productive than the first one.

Average Product – we want to determine how much a worker produces.

Stages of Production – Law of Diminishing Marginal Return

1. Increasing Return Stage – as additional variable input is added to your fixed input, the total
product increases at an increasing rate (marginal product).
 Marginal product > average product
 On stage 1, we say that there is an underutilization of the fixed input – because we
aren’t able to maximize yet the capacity of the 1-hectare land – and the capacity of the
land is 52 cavans of palay.
 2. Decreasing Return Stage – others also call this as Diminishing Return Stage – as additional
variable input is added to your fixed input, the total product increases at a decreasing rate.
 TP is increasing but MP is decreasing
 MP < AP
 Reaches the maximum capacity of the land
 Rationalization stage – we have to determine what combination of inputs maximizes the
output.
3. Negative Return Stage – we have decreasing return stage wherein total product declines.
 MP is negative while the AP is still positive

Graphs

TP Curve – y axis TP x axis L

When your MP = 0, we can assume that your TP = maximum

AP in relation with MP (MP>AP) – AP is below MP

AP>MP – AP is above MP
Theory of Cost

Economic cost – payment made by the firm from using the different economic resources.

- payment for the inputs that the firm uses in the production processes.

Two Kinds of Economic Cost

Explicit Cost – payment made by the firm from using outside resources.

Ex. Labor – we pay for employee’s wages

Implicit Cost - payment made by the firm from the use of its own resources.

Ex. You have a truck – we earn from it by rental but we use it for own business – the implicit here is the
forgone rent (sacrificed rent that’s supposedly to be earned)

When we say explicit and implicit cost, they are both considered as opportunity cost (the amount of
something that is sacrificed to gain something). We sacrifice money in explicit cost. We sacrifice forgone
opportunity in implicit cost.

Profit = Total Revenue – Total Cost

Accounting Profit = Total Revenue – Explicit Cost

Economic Profit = Total Revenue – (Explicit Cost + Implicit Cost) (need i-add yung forgone revenue kasi
that is your normal profit)

Different Kinds of Cost Based on the Production Period of the Firm

Immediate Period – TC = TFC

Short-run Period – TC = TFC+TVC

Long-run Period – TC = TVC

TFC – Total Fixed Cost – cost of the firm which does not vary throughout the production process.
TVC – Total Variable Cost – cost of production wherein it varies throughout the production process and
it depends upon the output produced.

TC – Total Cost – summation of all the cost of production.

Marginal Cost – additional cost incurred by the firm from producing one more output.

Short-run Period

0 Output = 0 TVC

If TFC is horizontal, TVC fluctuates, and TC imitates the movement of the TVC.

TVC gives the moment for TC.

Undefined – do not include in y.

AFC – downward – as numerator remains the same and denominator increases.

AVC – fluctuates – TC imitates.

MG – J-shaped

Long-run Period – pinagsama-samang short-run average cost curve

Economies of Scale –  AVC  Output – a company always aims for economies of scale – through the
use of technology.
Diseconomies of Scale -  AVC  Output – it is not favorable on the part of producer – he has to pay
more to produce an output.