CHAPTER 5

The profit maximizing firm

ProductionIt refers to any economic activity,

which combines the four factors of production.

1.Land2.Labor3.Capital4.Entrepreneurship

It is the process of converting inputs into outputs.

Inputs – commodities and services that are used to produces goods and services.

1. Land (natural resources, represents the gift of nature to our productive processes.

2. Labor ( mental and physical ability used in the production of goods and services.

3. Capital ( goods that are used in the production of other goods and services.

Outputs – various useful goods and services that result from the production process and are either consumed or employed in further production.

1. Final goods - goods and services that are ultimately consumed.

Ex. Clothes that we wear

2. Intermediate goods - goods that are used to produce other goods.

Ex. Sugar in the making of cakes

Technology- a body of knowledge

applied to how goods are produced.1. Labor Intensive Technology - utilizes more labor resources

2. Capital Intensive Technology-utilizes more capital resources

Fixed input- is any resource the quantity of which cannot be readily changed when market conditions indicate that a change in output is desirable.Variable input – is any economic resource the quantity of which can be readily changed in response to changes in output.

Short Run – a period of time so short that there is at least one fixed input therefore changes in the output must be accomplished exclusively by changes in the use of variable inputs.Long run - a period of time so long that all inputs are considered variable. It is also known as the planning horizon.

Production FunctionIt is the functional relationship

between quantities of inputs used in production and outputs to be produced. The production function specifies the maximum output that can be produced with a given quantity of inputs given the available technology.

Important Production Concepts

Total product – refers to the total output produced after utilizing the fixed and variable inputs in the production process.

Average Product – which equals total product divided by total units of input used.

Marginal Product of an input- the extra output produced by 1 additional unit of an input while other inputs are held constant.

Labor’s Marginal Product -the extra or additional output obtained by adding 1 unit of labor. We can derive marginal product using

the following equation:

MP = ∆TP∆I1. MP= TP2-TP1

IL2-IL1

Graphical Representation of Total Product, Marginal Product and Average Product

This figure shows the total, marginal and average products. Total product increases at a decreasing rate while marginal and average products first increase, reach their maximum and thereafter decline.

holds that we will get less and less extra output when we add additional amount of an input while holding other inputs fixed. In other words, the marginal product of each unit of input will decline as the amount of that input increases, holding all other inputs constant.

The Law of Diminishing Returns

Diminishing returns and marginal products refer to the response of output to an increase of a single input when all other inputs are held constant.

R E T U R N S

T o

S C A L E

Constant Returns to

Scale

Increasing Returns to

Scale

Decreasing Returns to

Scale

Indicate a case where a change in all inputs leads to a proportional

change in output.

Also called as economies of scale. It happens when an increase in all

inputs leads to a more-than-proportional increase in the level

of output.

It occurs when a balanced increase in all inputs leads to a

less-than-proportional increase in total output.

The theory of costCost refers to all expenses acquired during the economic activity or the production of goods and services.

Sales – Cost = Profit

Total Revenue–Total Costs= Profit

Total Opportunity cost- sum of explicit and implicit cost.Explicit Cost are payments to non-owners of a firm for their resources.Implicit Cost are the opportunity of costs of using resources owned by a firm.

Fixed cost or overheard or supplementary cost are those expenses which are spent for the use of fixed factors of production. It is sometimes called sunk costs.Example : Rent, Interest, Depreciation

Variable Cost or prime operating cost are those expenses which change as a consequence of a change in quantity of output produced.These include expenses on labor inputs, raw materials, electricity, etc.

Cost

Total variable cost (TVC) – consists of costs that are zero when output is zero and vary

as output increases or decreases.

Total fixed cost (TFC) – consists of costs that do not

vary as output varies and that must be paid even if output is

zero.

Total Costsum of total fixed cost and

total variable cost.

TC = TFC + VC

Average Fixed Cost (AFC)AFC = FC / QAverage Variable Cost (AVC)AVC = VC / Q Average Total Cost (ATC)ATC = AFC+AVC or TC / Q

Average Cost: Average Fixed Cost, Average Variable Cost and Average

Total Cost

Marginal Cost (MC)The cost of producing one

additional unit of output.The change in total cost when

one additional unit of output is produced.

MC = ∆TC ∆Q

MC = ∆TVC ∆Q

Profit – difference that arises when a film’s total revenue is greater than of it’s cost.

Profit Maximization – process by which a firm determines the price and output level that returns the greatest profit.

Profit = Total Revenue – Total Cost