THEORY OF THE FIRM AND THE PRODUCTION PROCESS

The other side of the microeconomic system is the firm. A business firm
purchase inputs in order to produce and sell outputs. In other words they
demand factors of production and supply goods and services.

NATURE OF PRODUCTION PROCESS

Production = is the process by which inputs are combined, transformed,

and turned into outputs.

Assumptions in the study of Production:

1. Production is not limited to firms

2. Perfect competition

The Behavior of Profit-Maximizing Firms

1. Primary objective: maximize profits

2. 3 Decisions that All Firms must make:

a. how much output to supply (quantity of a product)

b. how to produce that output (which production
technique/technology to use)
c. how much input to demand (quantity of inputs)

Bases for decision-making:

a. The market price of output
b. The techniques of production that are available
c. The prices of inputs
Short-run versus Long-run Decisions

Short-run is a period of time for which two conditions hold: (1) the
firm is operating under a fixed factor of production; and (2) new firms
cannot enter, and existing firms cannot exit.

Long-run is a period of time for which there are no fixed factors of

production. Firms can increase or decrease scale of operation, and new
firms can enter and existing firms can exit the industry.

PRODUCTION PROCESS: Total product, marginal product and

average product

The relationship between inputs and outputs (i.e. the technology of

production) expressed numerically or mathematically is called a
production function (or total product function). A production
function shows units of total product as a function of units of inputs.

A production schedule of a small sandwich shop is shown below.

Before we examine closely the data presented below, some assumptions
are set:

1. all the sandwiches made in the shop are grilled

2. the shop owns only one grill

LABOR TOTAL MARGINAL AVERAGE

UNITS PRODUCT PRODUCT OF PRODUCT OF
 (Employees) (Sandwiches) LABOR LABOR
0 0
1 10 10 10
2 25 15 12.5
3 35 10 11.7
4 40 5 10
5 42 2 8.4
6 42 0 7
7 40 -2 5.7

law of diminishing marginal returns which states that when additional

units of a variable input are added to a fixed inputs after a certain point,
the marginal product of the variable input declines

Average product is the average amount produced by each unit of a

variable factor of production. In other words, this is total product
divided by total units of labor.

Graphical representation:

THE SHAPES OF THE AVERAGE AND MARGINAL PRODUCT

CURVES

-AP curve usually rises at first, reaches a maximum and then falls
but it remains positive as long as the TP is positive
-MP curve also rises at first, reaches a maximum (before the AP
reaches its maximum) and then declines. The MP becomes zero
when TP is maximum and negative when TP begins to decline
STAGES OF PRODUCTION

The relationship between AP and MP curves are used to define 3 stages

of production

STAGE I – goes from the origin to the point where AP is

Maximum
STAGE II – goes from the point where AP is maximum
to the point where the MP is zero
STAGE III – covers the range over which MP is negative

The stages of production is used to analyze the efficiency of input or

resource:

 efficiency of input is measured by AP because it indicates the

amount of output obtained per unit of input
 the MP of the input is a measure of the efficiency of one
additional unit of variable input but it doesn’t reflect the
efficiency of all the units of variable input taken together as a
group
 THEORY OF COST/COST ANALYSIS

COSTS –money outlays that a firm must pay for the resources
used to produce output of goods and services. They are usually
called the out-of-pocket expenditures of the explicit costs.

SHORT-RUN COSTS OF THE FIRM

Assumption: Costs depend on the per unit price of input and the
quantity of inputs used

 Cost function = shows various relationships between

cost and the level of output. Meaning the number of
input, prices of input and the output determines firm’s
cost functions
 In the short-run, inputs are variable and fixed

• costs of fixed input = fixed costs to the firm

• costs of variable input = variable costs to the firm

TOTAL COST CURVES

1. Fixed Costs – remain the same regardless of the volume of
output.
Ex. Factory overhead (costs involved in the production
process which cannot be traced directly to the output
(salaries of foreman, rental of factory building, property
taxes)

2. Variable Costs – vary with output. It increases as output

increases
Ex. (a) direct labor – the wages paid to human resources
who directly work on the goods being produced
 (b) direct materials – costs of raw materials that
actually get incorporated into the finished product

TOTAL COST OF A FIRM IN THE SHORT RUN

No. of Total Total Total Total

Labor Product Fixed Variable Costs
Costs Costs (TC)
(TFC) (TVC)
0 0 P20
1 6 …
2 14 …
3 24 …
4 32 …
5 38 …
6 43 …
7 44 …

Price/output = P2.50
Price/input = P10.00
*TC AND TVC have the same shape. The distance between the
curves is the amount of TFC.

*TC and TVC behaviors can be explained by the law of

diminishing returns
• as variable input input increases while other input
is constant, additional productivity of the additional
unit of input diminishes
• if the productivity of input diminishes, then its costs
become more expensive to the firm as more of it is
used
PER UNIT COST CURVES

• more useful in price and output determination

• permits the firm to compare the cost of each
individual unit of input at various stages of
production
• useful in the analysis of profit maximization

Common Per Unit Costs

1. Average Fixed Cost (AFC)

TFC
Q

2. Average variable cost (AVC)

TVC
Q

3. Average Total Cost (ATC)

TC
Q

4. Marginal Cost (MC)

∆TC
∆Q

5. Average Total Cost (ATC)

AFC + AVC
COST BEHAVIORS

1. AFC

• lower volume of output, AFC is high but if the firm

produces more, AFC per unit if output decreases
reason: fixed cost remains the same regardless of
volume of output. As volume of production is
increased, FC is spread over more units of output
and each output bears a smaller share of the fixed
cost
• AFC continuously decline as output increases

2. AVC

• cost of labor that goes into each unit of output

• AVC decreases up to a certain point then it starts
to rise
• If one labor is employed output produced is
extremely small; second labor will facilitate the
work resulting in a more than proportionate
increase in output
• A doubling of the variable input resulted in a more
than twice an increase in output which means that
the variable cost per unit of output decreased

3. ATC

• at early stage of production, both AFC and AVC

are decreasing, so the ATC must also be
decreasing
 • ATC reaches its lowest point, but the the greater
Total production (38)
• The range of decrease of ATC is greater than AVC
because of the lowering influence of AFC

4. MC

• at certain levels of output, MC is decreasing, then

reaches minimum and starts to increase because
of law of diminishing returns
• AVC and ATC are decreasing as long as MC is
below them
• MC always intersects the AVC and ATC curves at
the lowest

UNDERSTANDING THE INTERSECTIONS

If AVC is decreasing, MC is < AVC

If ATC is decreasing, MC is < ATC
If AVC is increasing, MC is > AVC
If ATC is increasing, MC is > ATC
If AVC = MC, then AVC is min
If ATC = MC, then ATC is min