SUBJECT BASIC MICRO ECONOMICS

LEARNING OBJECTIVES
Student shall be able to:
1. Know the different functions and operations
of market structures; Analyze how and why
consumers demand for goods and services;
Analyze how producers or firms supply
goods and services; Analyze the equilibrium
and dis equilibrium condition of the forces of
demand and supply in the market SEMI FINAL 5-8 WEEKS
2. Determine the sensitivity of consumers and
producers in responding to price and income
changes; Demonstrate how the consumers
maximize their utility or satisfaction, given
the budget constraints they face
3. Describe the production process of firms;
Determine how firms incur and minimize
costs of production: Analyze the economic
analysis of profit maximization, comprehend
why market failure exist
EXPECTED OUTPUT Measurement Evaluation Quiz/Exam
After reading this module the student must be and Projects
able to
1. Demonstrate growth in real national
income.
Investment levels and the relationship
between capital investment and national
output
2. Understand the productivity of labor, which
influences other economic variables,
including an economy’s competitiveness in
international markets.
TOPICS MODULE 5: COST OF PRODUCTION
MODULE 6: THE THEORY OF THE
FIRM
Introduction
Cost of production refers to the total cost incurred by a business to produce a specific
quantity of a product or offer a service. Production costs may include things such as labor,
raw materials, or consumable supplies. In economics, the cost of production is defined as
the expenditures incurred to obtain the factors of production such as labor, land, and
capital, that are needed in the production process of a product.

What are costs?

Generally speaking, a cost is what you have to give up in order to acquire something you want.
In production, a cost is the necessary initial investment needed to initiate the production process.
For instance, the cost of making and selling hotdogs is the money invested in bread, sausages,
mayonnaise, mustard and a grill.
These are prerequisites if one wants to produce and sell hotdogs for profit.

The two main categories of costs

The production of certain goods requires very many costs. For example, opening a business
in the car manufacturing industry comes with hundreds of costs. However, whatever the
cost, it falls within one of two main categories of costs:
-Explicit costs
- Implicit costs

Explicit costs - Within the category of explicit costs, there are: - Variable Costs These are
costs that change with the level of production/output. They increase as output increases and
they decrease as output decreases. - Fixed Costs Fixed costs do not immediately change with
the level of output. They only change when the output significantly increases.

Explicit costs: illustrated

• Carmen wants to open a firm to sell cookies.
• She buys flour, sugar, chocolate chips…
• She also buys an oven.
• Now she is good to go!!

Explicit costs: illustrated (2)

 Variable costs are costs that change with the level of production/output.
• Carmen’s variable costs are flour, sugar and chocolate chips.
• If she wants to increase/increase her production of cookies, she has to buy more/less of
them.

Explicit costs: illustrated (3)

• Fixed costs are costs that do not easily change with the level of production/output.
• Carmen’s fixed cost is the oven.
• Producing more cookies does not immediately require the purchase of another oven.
• But at some higher levels of production, Carmen will need to purchase a new oven

Implicit costs - There are many kinds of implicit costs in a firm. They can all be grouped
under the concept of opportunity costs. For example, the owner of a business may run an
errand for the firm using his own car. He will not necessarily take money from the business
for his labor or for the use of his car. He would have earned money if he had run that errand
for another business. This is an implicit cost.

Production periods

There are two main production periods in the life cycle of any firm:
The short-run, the long-run. These two production periods are determined by whether the
firm has fixed costs or not.

Production periods- the short run

Reminder: Carmen’s variable costs are flour, sugar and chocolate chips
. • Her fixed cost is the oven.
• Let’s assume that Carmen can only make 50 cookies per day with one oven.
• So long as the quantity demanded for her cookies is 50 or lower, she is just fine with one
oven.
• The entire time period within which she only needs one oven (i.e. the fixed cost) is called
the short run.

Production periods: the long run

Now Carmen has become very popular on Auburn campus.
• The demand for her cookies has now exceeded 50 cookies per day.
• Therefore, she needs to buy a second oven.
• At this point, there is no more fixed cost.
• The oven has now become a variable cost.
• Carmen’s firm has now entered the long run.
This is the production period in which the previous fixed costs are not fixed anymore .

How to calculate profit (loss)?

One of the most important objectives of any firm is to make profit. Firms make profit
according to this formula.
Total Profit/Loss = Total Revenue – Total (Explicit) Cost
Total Profit/Loss = (P * Q) – (TFC + TVC

Total Revenue = Price * Quantity sold

Total Cost = Total Fixed Costs + Total Variable Costs

Accounting profit vs Economic profit

The profit computed as seen on the previous slide is called accounting profit. The economic
profit is computed by
including opportunity costs to the equation.
Total Profit = Total Revenue – Total Cost
Total Profit = (P * Q) – (TFC + TVC + OC)
Total Revenue = Price * Quantity sold
Total Cost = Total Fixed Costs + Total Variable Costs + Opportunity Costs

The production function

In the production process, inputs are used to make outputs. The costs incurred by the
firm are very closely linked to the level of inputs used in the production process. In the
example of the cookie selling firm owned by Carmen, the inputs are: sugar, flour, chocolate
chips and the oven. Now, let’s assume that the firm’s sole inputs are the number of hired
workers. The relationship between the inputs the firm uses and the output it creates is
shown by the production function. Following is a hypothetical production function.

The production function (2)

The production function (3)

 The marginal product of labor is the additional output (i.e. the extra number of
cookies) produced when one more worker is hired in the firm.
 When the firm has only 1 worker, 5 cookies are produced every day.
 When the firm hires a second worker, the production of cookies per day increases to
15.
 Therefore, the marginal product of hiring a second worker in the firm is 10

The production function (4)

  From 0 to 3 workers
 Total output rises at an increasing rate. It rises rapidly!
 Marginal product is positive and is rising.
 From 4 to 8 workers:
 Total output rises at a decreasing rate. It rises slowly!
 Marginal product is positive and is declining
 From 9 to 10 workers:
 Total output declines.
 Marginal product is negative.

The production function (6)

The total output (i) increases, (ii) reaches a maximum point and then (iii) decreases.
The marginal production (i) increases, (ii) decreases and (iii) further decreases below zero.
The total output curve is convex when the marginal product curve increases. The total
output curve is convex when the marginal product curve decreases. The total output curve
slopes downward when the marginal product curve is below zero.

The 3 production phases

Here, we identify three (3) main production phases.

(i) The first phase (0 to 3 workers) with increasing marginal product (increasing returns)
(ii) The second phase (4 to 8 workers) with diminishing marginal product (decreasing
returns)
(iii) The third phase (9 to 10 workers) with negative marginal product (negative returns
 The 3 production phases (2)

(i) The production phase of increasing returns in this production phase, increases in variable inputs (i.e. number of
workers) lead to an increase in the total output (i.e. number of cookies produced per day) Here, the total output increases
rapidly.
(ii) The production phase of diminishing returns in this production phase, increases in variable inputs (i.e. number of
workers) lead to an increase in the total output (i.e. number of cookies produced per day). Here, the total output increases
slowly.
The 3 production phases (3)

(iii) The production phase of negative returns in this production phase, increases in variable inputs (i.e. number of workers)
lead to a decrease in the total output (i.e. number of cookies produced per day).

Decision-making in the firm

 The production function of the firm gives us all the information we need about how
inputs and output are related.
 So, it is useful in the decision-making process. For instance
 If the firm wants to be the most profitable, how much output should be produced
every day?
 Questions about the level of production such as this one are very important for firms.
 However, another very important aspect to take into consideration is cost.
 Therefore, production and cost are the main factors when making decisions in a firm.

Short-run costs- Production and cost considerations are different depending on the
production period. Following is a hypothetical short-run cost schedule.
Formulas
TC = TFC + TVC
ATC = AFC + AVC
ATC = TC/Q
AFC = TFC/Q
AVC = TVC/Q

MC = ΔTVC / ΔQ = ΔTC / ΔQ (because TFC does not change. It is fixed)

WHAT IS MARGINAL COST?

Marginal cost in the additional cost incurred by the company as a result of producing
one more unit of output. In other words, it is how much it costs the company to produce one
more unit of output.

Short-run cost curves (2)

The TC and TVC curves have the same shape. The vertical distance between them is
the value of the TFC.
The MC, AVC and ATC curves are all U-shaped.
The ATC curve lies above the AVC curve. The vertical distance between them in the
value of the AFC.
The AFC curve is L-shaped.
The MC curve (in its upward sloping part) cuts the AVC and the ATC curves at their
lowest points.
the lowest point on the ATC curve is called the efficient scale.
 Long-run costs

In the short run, there are fixed costs.

In the long run, all costs are variable.
In the short run, the only decisions that are made are related to the level of
production.
In our earlier example, Carmen could decide to increase her production from 7
cookies to 8 cookies per day.
In the short run, the change in the level of production is not very significant.

Long-run costs (2)

In the long-run, the decisions are made with respect to the scale of the firm’s
activities.
When Carmen buys a second oven or even rents a second spot on campus to sell her
cookies, her level of production changes significantly.
The cost structure of her company will be affected.
Let’s talk about how the average total cost of the company changes in the long run .
 Short-run cost curves (2)
 The TC and TVC curves have the same shape. The vertical distance between them is
the value of the TFC.
 The MC, AVC and ATC curves are all U-shaped.
 The ATC curve lies above the AVC curve. The vertical distance between them in the
value of the AFC.
 The AFC curve is L-shaped.
 The MC curve (in its upward sloping part) cuts the AVC and the ATC curves at their
lowest points.
 The lowest point on the ATC curve is called the efficient scale.

Long-run costs
 In the short run, there are fixed costs.
 In the long run, all costs are variable.
 In the short run, the only decisions that are made are related to the level of
production.
 In our earlier example, Carmen could decide to increase her production from 7 cookies
to 8 cookies per day.
 In the short run, the change in the level of production is not very significant

Long-run costs (2)

 In the long-run, the decisions are made with respect to the scale of the firm’s
activities.
 When Carmen buys a second oven or even rents a second spot on campus to sell her
cookies, her level of production changes significantly.
 The cost structure of her company will be affected.
 Let’s talk about how the average total cost of the company changes in the long run.
 The long-run average total cost curve
 There are three main phases in the long-run average total cost curve.
 The first phase, where the average total cost falls - The second phase, where the
average total cost remains constant - The last phase, where the average total cost rises
 The changes in the average total cost are respectively due to
 Economies of scale (or increasing returns to scale) - Constant returns to scale -
Diseconomies of scale (or decreasing returns to scale)

DISECONOMIES OF SCALE

Economies of scales are factors that cause the average total cost of a firm to fall as the
output scale of the firm rises.
Hence it may cost a firm $1000 to produce 10 units of a good and $1500 to produce 20 units
of a good. Examples of economies of scale are Cheaper inputs - Specialization - Improved
efficiency (i.e. Research and Development).
You should now be able to…

1. Define costs and identify the main categories of costs

2. Identify the two kinds of explicit costs
3. Give examples of implicit costs
4. Identify the two production periods and the main difference between them
5. Calculate the accounting and the economic profit/loss
6. Explain what a production function is

You should now be able to… (2)

1. Explain the relationship between changes in output and changes in the marginal
product
2. Identify and comment on the 3 production phases
3. Identify the different types of short-run costs and how to calculate them
4. Draw the short-run cost curves
5. Draw the long-run average total cost curve
6. Identify the factors that define its shape
7. Define (dis-)economies of scale and give examples

REFERENCES:
Cbsuadepartmentofagriculturaleconomics

file:///C:/Users/user/Documents/MGT.pdf

SUBJECT TEACHER ANGELYN M. CALLOS

ADMINISTRATOR EFREN DANIEL DELEON