MICROECONOMICS

SIMPLIFIED

Edilberto B. Viray, Jr. MAE

Ma. Jesusa Avila – Bato, MAE
Lucky Raymundo M. Malveda, MAE
 MODULE IV
PRODUCTION
AND COST
Labor Market
Interest, Rent & Profit

ANVIL PUBLISHING INC., 2016

Learning Objectives

After reading and studying this chapter, you should be able to:

• Define production
• Describe the four factors of production
• Identify the two major types of production
• Define technology
• Differentiate labor intensive technology and capital-intensive
technology
• Explain the Law of Diminishing Returns
• Define the Theory of Cost
• Define input
• Explain the concept of profit maximization
• Illustrate how a firm can achieve profit maximization
 Production, Inputs, and
Outputs  The Law of
 Technology: Labor Diminishing Returns
Intensive or Capital  Returns to Scale
Intensive  The Theory of Cost
 The Production  Total Cost
Function  Average Cost
 Production Concepts  Marginal Cost
 Total Product  Short Run Cost
 Average Product Schedule:
 Marginal Product  Profit Maximization
What is Production?

Production refers to any economic activity,

which combines the four factors of production
(i.e., land, labor, capital and entrepreneurship)
to form an output which will give direct
satisfaction to the consumer

It is the process of converting inputs into

outputs
Technology is the production process employed by
firms in creating goods and services. It can be
classified as labor intensive or capital intensive.

 A labor intensive technology utilizes more labor resources

than capital resources

 A capital intensive technology utilizes more capital

resources than labor resources in the production process
Fixed Input & Variable Input
•A fixed input is any resource the quantity of which cannot
readily be changed when market conditions indicate that a
change in output is desirable.
•A variable input, on the other hand, is any economic resource
the quantity of which can be readily changed in response to
changes in output.

Short Run versus Long Run

•The short run is 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.
•The long run is a period of time so long that all inputs are
considered variable. The long run is therefore known as the
planning horizon. This is because in the long run, the firm can
build new factories or purchase new machinery.
Production function
 functional relationship between quantities
of inputs used in production and outputs to be
produced

Ex. Production function of making a dress:

ODRESS = f (Fabrics, Sewing Machine, Sewer, Thread, Buttons,

etc.)
Production Possibility Curve
 In order to see at which a firm is efficiently
producing its goods and services, we have to
understand the production possibility curve or
the production possibility frontier (PPF). The
Production Possibility frontier is a curve which
shows the combination of two or more goods
and services that can be produced by making
efficient use of all the available factor resources
or the factors of production.
The Law of Diminishing Returns holds that we
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 declines as the
amount of that input increases, holding all other
inputs constant.
Returns to Scale

Constant returns to scale indicates a case where a change in

all inputs leads to a proportional change in output

Increasing returns to scale (also called economies of scale)

happens when an increase in all inputs leads to a more-than-
proportional increase in the level of output

Decreasing returns to scale occurs when a balanced increase

in all inputs leads to a less-than-proportional increase in total
output
Explicit and Implicit Costs

 Economists define the total opportunity cost of a business as

the sum of explicit costs and implicit costs.

 Explicit costs are payments to non-owners of a firm for their

resources, thus, these are the expenses made for the use of
resources not owned by the firm itself

 Implicit costs are the opportunity costs of using resources

owned by the firm
Fixed Costs and Variable Costs
 Fixed cost or overhead or supplementary cost are
those expenses which are spent for the use of fixed
factors of production

 Variable costs or prime or operating costs, on the

other hand, are those expenses which change as a
consequence of a change in quantity of output
produced
Opportunity cost

To produce its output, a firm utilizes factors of

production: land, labor, capital, and
entrepreneurship. Another firm could have
used these same resources to produce
alternative goods or services. In Chapter 1, it is
said that opportunity cost is the best
alternative foregone.
Economic profit
 
A firm’s economic profit equals total revenue
minus total cost. Total revenue is the amount
received from the sale of the product. It is the
price of the output multiplied by the quantity
sold. Total cost is the sum of the explicit costs
and implicit costs and is the opportunity cost
of production.
Total Fixed Cost, Total Variable Cost and Total Cost
 As production expands in the short run, costs are
divided into two basic categories – total fixed cost
and total variable cost
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 variable cost (TVC) consists of costs that are

zero when output is zero and vary as output
increases (decreases)

 Total cost is the sum of total fixed cost and total

variable cost at each level of output:
TC = TFC + TVC
Average Cost: Average Fixed Cost, Average Variable
Cost and Average Total Cost

 In addition to total cost, firms. are interested in the

per-unit cost, or average cost. Thus, average cost is
stated on a per-unit basis
 Average cost includes average fixed cost (AFC),
average variable cost (AVC), and average total
cost (ATC)
 Average fixed cost is total fixed cost divided by the quantity
of output produced

AFC = FC / Q

 Average variable cost rises with output. Average variable cost

is total variable cost divided by the quantity of output
produced
AVC = VC / Q

 Average total cost is total cost divided by the quantity of

output produced
ATC = TC / Q or ATC = AFC + AVC
Short Run Cost Schedule
Profit Maximization
 Profit is simply defined as the difference that
arises when a firm’s total revenue is greater
than its total cost. This definition of ‘economic
profit’ differs from that used conventionally by
businessmen (accounting profit) in that
accounting profit only takes into account
explicit cost (refer to our definition in Chapter
V).
Efficiency

 Efficiency is such an important economic

concept that it is part of the definition of
economics. Economics is the efficient
allocation of the scarce means of production
toward the satisfaction of human wants.
Discussion Questions

1.What is the role of production in the economy and market?

2. What are the two major types of production?

3. What is input?

4. How can you maximize production cost?

5. How can a firm achieve profit maximization?

Learning Objectives

After reading and studying this chapter, you should be able

to:

• Define labor market

• Identify the determinants of market wage rates
• Explain why workers have different wages
• Explain the different concepts: Factor Markets, Efficiency-
Wage, Superstar
Phenomena, Labor Market Equilibrium, and Signaling
Theory
 Markets for the Factors of
Production
 Labor Market Equilibrium
 Factors that Explain Productivity
and Wages
Markets for the Factors of Production
 While economics largely focuses on the
markets for goods and services, or what we
commonly refer to as outputs of production,
there are also markets for the factors of
production or inputs to production.
Product Market and Factor Market
 A Product market is the market for a final good or
service which is usually considered to be a
consumer product.
 A Factor market, on the other hand, is the market
for the factors used in the production of a
consumer product, and not the good produced
itself.
 A Labor market is a market where people offer
their skills to employers in exchange for salaries
and other forms of compensation.
LABOR MARKET EQUILIBRIUM
 The demand for labor is simply like a demand for a good
so it generally follows the law of demand.
 Same principle with the law of supply which says that if
the price of labor increases, then the supply of labor will
also increase and vice versa.
 When the labor demand and supply meet at a certain
wage and quantity of workers, equilibrium takes place.
This point of equilibrium is called the market clearing
wherein firms may hire an employee at the existing
wage rate and people who would like to have that wage
rate would be able to do so.
What determines Market Wage Rates?
 A basic principle of economics is the notion that
the price or value of goods, services and even
resources such as labor, is determined by the
behavior of demand and supply.
 Higher wages improve worker morale and effort
 Higher wages reduce worker resignation and
labor turnover costs
 Higher wages attract more applicants
Equilibrium Wages

When the job tend to become difficult and

dangerous, workers would naturally require a
higher wage in order to perform such kind of
job. This compensating differential is the
difference in wages that arises to offset the
nonmonetary characteristics of different jobs.
Factors that Explain Productivity and Wages: Why
do workers earn different equilibrium wages?
 Such endeavors which can augment individual’s earnings are called human capital
investments.
 When people exhibit intelligence above the others, they usually get better wages
due to their natural ability. Being pretty is also a natural ability which can be an
advantage to get better wages since attractiveness may allow one to work as a
model or an actress and then be more productive.
 People who also work harder get better wages as they exert more effort. Chance
can also affect the wages given that change in technology can favor one whose
education is into Information Technology. The Workers with higher educational
attainment are often perceived to earn more because their higher ability to learn
more may make them more productive. In this case, the human capital view of
education signals companies to view education as a means to select individuals
which can reflect their work performances. Since it is more difficult to earn a college
degree, graduates are then perceived to be highly capable. This is a signaling
theory.
The Superstar Phenomenon
 Some athletes, actors and singers are performers get to earn huge
amounts of compensation, and if you should ask that a plumber get
paid millions like these individuals, the superstar phenomenon would
strongly disagree. This phenomenon suggests that only individuals
who are highly sought after or admired by large crowd earn huge
amounts of money can make them very important in the world.
 Markets have two characteristics that patronize the rise of
superstars: Individual wants to enjoy the good provided by the best
producer, and the other characteristic is that the good is produced
with a technology that makes it possible for the best producer to
supply at low cost.
The Efficiency-Wage Theory
 In some markets, wages are set above the equilibrium level for
the purpose of increasing the productivity of the worker. The
Efficiency-Wage theory, developed byeconomists Carl Shapiro
and Joseph Stiglitz (1984), explains that it would be beneficial
for firms to pay workers above the equilibrium wage rate to
encourage workers to work more efficiently and make more
profit firm. Efficiency wages are wages greater than the market-
clearing wage, as introduced by Alfred Marshall to denote wage
per efficiency of labor. Also called the Shapiro-Stiglitz theory,
analyzes wages and unemployment in labor market equilibrium.
Discussion Questions

1.What market/s do we consider when it comes to raw

materials?

2. Does a labor market equilibrium really exist?

3. Are the determinants of market wage rates valid?

4. Why do workers have different wages?

5. How do you understand the superstar phenomenon?

 Interest
 Rent
 Profit
 Market Niches
INTEREST
 The word interest is often encountered in our
daily lives when there are discussions about
loans and earnings. In economics, interest is
used in two ways- it can be the price of the
credit which is often referred to as loanable
funds, and, the return that capital earns as an
input in the production process.
Determinants of Interest Rate
 Interest rate is determined by the demand for
and supply of money available as loanable
funds. Demand for loanable funds comprises
the demand for consumption loans,
investment loans and even the government
while the supply of loanable funds comes
from people who save or consume less of
their incomes.
Nominal and Real Interest Rates
 Nominal interest rate is the rate determined by
the supply and demand in the market for loanable
funds. Considered as the simplest type of interest
rate, this is the stated rate of a given loan.
 Real interest rate is the nominal interest rate
adjusted for inflation.
 Real Interest Rate = Nominal Interest Rate –
Expected inflation Rate
RENT
 Actually, economic rent is the price paid for the
use of land and other natural resources or factors
of production that is in fixed supply. Rent has
been traditionally associated with land, a fixed
factor of production.
 The concept of economic rent applies to
economic factors not just land. Economic rent is
a payment in excess of opportunity costs.
PROFIT
 This is the income made by an entrepreneur for using his
entrepreneurial abilities to run a business. Profits are
divided into normal profits and economic profits. Profit is a
form of nonwage income.
 Payments made to entrepreneurs as the return on their risk
taking is called normal profits. Supplying entrepreneurship
in the market would yield normal profits.
 Economic profit is the entrepreneur’s return above and
beyond normal profits.
Market Niches
 As entrepreneurs become eager to receive
economic profits, they would like to know
market niches since these can provide
economic profits.
 Market niche is defined as a segment of the
market that demands a commodity that is
slightly differentiated from other
commodities.
Discussion Questions

1.How do interest rates affect you as a consumer?

2. What are the effects of interest in the business?

3. What do you think of the possibilities of considering

loanable funds in the future?

4. Is your family renting a house? How much is your rent?

5. What kind of profits do entrepreneurs receive?

End of Module IV