Microeconomics

Production and cost

 Theory of Production
 the process of transforming
both fixed and variable inputs into
finished goods and services.
 Theory of Production

 Enterprise
 refers to a single production
activity.
 Enterprise
Example :
A farmer simultaneously produces
rice and mung beam therefore she/ he
is involved in two different
enterprises.
 Theory of Production
Production Function
 The technical relationships between the
quantity of inputs used to produce a good and
the quantity of output of that good .
 It can be represented by table equation or
graph .
 Theory of Production

Inputs
 These are the factors of
production.
Inputs

Fixed – inputs whose use rate

does not change as the output
level changes

Example : Land
Inputs
 Variable – inputs whose use rate
changes as the output level
changes .

Example: labor, seeds ,fertilizer

 Theory of Production
Outputs
 Goods and services produced
using the inputs .
 Theory of Production
Total Product (Q)
 Total amount of output
produced in physical units.
 Theory of Production
Marginal Product (MP)
 the rate of change in output as an
input is changed by one unit , holding
all other inputs constant .
 Theory of Production
 Law of Diminishing Returns
 States that when successive units of a
variable input work with a fixed input,
beyond a certain point the additional
product produces by each additional unit
of a variable input decreases.
 Theory of Production
 Average Product (AP)
 Measures the total output per unit
of input used expresses the
productivity of an input associated
with efficiency ;
 Stages of production
 Stage 1
 product curves are increasing ends
where AP1 has reached its maximum
point.
 MP1 begins to decrease due to law of
diminishing returns.
 Stages of production

Stage 2
 begins where AP1 begins to decrease .
 Q 1 is still increasing but begins to taper
off
 MP1 continues to decrease till ends
where MP1 is zero.
 Stages of production
Stage 3
 begins where MP1 is zero and turns
negative .
 all product curves are decreasing
 Q1begins to decrease even though input
is being increased.
 Length of run
 Production processes can be
classified according to the length of
run of time period being considered.
 Length of run
 Long run
 all inputs to the production function can
be treated as variable .

 Management must evaluate investment

alternatives such as whether the firm
should purchase more land or equipment.
 Length of run
 Short run
 period of time is short enough that some
inputs can be treated as fixed.

 Management must evaluate which variable

resources should be combined with fixed
resources in order to maximize the profits of
enterprise.
 Length of run

Very short run

 so short that none of the inputs are
variable .
 Returns to scale
 the quantitative change in output of
a firm or industry resulting fro a
proportionate increase in all inputs.
 Returns to scale
 Constant returns to scale
 as all inputs are increased by a given
proportion, output increases by the same
proportion.
 Large firms are equally efficient and
could be expected to happily co exist.
 Returns to scale
Increasing returns to scale
 as all inputs are increased by a given
proportion , output increases by a greater
proportion.
 Expect to see larger firms driving the
smaller ones out of business since the larger
firms could produce more output per bundle
of inputs than the smaller firms.
 Returns to scale

 Decreasing returns to scale

 As all inputs are increased by a given
proportion output increases by a lesser
proportion.
 Profit
 The difference between
total revenue and total cost.

 Total revenue
 the amount a firm receives from the sale
of its output.
 Profit
Total cost
 the market value of the inputs a firm
uses in production
• Explicit Costs – require cash outlay , example
paying wages to workers .
• Implicit cost – do not require cash outlay,
example the opportunity cost of the owners
time .
 Profit
Types
• Accounting profit –total revenue minus total
explicit costs , ignores implicit costs so its
higher than economic profit.

• Economic profit – total revenue minus total

costs . ( Including explicit and implicit costs)
 Factors of production
 Land
 everything above and beneath the
land surface .
Example :
payment is rent
 Factors of production
Labor
 the physical and mental effort
exerted in the population of goods
and services.
Example :
Payment is wages
 Factors of production
Capital
 finished product such as machineries
equipment and processed raw materials
used to produce other goods and services.

Example :
Payment is interest
 Factors of production
 Management / Entrepreneur
 One who organizes the other
resources land, labor and capital .

Example :
Payment is profit
 Theory of Costs
Costs of production
 can be derived from
production function .
 Theory of Costs
Short run Costs
 the cost over a period during
which some factors of production
are fixed.
 Theory of Costs
 Long run costs
 the cost over a period long enough
to permit the change of all factors
of production .
 All factors are variable
 Theory of Costs
Total cost
 is a multivariate function , where
C is cost.
 X is output .
 T is technology
 P__is factor prices
 K is fixed factors.
 Total Cost

• In the short run ,

• In the long run ,
 Theory of Costs
 Total Cost (TC)
 Typically depicted as a function of
output .
 C= f (X) , ceteris paribus ;
represents the least cost needed to
produce each output level .
 Theory of Costs
 Total fixed Cost (TFC)
 sunk cost or overhead cost slope is
zero
Examples :
payment or rent for land ,
building and equipment .
 Theory of Costs
 Total variable Cost (TVC)
 changes as the amount of output
changes upward sloping curve starting
from the origin
Example :
Purchases of raw materials , wages ,
water , electricity fuel
 Theory of Costs
 TC – TFC + TVC
 graph is parallel to that of TVC ,
vertical distance between TC and
TV is TFC.
 Theory of Costs
 Marginal Cost (MC)
the rate of change in cost as output
is changed by one unit .
 U-shaped curve that
intersects AVC then AC at their minimum
points.
 Theory of Costs
 Average Cost (AC )
 measures the total cost per unit
of output used.

 AC/ TC/ Q ; U shaped curve

 Theory of Costs
Average fixed cost (AFC)
 Measures the total fixed cost per unit of
output used.

 AFC = TFC / Q slope declines but never

reaches zero a consequence of this is that
AC and AVC will never meet
 Theory of Costs
Average variable cost (AVC)
 Measures the total variable cost per unit
of output used.

 AC = TC / Q ; U –shaped curve .
 Theory of Costs
Average fixed cost (AFC)
 Measures the total fixed cost per unit of
output used.

 AFC = TFC / Q slope declines but never

reaches zero a consequence of this is that
AC and AVC will never meet
 Price and Output Determination in a perfectly
competitive Market .
 Perfectly competitive market
economic model with the following features .
• Numerous buyers and sellers that do not affect price
(price takers) .
• homogenous product, demand and supply work freely .
• Demand and supply work freely
• Goods and services freely enter and exit the market .
• Perfect information .
 Price and Output Determination in a perfectly
competitive Market .

 Total revenue (TR)

 gross income from selling a product.

• TR= P * Q 1
• where P is selling price of good for
services and
• Q is output level sold .
 Total revenue (TR)
• Marginal revenue (MR ) = TR/ Q
• Average revenue (AR) = TR / Q

• TR –is upward sloping with constant

slope ; P = MR= AR= D (horizontal line).

• Profit (n) = TR - TC
 Price and Output Determination in a perfectly
competitive Market .

Objective
 to identify profit maximizing level of
output by finding the price and output
level that will yield the largest surplus of
TR over TC.
 Profit Maximizing Condition

 P=
MR=MC
Profit is vertical distance between TR
and TC curves ( TR, TC vs Q).
Profit is vertical distance between TR
and TC curves ( TR, TC vs Q).
 Profit Maximizing Condition

b. Using per units curves (P,RC vs Q)

 Demand
 the amounts of a good or service that
consumers are both willing and able to
purchase at alternative prices in a given time
period, ceteris , paribus a relationship not a
point.

 Price
 the amount paid for a certain quantity
and quality of good service.
 Demand
Quantity Demand (Q d)
 how much of a good or service a buyer is
willing to purchase at a single specified
price in a given market , time , ceteris
paribus.
 a point not a relationship
 Law of Demand
 Negative /inverse relationship between Q d
and P ceteris paribus people are willing to
buy more goods if the price is low.
 Law of Demand
Substitution effect
 as the price of good A increases , ceteris
paribus , the relative price of good B
decrease and the consumer substitute B
for A consumption
 Law of Demand
Income Effect
 as the price of good A increases , ceteris
paribus the real income or purchasing
power of consumer falls and as a result
less of both good A and B is consumed .
Demand Curve
 Demand Curve – downward
slopping line
 Demand Curve
 Changes in D
 rightward increase in D or leftward decrease in D
shift the entire demand curve . Caused by the
change in income ( normal goods – D increases when
income increases.

 Inferior goods – D increases when income decreases

price of related products , population , tastea and
preferences or expectation of future prices and
income.
 Demand Curve

 Change in Qd
 refers to a change in the amount
along the demand curve or to a
change in P.
Supply (s)
 the amounts of a good or service that
consumers are both willing and able to
offer for sale all possible prices in a given
time period, ceteris paribus, a
relationship , not a point.
 Quantity Supplied Qs
 how much of a good or service a seller is
willing to offer at a single , specified
price , in a given market at a given time ,
ceteris paribus .
Law of Supply
 positive relationship between Qs and
P1 , ceteris paribus .

 sellers are willing to produce more at a

higher price .
 Supply Curve
 upward sloping curve

 Changes in S
 rightward (increase in S ) shift of the entre
supply curve , caused by change in prices of
inputs , prices of competing products ,
technology , institutional factors , weather ,
sellers expectation of future prices.
Supply Curve
 Changes in Qs
 refers to a change in the amount
along the supply curve due to a
change in own P.
 Market Equilibrium
 both P and Q are at levels at which the amounts
producers want to supply exactly match the
amounts consumers want to buy Q s = Q d

 S and D curves intersects at the equilibrium

price (P *) / equilibrium quantity (Q*)
Surplus
 or excess supply above P* shortage or
excess demand below P*.

 P* is also called market clearing

price.
 Elasticity
 The measure of responsiveness
of Qd or Qs to changes in P,
income .
 Percentage change in Q in
response to a 1 % change in P.
 Price Elasticity of Demand
( Ed)
 Measures the responsiveness of demand to
changes in the commodity own price.

 Measures the percentage change in the

quantity demanded resulting from a 1%
change in price.
 Price Elasticity of Demand ( E ) d
 Point Elasticity method
 Measures the elasticity at only one point
on the demand curve .
cv

 Arc elasticity method

 Measures the elasticity between two
separate points on the demand curve.
 Price Elasticity Values
 These coefficients can be found along a
linear D curve . , this implies
that a 1% increase (decrease) in thecv
price of good X results in a 4% decrease
(increase )in the quantity demanded of
good. X.
 Price Elasticity Values
a. Then perfectly inelastic.
b. Then inelastic. cv

c. then unit elastic.

d. then elastic .
e. then perfectly elastic
 Price Elasticity and the Shape of
the Demand curve
a. If demand curve is steep , this implies
that the quantity demanded does not
respond much to price changes.
b. If demand curve is relatively flat, this
implies that the quantity demanded
responds greatly to price change.
 Price Elasticity of Demand and total Household
Expenditure
a. When demand is inelastic, as a price increase
(decreases ) expenditure also increases
(decreases ).

b. When demand is elastic, as a price increases

(decreases) expenditure will decrease (increase ).

c. When demand is unit elastic, as price increases

(decreases) expenditure does not change.
 Price Elasticity of demand and total revenue

a. When demand is inelastic, as price increases (

decreases ) , TR also increases (decreases).

b. When demand is elastic, as a price increases

(decreases) TR will decrease (increase ).

c. When demand is unit elastic, as price increases

(decreases) TR does not change.
Determinants of price elasticity of Demand

q. E d for a commodity depends on the number and

closeness of the substitute that are available.
 Many close substitutes
Demand is likely to be elastic.
 Less close substitutes
Demand is likely to be inelastic.
 Perfect substitutes
Demand is infinite .
Determinants of price elasticity of Demand

b. E d for a commodity depend on the importance of the

commodity in consumer`s budget.
 Luxury or non basic goods
Price elastic .

 Necessities or basic goods

Price inelastic
 Determinants of price elasticity of Demand

c. E for a commodity depend on the length of time to which

the demand curve pertains.
Demand is likely to be more elastic over a long period of
time than over a short period of time.
The easier it is for consumers and business firms to
substitute one good another.

d. The more possible uses of the commodity , the greater is its

price elasticity .
 Income Elasticity of Demand (n )
i

 the proportion change in quantity

demanded resulting from a proportionate
change in income.
 Measures the percentage change in the
quantity demanded resulting from a 1%
change in income.
 Income Elasticity of Demand (n ) i

 Point Elasticity method

 Measures the elasticity at only one point
on the demand curve .

 Arc Elasticity method

 Measures the elasticity between two
separate points on the demand curve.
 Income Elasticity Values

 This implies that a 1% increase

(decrease) in the consumers income
results in a 3% increase (decrease ) in
the quantity for good X.
Income Elasticity Values
 Income Elasticity Values

c. If > 1 % change in income results in

more than 1% change in total quantity
demanded.

d. If < 1 % change in income results in less

than 1% change in total quantity demanded.
 Cross- Price Elasticity of
Demand (e ) xy
 Responsiveness of quantity demand of
good to change in the price of another
good .

 If positive (+) goods are substitutes and

if negative (-) goods are complements .
 Floor Price
 Also called minimum price policy .
 Limit on a price must be set above P*
(surplus) to be effective .

Example :
minimum wages
 Price Ceiling
 Also called maximum price policy .
 Upper limit on a price , must be set
below P* (shortage ) to be effective .

Example :
Jeepney fares
 Tax incidence
 Concerned with the effects of the
government taxes on consumption and
production.
a. Specific / Excise Tax
 Tax per unit of the product .
b. Ad valorem tax
 Tax as a percentage of the ceiling
price .
 Consumer Surplus
 Difference between what a consumer
is willing to pay and what he /she
actually pays for the good.

 Market price decrease raises

consumer surplus.
 Producer Surplus
 Difference between what a producer
receives and the amount that will
motivate her/him to sell the product.

 Market price decrease raises

producer surplus.
 CONSUMPTION
 Utility
 the amount of satisfaction
derived from the consumption of
a good or service.
 CONSUMPTION
 Utils
 the unit of measurement .
 CONSUMPTION
 Approaches
 Cardinal Utility
 Can assign values for utility.

 Ordinal Utility
 instead of assigning values for utility ,
ranking preferences is done.
 CONSUMPTION
 Total Utility (TU)
 In general total utility increases
with Q.
 If TU is increasing , marginal utility
(MU) > 0 but is declining as explained by
the law of Diminishing Marginal Utility.
 CONSUMPTION
 Law of Diminishing Marginal Utility
 As more and more of a good is
consumed, the process of consumption
will , at some point , yield smaller
addition to utility.
 Consumer Equilibrium
 Marginal utility per Peso
 Additional utility derived from
spending the next peso on the
good.
MU / P
 Consumer Equilibrium
 Equimarginal Condition
We are the
Group - 2