Cost of Production, Production Function, and Law of Diminishing Returns

1. Costs of Production
Production Function
Law of Diminishing Returns

2. Theory of Production
1. fundamentals of the production theory
2. essential concepts of business costs
3. production + cost = businesses decide how much output to
produce

3. Terminologies:
 Economic costs – payments a firm must make, or the
incomes it must provide, to attract resources it needs
away from alternative production opportunities
 2 kinds of economic costs:
1) explicit costs – monetary payments (or cash
expenditures) for the use of resources owned by others
2) implicit costs – opportunity costs of using self-
owned, self-employed resources

4. Example:
 You are earning Php 360,000 a year as a sales representative
for a T-shirt manufacturer. At some point, you decided to
open a small retail store of your own to sell T-shirts.
 You invest Php 150,000 of savings that have been earning you
Php 10,000 per year. And you decided that your retail store
shall be set up a small space you own and currently leasing
out to another and which you receive Php 120,000 a year for
rent. You plan to hire a store clerk, paying her Php 120,000 a
year.
 A year after you open the store, you total up your accounts
and find the following:

5. Example:
 Total sales revenue Php1,650,000
Cost of T-shirts Php145,000
Clerk’s salary 120,000
Utilities 200,000
Total explicit costs 465,000
ACCOUNTING PROFIT 1,185,000

6. Example:
 Accounting profit Php1,185,000
Foregone interest 10,000
Foregone rent 120,000
Foregone wages 360,000
Foregone entrepreneurial income 120,000
Total implicit costs 610,000
ECONOMIC PROFIT 575,000

7. Terminologies:
 Normal Profit as a Cost
the cost of doing business
The economist includes as costs of production all the costs --
- explicit and implicit, including normal profit --- required to
attract and retain resources in a specific line of production.
 Economic Profit (or Pure Profit)
Economic profit = total revenue – economic costs
NOTE: An economic profit is NOT A COST, because it is a return
in excess of the normal profit that is required to retain the
entrepreneur in this particular line of production.

8. Terminologies:
 Types of Inputs:
Fixed – inputs the quantity of which cannot be readily changed
when market conditions indicate that a change in output is desirable.
Variable – inputs the quantity of which may be readily changed
when market conditions indicate that a change in output is desirable.
 Time Periods:
Short run – period of time when one or more productive agent
(input) is fixed
Long run – all inputs are variable

9. Short Run Production Relationships
Terminologies:
 Total product – total quantity or total output of a particular good
produced
 Marginal product – an extra output or added product associated
with adding a unit of variable resource, in this case, labor
Marginal product (MP) – change in total product/change in
labor input
 Average product – labor productivity; output per unit of labor
input
Average product (AP) – total product/units of labor

10. Complete the Table
(Compute for MP and AP)
Units of
variable inputs
(labor)
Total Product Marginal Product
Change in TP/Change
in labor
Average Product
(TP/Labor)
0 0
1 10 10 10
2 25 15 12.50
3 45 20 15
4 60 15 15
5 70 10 14
6 75 5 12.50
7 75 0 10.72
8 70 -5 8.75

11. Instructions:
 Plot your TP, AP and MP on a graph
 Labor on the X axis; TP, AP and MP on the Y
axis

12. Behavior of MP and AP
1. Both MP and AP first increase, then decrease, with MP
becoming negative.
2. MP reaches a peak before the peak of AP is attained.
3. At the peak of AP, MP will equal AP.
All these because TP at first increases at an
increasing rate, then increases at a decreasing
rate, and finally decreases.

13. Law of Diminishing Marginal Returns
 As successive units of a variable resource (say,
labor) are added to a fixed resource (say, capital
or land), beyond some point the extra or marginal
product that can be attributed to each additional
unit of the variable input will decline.

14. 3 Stages of Production
 Stage 1
covers the range of variable input used over which AP
increases; area in which AP is at its peak
 Stage 2
area at which MP is positive but less than AP
 Stage 3
area at which MP is negative or TP is declining