1. PRODUCTION, COST AND THE BUSINESS
ORGANIZATION
This chapter focuses on the other economic agent, the
firm. The firm is an entity that purchases and employs
resources or factors of production to produce goods and
services. In the Philippines, there are many types of firms and
business organizations. This chapter looks at the production
function of the firm, defines the short run and long run time
periods, distinguishes between fixed and variable inputs, as
well as defines the different product concepts.

2. THE PRODUCTION FUNCTION
It refers to the physical; relationship between the inputs of the firm
and their output of goods and services at a given period of time,
assuming all other things remain the same.
Examples:
In the production of rice, there are many things needed to produce
it like land, labor, seeds, water, insecticide, and fertilizer.
In production of television program, it requires actors, a director, a
script, costumes, etc.

3. Types of Inputs used by a firm
1. Fixed Inputs
- used in constant amount in production
2. Variable Inputs
- pertain to resources that can change in quantity depending on
the level of output being produced
*For example, in producing a cloth, the fixed input is the used of
the same amount of sewing machine. The variable input is the
increase of labor.

4. SHORT AND LONG RUN
Short Run
- it is a period of time that is too short for any firm to exchange the
amount of at least one of its inputs
- the input is permanent or fixed that is no longer changed
Long Run
- it is a period that is long enough for the firm to adjust the
quantities of all the inputs that it employs
- all inputs are variable or the input can be changed
*For example, land may initially be a fixed input but in the long
run, the farmer may be able to increase or decrease the amount
of land he is utilizing depending on the profitability of producing
the output.

5. SHORT RUN PRODUCTION
(PRODUCTION WITH ONE VARIABLE
INPUT)
Total product refers to the total quantity or output of a
particular good produced in physical units. The amount of output
depends on a given set of inputs and the underlying technology.
The table assumes that land is fixed at 1 hectare. The
variable input is labor. Hiring one unit of the variable input brings
total product up to two tons, a second unit of labor increases
output to 6 tons. Total product peaks at 32 tons, when the
seventh worker is hired.

6. Example: The production function of a vegetable farmer
Land
(ha)
Labor Total Product(TP) Marginal
Product(MP)
Average
Product(AP)
1 0 0 0 0
1 1 2 2 2.0
1 2 6 4 3.0
1 3 12 6 4.0
1 4 20 8 5.0
1 5 26 6 5.2
1 6 30 4 5.0
1 7 32 2 4.5
1 8 32 0 4.0
1 9 30 -2 3.3
1 10 26 -4 2.6

7. Another way to represent it is through the use of total product curve.
34
32
30
28 TPL
26
24
22
20
18
16
14
12
10
8
6
4
2
0
0 1 2 3 4 5 6 7 8 9
10
Labor (L)
T
o
t
a
l
P
r
o
d
u
c
t

8. The fourth column in the table is the marginal product of
labor. It is the extra output that is associated when one more unit of
the variable input labor is used. It can be expressed as:
Marginal Product (MP) = change in total product
change in the variable input
The phenomenon of the declining the marginal product is
known as the Principle of Diminishing Marginal Product. As the use
of one input increases (with the use of other inputs remaining
fixed), beyond some extra point, the additional or marginal product
that can be attributed to each additional unit of the variable input
will decline. In other words, the marginal product of the additional
variable input declines because there are more variable inputs in
proportion to the fixed amount of other input.

9. In the table, it can be seen that up to four units of labor, it
contributes greater additional output. However, the fifth unit of
labor contributes only six tons and other contribute even less. A
related concept is average product.
The formula is: Average Product = total product
units of the variable input
The average product measures the contribution of each
unit of input used. The greater the average product, the higher the
efficiency of the input in physical terms.

10. 8
7
6
5
4
3
2 APL
1
0
-1 1 2 3 4 5 6 7 8 9
10
-2
-3
-4 MPL
Labor (L)
AP
and
MP
As a “rule of thumb,” if MP is greater than AP, then AP is increasing.
This is because each additional unit of output that is higher than the average
output will tend to pull up the average product. On the other hand, if MP <
AP will fall. When MP=AP, AP is at its maximum.

11. Combining the three product curves:
34
32
30
28
26 TPL
24
22
20
18
16
14
12
10 STAGE I STAGE II STAGE III
8
6
4
2
0
0 1 2 3 4 5 6 7 8 9 10
8 C
7
6 A
5
4
3
2 APL
1
0 D
-1 1 2 3 4 5 6 7 8 9 10
-2
-3
-4 MPL
LABOR(L)

12. Stage I is bounded by the y-axis and the intersection of the
MP and AP curves at point A. The increasing AP implies increasing
labor productivity. Likewise, in Stage I, output is increasing at an
increasing rate. However, the peaking (at point C) and then the
declining of marginal product has set in.
Stage II starts from the intersection of the MP and AP curve
(at point A) and ends where MP is zero (point D). This implies that
total product is at its maximum level.
Stage III starts where MP is zero (point D) and total output
is falling. All the product curves are declining at this stage.

13. COSTS OF PRODUCTION
The production function looked only at the physical
relationship of output with the inputs employed. In reality, we need
to translate this to their corresponding cost concepts. We need to
identify the cost conditions in both the short run and long run. We
also need to look at the concepts of total cost and per unit cost.
These will serve as the foundation of the firm’s supply decisions
and ultimately, the price and output levels in the market.