The document discusses key concepts in production theory and the theory of the firm. It explains the production function and how output responds to changes in variable inputs. It also discusses costs like fixed, variable, marginal and sunk costs. The document covers revenue, profit maximization, and how firms can grow through reinvestment of profits or mergers and acquisitions.

1. The Theory of Production
and Production Theory
Academic Decathlon--
Lesson 9
Berryhill Economics

2. The Theory of Production
 The theory of production deals with
the relationship between the factors
of production and the output of
goods and services.
 It is based on the short run, a period
of production that allows producers
to change only the amount of the
variable input labor

3. The Theory of Production
 Thiscontrasts with the long run,
which is a period of production long
enough for producers to adjust the
quantities of all their resources,
including capital.

4. Law of Variable Proportions
 The law of variable proportions states
that, in the short run, output will change
as on input is varied while the others are
held constant.
 How is the output of the final product
affected as more units of one variable
input or resource are added to a fixed
amount of other resources
 Adding salt to a meal will make the meal
better, to a point, but will eventually ruin
the meal.

5. Production Function
 The production function is the
concept that describes the
relationship between changes in
output to different amounts of a
single input, ceteris paribus
 As you add one more resource (like
labor) and you keep everything else
the same, how will the final product
change?

6. Production Function
 The first column of the production
function is the variable input (usually
number or workers or hours of labor)
 The second column is the total
product or total output—the total
amount of finished product that is
made.

7. Production Function
 The next column is the marginal
product—the extra output or change
in total product caused by the
addition of one or more units of input
 In other words, how much the final
product changes as you add one unit
of input (a worker)

8. Remember:
 Everything else stays the same, the
number of factories, the amount of
raw materials, equipment, etc.
 Only number of workers is changing.

9. Think about it
 As we add workers, at first it will
help our production.
 Jobs will be split, we’ll see division of
labor and specialization.
 Production should increase.
 But at a point, adding another
worker in a full factory will start
slowing down production.

10. Production Function
number total marginal
of workers product product
0 0 0
1 7 7
2 20 13
3 38 18
4 62 24
5 90 28
6 110 20
7 129 19
8 138 9
9 144 6
10 148 4
11 145 -3
12 135 -10

11. Stages of Production
 Stage one is increasing returns (returns
being what you get back from putting
something in)—as the number of workers
increases they make better use of their
time, machinery and resources and
become increasingly more efficient in their
work
 There is increasing marginal product with
every worker added because that worker
can add efficiency and help increase
production

12. Stages of Production
 Stage two is diminishing returns—total
production keeps growing, but by smaller
and smaller amounts.
 The rate in increase in total production is
starting to slow down.
 Each additional worker is making a
diminishing, but still positive, contribution
to total output
 Diminishing returns—output increases at a
diminishing (smaller and smaller) rate

13. Stages of Production
 Stage three is when there is too
much input.
 Total output decreases as input
increases.
 Marginal product is negative—as
input increases, total plant output
decreases.
 There’s too much salt in the meal
and the meal is now ruined.

14. Production Function with Stages
number total marginal
of workers product product
0 0 0
stage 1 1 7 7
increasing 2 20 13
marginal 3 38 18
product 4 62 24
5 90 28
stage 2 6 110 20
diminishing 7 129 19
returns 8 138 9
9 144 6
10 148 4
stage 3 11 145 -3
negative ret. 12 135 -10

15. Now Graph These Points
It will look like this, increasing, then
starting to even out, then decreasing

16. The Purpose of a Business
 What is the purpose of a business?
 If you are a business owner, what do
want?
 Hopefully you said to make the most
money possible (which is very different
than making the most amount of a
product possible).
 How do we make money?
 We earn more than we spend. There
are a few fancy terms that economists
use to explain this very simple idea.

17. Costs
A business must analyze costs before
making decisions.
 To simplify decision making, cost is
divided into several different
categories.
 Fixed cost—cost a business incurs even
if the plant is idle and output is zero
– -In other words, how much it costs
you to have the company even if you
aren’t producing anything
– Examples: salaries, rent, property
taxes, car notes

18. Costs
 Variable
costs—costs that change
when the business rate of operation
or output changes
– Costs that change according to how
much you produce
– Examples: wages (per hour), electricity
bill, freight/shipping charges

19. Costs
 Total cost (or overhead)—the sum of
the variable and fixed costs
 Marginal Costs—extra cost incurred
when a business produces one
additional unit of a product
– How much do total costs increase if you
produce one more unit of output?
– Fixed costs do not change—marginal
cost is the per unit increase in variable
costs that stems from using additional
factors of production.

20. Sunk Costs
 Costs that have already been
invested
 Should not be taken into account
when making economic decisions

21. Revenue (Makin’ Money)
 We want to make more than we
spend. We’ve already looked at
what we spend (costs), now we need
to look at the amount of money we
pull in (revenues).
 Total Revenue—total amount of
money that comes into the business
# of units sold multiplied by average
price per unit
Or quantity sold multiplied by price per

22. Revenue
 Marginal revenue—extra revenue
associated with the production and
sale of one additional unit of output
MR = difference in total revenue /
marg. Prod.

23. Marginal Analysis
 Economists use marginal analysis, a
type of cost-benefit decision making
that compares the extra benefits to
the extra costs of an action.
 This analysis will show us when we
are losing money, when we are
making money, and when we are
breaking even.
 Break-even point—total output or
total product the business needs to
sell in order to cover its total costs.

24. Marginal Analysis
A business wants to do more than
just cover its costs and break even.
 It wants to make money! That’s the
goal of a business.
 We want to minimize our costs and
maximize our revenues to find the
point that will make use the most
amount of money
 Profit-maximizing quantity of
output—when marginal cost and
marginal revenue are equal.

25. Profits
 Profit—your revenue minus your costs
(how much is left over after you pay
your bills)
 Total profit—Total revenue minus total
costs
 The total profit is maximized where
marginal costs equal marginal revenue.
This is were business should operate to
make the most possible money.
 This is where they are not missing any
would be profits and they are not losing
any money.

26. Derived Demand
 Because consumers have a desire
and willingness to buy goods and
services to satisfy their wants and
needs, producers have a desire and
willingness to buy the factors of
production or resources.
 This is called derived demand.

27. Derived Demand
 There is a derived demand for
autoworkers because there is a
demand for automobiles.
 There is no demand for buggy-whip
braiders because there is no demand
for buggy-whips.

28. Derived Demand
 Consumers’ buying decisions make
the production of some products
profitable, and the production of
other products unprofitable, thus
restricting the choice of businesses in
deciding what to produce.
 Businesses must match their
production choices with consumer
choices or else face losses and
eventual bankruptcy.

29. Growth Through Reinvestment
 Businesses can take their revenue
and subtract out all costs (wages,
interest payments, depreciation,
taxes, etc) to get their profit (also
known as cash flow)
 Businesses then have the power to
decide what to do with the profit—
some may be paid back to owners or
given in the form of bonuses to
employees; the rest is usually
reinvested

30. Growth Through Reinvestment
 Reinvestment of profits—putting
money back into the company to
build more factories, hire more
workers, buy more capital, etc—
allows firm to produce more and
grow

31. Growth Through Mergers
 Merger—a combination of two or
more businesses to form a single
firm
 Why? To grow faster to become
more efficient, to acquire or deliver a
better product, to eliminate a rival,
or to change its image

32. Types of Mergers
 Horizontal merger—when two or
more firms that produce the same
kind of product join forces
 Vertical merger—when firms involved
in different steps of manufacturing or
marketing join together

33. Growth Through Mergers
A corporation may become so large
through mergers and acquisitions
that it becomes a conglomerate.
 Conglomerate—a firm that has at
least four businesses, each making
unrelated products, none of which is
responsible for a majority of its sales

34. Growth Through Mergers
 Diversification—one of the main
reasons for a conglomerate; keeps
company from depending on one
type of product for its income
 Multinationals—corporations that
have manufacturing or service
operations in a number of different
countries