MODULE 5 and 6

APPLIED ECONOMICS

Session Topic: Theory of Production and Cost

1. Introduction to economics
2. Basic economic activities
3. An overview of the economy
Learning Objectives
1. Distinguish between the concepts of total product, marginal product, and average product
2. Describe the concept of diminishing returns
Key Points
Marginal Diminishing Production Variable Cost Fixed cost
product returns

Core Content
Introduction
The theory of production is an analysis of output-input relationship. As such, discussions touch on the relation
of output to the size, combination and efficiency of resources. In turn, this output function serves as a tool in analyzing
cost-output relationship. The fundamental concepts in this chapter are the Law of Diminishing Returns which explains
the output function in different resource conditions
.
In-text Activities
Production Function
PRODUCTION refers to any economic activity, which combines the four factors of production to form an output which
will give direct satisfaction to the consumer.
Theory of Production
An increase in the quantity of factor inputs will lead to an increase in output. The theory of production is the study of
how the output level changes as the quantity of factor inputs changes. To increase output, firms need to employ more
factor inputs which will lead to an increase in costs.
Inputs are commodities and services that are used to produce goods and services.
Outputs are useful goods and services that result from the production process.
In economics, we distinguish between two types of factor inputs:
Variable Input
Variable factor inputs are those whose quantities can be changed in response to changes in output. Examples include
electrical power consumption, transportation services, and most raw material inputs.
Fixed Input
A fixed factor of production is one whose quantity cannot readily be changed. Examples include major pieces of
equipment or suitable factory space
Short-Run
The short run is the time period during which at least one of the factor inputs used in the production process is fixed.
Long-Run
The long run is the time period after which all the factor inputs used in the production process are variable
Short-Run vs Long-Run
Consider the example of a hockey stick manufacturer. A company in that industry will need the following to
manufacture its sticks:
Raw materials such as lumber
Labor
Machinery
A factory
It might be time-consuming to add equipment. Whether new equipment will be considered a variable input
will depend on how long it would take to buy and install the equipment and to train workers to use it. Adding an extra
factory, on the other hand, is certainly not something that could be done in a short period of time, so this would be the
fixed input.

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The short run is the period in which a company can increase production by adding more raw materials and more labor
but not another factory. Conversely, the long run is the period in which all inputs are variable, including factory space,
meaning that there are no fixed factors or constraints preventing an increase in production output.
In the long run, if a firm wants to increase output, not only can it employ more labor, it can also employ more capital
whose quantity is fixed in the short run.
Productivity refers to the amount of output a firm can get from the resources it employs
Total Product
Single-input production are sometimes called total product. Shows how total output depends on the level of input
I (L) TP

0 0

6 20

12 96

18 162

24 192

30 150

Marginal Product of an input is the extra output produced by one additional unit of input.
MP = TP / I
Marginal Product

I (L) TP MP

0 0 0

6 30 5

12 96 11

18 162 11

24 192 5

30 150 -7

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Average Product is the average amount of output per unit of input (labor).
AP = TP/I
I (L) TP AP (units)

0 0 0

6 30 5

12 96 8

18 162 9

24 192 8

30 150 5

I (L) TP MP AP

0 0 0 0

6 30 5 5

12 96 11 8

18 162 11 9

24 192 5 8

30 150 -7 5

Increasing Marginal Returns to Labor

An increase in the quantity of labor increases total output at an increasing rate
Diminishing Marginal Returns to Labor
An increase in the quantity of labor still increases total output but at a decreasing rate
Diminishing Total Returns to Labor
An increase in the quantity of labor decreases total output

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Law of Diminishing Marginal Returns
Holds that we will get less and less extra output when we add additional amount of input while holding other inputs
fixed.

Theory of Cost
Cost refers to all expenses acquired during the economic activity or the production of goods and services.
Sales – Cost = Profit or
Total Revenue – Total Cost
Fixed Cost are costs that are spent for the use of fixed factors of production. These expenses do not change
regardless of a change in quantity of output produced.
Variable Cost are expenses which change as a consequence of a change in quantity of output produced. Examples
are labor and raw materials.

Total Cost
Fixed Cost + Variable Cost = Total Cost
Marginal Cost is the additional cost of one unit of product.

Output Variable Cost Fixed Cost Total Cost Marginal Cost

0 0 ₱10 ₱10 -

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 1 ₱10 ₱10 ₱20 ₱10

2 ₱17 ₱10 ₱27 ₱7

3 ₱25 ₱10 ₱35 ₱8

4 ₱40 ₱10 ₱50 ₱15

5 ₱60 ₱10 ₱70 ₱20

6 ₱110 ₱10 ₱120 ₱50

Per unit Cost

Calculate the following:

1. ATC of 6 units
2. AFC of 2 units
3. AVC of 4 units
4. ATC of 1 unit
5. AVC of 5 units
6. AFC of 5 units
Output Variable Cost Fixed Cost Total Cost Marginal Cost

0 0 ₱10 ₱10 -

1 ₱10 ₱10 ₱20 ₱10

2 ₱17 ₱10 ₱27 ₱7

3 ₱25 ₱10 ₱35 ₱8

4 ₱40 ₱10 ₱50 ₱15

5 ₱60 ₱10 ₱70 ₱20

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 6 ₱110 ₱10 ₱120 ₱50

AVC AFC ATC

- - -

₱10 ₱10 ₱20

₱8.5 ₱5 ₱13.5

₱8.33 ₱3.33 ₱11.66

₱10 ₱2.5 ₱12.5

₱12 ₱2 ₱14

₱18.33 ₱1.67 ₱20

The Isoquant-Isocost Model

 An isoquant shows all combination of factors that produce a certain output
 An isocost show all combinations of factors that cost the same amount.
 Isocosts and isoquants can show the optimal combination of factors of production to produce the maximum
output at minimum cost.

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 In this diagram, the isoquant shows all the combinations of labour and capital that can produce a total output (Total
Physical Product TPP) of 4,000. In the above isoquant, this could be

 20 capital and 18 labour or (more capital intensive)

 9 capital and 35 labour. (more labour intensive
An isoquant is usually shaped concave because of the law of diminishing returns. With fixed capital employing
extra workers gives a declining increase in the marginal product (MP)
Marginal rate of factor substitution

The marginal rate of substitution is the amount of one factor (e.g. K) that can be replaced by one factor (e.g.
L). If 2 units of capital could be replaced with one-factor labour, the MRS would be 2

Summary
 Marginal cost of production is the cost of producing one additional unit of
 output.
 Most firms face diminishing marginal returns (and, therefore, increasing
 marginal costs) after some level of output.
 Fixed costs do not vary with production levels. Variable costs do.
 The short run is the time over which fixed costs are fixed. The long run is
 any length of time greater than the short run.

LEARNING ASSESSMENT : Introduction to Economic Theory

Name:_______________________________ Professor:____________________
Year and Section:_____________________ Rating:_______________________
A. Complete the table. Show the solution.
Labor input TP MP AP
1 6.00
2 9.00
3 14.00
4 17.00
5 22.00
6 27.00
7 29.00
8 25.00
9 16.50
10 10.00
11 6.00
12 3.00
13 1.00
14 0.00

B. Complete the table of MRS for this production Isoquant

Labor Input Capital Input MRS

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 1 37.00
2 43.00
4 36.00
6 17.75
7 9.25
9 21.00
10 16.50
11 15.75
14 3.00
16 12.00

References
Refer to the references listed in the syllabus of the subject

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