MABALACAT CITY COLLEGE

Eco 1

Theory of Production and

Cost
Market Structure

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Theory of Production and Cost

Objectives

At the end of the lesson the student should be able to:

•Identify and categorise the factors of production;

•Analyse the relationship between the input of factors and the output ofgoods and
services in the short-run and in the long-run

•Define fixed and variable costs and show, that in the short-run, average and marginal c osts will
even tu ally rise as „diminishing r e tur ns ‟c o m e i n t o operation

•Explain the role of economics and diseconomics of scale in determining the shape of a firm‟s long-
run average cost curve

•Show that a firm‟s profits will be maximised at the point where the marginal cost cuts the marginal
revenue curve from below

Overview

A firms as one economic actor performs a vital role. As we all know, they provide goods and services.
One thing that motivates firm to provide us product is profit. In layman's terminology, profit is the gain
for the effort, time and risks exerted by the entrepreneur or business man.
Before to come-up with profit, we must talk first the components of it; the revenue and cost. Firm
doesn't have direct control to revenue because it depends on the marketability of the product, the
another thing that firm may does is to control the cost.
Lesson Proper

The Market Forces of Supply and Demand

Supply and demand are the two words that economists use most often. Supply and demand are the
forces that make market economies work. Modern microeconomics is about supply, demand, and
market equilibrium. Profit, Total Revenue and Total Cost

The firm's main goal or objective is to maximize profit. As we all know, profit is computed as the
difference of Total Revenue and Total Cost
𝛱= TR - TC
Total revenue is the amount of goods being sold or services being rendered. This can be computed as
quantity sold multiply by its price.
TR = P XQ
Total Cost is the market value of the inputs a firm uses in production. A firm's cost of production
includes all the opportunity costs of making its output of goods and services. A firm's cost of production
includes explicit costs and implicit costs.
Explicit costs are input costs that require a direct outlay of money by the firm.
Implicit costs are input costs that do not require an outlay of money by the firm.

Opportunity cost
The value of the next best alternative that is forgone when another alternative is chosen.
The opportunity cost of a particular alternative is the payoff associated with the best of the alternatives
that are not chosen.

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Example: What is the cost to an airline of using one of its planes in scheduled passenger service?
An airline's expenditures on fuel and salaries are explicit costs Whereas the income it forgoes by not
leasing its jets is an implicit cost. The sum total of the explicit costs and the implicit costs represents
what the airline sacrifices when it makes the decision to fly one of its planes on a particular route which
is the opportunity cost.

Case No. 5.1

Suppose that you own and manage your own business and that you are contemplating whether you
should continue to operate over the next year or go out of business, if you remain in business, you will
need to spend Php100,000 to hire the services of workers and Php80,000 to purchase supplies; if you go
out of business, you will not need to incur these expenses. In addition, the business will require 80 hours
of your time every week. Your best alternative to managing your own business is to work the same
number of hours in a corporation for an income of Php 75,000 per year
In case number 6.1, the opportunity cost of continuing in business over the next year is Php55,000. This
amount includes an explicit cost of Php80,000—the required cash outlays for labor and materials; it also
includes an implicit cost of Php 75,000—the income that you forgo by continuing to manage your own
firm as opposed to choosing your best available alternative

Economic Versus Accounting Profit

Economic profit
- Total revenue minus total cost, including both explicit and implicit costs.
Accounting profit
- The firm's total revenue minus only the firm's explicit cost

Production And Costs

The production function shows the relationship between quantity of inputs used to make a good and
the quantity of output of that good. Figure 5. 2 show the graph of production function.
Along the production function curve, you can notice the do we call marginal product. The marginal
product of any input in the production process is the increase in output that arises from an additional

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unit of that input. It is the slope of production function curve.

Relationship between Production Function, Marginal Product and Average Product

As shown in Figure 5.2, total product (TP) function is increasing while marginal product (MP) and
average product (AP) are in decreasing pattern. But when the firm added the gth worker, total product
starts to decline.
As you can notice at 8th worker, the marginal product (MP) curve starts to intersects x axis which means
marginal product is equal to zero. Another thing that is noticeable from the graph is that when the MP
intersects the AP, AP starts to decline.
In short the relationship of the production curves is as follows:
1. When TP is on its peak, MP is equal to zero.
2. When TP starts to decline, MP is negative.
3. When MP is equal to AP, AP starts to decline.
Law of Diminishing Marginal Productivity
As we can noticed from the graph, MP is declines as we add more and more units of labor. This can be
explained by the law of diminishing marginal productivity or marginal return. The law states that as the
firm adds extra units of inputs, the marginal product declines, holding other variables constant.
An example of this situation is, imagine you are working in a plant site with the size good enough with 3
machines and workers. At first, when you are the only one worker, definitely you are very productive
since you can utilize the three machines and the whole plant size. But as you add more and more
workers, time will come that you need to pause for a while and wait the machine to vacate so you can
operate. Therefore there will be idle time which leads to decline of marginal product.

The Various Measures Of Cost

Earlier, we already discuss the one measure of cost, the implicit and explicit cost. Now, we're going to
discuss another measure of cost of production. In terms of explicit cost, we have fixed cost and variable
cost.
Fixed costs are cost incurred by the firm that does not vary with the production. Whether you produce
or not, you still incur that cost. The best example of this cost is the depreciation cost. If you stop the
production, your plant site, machine and others will depreciate and on your book, you're going to
account for it. If you produce more, the same value of depreciation that you account on your accounting
book. That's why it does not vary with the production.
Variable cost on the other hand is cost incurred by the firm in which it does vary with the production. If
you have your production you will incur it, if you have zero production, your variable cost is equal to
zero too. An example of this is the cost for your raw materials. As you produce more, of course you're
going to use more raw materials; therefore you will incur more cost on it.

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The Various Measures Of Cost
Earlier, we already discuss the one measure of cost, the implicit and explicit cost. Now, we're going to
discuss another measure of cost of production. In terms of explicit cost, we have fixed cost and variable
cost.
Fixed costs are cost incurred by the firm that does not vary with the production. Whether you produce
or not, you still incur that cost. The best example of this cost is the depreciation cost. If you stop the
production, your plant site, machine and others will depreciate and on your book, you're going to
account for it. If you produce more, the same value of depreciation that you account on your accounting
book. That's why it does not vary with the production.
Variable cost on the other hand is cost incurred by the firm in which it does vary with the production. If
you have your production you will incur it, if you have zero production, your variable cost is equal to
zero too. An example of this is the cost for your raw materials. As you produce more, of course you're
going to use more raw materials; therefore you will incur more cost on it.

Most of the time, economist deals with the average total cost. Average total cost is the quotient of total
cost and total output.
ATC = TC / Q
Average total cost is important to determine because it depicts the cost incurred of 1 unit of product.
Hence, it can be used as the basis for your pricing. Remember that your price must be greater than ATC.

Average variable cost is the quotient of variable cost and quantity. It denotes the variable cost incurred
of 1 unit of product
AVC = TVC/Q
Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.
Marginal cost helps answer the following question:

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How much does it cost to produce an additional unit of output?
MC = (change in total cost) = TC
(change in quantity) Q
Applying the formula, we may fill up the table:

HYPOTHETICAL COSTS SCHEDULE

Table 5.1 Cost Table Incurred by Firm

Cost also varies depending on the timeframe. When we talk about timeframe, we are talking about
short-run and longrun. Actually there is no specific time in which we can say it is short-run or long run.
Short-run is the timeframe in which require an immediate concern while long-run require planning
before you can make a decision. Between today and tomorrow, short run is today while tomorrow is the
long-run.
Notice that these costs are incurred by the firm for short-run. In long-run, all cost become variable cost.
To prove this, examine the table:

As shown in the table5.2, in short-run fixed cost is constant as 3.00. In long-run, the cost and quantity
were computed by adding the cost incurred in the next short-run period. As you can notice, as quantity
increases, total cost also increases

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Market Structure

Objectives

Students will understand market structures and how sellers within the market compete
both perfectly and imperfectly. Students will understand the relationship between
different market structures and how they compare and contrast with one another.

Overview

As individual, we must admit that our behaviour depending on the environment and number of persons
where we belong. You have different behaviour if you're alone, and different if you are within the circle
of your friends. Definitely, you behave differently if you are in a large group. The same with the firm, its
behaviour varies depending on its environment which is known as the market structure.

Lesson Proper

Market structure is divided into four types, the perfect competitive market, monopoly, oligopoly, and
monopolistic competition.

Perfectly Competitive Market

A perfect competitive market is a market structure which is known for many buyers and many sellers
selling the same product. A perfectly competitive market has the following characteristics:
There are many buyers and sellers in the market. An industry that consists of many small buyers and
sellers; one of the characteristics of a perfectly competitive industry.
The products sold by the sellers are homogenous. Products that consumers perceive as being identical
Products that consumers perceive as being identical.
Firms can freely enter or exit the market. Equal access to resources A condition in which all firms--those
currently in the industry, as well as prospective entrantshave access to the same technology and inputs.
consumers of the prices charged by all sellers in the market; one of the characteristics of a perfectly
competitive industry.

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Due to these characteristics, the firms under this market become:
Both buyer and seller are price taker. This is implied by the first characteristics. A seller or a buyer that
takes the price of the product as given when making an output decision (seller) or a purchase decision
(buyer. That is, a firm takes the market price of the product as given when making an output decision
and a buyer takes the market price as given when making purchase decisions.
There is law of one price. This is the implication of the second and third characteristics. In a perfectly
competitive industry, the occurrence of all transactions between buyers and sellers at a single, common
market price. Transactions between buyers and sellers occur at a single market price. 90 Time

Because the products of all firms are perceived to be identical and the prices of all sellers are known, a
consumer will purchase at the lowest price available in the market. No sales can be made at any higher
price.
Firms have free entry and exit. This is the implication of the fourth. Characteristic of an industry in which
any potential entrant has access to the same technology and inputs that existing firms have. That is, if it
is profitable for new firms to enter the industry, they will eventually do so. Free entry does not mean
that a new firm incurs no cost when it enters the industry, but rather that it has access to the same
technology and inputs that existing firms have. With regards to the free exit, because firm can easily
enter the industry, it is also possible that firms may gain loss and decide to stop producing and exit in
the market. It is also easy for the firm to exit with no legal or technological barriers to consider.
Example of product under this type of market structure (national market) are rice, flour, and sugar. If
you can notice, nationally, all of this product have the same characteristics and almost same prices.

Different Market Situations

MONOPOLY
If perfect competitive firm is composed of many buyers and sellers, the extreme opposite of it is the
monopoly. Monopoly is considered as the extreme of imperfect competition. A firm is considered a
monopoly if...
It is the sole seller of its product or the only producer of goods and services. This gives a reason why
seller in this type of market is price maker while the consumers are price taker. Firms are the one who
can set the price since it is the sole seller.
Its product does not have close substitutes. There are times that you are the sole seller of the said
product but the problem is that there are goods or services who can satisfy the same needs and wants.
If this case occur in the market, you cannot be consider as monopoly since seller doesn't have the
control in the market. Consumer can still make a choice between two products.
Classification of Monopoly
1. Natural Monopoly. Single firm car supply the entire market.
2. Legal Monopoly. Government grants to a private individual or firm over the product or service
3. Coercive Monopoly. It includes the principle of pure

Monopoly arises because of the barriers to entry. These barriers usually fall in this category.
- Technological barriers. it is the requirement of firm which is technological in nature. Technology refers
to the machinery, processes and methodology to produce a certain goods. It always requires large
capitalization that's why only one sector or the government invests to this type of market structure. The
products under this type of market usually are the necessity of the society that's why consumer cannot

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avoid patronizing the goods and services provided by monopolist.
-Legal Barriers. It is the requirements necessary to establish a business under this industry which is
mandated by the government. With regards to being the sole seller, government gives the single right to
produce the good.
In a small market, there are times in which natural monopoly exist. Natural monopoly exists when single
firmcan supply a good or service to an entire market at a smaller cost than could two or more firms.
Example of product under this market is electricity, water and the LRT and MRT. All of these services are
necessity of household and there is only one provider. They can control the price but still government
intervenes here to protect the welfare of the society.

Oligopoly

The first two types of market structure are the extreme of two parties. Now, it's time to go to the
market that lies between the two. First of it is the oligopoly. Oligopoly is a market structure having few
seilers..
The characteristics of an Oligopoly Market are as follows:
-Few sellers offering similar or identical products. There is no specific number in the word of few, as long
as you can still notice how many sellers you have in the marker that is still few.
-Interdependent firms. The firms under this type of market depend on each other. The action of one
firm has noticeable effect on the other firm.
-Best off cooperating and acting like a monopolist by producing a small quantity of output and charging
a price above marginal cost
Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-
interest.
Cooperation is the situation in which firms under the market creates either collusion or cater.
-Collusion is an agreement among firms in a market about quantities to produce or prices to charge.
-Cartel is a group of firms acting in monopoly or onefirm.
Self-interest is a condition in which the competition prevails among the group of sellers in the industry.
This is the opposite cooperation. Because of self-interest, strategic planning exists. The firms must know
to play the game of gaining customers.
It seems that cooperation is favourable in the part of firm. But, on part of consumer, it is not.
Competition among sellers is good in the consumer because it tends to lower the price of commodity.
This is the reason why cartel and collusion is prohibited by law.
Product under this market structure nationally is the oil and telecommunication. This industry composes
only of few firms competing to the large market.

Monopolistic Competition

The last type of market structure which falls between perfect competition and monopoly is the
monopolistic competition. From the name itself, we can determine its meaning, monopoly with
competition or the combination of monopoly and perfect competition. Monopolistic competition is a
type of market structure having many buyers and sellers selling differentiated product. In this type of
market, they can set their own price since they product differentiated product. The cost incurred in
producing the goods varies depending on the raw materials they used in production.

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The characteristics of Monopolistic Competition are the following:
-Many sellers. This characteristic of this type of market is being adopted in the perfect competitive
market.
-Product differentiation. In this type of market, the product is differentiated or heterogeneous. Each
product produce by a certain firm is not similar to those produce by other businesses.
-Free entry and exit. Unlike the monopoly and oligopoly, there are low barriers to enter in this type of
market. The technology adopted by this firm most of the time is not too sophisticated which requires
small amount for capitalization. Legally, government does not give the sole rights to produce the
commodity. The government requirements they just looking is the business permit, sanitary permits and
others. Besides from that, there are no high legal barriers for this.
Products under this type of market structure are the CD's or DVD, novels, books, restaurants, and
apparels. if you will observe the way of setting their price, each firm can set their own price. Even the
product itself, it is different in the specification but similar in nature.

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BOOK REFERENCES:

• Basic Economics: with Taxation and Land Reform, Andres delos Santos, et al., Jimczyville
Publications
• Principles of Economics. Castaneda, S. Metro Manila: Mutya Publishing House, Inc.
• Economics: Its Concepts and Principles (with Taxation and Agrarian Reform). Gabay, B. Quezon
City: Rex Bookstore, Inc.
• Principle of Economics 7th Edition. Mankiw, G. Boston: South-Western Cengage Learning.
• Principles of Economics (with Taxation and Agrarian Reform) Simplified.Marcelino, R., Viray, E.,
Avila-Bato, J., & Bautista, A. Mandaluyong: National Bookstore.
• Economics: Principles, Problems, and Policies.McConnell, C., Brue, S., & Flynn, S.). New York:
McGrawHill.
• Economics 17th Edition Samuelson, P., & Nordhaus, W.. New York City: McGrawHill.
• Principles of Economics', Roberto Medina, Rex Bookstore

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