MANAGERIAL ECONOMICS

Lesson 2 – Theory of Production

Overview
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. The fundamental concepts in this lesson are the Law
of Diminishing Returns which explain the output function in different resources conditions. As a practical model
and tool of analysis, its one-variable resource assumption basically reflects on the dynamics of a multi-resource
condition. Specifically, after completion of this lesson, the students will have a thorough understanding about the
following:

● Production function

● The Law of Diminishing Returns

● Productivity

● Resource efficiency

Desired Learning Outcomes

1. Explain the production function and its ways to improve production.
2. Describe the concept of Law of Diminishing Returns
3. Discuss the basic ways on how to improve resource efficiency
4. Show how productivity is measured via formula
5. Solve exercises involving production function.

Lesson 2 Theory of Production

Content-Discussion
Terms to remember
• Production-basically means act of manufacturing a product
• Productivity-the efficiency and therefore the power of inputs to produce
• Marginal product-product due to the additional or last unit of the variable resource input
• Economic efficiency-profitable improvement in overall resource efficiency
• Resource mix or combination-defined as how much of one resource is used per unit

Production function
Plant size and the efficiency of its resources (land, labor, and capital) determine plant capacity
(maximum output). Resources are fixed in the short run, which is generally described as a period when
conditions have not changed yet. But as plant size and resource efficiency change in the long run, so is
production capacity.
PRODUCTION FUNCTION

LABOR TOTAL PRODUCT MARGINAL AVERAGE PRODUCT

Man Hours OR OUTPUT PRODUCT (units) (units) STAGE

1 5 5 5

2 10 5 5 STAGE 1

3 16 6 5.3

4 21 5 5.2

5 24 3 4.5 STAGE 2

6 24 0 4

7 21 -3 3

8 16 -5 2 STAGE 3

9 10 -6 1.1

10 5 -5 0.5

11 2 -3 0.2 STAGE 4

12 0 -2 0

The production function illustrates how variations in a certain resource (e.g., labor) change the total product (TP)
or output, assuming the other resource (e.g., capital) to be fixed. The TP or output rises with more labor inputs in
the first two stages but eventually declines in the last stage. The marginal product influences this trend and is
defined as the product due to the additional or last unit of the variable resource input and measured as follows:
MP = ∆Q
∆I
Where:
MP = Marginal product or output
QP = Total product/output
I = Resource Input
∆ = Change
The table shows that the 2nd unit of labor yields an additional output of 5 which is actually the MP of using 2 units of
the resource. In turn, this additional product (MP) increases TP from 5 to 10 because of that 2 nd or last unit of labor.
But the 7th unit of labor has a negative product or an MP of -3, which decreases TP from 24 to 21. At stage 1, every
additional input of labor churns out a bigger chunk with a higher MP to accelerate the TP. At stage 2, additional
input churns out a smaller chunk with a lower MP to still increase but decelerates TP. MP continues to decline to
negative levels at stage 3 where additional labor input has negative returns and decreases TP.

• The Law of Diminishing Returns

The production function shows that stretching the use of variable resources against the limits of fixed
resources decreases additional product (MP). This is the Law of Diminishing Returns, which is basically
due to the limits of a fixed plant size. Having too much of one resource and too little of another can even
result in a resource imbalance that decreases production capacity stretching resource use to the point of
imbalance or overusing breeds counter-productive conditions which directly cause diminishing or even
negative returns. The saying “Too many cooks spoil the broth” applies to production. It also states that the
use of variable resources against the limits of fixed resources or describes the tendency at some point for
each succeeding addition to output to become smaller as the firms add succession units of variable input
to some fixed inputs.

Two important lessons:

a. Size of a resource, given the rest as fixed, should not go beyond its product-maximizing point.
b. Plant capacity can only increase with more resources combined unless technology changes.

• Productivity
It is the efficiency and therefore the power of inputs to produce. It confines discussions to resource inputs
which are basic to production. Productivity is measured as output per unit of input which is illustrated
below.
Productivity = Q
I
Where:
Q = Output
I = Input

The foregoing, which is average productivity, is the efficiency of inputs taken as a whole and is measured as their
average output (as in the above formula). On the other hand, marginal productivity is the efficiency of additional
inputs and it is measured as their marginal output which is also illustrated below.
Marginal Productivity = ∆Q
∆I
Where additionally:
∆ = Change
In the production function, the average product (AP) of labor measures its average efficiency, while marginal
product (MP) measures its marginal efficiency.

Advantages
 Productivity improvement means more output per unit of input as the increase in the efficiency ratio
[ ]
Q
I
indicates. It also means less input for output as the decrease in the ratio’s inverse

[ ]
I
Q
indicates. Therefore, efficiency is not a matter of size. A bigger plant is not necessarily more efficient than its

smaller counterparts. For example: a class may best the rest in a school fund drive by the sheer number of
soliciting members. But the most efficient class has the biggest amount solicited by every member which reflects on
individual initiative. However, productivity is not an end, but a means to compete and survive in the free market.

Resource efficiency
Production resources are complementary not only in function but also in efficiency. A better machine also
enables its operator to work faster or the other way around. Resources do not become more internally efficient at
the same time, but every improvement contributes to the overall productivity picture. In addition, the time lag
between productivity improvements can alter the optimum combination of resources.
For example:
Replacing old machines with modern and more efficient ones improves work and shifts the TP, AP, and MP
upward. But plant expansion favors the use of more efficient capital than less efficient labor. The shift is
economically efficient since every peso of labor given up, which is additional spent for capital, yields a net increase
in output.

Basic ways to improve resource efficiency

1. Change the nature of the resource through innovation.
Example, a worker in a car assembly plant does more in tightening bolts than with other jobs like
mounting wheels.
2. Change the external condition of resources.
Example, increasing the number of customers served in a drug store by temporarily reassigning resources
to augment the sales group during peak hours. This set-up minimize imbalance in work distribution and
labor idle time.
3. More balanced resource combination.
Example, investment in an irrigation system (capital) enables the rice farmer to plant and harvest three
times a year with the same land area. But without irrigation, capital is at minimum and land is only
productive once a year.
4. Using resource-saving technology
Example, computers have become more powerful and cost efficient and resource combination in
industrialized economies favors their use to save on scarce and costly labor resources.

Progress check: Briefly answer the following

To be submitted/placed in your portfolio in our Google classroom.

1. Cite some successful businesses in the Philippines that uses resource efficiency (20 points)
 2. Cite your own examples as regards ways to improve resource efficiency (20 points)

Exercises
A. Complete the table below. (30 points)
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 16.00

10 10.00

11 6.00

12 3.00

13 1.00

14 0.00

Self-evaluation: Quiz
B. Write T if the statement is true. If the statement is false, underline the wrong word and write the correct answer
on the blank before each number. (2 points each)
1. Productivity is the output produced by a unit of factor input during a given span of
Factor input during a given span of time.
2. The theory of production describes the functional relationships of output and
economic resources, assuming these are of fixed size.
3. A production function illustrates the varied combinations of inputs at the same
level of plant capacity.
 4. The AP and MP of a production function may shift downward or upward only
because the overall productivity level of that firm may also change.
5. Computers and computerized machineries are means of improving overall
efficiency by utilizing resource-saving technology.

Rubrics for essay

Assessment: 20 points 30 points
Present ideas in an original manner 5 8
Organization of thought (strong and organized) 5 7
Understanding (writing shows clear understanding) 4 7
Word choice (use of nouns and verbs make the essay very informative) 3 4
Sentence structure is evident; sentences mostly flow 3 4
20 points 30 points

References for further readings

Arnold, Roger A. (2019) Microeconomics 13th Edition
Mc Eachern, William A. (2017) Microeconomics
Bato, Ma. Jesusa Avila (2016) Microeconomics Simplified
Marcelo Jr. Danilo F. (2016) Microeconomics Theories and Applications OBE Approach Pagaso, Cristobal M.
(2015) Introducing Microeconomics

Online Sources:

⮚ https://www.researchgate.net/publication/47804534_Basic_microeconomics

⮚ https://www.researchgate.net/publication/236784560_modern_microeconomics
 MANAGERIAL ECONOMICS

Lesson 3 – Pricing and Output Under Pure Competition

Overview
Competition has always been part of human motivation and activity. This lesson shows how the price system
operates in a purely competitive market. Competition can make wonders in the economy. Fair competition can
make wonders both in human activities and in the market system, say, the best shoes can be produced in the
market if there is fair competition among the shoe producers. Needles to say, perverted and unbridled competition
can lead to undesirable ends. After the completion of this lesson, the students will have a thorough knowledge
about the following:

● Pure and Perfect Competition

● A Note on Profits

● Profit Maximizing Output: Pure Competition Total Revenue-Total Cost Approach

● Profit Maximizing Output: Pure Competition Marginal Revenue=Marginal Cost Approach

Desired Learning Outcomes

1. Define a perfectly competitive market and explain its effect on demand.
2. Distinguish an accountant’s view from an economist’s view as regards a corporation’s net income or profit
and economic profits.
3. Identify how concepts of efficiency are used to judge market performance
4. Compute for the profits with the given data on the following approaches:
a. Total Revenue-Total Cost Approach
b. Marginal Revenue=Marginal Cost Approach

Lesson 3 Pricing and output under pure competition

Content/Discussion
Terms to remember

● Pure competition-a market wherein there is a large number of buyers and seller of a commodity

● Profits-pure surplus or an excess of total receipts over all costs of production incurred by a firm.

● Marginal cost-the additional cost incurred when additional units of output are produced.

● Marginal revenue-the additional revenue obtained by putting the additional units of output in the

market.

● Economic profits-the difference between the net income of the firm and the opportunity cost of the

inputs used; also known as economic value added.

 ● Pure and perfect competition

Economists make a distinction between pure and perfect competition. A market is said to be perfectly
competitive if it contains all the characteristics of pure competition plus an additional characteristics, i.e.,
consumers, resource owners, and firms in the market have perfect knowledge of present and future prices
and costs. Perfect knowledge means that a person knows the price of a commodity being charged in the
markets. Based on this knowledge, he can make his decision whether to buy from one market or the other
based on price differences.

A market is said to be purely competitive if:

1. There is a large number of sellers and buyers of the commodity, each too small to affect the price of the
commodity.
2. The outputs of all firms in the market are homogeneous, i.e., the product of any seller is considered exactly
alike in all respects to the product of any other seller.
3. There is perfect mobility of resources, i.e., there is freedom of entry into and exit from the industry.

When there is a large number of seller and buyers of a commodity, each would be too small to affect the price of the
commodity. For example, a typical rice farmer, since he is only one of the millions of farmers in the Philippines, his
individual decision regarding the pricing of his product would not significantly affect the price of rice in the market.
This means that both the producers and the seller are price takers. Given this condition, the demand curve under a
purely competitive market is shown below.
Price Firm

P Demand

Output

As can be seen from the graph above, the firm faces an infinitely elastic demand curve. The firm can sell any amount
it can produce at the price. However, while each individual firm faces a horizontal demand curve, the industry
demand curve is still downward sloping. The demand and supply curves in the industry are subject to various
influences which generally make the demand curve downward sloping and the supply curve positively sloped.

• A note on profit
The term profit can sometimes be ambiguous. To avoid this, let us make explicit definitions on profit.
Profit-is a pure surplus or an excess of total receipts over all costs of production incurred by a firm. Included as
cost are obligations incurred for all resources used, which include opportunity costs. These costs include returns to
the owners of capital used equivalent to what they could get.
 Let us look at how an accountant would look at a corporation’s net income or profit compared with an
economist’s view of economic profits. Assuming that corporate income taxes are ignored, corporate profits are
determined by the accountant as follows:
Gross Income - Expenses = Net Income or Profits

The economist would view profit from a slightly different light. Obligations incurred to the owners of the
corporation’s capital (its stockholders) are as much cost of production as those incurred for labor or for raw
materials. This means that a company has to make payments to capital owners in the form of dividends from the
corporation’s profits. To arrive at economic profits, dividends payments equal to what investors could earn, should
be subtracted from the corporation’s net income as follows:

Gross Income - Expenses

= Net Income or Profit

Net Income of Profit-Average Dividends

= Economic Profits

Given the market price of a product, the producer in a competitive market is faced with the following questions:
1. Should I produce?
2. If so, what will I produce and how much?
3. Will profit be realized (or loss)?
4. If so, how much profit (or loss)?
One of the approaches in answering these questions and arriving at the break-even point and maximum profit is
through the total revenue minus total cost approach. The break-even point is arrived at when total revenue equals
total cost. This is a very important concept in economics. Total profits equal total revenue minus total cost. So long
as revenues are greater than costs, the firm receives profits; if costs are greater than revenues, the firm is operating
at a loss. The following table will illustrate the concept.

PROFIT MAXIMIZING OUTPUT: PURE COMPETITION

TOTAL REVENUE-TOTAL COST APPROACH
QUANTITY TOTAL REVENUE FIXED COST VARIABLE COST TOTAL COST PROFITS

0 Php0 Php200 Php0 Php200 Php-200

2 262 200 180 380 -118

4 524 200 340 540 -18

6 786 200 480 680 106

8 1,048 200 600 800 248

10 1,310 200 740 940 370

 12 1,572 200 900 1,100 472

14 1,834 200 1,080 1,280 554

16 2,096 200 1,300 1,500 596

18 2,358 200 1,560 1,760 598

20 2,620 200 1,860 2,060 560

Based on the table above, Total revenue (TR) is derived by multiplying price by quantity
(TR=P X Q). Assuming a market price of PHP131, the total revenue curve (column 2) is obtained by multiplying the
value under quantity (column 1) by price.
Total cost (TC) is obtained by adding fixed cost (column 3) and variable cost (column 4). Thus, we have the
question:
Total cost (TC)=Fixed cost (FC) +
Variable cost (VC)

Question:
At what output would the firm maximize profit?
Answer:
From the table, we can see that profit is maximized at output 18. The size of profit at this point is Php598, the
highest profit that be possibly obtained from the profit column. Profit is obtained by subtracting total cost (column
5) from total revenue (column 2). Thus, we have the equation:
Profit = Total Revenue – Total Cost

PROFIT MAXIMIZING OUTPUT: PURE COMPETITION

MARGINAL REVENUE = MARGINAL COST APPROACH
QUANTITY P = MR MC AC PROFIT/UNIT TOTAL PROFIT

2 Php131 Php90 Php190 Php-59 Php-118

4 131 80 135 -4 -16

6 131 70 113.33 17.67 106

8 131 60 100 31 248

10 131 70 94 37 370
 12 131 80 91.67 39.33 472

14 131 90 91.43 39.57 554

16 131 110 93.75 37.25 596

18 131 130 97.78 33.22 598

20 131 150 103 28.00 560

Another way of determining profits in a competitive firm is through the marginal revenue
(MR) = marginal cost (MC) approach. Marginal revenue is the additional revenue obtained by putting the
additional units of output in the market. This is obtained in the equation.
MR = ∆TR
∆Q
Marginal cost is the additional cost incurred when additional units of products are produced. It is computed as the
change in total cost divided by the change in units produced. Thus, we have the equation:
MC = ∆TC
∆Q

Question:
At what output will the firm maximize profit?
Answer:
Profit is maximized where MR = MC. This is obtained at output 18. At this point, total profit is Php598, the highest in
all profit columns. Total profit is obtained by multiplying profits per unit by quantity. Any point outside output 18
will give the firm lesser profit.

Price competition induces sellers/producers to find the most efficient resources and use them most
efficiently. An example of resource misallocation that eventually self-corrects toward collective efficiency is the
mushrooming of Internet cafes in contrast to the rarity of gift shops in the market. Overinvestment in Internet cafes
leaves behind idle resources that only add to cost. However, these idle resources could otherwise be profitable
investments in fixtures and stocks of additional gift shops. Thus in the long run, more and more will invest in gift
shops as attracted by resources, technology, and size, so are consumers in taste and preference. That they are
identical and many also explains why everybody is a price taker in the market. Reinforcing equity and equality is
the competitive environment that not only drives the same production efficiency but also keeps every market actor
in check. The latter means that perfect mobility and information clear the market of barriers that diversify it in
product and taste. In other words, mobility and information enable producers (sellers) and consumers to imitate,
and therefore, neutralize one another toward homogeneity and equality.

Progress check:
To be submitted/placed in your portfolio in our Google classroom
Exercises
A. Draw the demand curve of a firm under pure competition. (20 points)

B. Complete the following table. (25 points)

Answer the questions that follow
PRICE Qd TC TR AC MR MC PROFIT

Php3.00 5 10

3.00 10 25

3.00 15 30

3.00 20 33

3.00 25 45

3.00 30 66

1. At which quantity above is profit maximized? (5 points)

2. Is this extra ordinary or normal profit? Why? (5 points)

Rubrics for essay

Assessment: 20 points 30 points
Present ideas in an original manner 5 8
Organization of thought (strong and organized) 5 7
Understanding (writing shows clear understanding) 4 7
Word choice (use of nouns and verbs make the essay very informative) 3 4
Sentence structure is evident; sentences mostly flow 3 4
20 points 30 points

References for further readings

Arnold, Roger A. (2019) Microeconomics 13th Edition
 Mc Eachern, William A. (2017) Microeconomics
Bato, Ma. Jesusa Avila (2016) Microeconomics Simplified
Marcelo Jr. Danilo F. (2016) Microeconomics Theories and Applications OBE Approach Pagaso, Cristobal M.
(2015) Introducing Microeconomics

Online Sources:

⮚ https://www.researchgate.net/publication/47804534_Basic_microeconomics

⮚ https://www.researchgate.net/publication/236784560_modern_microeconomics