Theory of Production,

Cost and Profit

Fernandez, Joan Christey J.

Abaya, Maria Carmela
Recto, Rhea
 What is Production?
• Production is a process of combining
various material inputs and immaterial
inputs in order to make something for
consumption. It is the act of creating an
output, a good or service which has value
and contributes to the utility of
individuals.
 What is profit?
• Profit is a financial benefit that is realized
when the amount of revenue gained from a
business activity exceeds the expenses, costs,
and taxes needed to sustain the activity. Any
profit that is gained goes to the business's
owners, who may or may not decide to spend
it on the business. Profit is calculated as
total revenue less total expenses.
 What is Cost?
• Cost, in common usage, the monetary value of
goods and services that producers and consumers
purchase. In a basic economic sense, cost is the
measure of the alternative opportunities foregone
in the choice of one good or activity over others.
This fundamental cost is usually referred to
as opportunity cost. For a consumer with a fixed
income, the opportunity cost of purchasing a new
domestic appliance may be, for example, the value
of a vacation trip not taken.
 Key Terms
• Explicit cost: A direct payment made to others in the course
of running a business, such as wages, rent, and materials, as
opposed to implicit costs, which are those where no actual
payment is made.
• Implicit cost: The opportunity cost equal to what a firm must
give up in order to use factors which it neither purchases nor
hires.
• Economic profit: The difference between the total revenue
received by the firm from its sales and the total opportunity
costs of all the resources used by the firm.
• Accounting profit: The total revenue minus costs, properly
chargeable against goods sold.
 Accounting Profit
• Accounting profit is the difference between total monetary
revenue and total monetary costs, and is computed by using
generally accepted accounting principles (GAAP). Put another
way, accounting profit is the same as bookkeeping costs and
consists of credits and debits on a firm’s balance sheet. These
consist of the explicit costs a firm has to maintain production (for
example, wages, rent, and material costs). The monetary revenue
is what a firm receives after selling its product in the market.

• Accounting profit is also limited in its time scope; generally,

accounting profit only considers the costs and revenue of a single
period of time, such as a fiscal quarter or year.
 Economic Profit
• Economic profit is the difference between total
monetary revenue and total costs, but total costs
include both explicit and implicit costs. Economic
profit includes the opportunity costs associated
with production and is therefore lower than
accounting profit. Economic profit also accounts for
a longer span of time than accounting profit.
Economists often consider long-term economic
profit to decide if a firm should enter or exit a
market.
 Explicit and Implicit Cost
• Explicit costs are costs that involve direct monetary payment.
Wages paid to workers, rent paid to a landowner, and material
costs paid to a supplier are all examples of explicit costs.

• In contrast, implicit costs are the opportunity costs of factors of

production that a producer already owns. The implicit cost is what
the firm must give up in order to use its resources; in other words,
an implicit cost is any cost that results from using an asset instead
of renting, selling, or lending it. For example, a paper production
firm may own a grove of trees. The implicit cost of that natural
resource is the potential market price the firm could receive if it
sold it as lumber instead of using it for paper production.
Accounting Profit vs. Economic Profit
 Key Terms
• Economic profit = total revenue – ( explicit costs + implicit costs).
Accounting profit = total revenue – explicit costs.

• Economic profit can be positive, negative, or zero. If economic profit is positive,

there is incentive for firms to enter the market. If profit is negative, there is
incentive for firms to exit the market. If profit is zero, there is no incentive to enter
or exit.
• For a competitive market, economic profit can be positive in the short run. In the
long run, economic profit must be zero, which is also known as normal profit.
Economic profit is zero in the long run because of the entry of new firms, which
drives down the market price.

• For an uncompetitive market, economic profit can be positive. Uncompetitive

markets can earn positive profits due to barriers to entry, market power of the
firms, and a general lack of competition.

• normal profit: The opportunity cost of an entrepreneur to operate a firm; the next
best amount the entrepreneur could earn doing another job.
 Variable Cost
• A variable cost is a company's cost that is
associated with the amount of goods or
services it produces. A company's variable cost
increases and decreases with its production
volume. When production volume goes up,
the variable costs will increase. On the other
hand, if the volume goes down, the variable
cost will decrease.
 Fixed cost
• A fixed cost is the other cost incurred by
businesses and corporations. Unlike the
variable cost, a company's fixed cost does not
vary with the volume of production. It remains
the same even if no goods or services are
produced, and therefore, cannot be avoided.
 Production of the firm in the short run
• The short run is the conceptual time period where
at least one factor of production is fixed in amount
while other factors are variable.
• In the short run, a firm that is operating at a loss
(where the revenue is less that the total cost or the
price is less than the unit cost) must decide to
operate or temporarily shutdown. The shutdown
rule states that “in the short run a firm should
continue to operate if price exceeds average variable
costs. ”
 Law of Diminishing marginal returns
• The law of diminishing returns, also referred to as the
law of diminishing marginal returns, states that in a
production process, as one input variable is increased,
there will be a point at which the marginal per unit
output will start to decrease, holding all other factors
constant. In other words, keeping all other factors
constant, the additional output gained by another one
unit increase of the input variable will eventually be
smaller than the additional output gained by the
previous increase in input variable. At that point, the
diminishing marginal returns take effect.
Cost of production in the short run
• The cost of producing a firm’s output depends on how much
labor and physical capital the firm uses. A list of the costs
involved in producing cars will look very different from the costs
involved in producing computer software or haircuts or fast-food
meals.

• However, the cost structure of all firms can be broken down into
some common underlying patterns. When a firm looks at its
total cost of production in the short run, a useful starting point is
to divide total cost into two categories: fixed costs that cannot
be changed in the short run and variable costs that can be
changed in the short run.
 Total cost
• The total cost formula is used to derive the combined variable and fixed
costs of a batch of goods or services. The formula is the average fixed cost
per unit plus the average variable cost per unit, multiplied by the number of
units.
The calculation is:
(Average fixed cost + Average variable cost) x Number of units = Total cost

• For example, a company is incurring $10,000 of fixed costs to produce 1,000

units (for an average fixed cost per unit of $10), and its variable
cost per unit is $3. At the 1,000-unit production level, the total
cost of the production is:

• ($10 Average fixed cost + $3 Average variable cost) x 1,000

Units = $13,000 Total cost
 Average Cost
• It is the total cost of making a single product
calculated by dividing the Total cost by the
number of product manufacture. The most
important components in average cost are fixed
cost and Variable cost. It is also called as Unit
cost.
Formula:
Total Cost (Fixed Cost + Variable Cost) / Number
of units Manufactured
 Marginal Cost
• It is a cost incurred due to the change in total
cost due to an increase in the unit of product.
So it is an additional cost or extra cost as a
result of an increase in the production of one
more unit of product.
Formula:
Change in Total Cost / Change in number of units
Manufactured
 Cost in the long run
• The Long-run Cost is the cost having the long-
term implications in the production process,
i.e. these are spread over the long range of
output. These costs are incurred on the fixed
factors, Viz. Plant, building, machinery, etc.
but however, the running cost and the
depreciation on plant and machinery is a
variable cost and hence is included in the
short-run costs.
 Stages of Production
Stage One
• Stage one is the period of most growth in a company's production. In this period, each
additional variable input will produce more products. This signifies an increasing marginal
return; the investment on the variable input outweighs the cost of producing an additional
product at an increasing rate. As an example, if one employee produces five cans by himself,
two employees may produce 15 cans between the two of them. All three curves are
increasing and positive in this stage.
Stage Two
• Stage two is the period where marginal returns start to decrease. Each additional variable
input will still produce additional units but at a decreasing rate. This is because of the law of
diminishing returns: Output steadily decreases on each additional unit of variable input,
holding all other inputs fixed. For example, if a previous employee added nine more cans to
production, the next employee may only add eight more cans to production. The total
product curve is still rising in this stage, while the average and marginal curves both start to
drop.
Stage Three
• In stage three, marginal returns start to become negative. Adding more variable inputs
becomes counterproductive; an additional source of labor will lessen overall production. For
example, hiring an additional employee to produce cans will actually result in fewer cans
produced overall. This may be due to factors such as labor capacity and efficiency limitations.
In this stage, the total product curve starts to trend down, the average product curve
continues its descent and the marginal curve becomes negative