PAULA CHRISTINE HIPONIA temporarily add human

resource/temporary workers if demand

MODULE 4: FIRM BEHAVIOR
suddenly increases.)
THE NATURE OF THE FIRM – Less than four to six months
• Firms are also known as businesses.
• Their main economic goal is to realize and • LONG-RUN ADJUSTMENTS: all inputs of
maximize profits. production are variable
• Firms are technically the producers of the – Usually longer than six months
economic system. – Example: both labor and capital

Why study firms and their behavior? COSTS OF PRODUCTION

• To gain a better understanding of the decisions 1. Cost – one of the most important concepts in
made by producers economics
• To realize that firms and their behaviors are – the actual expenses incurred in the
dependent on market structures production of goods and services
2. In cost analysis we designate:
PRODUCTION  Fixed input as TOTAL FIXED COST (TFC)
• The process of transforming resources into goods  Variable input as TOTAL VARIABLE COST (TVC)
and services that could be of value to consumers
TFC vs TVC
FACTORS OF PRODUCTION • Total Fixed Costs (TFC) – include costs that do not
• Land change as the output increases. Example: RENT
• Labor INPUTS which is the payment for land use
• Capital • Total Variable Costs (TVC) – include costs that
• Entrepreneurship change as the output increases. Example: LABOR
COSTS
Two kinds of INPUTS
1. FIXED INPUTS – do not change as output increases. TABLE OF COST FORMULAS
Example: land resources
2. VARIABLE INPUTS – change as output increases.
Example: labor and capital

THE PRODUCTION FUNCTION

• refers to the greatest output that can be created
given an exact number of inputs
• is the relationship by which inputs are combined to
produce output.
• the simple production function can be expressed
as:
Q = f (land, labor, capital)
REVENUE & PROFIT
wherein:
• Revenue – is the amount of money received by
Q stands for OUTPUT
firms from selling goods and services.
• Profits – the difference when total costs are
deducted from total revenue
• The relationship of these concepts is expressed by:
Profit = Total Revenue – Total Costs

TABLE OF REVENUE AND PROFIT FORMULAS

TIME FRAME USED IN PRODUCTION ANALYSIS

• SHORT-RUN ADJUSTMENTS: a firm only adjusts its
variable input but there is still at least one fixed
input in the production
– Only variable inputs are adjusted because
they can quickly be changed in order to
increase or decrease output production.
Example: LABOR (You can quickly and
IMPORTANT POINTS:
• For a firm to maximize profit in a competitive Figure 3. TC, TR, and Break-even Point Analysis
market, marginal revenue (MR) and marginal cost • This shows the relationship or TR and TC.
(MC) must be balanced with the price (P). • In the early stages, the firm experiences initial
• Technically, if total revenue (TR) is equal to total losses because fixed costs are too expensive.
cost (TC), there will be no profits and no losses. • When Q reached almost 5, the firm experiences
• If there are no profits and losses, the firm incurred break-even then started to earn profits (TR is
a break-even. above TC).
• Break-even point refers to a situation where a • If the firm produces 6-14 units of output, it will
firm’s gain from its economic activity equals the continue to earn profits in the short run.
costs it incurred.

Figure 4. MR, MC, ATC, AVC, and the Profit-maximization

Level
• This shows the profit-maximization level in a
competitive market which is MR=MC=P, where the
price of the product is the same as the marginal
revenue and marginal cost. In this case, profit is
maximized at P=25
Figure 1. TC, TFC, TVC
• Both total cost and total variable costs increase at
an increasing rate.
• Total fixed costs do not change as quantity or
output increase.
• The space between total cost and total variable
represents the difference, which is the fixed cost.
This is why the total cost and the total variable
costs will never intersect. The LAW OF DIMINISHING MARGINAL RETURNS
“When more and more of a variable resource is added to a
given amount of a fixed resource, the resulting change in
output will eventually diminish and could become negative.”
• If the productivity of a variable input declines, then
more of it is needed to produce a given quantity of
output.
• This leads to an increase in the cost of production;
thus, a higher supply price is needed.
Figure 2. ATC, AFC, AVC
Example
• Average fixed cost is at a decreasing rate.
• If capital inputs such as machinery and equipment
• Average variable cost in the early stages decreases
are constant (no other additional machines will be
then stops, then starts to expand at an increasing
used in the production), and more workers (labor)
rate.
were added, the additional amount of output
• The most important thing is to indentify at which
produced will gradually fall.
quantity the ATC will be at its lowest, and in this
• Why? Because labor productivity falls as additional
example, it is when Q is 10.
outputs are produced.
 • Marginal Product (MP) – the change in total ECONOMIC PROFIT
product that occurs when the usage of a particular • When total revenue exceeds both explicit and
resource increases by one unit, all other resources implicit costs, the firm earns economic profit.
constant • Usually lower than accounting profit
• Total Product (TP) – the total output produced by
a firm ACCOUNTING PROFIT
• Average Product (AP) – total product per unit of • Usually higher than economic profits because
added input (TP/L) implicit costs are being ignored.

ECONOMIES OF SCALE
• are cost advantages companies experience when
production becomes efficient, as costs can be
spread over a larger amount of goods.
• A business's size is related to whether it can
achieve an economy of scale—larger companies
will have more cost savings and higher production
levels.
• Companies can achieve economies of scale by
increasing production and lowering costs.
SUMMARY OF RETURNS TO SCALE • Economies of scale can be both internal and
external.
– Internal economies of scale are based
on management decisions.
– External ones have to do with outside
factors. Example: technological
advancements, economic growth of a
country

• Economies of Scale: Forces that cause the

Returns to scale - the quantitative change in output of a
decrease in a firm’s average cost as the scale of
firm or industry resulting from a proportionate increase in
operations increases in the long run.
all inputs.
• Diseconomies of Scale: Forces that cause a firm’s
ECONOMIC PROFIT & ACCOUNTING PROFIT average cost to increase as the scale of operations
increases in the long run.
ECONOMIC PROFIT ACCOUNTING PROFIT
• Economists solve • Accountants solve
this through this by subtracting TYPES OF ECONOMIES OF SCALE
subtracting explicit costs from
opportunity costs the total revenue.
(both explicit and
implicit) from the
total revenue.

IMPLICIT COSTS vs EXPLICIT COSTS

EXPLICIT COSTS IMPLICIT COSTS

• involve a direct • do not involve a

money outlay for direct money
factors of outlay for factors
production of production Technical Economies of Scale
 • To produce tap water, water companies had to
invest in a huge network of water pipes stretching
throughout the country. The fixed cost of this
investment is very high. However, since they
distribute water to over 25 million households, it
brings the average cost down.

Specialization Economies of Scale

• The production process of creating cars involves
many different complex stages. Therefore to
produce a car you should split up the process and
have workers specialize in producing a certain part.
– e.g. a worker may become highly
specialized in the design of a car; another
in testing e.t.c. Specialization requires less
training of workers and a more efficient
production process.

Marketing Economies of Scale

• If you spend Php 320,000 on a national tv
advertising campaign, it is only worthwhile if you
are a big national company like McDonalds or
Mang Inasal. If your output is small, the average
cost of the advertising is much higher.