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Ch. 5: 1

CHAPTER

THEORY OF PRODUCTION

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Ch. 5: 2

DEFINITION OF PRODUCTION
Definition
Production means the process of using the factor of

production to produce goods and services.

Production is the process of transforming inputs into
outputs.
OUTPUTS

INPUTS
Inputs refers to the
factors of production
that a firm use in the
production process.

Principles of Economics second edition

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Processing

Refers to what we
get at the end of the
production process
that is finished
products.

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Ch. 5: 3

LAND

LABOUR

All natural resources

or gift of nature

Physical or mental
activities of human beings

CLASSIFICATION
OF FACTORS OF
PRODUCTION
CAPITAL
Part of man-made wealth
used for further production

Principles of Economics second edition

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ENTREPRENEUR
A person who combines the different
factors of production, and initiates
the process of production and also
bears the risk
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Ch. 5: 4

PRODUCTION FUNCTION
A production function is a statement of the

functional relationship between inputs and

outputs, where it shows the maximum output that
can be produced with given inputs.
Q = (K, L, M, etc.)
Where: Q = Output
K = Capital
L = Labour
M = Raw Material
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Ch. 5: 5

SHORT RUN AND LONG RUN

PRODUCTION FUNCTION
Two Types of Factor Inputs
1. Fixed Input
An input which the quantity does not change according to the amount of
output.
Example: Machinery, land, buildings, tools, equipments, etc.

2. Variable Input
An input which the quantity changes according to the amount of output.
Example: Raw materials, electricity, fuel, transportation, communication, etc.

Short Run and Long Run Period

Short run period is the time frame, which at least one of the inputs (factor of
production) is fixed and other inputs can be varied.
Long run period is the time frame which all inputs are variable.

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Ch. 5: 6

SHORT RUN PRODUCTION FUNCTION

In the short run, we assume that at least one of the

inputs is fixed that is capital.

Therefore, in the short run the production function
can be written as:
Q = ( K , L)

Where: Q = Output
L = Labour
K = Capital (fixed)

Principles of Economics second edition

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SHORT RUN PRODUCTION FUNCTION

(cont.)
LAW OF DIMINISHING MARGINAL RETURNS
It states that if the quantities of certain factors are

increased while the quantities of one or more factors

are held constant, beyond a certain level of
production, the rate of increase in output will
decrease.
OR
Law of diminishing marginal returns states that as
more of a variable input is used while other input and
technology are fixed, the marginal product of the
variable input will eventually decline.
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SHORT RUN PRODUCTION

FUNCTION (cont.)
TOTAL PRODUCT (TP)
The amount of output produced when a given amount of that
input is used along with fixed inputs.

AVERAGE PRODUCT (AP)

Divide the total product by the amount of that input
used in the production
Average Product (APL) = Total Product
Total Labour
APL = TP/ L

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Ch. 5: 9

SHORT RUN PRODUCTION FUNCTION

(cont.)

MARGINAL PRODUCT (MP)

Change in the total product of that input corresponding to an addition
unit change in its labour assuming other factors that is capital fixed.

Marginal Product (MPL) = Change in Total Product

Change in Total Labour
MPL

Principles of Economics second edition

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= TP/ L

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Ch. 5: 10

SHORT RUN PRODUCTION FUNCTION

(cont.)
Capital
(Fixed
input)

Labour
(Variable
input)

Total
Product

Marginal
Product

Average
Product

10

10
10
10
10
10
10
10
10
10
10

1
2
3
4
5
6
7
8
9
10

8
20
33
44
50
54
56
56
54
50

8
12
13
11
6
4
2
0
-2
-4

8
10
11
11
10
9
8
7
6
5

MP = 54 - 56
9-8
= -2
Principles of Economics second edition
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Stages of
Production

STAGE I

STAGE II

STAGE III

AP = 56
8
= 7
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Ch. 5: 11

SHORT RUN PRODUCTION FUNCTION

(cont.)
RELATIONSHIP BETWEEN TP AND MP
When MP is increasing, TP increase at an increasing rate.
When MP is decreasing, TP increase at a decreasing rate.
When MP is zero, TP at its maximum.
When MP is negative, TP declines.

60

RELATIONSHIP BETWEEN AP AND MP

When MP is above AP , AP is increasing
When MP is below AP, AP is decreasing.
When MP equals to AP, AP is at maximum.

TP MAX

STAGE II

STAGE I

STAGE III

50
40
TP

30

MP

20

AP MAX;
AP =MP

AP

10
MP=0

0
1

10

-10
Principles of Economics second edition
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SHORT RUN PRODUCTION FUNCTION

(cont.)
Stage I

Stage II

Proportion of fixed factors are

greater than variable factors
Under utilization of fixed factor
Operation involves a waste of resources

Called law of diminishing returns

The most efficient stage of production
because the combinations of inputs are fully
utilized

STAGES OF PRODUCTION
Stage III
Proportion of fixed factors is lower than variable factors

Increase in variable factors decline the TP because of overcrowding

A producer would not like to operate at this stage

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Ch. 5: 13

LONG RUN PRODUCTION FUNCTION

ISOQUANT ANALYSIS
An isoquant or iso-product represents all the

possible combination of two factor inputs, which

gives the same level of output (total product).
Represents all the possible combinations of

variable inputs that used to generate the same

level of output (total product).

Principles of Economics second edition

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Ch. 5: 14

LONG RUN PRODUCTION FUNCTION

(cont.)
ISOQUANT SCHEDULE
Production with two variable inputs
Capital

Labour

250

450

550

700

800

450

650

800

900

950

600

800

950

1050

1100

700

900

1050

1150

1200

800

950

1100

1200

1250

There are various combination of capital and labour. Using 2 units of capital and 2
units of labour, the total output would be 650 units. If a firm needs 900 units of
output, there are a few combinations such as 2 labour and 4 capital or 4 labour with
2 capital.
Principles of Economics second edition
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Ch. 5: 15

LONG RUN PRODUCTION FUNCTION

(curve) (cont.)
Characteristics of Isoquant Curve
1. Isoquant curve slope downward from left to right. (Figure A)
2. Isoquant curve are convex to the origin. (Figure A)
3. An isoquant lying to the right represents a larger output.
(Figure B)
4. Isoquant curve never intersect each other. (Figure C)
Isoquant Curves Cannot Intersect

Isoquant and Output

Isoquant is Convex to the Origin

14
12
10

18

18

16

16

14

14
12

12

10

6
Output

Factor Y

Q3
Q2

10

Q1

8
6

Factor X

A
Principles of Economics second edition
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3
IC1

IC2

C
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Ch. 5: 16

LONG RUN PRODUCTION FUNCTION

(cont.)
Isoquant Map
Refers to a number of isoquants that are combined

in a single graph.
Can be used to estimate the maximum attainable

output from different combinations of inputs.

A higher isoquant curve represents a higher level of

output.

Principles of Economics second edition

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Ch. 5: 17

LONG RUN PRODUCTION FUNCTION

(cont.)
Isoquant map
6

Capital

5
4

Q3=1200

Q2=800

1
0

Q1 =450
1

Principles of Economics second edition

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Ch. 5: 18

LONG RUN PRODUCTION FUNCTION

Marginal Rate of Technical Substitution

The technique to estimate the amount of capital input to be
replaced by labour input without increasing or decreasing output.

MRTS

= - Change in Capital
Change in Labour

MRTS = - K / L

Principles of Economics second edition

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Ch. 5: 19

SCALE OF PRODUCTION
INCREASING RETURNS TO SCALE

All the factors of production are increased in a given proportion,

output would increase by a greater proportion.
When labour and capital are
doubled (100 units to 200
units), output increases
from 20 units to 60 units,
which is more than double.

Capital

200
IQ = 60
100%
> 100%

100
IQ =20

Labour
100

200

The causes of increasing

returns to scale are
specialization, technical
economies, managerial
economies which are also
known as economies of
scale.

100%

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Ch. 5: 20

SCALE OF PRODUCTION (cont.)

CONSTANT RETURNS TO SCALE

All the factors of production are increased in a given proportion,

output would increase by same proportion.
Capital

When labour and capital are

doubled (100 units to 200
units), output increases
from 20 units to 40 units.

200
IQ = 40

100%
100%

100
IQ =20

Labour
100

200
100%

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Ch. 5: 21

SCALE OF PRODUCTION (cont.)

DECREASING RETURNS TO SCALE

All the factors of production are increased in a given proportion,

output would increase by a smaller proportion.
When labour and capital are
doubled (100 units to 200
units), output increases
from 20 units to 30 units,
which is less than double.

Capital

200
IQ = 30
100%
< 100%

100

The causes of decreasing

returns to scale are internal
and external diseconomies
of scale.

IQ =20
Labour
100

200

100%

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Ch. 5: 22