THEORY OF PRODUCTION

The Production Function

The production function
refers to the physical
relationship between the inputs
or resources of a firm and their
output of goods and services at
a given period of time, ceteris
paribus.

The production function is

dependent on different time
frames. Firms can produce for a
brief or lengthy period of time.
 Firms Inputs

Inputs - are
resources that
contribute in the
production of a
commodity.

Most resources fall

into three categories:
Land,
Labor,
Capital.
 Fixed vs. Variable Inputs
Fixed inputs -resources used at a constant amount in the
production of a commodity.
Variable inputs - resources that can change in quantity
depending on the level of output being produced.
The longer planning the period, the distinction between
fixed and variable inputs disappears, i.e., all inputs are
variable in the long run.
Production Analysis with One Variable Input
Total product (Q) refers to the total amount of output
produced in physical units (may refer to, kilograms of
sugar, sacks of rice produced, etc)
The marginal product (MP) refers to the rate of change in
output as an input is changed by one unit, holding all
other inputs constant.

TPL
MPL
L
 Total vs. Marginal Product
Total Product (TPx) = total amount of output
produced at different levels of inputs
Marginal Product (MPx) = rate of change in output as
input X is increased by one unit, ceteris paribus.
TPX
MPX
X
 Production Function of a Rice Farmer
Units of L Total Product Marginal Product
(QL or TPL) (MPL)
0 0 -
1 2 2
2 6 4
3 12 6
4 20 8
5 26 6
6 30 4
7 32 2
8 32 0
9 30 -2
10 26 -4
 QL
Total product
32
30
26 QL

20

12

2
L
0 1 2 3 4 5 6 7 8 9 10

Labor

FIGURE 5.1. Total product curve. The total product curve shows
the behavior of total product vis-a-vis an input (e.g., labor) used
in production assuming a certain technological level.
 Marginal Product
Observe that the marginal product initially
increases, reaches a maximum level, and beyond
this point, the marginal product declines, reaches
zero, and subsequently becomes negative.

The law of diminishing returns states that "as the

use of an input increases (with other inputs fixed), a
point will eventually be reached at which the
resulting additions to output decrease"
 Total and Marginal Product
35

30

25

20
TPL
15

10

0 MPL
0 1 2 3 4 5 6 7 8 9
-5

-10
 Law of Diminishing Returns (Law of Variable
Proportions)
As more and more of an input is added (given a fixed
amount of other inputs), total output may increase;
however, as the additions to total output will tend to
diminish.
Counter-intuitive proof: if the law of diminishing returns
does not hold, the worlds supply of food can be produced
in a hectare of land.
 Average Product (AP)
Average product is a concept commonly associated with
efficiency.
The average product measures the total output per unit of
input used.
The "productivity" of an input is usually expressed in
terms of its average product.
The greater the value of average product, the higher the
efficiency in physical terms.
Formula:
TPL
APL
L
The slope of the line from the origin is a measure of the
AVERAGE
Y

rise Y
Slope =
run L

a b Y

Rise = Y

L1 L2 L
0 Run = L
Q Highest Slope of Line
from Origin
Max APL

Inflection point
Max MPL TPL

0 L1 L2 L3 L
 Relationship between Average and Marginal Curves:
Rule of Thumb
When the marginal is less than the
average, the average decreases.
When the marginal is equal to the
average, the average does not
change (it is either at maximum or
minimum)
When the marginal is greater than
the average, the average increases
AP,MP

At Max AP,
MP=AP

Max MPL
Max APL

APL

0 L1 L2 L3 L
MPL
 TP

TPL

0 L1 L2 L3
Stage II L
MP<AP Stage III
Stage I MP<0
AP decreasing
AP,MP MP>AP
MP still positive AP decreasing
AP increasing

APL

0 L1 L2 L3 L
MPL
 Three Stages of Production
In Stage I
APL is increasing so MP>AP.
All the product curves are increasing

Stage I stops where APL reaches its maximum

MP peaks and then declines, so the law of

diminishing returns begins to manifest at this stage
 Three Stages of Production
Stage II
starts where the APL of the input begins to decline.
QL still continues to increase, although at a
decreasing rate, and in fact reaches a maximum
Marginal product is continuously declining and
reaches zero, as additional labor inputs are
employed.
 Three Stages of Production
Stage III starts where the MPL has turned
negative.
all product curves are decreasing.
total output starts falling even as the input is
increased
 Optimal Use of the
Variable Input

Marginal Revenue
MRPL = (MPL)(MR)
Product of Labor

Marginal Resource TC
MRCL =
Cost of Labor L

Optimal Use of Labor MRPL = MRCL

 Production with Two
Variable Inputs (Long run)

Isoquants show combinations of two inputs

that can produce the same level of output.

Firms will only use combinations of two inputs

that are in the economic region of production,
which is defined by the portion of each
isoquant that is negatively sloped.
 Production with Two
Variable Inputs
Marginal Rate of Technical Substitution

MRTS = -K/L = MPL/MPK

 Optimal Combination of Inputs
Isocost lines represent all combinations of two
inputs that a firm can purchase with the same
total cost.

C Total Cost

w Wage Rateof Labor ( L)

r Cost of Capital ( K )
 Returns to Scale

Production Function Q = f(L, K)

Q = f(hL, hK)

If = h, then f has constant returns to scale.

If > h, then f has increasing returns to scale.
If < h, then f has decreasing returns to scale.
 RETURNS TO SCALE

Over time, the major carpet manufacturers

have increased the scale of their operations
by putting larger and more efficient tufting
machines into larger plants. At the same
time, the use of labor in these plants has
also increased significantly. The result? Proportional increases in inputs
have resulted in a more than proportional increase in output for these
larger plants.

The U.S. Carpet Industry

Carpet Sales, 2005 (Millions of Dollars per Year)
1. Shaw 4346
2. Mohawk 3779
3. Beaulieu 1115
4. Interface 421
5. Royalty 298