THEORY OF PRODUCTION

Lesson Objectives
 To explain the input output

relationship;

 To describe the importance

of Law of Diminishing Return;

 To analyze the Different

Cost in production; and

 To know the meaning of

Economies and
Diseconomies of Scale.
 What is Theory?

It is a set of ideas formulated for reasoning to

explain something. The theory of

production Is a must in principle of

economics since the problem of scarcity

paves the way to expand production. The

available products that we have which

are not sufficient to give satisfaction for

everyone’s demand needs to increase

the bulk of production. It is the very

reason why we need to know the theory

of production.
 What is Production?

Production is basically an
activity of transformation ,
which connects factor
inputs and outputs.
 Basic Concepts of Production Theory:
Classifications of Inputs

 (i) labour (ii) capital

 (iii) land (iv) raw materials

 (v) time.

 These variables are measured per unit of

time and hence referred to as flow

variables.

 Entrepreneurship has been added as

part of the production inputs, though this

can be measured by the managerial

expertise and the ability to make things

happen.
 Two Elements of Production

•An input is a good or service that

goes into the production process. Variable Inputs
As economists refer to it, an (Labor, Raw materials like fertilizers, leather,
wood; electricity, office supplies, etc. since the
input is simply anything which a variable inputs actually are expenditure it is
firm buys for use in its called VARIABLE COST.)

production process.
(Example: To manufactured sugar, Fixed Inputs
the inputs are: sugarcane, labor,
chemicals, machinery, and (Machineries and equipment, building, factory
intrepreneur to sell the product.)
plant. Fixed Input is also expenditure in
production so it is known as FIXED COST.)

•An output, on the other hand, is

any good or service that comes Law of Diminishing
out of a production process. Return?
 A variable factor of production is one whose usage rate can be changed easily.

Examples include electrical power consumption, transportation services, and

most raw material inputs.

A fixed factor of production is one whose quantity cannot readily be changed.

Examples include major pieces of equipment, suitable factory space, and key

managerial personnel.
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.
 A Farmer Example of Diminishing
Returns

Consider a corn farmer with one acre of land. In addition to land, other factors
include quantity of seeds, fertilizer, water, and labor. Assume the farmer has
already decided how much seed, water, and labor he will be using this season. He
is still deciding on how much fertilizer to use. As he increases the amount of
fertilizer, the output of corn will increase. It may also reach a point where the
output actually begins to decrease since too much fertilizer can become
poisonous.

The law of diminishing returns states that there will be a point where the additional
output of corn gained from one additional unit of fertilizer will be smaller than the
additional output of corn from the previous increase in fertilizer. This table shows
the output of corn per unit of fertilizer:
As the farmer increases from one to two units of fertilizer, total

output increases from 100 to 250 ears of corn. Therefore the

marginal, or additional, ears of corn gained from one more unit of

fertilizer is 150 (250 - 100). From two to three units of fertilizer, the

total output increases from 250 to 425 ears of corn, a 175 marginal

increase.
Production Function of Rice
 Production Schedule of Rice
TOTAL PRODUCT

INPUT OUTPUT MARGINAL AVERAGE

(Farmer) (Cavans of Rice) Product Product
1 2 2 2

2 4 2 2

3 10 6 3.33

4 18 8 4.5

5 27 9 5.4

6 27 0 4.5

7 23 -4 3.22

8 18 -5 2.25

9 12 -6 1.33
Analysis:

The graph in Figure 1 indicates a production function curve. The

maximum output that will yield through employing 5 and 6 farmers in 27 cavans.

This is the point in the graph where it has attained peacked and the started to

decline. After the additional farmers (variable input) it employs to be able to harvest

more cavans of rice. There is a point where the total product already start to

diminish. That is the diminishing return or diminishing marginal product. The reason

is how many farmers you employ as long as the size of land (fixed input) is still the

same. It will not give additional harvest.

price Unit sold Total Cost Total Return Profit
20 100 2000 2000 0
19.5 105 1900 2047.50 147.50
18 110 1950 1980 30
17 120 1800 2040 240
15 130 1500 1950 450
TP(ou TFC TVC TC AFC AVC ATC MC TR Profit
tput}
0 2 0 2

1 2 3 5 2 3 5 3 5 0

2 2 9 11 1 4.5 5.5 6 10 -1

3 2 12 14 0.66 4 4.66 3 15 1

4 2 16 18 0.5 4 4.5 4 20 2

5 2 20 22 0.4 4 4.4 4 25 3

6 2 25 27 0.33 4.16 4.49 5 30 3

7 2 32 34 0.285 4.57 4.85 7 35 1

8 2 40 42 0.25 5 5.25 8 40 -2

9 2 50 52 0.22 5.55 5.77 10 45 -7

10 2 70 72 0.2 7 7.2 20 50 -22

 Computation of Different cost in
production

1. Total Fixed Cost= Total Cost – Total Variable Cost

TFC = TC – TVC

Total fixed costs are the sum of all expenses that are constant that a
company must pay.
2. Total Variable Cost = Total Cost- Total Fixed Cost
TVC= TC- TFC
3. Total Cost = Total Fixed Cost+ Total Variable Cost
TC= TFC+TVC

the costs included in one individual's personal budget, or even

the costs of something being proposed (like a stock market
investment.)
As an example, let's say that we need to put together a personal
budget to save money. In our case, our fixed costs are: rent = $800,
utilities = $250, phone bill = $25, internet bill = $35, gasoline for
commuting to work = $200, and groceries = $900. Adding these up,
we find that our total fixed costs are $2210.
4. Average Fixed Cost = Total Fixed Cost/Quantity
AFC= TFC/Qty

For example, you could recognize that you produce 10,000 units
every two months and use that time constraint to figure out your
fixed costs.
6. Average Total Cost = Total Cost/ Quantity
AC= TC/ Qty
To calculate marginal cost, you will need to take the change in total cost divided
by the change in total output.
8. Total Cost in the sum of all the fixed and variable
cost in producing a product over period of time
9. Fixed Cost The cost incurred which does not
change regardless of the volume of the product
produce.
10. Variable Cost- The Cost incurred that change as output is produced over
a period of time.

11. Marginal Cost- Is the additional Cost incur in producing additional unit
of product
Short Run - This period of time in production where only the
variable inputs/cost could be changed.

Long Run- This is a period of time in producton where the

producer could already change his fixed input/cost
Economies of Scale- This exist when an additional unit of
input causes a double number of the total product produce.

Diseconomies of Scale- This exist when the managerial

function of the manager was innacurately done.