The Theory Of Production

Firm behavior
Production function
•Inputs, output, profit
•Short run And Long Run
•TP, MP, and AP

Short Run Production Function

•Law of Variable Proportion
•Relation between Total product, Marginal Product and Average Product

Long Run Production Function

•Returns to scale
•Isoquant
•Marginal rate of Technical Substitution
•Expansion Path
 Overview of Production Process

 Production naturally brings to mind inputs and outputs

 Inputs include resources
◦ Labor
◦ Capital
◦ Land
◦ Raw materials
◦ Other goods and services provided by other firms

 a certain amount of inputs per unit of time are used to produce a certain
amount of outputs per unit of time period at some location………FLOW variables
 Way in which these inputs may be combined to produce output is the firm’s
technology
 A firm’s technology is treated as a given

◦ Constraint on its production, which is spelled out by the firm’s production function
◦ For each different combination of inputs, the production function tells us the
maximum quantity of output a firm can produce over some period of time
Different
Alternative Input
Combinations
Production Quantities of
Output
Function
Analogous to Consumers' decision
Production technology

Cost of production

Inputs Combination
 The Firm’s Behavior

Owners

Initial Financing Profit After Taxes

Input Costs Taxes

Input The Firm
Government
Suppliers (Management)
Inputs Government Services
Government Regulations
Output Revenue

Customers
 Firm’s Behavior
 A business firm is an organization, owned and operated by private individuals, that
specializes in production

 Production is the process of combining inputs to make outputs. Base on how

readily their usage can be changed, two type os inputs
INPUTS
Fixed Inputs Variable Inputs
Supply is inelastic in short run Supply is elastic in short run
Remain fixed for some period Varying with the level of output

 Profit of the firm = sales revenue – input costs

Long Run and Short Run

Short Run: The short run is a time period where at least one factor of production is in fixed supply. A
business has chosen it’s scale of production and must stick with this in the short run. We assume that the quantity
of plant and machinery is fixed and that production can be altered by changing variable inputs such as labour,
raw materials and energy. Under Law of variable Proportion.
Long Run: All factors are variable and described under Law of Returns to scale
Concepts of Production and Production Function
The production function shows the relationship between quantity of
inputs used to make a good and the quantity of output of that good.

Y= f(K,L, N, R, t, T), K=capital, L=labur, N= land, R= raw

material, t=time and T=technology

For sake of convenience, economists have reduced the

number of variables used in a production function to
only two: capital (K) and labour (L).

Therefore, in the analysis of input- output relations, the production

function is expressed as:

Q = f(K, L)

Increasing production, Q, will require K and L, and whether the firm

can increase both K and L or only L will depend on the time period it
takes into account for increasing production, that is, whether the firm
is thinking in terms of the short run or in terms of the long run.
 TP, MP and AP

MP: The marginal product of any input in the production process is the
increase in output that arises from an additional unit of that input keeping
other inputs constant. TP
MP 
L
Diminishing Marginal Product: is the property whereby the marginal
product of an input declines as the quantity of the input increases.

Example: As more and more workers are at a firm, each additional worker
contributes less and less to production hired because the firm has a limited
amount of equipment.

AP: The average product of any input in the production process is the
production per unit of input. total output divided by total units of
input,
AP tells us , on average how many units are produced per unit of
inputs produced AP 
TP
L
 Production function
Thomas Machine Company, when K= 2

Amount of Labor Output of Parts AP Labor MP Labor

(annual # units) (hundreds/year)
1 12 12.0
2 27 13.5 15
3 42 14.0 15
4 56 14.0 14
5 68 13.6 12
6 76 12.7 8
7 76 10.9 0
8 74 9.3 -2
Corn Farmer example: 1 acre =land

Output of corn per unit fertilizer

 Short Run Production Function
In short run, producer keep all fixed factors as constant and few inputs are varying in
quantity. When we consider two variables,
Short Run production function = Q= f(L,K)= f(L)

•Law of Variable Proportion (LVP) or Law of diminishing Return (DMR) : An increase

in some inputs relative to other fixed inputs in a given state of technology cause output to
increase, but after a point the extra output resulting from the same addition of extra inputs
will become less”.

This law explains that, in short run production function, when quantity of one input
(L) is varied, keeping other input(K) constant, the proportion between
factors changes. When the proportion of variable factors increases, the
total output change doesn't always in the same proportion, but in varying
proportion.
This law examines how production function is changed or flow of output changes due to
change in one input and keeping the other factors quantities fixed.

Assumptions:
a. Short time period: the time is too short to change the quantity and quality of fixed
inputs and only input will be varying in quantity.
b. “Constant technology’: the technology remains unchanged during the production
c. Homogeneous Factors: each unit of the inputs are identical in amount and quality
d. Input prices are fixed
Relation Between TP, MP
The slope of the production function
measures the marginal product of an input,
such as a worker.
When the marginal product declines, the
production function becomes flatter.

• First Phase: MP grows, which means,

TP grows faster than the amount of input.
MP>0

•Second phase, P- Point of inflexion,

MP is maximum
Beyond point P, MP declines, but
positive – means, TP grows slowly than
the amount of used input,
MP>0
Then MP=0 (S) where TP is maximum at
M

•Third Phase,– MP is negative, which

means decline in TP.
when , Mp<0,
Three Stages of Production (Relation between TP,AP & MP)
Stage 1(Increasing Returns)- TP at Increasing rate (convex)
As input X increases, TP increases. MP and AP increases

MP of X is increasing more than AP, MP>AP

Explanation: Another input(Y) is fixed and abundant, and X inadequate

Thus, Y gets utilized better with every unit of addition of X. Hence, TP
increases more. After Inflexion point (F), MP falls but MP>0.
AP increases, MP>AP
Stage on ends with AP reaches at its maximum (S) where MP cuts AP.

Stage 2(Diminishing Returns)- TP increases but at diminishing rate

till TP reaches at maximum. H
Here AP and MP both falling though (diminishing returns),TP increases
at diminishing rate till the point TP reaches its maximum, MP=0

Explanation: Here fixed factor becomes inadequate relative to the quantity

Of the variable input. As more and more variable input employed, the
marginal and average product decline.

Stage 3 (Negative Returns)- TP begins to decrease. MP<0

AP diminishes.
Explanation: Y becomes scarce as compared to variable factor. Variable
factor becomes excessive relative to fixed variable .Hence overutilization
of Y cause TP to decline with every additional unit of X.

“Too many cooks spoil the broth”

Example: 4 man rowing team

Does LVP or DMR hold here? Output here is Speed

A Rational Producer will produce in which stage?
The is there hope to improve technology or getting better stand
of life?
Long Run Production and Law of Returns to Scale
In the long run, all of the factors of production can change giving a business the
opportunity to increase the scale of its operations. For example a business may grow by
adding extra labour and capital to the production process and introducing new technology
into their operations.

While the choices of inputs will obviously vary the type of firm,a simplifying assumption is
often made that, firm uses labpur and Capital
Q= f(K,L)

Law of Returns to Scale: “refers to the relationship between changes of outputs and
proportionate changes in the in all factors of production”.

% (quantity of output)
Returns to Scale 
%(quantity of all inputs)

•Increasing Returns to Scale: If a 1% increase in all inputs results in a greater than 1%

increase in output, then the production function exhibits increasing returns to scale.

•Decreasing Returns to scale: If a 1% increase in all inputs results in a less than 1% increase
in output, then the production function exhibits decreasing returns to scale.

•Constant returns to scale: If a 1% increase in all inputs results in exactly a 1% increase in

Example on IRS,DRS and, CRS
 Isoquant
Isoquant: An isoquant represents all those possible combination of two inputs ,which is
capable of producing same level of output. Iso (Greek word) means equal.
Salient Properties:
1. Negative sloped
2. Convex to origin
3. Cannot intersect or be tangent to each other
4. Upper isoquant represent higher level of output

Combination Capital labor Output

level
A 20 1 100
B 18 2 100
C 12 3 100
D 9 4 100
E 6 5 100
F 4 6 100
F G 2 7 100
 Marginal Rate of Substitution(MRST) and Isoquant
The marginal rate of technical substitution
measures the amount of an input, L, the firm
would require in exchange for using a little
less of another input, K, in order to just be
able to produce the same output as before.

The rate at which the quantity of capital that

can be increased for every unit of decrease in
the quantity of labor, holding the quantity of
output constant

MRTSL,K = -K/L (for a constant level of

output)

as we move down the isoquant, the slope Relation between MP and MRTS
decreases, decreasing the MRTSL,K
-this is diminishing marginal rate of Marginal products and the MRTS are related:
technical substitution
-as you focus more on one input, the MPL(L) + MPK(K) = 0
other input becomes more productive

=> MPL/MPK = -K/L = MRTSL,K

 Iso-Cost Curve
Isocost - An isocost line shows the different combinations of factors of
production that can be employed with a given total cost.

C = wL + rK Notation: PK=r = price of capital, PL=w = price of labour , q=Q= output

• For a given cost C, the vertical intercepts of these lines are C/r. C/r is the amount
of capital that can be employed when no labor is used.

• The slope of the line is -w/r = the negative of the factor price ratio.
When C, total cost, increases, the isocost line shifts out in a parallel fashion, but
the slope of the line does not change
Amount of labor
used (per unit of
time)
(0, c/r)

Slope of Isocost line, -W/r

(0, c/w) Amount of labor used

(per unit of time)
 Cost Minimization
cost-minimization - We can now determine which combination of factors
produces a given quantity at the lowest total cost. There are three isocost lines. The firm
wants to produce Q1units. The cost minimizing point is at A.

A
K1

•Total cost increases by moving from each isocost line. L1

•The firm can produce Q1 units along the isoquant Q1(10 units output).
•The total cost of produces Q1 units is minimized at point A.
If the firm is producing Q1 units at minimum total cost, the slope of the isoquant equals
the slope of the isocost line:
MRTS=-w/r (Minimum cost Condition)
“FIRM ALWAYS MINIMIZE COST TO PRODUCE A CERTAIN AMOUNT OF
OUTPUT”
 The Choice of Optimal Expansion Path
Expansion path - the efficient input combination (least cost) for every level
of output.A line connecting all optimal input combinations as the scale of
production expands.

•When factor prices remain constant

•Along the path MRTS equals to input price ratios
•The point on an expansion path occurs when isocost line is tangent to isoquant.

To minimize total cost, the additional

output due to the last dollar spent on labour
must be equal to the addition output due to
the last dollar spent on capital,

MPL/MPK = -w/r = MRTS

MPL/W=MPK/r

Optimal input combintion is,

MPl/MPK= -w/r
K
The Economic and the Uneconomic Regions of Production
Uneconomic Due to the law of diminishing marginal
region returns, increasing one input will
eventually decrease total output (ie: 50
MPK < 0 Isoquants workers in a small room)
When this occurs, in order to maintain a
level of output (stay on the same
isoquant), the other input will have to
increase
This type of production is not
economical, and results in backward-
bending and upward sloping sections of
the isoquant:

Q = 20

MPL < 0

Economic region Q = 10

L
L
 Returns to Scale

Returns to Scale v.s Marginal Returns

• Returns to scale: all inputs are increased simultaneously
• Marginal Returns: Increase in the quantity of a single input holding all others
constant.