Chapter IV

Theory of Production
(Producer Behavior)
4.1 Theory of production in the short run
4.1.1 Definition of production
• Production is the transformation of resources
(inputs) in to outputs
• The end products of the production process are
outputs which could be tangible (goods) or
intangible (services).
• Output services includes banking, legal counsel,
transportation, health services, etc.
4.1.2 Production function
• shows the relationship between various combinations
of inputs and the maximum output obtained from
those combinations.
• It represents the maximum output that can be
obtained from given combination of inputs, given the
state of technology.
• We can see the production function in tabular,
graphical, or in equation form
• A general equation for production function can be
described as:

where, Q is output and X1, X2, X3,…, Xn are different

types of inputs
Input types
• The process of production requires productive
ingredients called inputs.
• An input is any thing that the firm uses to produce
out put.
• In analyzing production process, we have two types
of inputs:
• Fixed and Variable inputs
• Fixed Input: - is an input whose quantity cannot
change during a given period of time.
• Example: Highly skilled labor and capital (firms
plant and equipment) i.e. the factory, buildings,
• Variable Input: - is an input whose quantity can
be changed (Increased or decreased) during a
given period of time
• Example: Unskilled labor, raw materials, etc.
The Short Run and the Long Run
• In economic sense production period varies over
time.
• Whether an input is considered variable or fixed
depends on the length of the period under
consideration.
• The longer the period the more inputs are
variable. The shorter the period, the more inputs
• Although the length of the period varies from
one firm to another, there are generally two
agreed time periods:
• The short run and the long run.
• The short run refers to the time period in which
the quantity of at least one input remains fixed.
• Under this time period the firm’s plant and
equipment are fixed
• The long run is a time period so long that a firm
can vary the quantities of all of its inputs.
• Under this time period all inputs are variable.
• It is important to note that the short run and the
long run are conceptual periods rather than
calendar time periods.
• For a firm engaged in the production of foodstuff, a
period of five years may be along run phenomenon.
• Where as, for a firm engaged in the production of
automobiles and airplanes such as Toyota and
Boeing, it will take them years to construct and
install new plant,
• For the heavy industries, a period of five years is a
short run phenomenon.
• a period of fifty (50) years is a long run even for
heavy industries.
The short Run Production Function (Production
with one Variable Input)
• Consider a firm that uses two inputs: capital
(fixed input) and labor (variable input).
• Given the assumptions of short run production,
the firm can increase output only by increasing
the amount of labour it uses. Hence, its
production function can be given by:
L)
where, Q is output and L is the quantity of labor
Total, Average, and Marginal Product
• In production, the contribution of a variable input can be
described in terms of total, average and marginal product.
• Total product (TP) –it is the total amount of output that can be
produced by efficiently utilizing specific combinations of the
variable input and fixed input.
• Increasing the variable input (while some other inputs are
fixed) can increase the total product only up to a certain point.
• The total output of a good or service produced by labor is
known as Total product of labor (TPL).
• Average product (AP) –refers to output per unit of labor input.
• Average product is the firm’s total output divided by the
amount of labor employed.
AP TP
L
• Average product is also called Labor productivity.
• Marginal product (MP) –The marginal product of
any input is the increase in total product
resulting from an increase of one unit of that
input.
• The MP of labor is the change in total product
resulting from one unit increase in the quantity
of labor employed.
MP TP
L
• Marginal product is the slope of the total product
curve.
• Consider the following hypothetical short run
production Schedule:
Quanti Total Average Marginal Stages
ty of product product product of
labor (TP) In (AP) (MP) Producti
(L) quintals on
0 0 - -
1 2 2 2
2 6 3 4
Stage 1
3 12 4 6
4 20 5 8
5 25 5 5
6 27 4.5 2
7 28 4 1 Stage II
8 28 3.5 0
9 27 3 -1
• In the above schedule, the first two columns
provide a hypothetical quantity of labor (L) and
the total production (TP) of this labor.
• The production may be cultivating wheat on a
given land of fixed size.
• By using the total product (TP) and labor (L), we
can derive the average and marginal products
schedule.
 Production Function … Cont’d
hypothetical graph
• Properties of and relationships between TP, AP,
and MP curves
• The Total product curve starts from the origin,
rises to its maximum and then declines.
• The TP curve rises first at an increasing rate and
then at a decreasing rate until it reaches its
maximum point.
• The marginal product first rises and reaches its
maximum point known as the point of
Diminishing Marginal Returns or Inflection point
(point D).
• The MP, after achieving it maximum point,
declines and assumes a zero value when the TP
curve is at its maximum.
• When the TP curve declines, MP becomes
negative.
• The Average product initially rises, attains its
maximum value, and then declines.
• The point at which AP curve attains its maximum
point (value) is known as the point of diminishing
average returns (point E).
• Increasing marginal returns occur when the
marginal product of an additional worker (labor)
exceeds the marginal product of the previous
worker employed.
• Example: - When the 1st, 2nd, 3rd, and 4th units of
labor are employed successively, they produce a
higher output of wheat than their previous partners.
• Where as, decreasing (Diminishing) marginal returns
occur when the marginal product of an additional
worker falls short of the marginal product of the
previous worker.
• In our example, employing 5 and above units of
labor brings us lesser out put of wheat.
• When the AP curve is rising, the MP curve is above
it.
• When the AP curve is falling, the MP curve is
below it, and
• when the AP curve is at its highest point, the MP
curve intersects the AP curve.
The Law of Diminishing Marginal Returns (LDRM)
• The Law of Diminishing Marginal Returns state
that as more and more units of a variable input
are added to a fixed input, after some point, the
extra or marginal product attributable to each
additional unit of the variable input gets smaller
and smaller.
• It is important to note that the Law of
Diminishing Marginal Returns holds true only if
the following conditions are maintained:
• When technology is assumed to remain fixed.
Since technological improvement boosts
production.
• When there is at least one fixed input.
• The LDMR assumes all units of the variable input
(say, labor) are of equal quality
• The Law of Diminishing Marginal Returns is a
short run phenomenon.
Stages of production
• Firms can face three distinct and of course
important production stages that determine the
existence of the firm.
• The relationship among TP, AP, and MP can be
used to determine the three stages of
production.
• The range from the origin to the point where AP
is maximum is stage I of production for the
variable input.
• In this case, AP is rising to its maximum while MP
rises, reaches its pick point, and then starts to
decline.
• In stage I of production: The fixed input is
underutilized (underemployed)
• AP is rising (productivity is rising)
• This stage is not an efficient region of production
though the MP of variable input is positive
• Thus, more production can be made possible by
employing successive (additional) units of labor.
• Stage II of production proceeds from the point
where AP is maximum to the point where MP is Zero.
• In this stage, both AP and MP are declining but
remain positive.
• This means that the productivity of all workers
decline.
• In addition, the extra output from each additional units
of labor declines but still adding to Total product.
• This is the stage in which a rational producer (profit
maximizing firm) has to operate.
• Stage III ranges over the area where MP is negative.
• In this stage, total product is declining.
• Each additional units of labor brings no output but makes
TP to decline.
• This is because the fixed input is over utilized.
• The overall labor employed does not have enough
complementary (fixed input) to work with
• It means greater output (TP) can be achieved by
decreasing workers (labor).
• Obviously, a rational firm should not operate in stage III