Theory of Production

5
Theory of Production
“Production is thus at the same time consumption, and consumption is at the same time
production. Each is simultaneously its opposite. But an intermediary movement takes place
between the two at the same time. Production leads to consumption, for which it provides the
material; consumption without production would have no object. But consumption also leads to
production by providing for its products the subject for whom they are products. Without
production, there is no consumption, but without consumption there is no production either, since
in that case, production would be useless”. (Karl Marx: Critique of Political Economy)

Objectives:

After studying this chapter, the students should be able to:

1. Explain the production function

2. Explain the principle of diminishing marginal returns
3. Discuss the stages of production in relation to the product curves
4. Differentiate production isoquants and isocosts

I. What is Production?
Production is a process of combining various material inputs and immaterial inputs
(plans, know-how) in order to make something for consumption (the output). It is the act
of creating output, a good or service which has value and contributes to the utility of
individuals.

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 Theory of Production

Business Dictionary defines production as something that refers to the processes used and
methods to transform tangible inputs (raw materials, semi-finished goods, subassemblies)
and intangible inputs (ideas, information, knowledge) into good or
services. Resources are used in this process to create an output that is suitable for use or
has exchange value.

Refer to Chapter 1: Introduction to Economics for the detailed discussion about the
economic resources or factors of production namely land, labor, capital, and
entrepreneurship.

II. Theory of production

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Theory of Production

The theory of production explains the principles by which a business firm decides how
much of each commodity that it sells will produce as well as how much of each kind of
its inputs or factors of production it will use. This includes the relationship between the
prices of goods and services and the cost of production inputs.

III. Production Function:

Considering the product quality and the prices of the corresponding production inputs,
every producer’s objective is to find the most efficient way and the cheapest combination
of factors of production that can produce the goods and services. A resource input
combination is said to be efficient if lesser quantity of any one or more inputs results to
increased production.

The relationship between the quantities of production inputs and outputs can be
expressed in an equation called the production function. The established physical
relationship among inputs, process, and outputs in a production situation can be
expressed in mathematical form:

Q = f (x)

Where: Q = Output
f = is a function of
X = Inputs

Fixed and Variable Inputs

Fixed resource is an input for the production of goods and services that does not change
in the short run like factory, building, equipment, or other capital used in production. It is
not affected by the volume of production. When business is doing well, the company
cannot immediately construct a new factory, hence, it remains fixed. When one is renting
office space and has a contract to lease for a year, the company has to pay the fixed
monthly rental, even if there is a boom or lull in production.

Variable resource is an input whose quantity can be changed in the time period under
consideration like labor and raw materials. The company can decide to hire additional
workers to be able to meet the increasing demand for its product or service and to lay-off
some when called for. The raw materials can likewise be adjusted depending on the
volume of production, hence, classified as a variable resource.

IV. Short Run and Long Run in Production

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 Theory of Production

Short–run is a period of time during which at least one input is fixed while the others are
variable. It is short enough that not all factors of production can be adjusted. The
company has not yet utilized the full capacity of its plant, hence, a fixed input to meet the
increasing demand for its product with additional labor and raw materials as variable
input.

Long–run is a period of time long enough that all factors of production can be adjusted.
With the business continuous growth and more investors coming in, the company can
venture into construction of additional plants and warehouse, upgrading its machineries
and equipments, increase its manpower, and contract additional suppliers. All production
inputs are being adjusted to meet the increasing business operations.

V. Law of Diminishing Returns

The law of diminishing return in productivity states that if some inputs are held
constant while others vary, the marginal productivity will decline at some point as a
result of adding more units of the variable inputs.

Table 4.1: Schedule of Total Product

INPUTS (X) TP MP AP
0 0 ***** ****
1 5 5 5
2 12 7 6
3 20 8 6.7
4 27 7 6.8
5 33 6 6.6
6 38 5 6.3
7 42 4 7
8 45 3 5.7
9 42 -3 4.8
10 38 -4 3.8

Production in the short run is influenced by the Law of Diminishing Returns.

1. Total Product (TP) is the total amount of production employing the necessary
factors of production over a certain period of time.

2. Marginal Product (MP) is the change in total product per unit change in the
quantity of the variable input (X) holding the level of usage of all other inputs
constant

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 Theory of Production

MP = ∆TP
∆X

3. Average Product (AP) is the total product per unit of variable input
AP = TP
X
VI. The Product Curves
Graphical representations of Table 4.1: Schedule of Total Product
Total Production
50
40
30
20 TP
10
0
0 1 2 3 4 5 6 7 8 9 10
Input (X)

MP/AP

VII. STAGES OF PRODUCTION Input (X)

VI. The Stages of Production and Diminishing Marginal Returns

TP
50
40
Principles of Economics, Taxation and Agrarian Reform 5
30
20 TP
 Theory of Production

Stage 1
Stage 2
Stage 3

Input (X)

MP/AP

Input (X)

Stage 1 of the production process is characterized by increasing TP; AP increases and

reaches maximum; MP increases and reaches maximum and decreases; MP is greater
than AP, except when AP is maximum; boundary of Stage 1 and 2 is the intersection of
AP and MP; AP intersects MP at its maximum point.

Stage 2 of the production process corresponds to decreasing increase in return. AP begins

to decline; TP increases and reaches maximum; MP decreases and becomes zero (0).
Based on the graphs, Stage 2 is from range of X from 4 to 8. The end point of Stage 2 is
the point of maximum output on the TP curve, when MP is equal to zero. This serves as
the boundary between Stages 2 and 3. Both the MP and the AP are declining at this level.

Stage 3 is characterized by negative returns. The TP and the AP are both decreasing
while the MP is negative. Stage 3 occurs when the input (X) exceeds 8.

STAGE 1 STAGE 2 STAGE 3

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Theory of Production

Increasing Decreasing Negative

Returns Increase in Returns
Returns
TP increases Increases and Decreases
reaches
maximum
AP Increases and Begins to Decreases
Reaches decline
maximum
MP MP > AP Decreases and Negative
becomes zero
Stages of Diminishing Productivity

VII. Production Isoquants and Isocost

Isoquant indicates various combinations of two factors of production which give the
same level of output per unit of time.

Isoquant is also called as equal product curve or production indifference curve or

constant product curve.

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 Theory of Production

Characteristics of Isoquant

1. Isoquants do not intersect

2. A higher IQ implies a higher level of output

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Theory of Production

3. IQs are convex to the origin:

Isoquants possess continuous substitutability of K and L over a stretch. Beyond this

stretch, K and L are not substitutable for each other.

An isoquant map is composed of series of isoquants as shown below:

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 Theory of Production

Isocosts

Isocost curve is a producer's budget line. It is the locus traced out by various
combinations of L and K, each of which costs the producer the same amount of money.

An isocost line is also called outlay line or price line or factor cost line. An isocost line
shows all the combinations of labor and capital that are available for a given total cost to-
the producer. The greater the total cost, the further from origin is the isocost line.

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Theory of Production

Optimal Combination of Inputs

The isocost line is combined with the isoquant map to determine the optimal production point at
any given level of output. The point of tangency between any isoquant and an isocost line gives
the lowest-cost combination of inputs that can produce the level of output associated with that
isoquant. This analysis is based on the following assumptions:

1. There are two factors: labor and capital.

2. All units of labor and capital are homogeneous.
3. The prices of units of labor (L) and that of capital (K) are given and constant.
4. The cost outlay is given.
5. The firm produces a single product.
6. The price of the product is given and constant.
7. The firm aims at profit maximization
8. There is perfect competition in the factor market

Referring to the graph below, the optimal combination of inputs given a certain budget would be
at the point of tangency of the isocost line (red line) and isoquant IQ3 with K2 units of capital
and L2 units of labor.

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 Theory of Production

References:

Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University: South-
Western, Cengage Learning

Mastrianna, F.V., (2013).Basic Economics 16th Edition. South-Western Cengage

Learning

McConnel, C., et.al (2012). Economics: Principles, Problems, and Policies (Global
Edition). McGraw Hill Co., Inc.

Paraiso, O.C., et.al (2011). Introduction to Microeconomics, Mutya Publishing House,

Inc.

Stock, W.A., (2013) Introduction to Economics: Social Issues and Economic Thinking

http://www.businessdictionary.com
http://glossary.econguru.com/
ph.images.search.yahoo.com
http://wikieducator.org

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