Chapter Three

Theory Of Production
Introduction
• In the supply process, people first offer their factors of production to the
market.
• Then the factors are transformed into goods that consumers want.
• PRODUCTION is the name given to that transformation of factors
into goods.
• Such a transformation is carried out by FIRMS
The Role of the Firm
• The firm is an economic institution that transforms factors of production
into consumer goods. As such, it:
• Organizes factors of production.
• Produces goods and services.
• Sells produced goods and services.
Introduction

• Production refers to the process of transferring inputs

into outputs.
• Production function is a technical relationship between
inputs and outputs.
• Mathematically,
Q = f(X 1 , X 2 , X 3 ,..., X n )
• X1, X2, X3,…, Xn are different types of inputs.
• More specifically,
Q = f(K, L)
 Classification of inputs
• Fixed inputs – quantity remains constant(fixed) for a
given period of time.
• Variable inputs – inputs that can change in quantity
depending on the level of output being produced.
Production period
• Long run – period of time in which all inputs used are
variable. A firm chooses from all possible production
techniques.
• Short run – period of time in which at least one input
remains fixed. A firm is constrained with respect to what
production decisions it can make.

The terms long run and short run do not necessarily refer to specific periods
Note

of time, but to the flexibility the firm has in changing the level of output
 The Short-run Production Function: one variable input
Production Tables & Production Functions

• Firms combine factors of production to produce goods and services

• A production table is a table showing the output resulting from various
combinations of factors of production or inputs
• Real-world production tables are complicated
• This analysis will concentrate on short run production, during which at least
one of the factors is fixed!
Production Function:
• It describes a technological relationship between inputs (factors of
production) and outputs.
• It contains only those technically efficient methods (combination of inputs)
of production.
• A method of production is said to be technically efficient if it is impossible to
reduce the amount of one input without increasing the amount of any of the
other inputs to produce a unit of output.
The Short-run Production Function: one variable input

• E.g. Let labor (L) & capital (K) be the only factors
of production used in producing product X, then a
unit of X could be produced by several methods:
such as 3L & 1K, or 2L & 2K, or 4L & 1K. But the
production function of X. Should exclude the 3rd
method of production! Why?
• In other words, the production function depicts the
maximum amount of output that can be produced
from a given amount of inputs, with the available
state of technological knowledge.
• The production function is also alternatively known simply
as TECHNOLOGY.
The Short-run Production Function: one variable input

Marginal Product (MP):

• Is the additional output that will be produced from an

additional unit of input (say labor, L), other inputs
remaining constant.
• Formally, it is given by:
MPL= (Change in Total Output) ⁄ (Change in the Amount of Labor)
TPL dQ
MPL = MPL =
L or dL

• Read this as “change in total output due to a unit change

in labor input”
The Short-run Production Function: one variable input

Average product (AP)

• It is calculated by dividing total output by the amount of the input.
It measures the output per unit of the input used.
• Formally it is given by:
APL = Total Output ⁄ Amount of Labor

= TP ⁄ L
• It should be noted here that MP & AP are both measures of
factor (input) productivity

Total product (TP)

• It is total amount of output produced at different levels of
inputs
The Short-run Production Function: one variable input

L TPL APL MPL

0 0 - -
1 2 2 2 Average Product is the output per worker
2 6 3 4
3 12 4 6
4 20 5 8 Marginal Product: is the additional output
that can be produced from an additional
5 26 5.2 6 worker, other inputs held constant.
6 30 5 4
7 32 4.6 2
8 32 4 0
9 30 3.3 -2
10 26 2.6 -4
 Numerical Illustration
• Suppose that the short-run production function
for cut-flower by a certain Ethiopian firm is given
by: Q = 4KL -0.6K 2 -0.1L2
a) Determine the average product of labor (APL)
function.
b) Determine the average product of labor (MPL)
function.
L TPL APL MPL
0 0 - -
1 2 2 2
2 6 3 4
3 12 4 6
4 20 5 8
5 26 5.2 6
6 30 5 4
7 32 4.6 2
8 32 4 0
9 30 3.3 -2
10 26 2.6 -4
 Law of Diminishing Marginal Returns
• Also known as the law of diminishing marginal returns, or
the law of variable proportions.
• It is a law governing the short-run production function, and a
major factor behind the relationship between TP, MP, and
AP.
• The law states that as equal amounts of one variable factor
input are added into the production function, the quantities
of all other factors remaining fixed, a point is reached
beyond which the resulting addition to output (i.e. the MP of
the variable input) begins to decrease, as shown the above
figure & table.
Stages of Production
• Stage I – Increasing return
• Stage 2 – Diminishing return(Economic region)
• Stage 3 – Negative return
13
 TP

TPL

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

APL

0 L1 L2 L3
MPL
The Stages of Production in the Short-Run
Economists use the relations between AP and MP to
define 3 stages of production:

Stage I: covers that range of variable input use over which MP is

above AP; i.e. variable input use over which MP is greater than AP,
implying that AP is continually rising over stage I.

Stage II: covers the range of variable input use over which MP is less
than AP, but POSITIVE
Stage III: covers the range of variable input use over which MP is
NEGATIVE, i.e. the last unit of input actually causes a decrease in total
product.
The Long-run Production Function: two variable inputs

• LR is a period of time which is sufficient for the firm to

change the quantity of all inputs.
• This can be expressed in equation form as: Q = f(L, K)
• The firm can now produce its output in a variety of ways
by combining different amounts of labor and capital.
• To find the combination that maximizes the profit of the
firm, we make use of isoquant and isocosts.
 (A) The Isoquants
• An isoquant is the set of all combinations of inputs L and K that are
just sufficient to produce a given amount of output.
• The slope of the isoquant = the Marginal Rate of Technical
Substitution (MRTS) = the Technical Rate of Substitution (TRS).
• MRTS (TRS): The number of units of K that we can dispose of if one
more unit of L becomes available while remaining on the original
isoquant.

Input Combination Labor (L) Capital(K) Maximum Output

A 1 12 50
B 2 8 50
C 3 5 50
D 4 3 50
E 5 2 50
 Isoquant Curve and Map
K E
K 5
7
6
4
5

4 3
A B C
3
2
2
Q3 =90
1 D
1 Q2 =75
Q1 =55
0 1 2 3 4 5 6 7 L 1 2 3 4 5 L

The complete collection of isoquants is

Isoquant curve. called the isoquant map.

19
Properties of isoquant curves

- Have negative slope.

- Iso-quants are convex to the origin.
- Iso-quants never intersect each other.
- Upper iso-quants represent a higher level of
output.

20
Solve for:

(A) then the marginal product of labor is:

(B) The marginal product of input 2 is:

21
 Technical Rate-of-Substitution

- The slope is the rate at which capital (k) must be substituted for labor (L) input
so as to maintain the same output level. The slope of an isoquant is called
Technical Rate-of-Substitution (TRS), OR Marginal Rate of Technical
Substitution (MRTS).
MPL
MRTS L for K =-
MPK
➢ How is a technical rate-of-substitution computed?
➢ The production function is :
Q = f(L, K)
➢ A small change (dL, dk) in the input bundle causes a change to the output
level & this is given by:

22
Along an individual isoquant,

therefore the changes dL and dK must satisfy the following,

which rearranges to:

Thus, for very slight movements along an isoquant, the Marginal

Rate of Technical Substitution (MRTS) equals the ratio of the
Marginal Products of the two inputs.
 Long-run Equilibrium
• Two inputs, labour (L) & capital (K), and both are
variable
• Consider the COST CONSTRAINT:
C= wL + rK
• Where - w: wage rate, and r: rental rate of capital
• Rearranging (solving for K), we have:
K=C /r - (w/r) L
 COST CONSTRAINT
• The cost constraint of the firm is given by the Isocost
curve, which represents the various combinations of
inputs that can be purchased for a stipulated amount of
expenditure (Č). The equation for the isocost curve is
given by Č=wL+ rK. When solved for K, we get:
K=C /r - (w/r) L
• DK/DL = (-) w/r is the Slope of the isocost curve. It
measures the rate at which the firm can substitute
capital for labour in the market.
Equilibrium
Equilibrium
 Laws of returns to scale
• The long run production process is described by the
concept of returns to scale.
• Marginal product describe the change in output level as
the level of a single input changes, all else constant: in
the short-run.
• Returns to scale describes what happens to total output
as all of the inputs are changed by the same proportion.
e.g. all input levels doubled: in the long-run
• What happens to the level of output when the scale of
production (i.e. the employment of all inputs by the
same percentage, say by a 100%) changes?
 Laws of returns to scale

• Three laws of return to scale

 Increasing returns to scale (IRS)
 Constant returns to scale (CRS)
 Decreasing returns to scale (DRS)
Laws of returns to scale
Laws of returns to scale
Laws of returns to scale
Laws of returns to scale
• Factors that cause IRTS
• Division of labor & specialization
• Technical and managerial indivisibility (Non-
division of factors)
• Dimensional relations (Scale effect)
• Factors that cause DRS
• Diseconomies of scale
• Exhaustibility of natural resources
• Cobb-Douglas production functions
hQ = A(rK ) (rL) = Ar r  ( K  L ) = r + ( AK  L )

• Give as, if input L & K is multiplied by a

factor ‘r’ & output by ‘h’, then the equation
becomes: Q = AK  L , h = r  +

Q = f ( K , L), Q=AK L
• Since
• If α +β >1 ，h > r → IRS
• If α +β =1 ，h = r, → CRS
• If α +β <1 ，h < r, → DRS
Optimum combinations of inputs

• The objective of any firm is maximizing profit which

could be achieved by either
• Output maximization or
• Cost minimization or by both.
• In general, the optimum of the producer refers to the
least cost combination of inputs providing the
maximum achievable output level.
Producer’s equilibrium: Maximization of output with a given cost

• The firm is said to be equilibrium when it maximizes

its output given his TC or outlay & the prices of the
factors, w & r. Two conditions must be fulfilled for the
producer to be in equilibrium.
• The first order condition (F.O.C):- is that the slope of
the isoquant (MRTSL,K) must be equal to the ratio of
the input prices (i.e. slope of isocost line)
−K MPL PL w
MRTSL , K = = = = … this is necessary but not sufficient
L MPK PK r condition for maximization.
• Second order condition (S.O.C):-
 • Graphically, this could easily be put as follows.

* point P and R, are on the lower isoquant

Capital (Q1) denotes lower output level than
(K) Q2 and Q3 is totally unattainable. a
small output
* At point ‘E’ both the F.O.C & S.O.C are
fulfilled
P

E Q3
K* Q2

Q1
R
Labor (L)
L*

38
Mathematical derivation of the equilibrium
• Given to Maximise Q = F (L, K) Subject to
TC = wL + rK,
• we can solve this constrain maximizing problem by
using Lagrange multiplier method.
The steps involved in this method are:
• Step1: Define the Lagrangian function:
F = Q −  [ wL + rK − TC ] or F = Q +  [ TC − wL − rK ]
• Step 2: Employ the necessary conditions (F.O.C)
• Step 3: Check using the S.O.C.
Minimization of cost (the least-cost input combination)

• This is minimization of cost for a given level of output.

The input combination at J, E & K all

used to produce Q
K**
K per period The input combination at E
L*
C1 - where the isoquant is
J
C3 tangent to the isocost line,
is the least expensive
C2
E
K
Q

L per period
 Numerical Illustration
Suppose a certain small enterprise allocates only 20,000 birr for the
production of furniture (school armchairs). The enterprise wants to
employ workers (L) whose wage is w=1000 birr and purchase
implements (K) at a price of r=4000 birr. Suppose further that the
production function for furniture is given by .
Q = 10L0.5 K 0.5
a)Determine the marginal product functions of workers and
implements.
b) Find MRTSL, K and MRTSK, L
c)How many workers (L) and implements (K) must be acquired
for the small enterprise to produce the maximum possible
number of armchairs.
d)How many armchairs will be produced at the equilibrium of
the enterprise?
41
-----End of Chapter Three-----