UNIT 4: THEORY OF PRODUCTION

Production function

The production function of a firm is a relationship between inputs used and output
produced by the firm. For various quantities of inputs used, it gives the maximum
quantity of output that can be produced.

Consider the farmer we mentioned above. For simplicity, we assume that the farmer
uses only two inputs to produce wheat: land and labour. A production function tells us
the maximum amount of wheat he can produce for a given amount of land that he uses,
and a given number of hours of labour that he performs. Suppose that he uses 2 hours of
labour/ day and 1 hectare of land to produce a maximum of 2 tonnes of wheat. Then, a
function that describes this relation is called a production function.

One possible example of the form this could take is:

q = K × L,

Where, q is the amount of wheat produced, K is the area of land in hectares, L is the
number of hours of work done in a day. Describing a production function in this manner
tells us the exact relation between inputs and output. If either K or L increases, q will
also increase. For any L and any K, there will be only one q. Since by definition we are
taking the maximum output for any level of inputs, a production function deals only
with the efficient use of inputs. Efficiency implies that it is not possible to get any more
output from the same level of inputs.

A production function is defined for a given technology. It is the technological

knowledge that determines the maximum levels of output that can be produced using
different combinations of inputs. If the technology improves, the maximum levels of
output obtainable for different input combinations increase. We then have a new
production function.

The inputs that a firm uses in the production process are called factors of production. In
order to produce output, a firm may require any number of different inputs. However,
for the time being, here we consider a firm that produces output using only two factors
of production – labour and capital. Our production function, therefore, tells us the
maximum quantity of output (q) that can be produced by using different combinations
of these two factors of productions-

Labour (L) and Capital (K).

We may write the production function as

q = f(L,K) (3.1)

Where, L is labour and K is capital and q is the maximum output that can be produced.

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A numerical example of production function is given in Table 3.1. The left column shows
the amount of labour and the top row shows the amount of capital. As we move to the
right along any row, capital increases and as we move down along any column, labour
increases. For different values of the two factors, the table shows the corresponding
output levels.

For example, with 1 unit of labour and 1 unit of capital, the firm can produce at most 1
unit of output; with 2 units of labour and 2 units of capital, it can produce at most 10
units of output; with 3 units of labour and 2 units of capital, it can produce at most 18
units of output and so on.

In our example, both the inputs are necessary for the production. If any of the inputs
becomes zero, there will be no production. With both inputs positive, output will be
positive. As we increase the amount of any input, output increases.

Law of Diminishing Marginal Returns

The law of diminishing marginal returns is a theory in economics that predicts that after
some optimal level of capacity is reached; adding an additional factor of production will
actually result in smaller increases in output.

The law of diminishing marginal returns is also referred to as the "law of diminishing
returns," the "principle of diminishing marginal productivity," and the "law of variable

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proportions." This law affirms that the addition of a larger amount of one factor of
production, ceteris paribus, inevitably yields decreased per-unit incremental returns.
The law does not imply that the additional unit decreases total production, which is
known as negative returns; however, this is commonly the result.

At a certain point, employing an additional factor of production causes a relatively

smaller increase in output.

 Diminishing returns occur in the short run when one factor is fixed (e.g. capital)

 If the variable factor of production is increased (e.g. labour), there comes a point
where it will become less productive and therefore there will eventually be a
decreasing marginal and then average product.
 This is because, if capital is fixed, extra workers will eventually get in each
other’s way as they attempt to increase production. E.g. think about the
effectiveness of extra workers in a small café. If more workers are employed,
production could increase but more and more slowly.

 This law only applies in the short run because, in the long run, all factors are
variable.

Example:

 Assume the wage rate is £10, then an extra worker costs £10.
 The Marginal Cost (MC) of a sandwich will be the cost of the worker divided by
the number of extra sandwiches that are produced
 Therefore as MP increases MC declines and vice versa
 Total Product (TP) This is the total output produced by workers
 Marginal Product (MP) This is the output produced by an extra worker.

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  The first worker adds two goods. If a worker costs £20. The MC of those two
units is 20/2 = 10.
 The 3rd worker adds six goods. The MC of those six units are 20/6 = 3.3
 The 5th worker adds an extra ten goods. The MC of these 10 is just 2.
 After the 5th worker, diminishing returns sets in, as the MP declines. As extra
workers produce less, the MC increases.

Diagram of diminishing returns

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In this example, after three workers, diminishing returns sets in.

After employing 4 workers or more – the marginal product (MP) of the worker declines
and the marginal cost (MC) starts to rise.

Video: https://youtu.be/lt6LpwBNSlM

Total product, average product and marginal product

Total Product

Suppose we vary a single input and keep all other inputs constant. Then for different
levels of that input, we get different levels of output. This relationship between the
variable input and output, keeping all other inputs constant, is often referred to as Total
Product (TP) of the variable input.

Suppose capital is fixed at 4 units. Now in the Table 3.1, we look at the column where
capital takes the value 4. As we move down along the column, we get the output values
for different values of labour. This is the total product of labour schedule with K2 = 4.
This is also sometimes called total return to or total physical product of the variable
input. This is shown again in the second column of table in 3.2

Once we have defined total product, it will be useful to define the concepts of average
product (AP) and marginal product (MP). They are useful in order to describe the
contribution of the variable input to the production process.

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Average Product

Average product is defined as the output per unit of variable input. We calculate it as

APL=TPL/L

The last column of table 3.2 gives us a numerical example of average product of labour
(with capital fixed at 4) for the production function described in table 3.1. Values in this
column are obtained by dividing TP (column 2) by

L (Column 1).

Marginal Product

Marginal product of an input is defined as the change in output per unit of change in the
input when all other inputs are held constant. When capital is held constant, the
marginal product of labour is

MPL= change in output/change in input

=PL/L

Where, D represents the change of the variable. The third column of table 3.2 gives us a
numerical example of Marginal Product of labour (with capital fixed at 4) for the
production function described in table 3.1. Values in this column are obtained by
dividing change in TP by change in L. For example, when L changes from 1 to 2, TP
changes from 10 to 24.

MPL= (TP at L units) – (TP at L – 1 unit) (3.4)

Here, Change in TP = 24 -10 = 14

Change in L = 1

Marginal product of the 2nd unit of labour = 14/1 = 14

Since inputs cannot take negative values, marginal product is undefined at zero level of
input employment. For any level of an input, the sum of marginal products of every
preceding unit of that input gives the total product. So, total product is the sum of
marginal products.

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Average product of an input at any level of employment is the average of all marginal
products up to that level. Average and marginal products are often referred to as
average and marginal returns, respectively, to the variable input.

Three stages of production in Short run

The three stages of production are characterized by the slopes, shapes, and
interrelationships of the total, marginal, and average product curves. The first stage is
characterized by a positive slope of the average product curve, ending at the
intersection between the average product and marginal product curves; the second
stage by continues up to the point in which the marginal product becomes negative, at
the peak of the total product curve; and the third stage exists over the range of in which
the total product curve is negatively sloped. In Stage I, average product is positive and
increasing. In Stage II, marginal product is positive, but decreasing. And in Stage III, total
product is decreasing.

Short-run production by a firm typically encounters three distinct stages as a larger

amounts of a variable input (especially labor) are added to a fixed input (such as
capital). The first stage results from increasing average product. The second stage sets it
at the peak of average product, experiencing a wide range of decreasing marginal
returns, and the law of diminishing marginal returns. The third stage is then
characterized by negative marginal returns and.

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Three Product Curves

The three stages of short-run production Three Stages

are readily seen with the three product
curves--total product, average product,
and marginal product. A set of product
curves is presented in the exhibit to the
right. The variable input in this example is
labor.

The top panel contains the total product

curve (TP). It generally rises, reaches a
peak, then falls. The bottom panel contains
the marginal product curve (MP) and
the average product curve (AP). Both
curves rise a bit for small quantities of the
variable input labor, then decline.
Marginal product eventually turns
negative, but average product remains
positive.

The three short-run production stages are

conveniently labeled I, II, and III, and are
separated by vertical lines extending
through both panels.

Stage I

Short-run production Stage I arises due to increasing average product. As more of the
variable input is added to the fixed input, the marginal product of the variable input
increases. Most importantly, marginal product is greater than average product, which
causes average product to increase. This is directly illustrated by the slope of the
average product curve.

Consider these observations about the shapes and slopes of the three product curves in
Stage I.

 The total product curve has a positive slope.

 Marginal product is greater than average product. Marginal product initially
increases, the decreases until it is equal to average product at the end of Stage I.
 Average product is positive and the average product curve has a positive slope.

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Stage II

In Stage II, short-run production is characterized by decreasing, but positive marginal

returns. As more of the variable input is added to the fixed input, the marginal product

of the variable input decreases. Most important of all, Stage II is driven by the law of
diminishing marginal returns.

The three product curves reveal the following patterns in Stage II.

 The total product curve has a decreasing positive slope. In other words, the slope
becomes flatter with each additional unit of variable input.
 Marginal product is positive and the marginal product curve has a negative
slope. The marginal product curve intersects the horizontal quantity axis at the
end of Stage II.
 Average product is positive and the average product curve has a negative slope.
The average product curve is at it’s a peak at the onset of Stage II. At this peak,
average product is equal to marginal product.

Stage III

The onset of Stage III results due to negative marginal returns. In this stage of short-run
production, the law of diminishing marginal returns causes marginal product to
decrease so much that it becomes negative.

Stage III production is most obvious for the marginal product curve, but is also indicated
by the total product curve.

 The total product curve has a negative slope. It has passed its peak and is
heading down.
 Marginal product is negative and the marginal product curve has a negative
slope. The marginal product curve has intersected the horizontal axis and is
moving down.
 Average product remains positive but the average product curve has a negative
slope.