CHAPTER-5 Econ

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CHAPTER 5

THEORY OF PRODUCTION

At the end of this chapter, the students will learn to:


a. Describe the production process given a fix and a variable input in the short-run.
b. Clearly state the law of diminishing marginal returns and its influence in production.
c. Analyze the production process when two variable inputs are utilized.

In our previous analysis of the market economy, we were able to identify two basic
economic entities, the consumer and the producer. The preceding chapter focused on the
behavior of the consumers and producers alike, i.e. how they react when factors affecting
demand and supply changes, respectively. This chapter will focus mainly on the other agent in
the economy – the firm. Its behavior or production capacity given available resources shall be
examined.

A firm is an entity concerned with the purchase and employment of resources in the
production of various goods and services. It will be assumed throughout the course of our
discussion that the firm aims to maximize its output with the use of resources that are
substitutable to a certain degree. Furthermore, the firm is a price taker in terms of the resources
it uses.

Production Function

Production is the creation of goods and services using the inputs of production. The
physical relationship between the inputs and outputs of goods and services at a given period of
time, ceteris paribus is called a production function and is expressed in the mathematical form:

Q = f(x)

where Q = output
x = inputs
f= production process

Output refers to the goods and services that have been created using the production
inputs.

Inputs of production refer to the factors of production which include land, labor, capital,
and entrepreneurship (see detailed discussion in the introductory part). Inputs are classified as
follows:

1. Fixed inputs – they are those that remain regardless of the volume or quantity of
production. This means that whether you produce or not, the factors of production is
unchanged.
2. Variable inputs – these are those that vary in accordance to the volume or quantity
of production. If there is no production; then, there is no variable inputs.

For instance, a rice farmer’s production function may include several possible
combinations of land (fixed input), labor and seeds (variable inputs) in the production of varying
amounts of rice. In a similar way, the production function of a fish-cracker maker may include
combinations of machinery (fixed input) and workers (variable) in the production of varying
amounts of fish-crackers.

Production Analysis with One Variable Input

The Law of Diminishing Returns


It states that when successive units of the variable input is combined with a fixed input,
the total product (TP) or output (Q) will increase, but beyond some points the resulting increases
in output will become smaller and smaller. The following concepts will be used in analyzing this
principle.

Total Product (TP). It refers to the total production or output (Q).

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Marginal (Physical) Product (MP). It is the additional output produced by employing one
additional unit of input (X) holding the level of usage of all other inputs constant.

MP = ∆Q or using Q to denote TP; thus, MP = ∆Q


∆x ∆x

Average (Physical) Product (AP). It is the output produced per unit of the input.

AP = TP or using Q to denote TP; thus, AP = Q


x x

Table 5.1 shows the production schedule of a rice farmer given the variable input –
workers. Total, average and marginal production in this case is measured in physical units
(cavans). Notice that as more workers are employed, Total Product increases although at some
point beyond the 8th worker, production has declined. Increases in the production for rice as an
additional worker is hired are reflected by the Marginal product column. We can observe that
each additional worker from workers 1 to workers 2 to the 7th worker, yield positive increases to
production. However, the increment to production is diminishing! This scenario explains the law
of diminishing returns at work. This means that we cannot produce every rice needs in our
country in single piece of land. Further, Table 5.1 is graphically illustrated in Figure 5.1.

Table 5.1. Total product (in cavans) schedule of rice production with workers as
variable input (x).

Units of workers Total product (TP) or Average product Marginal Product


(x) Output (Q) (AP) (MP)
0 0 -
1 5 5.0 5
2 15 7.5 10
14
3 29 9.7
15
4 44 11.0
11
5 55 11.0
6
6 61 10.2
3
7 64 9.1 0
8 64 8.0 -2
9 62 6.9 -3
10 59 5.9

Three Stages of Production

The stage 1 of the production process is characterized by an increasing AP. In Figure 5.1,
this occurs from the origin (0) up to x=4. The increasing AP is explained by specialization and
teamwork gained from an additional X. Moreover, at this stage the fixed input is grossly
underutilized. The point of equality between AP and MP serves as the boundary between stages 1
and 2 of the production process. At this point of intersection (MP=AP), it is noticeable that the AP
has reached its maximum value.
The stage 2 of the production process corresponds to the range of x from 5 up to 8. The
end point of stage 2 corresponds to the point of maximum output on the TP curve. This
maximum TP happens when the MP is equal to zero (MP=0). This serves as the boundary
between stages 2 and 3 of the production process. At this level, MP and AP are declining.
The stage 3 of the production process encompasses the range of x over which the total
product is declining (which corresponds to a negative MP). Stage 3 occurs when x exceeds 8
where the crowding out effects overwhelms any output attributable to additional workers. In
order to identify the stages of production the condition of boundaries should be satisfied as
showed in Table 5.2.

Table 5.2. Condition of the Boundaries


Boundary I Boundary II
1. AP is at maximum 1. TP is at maximum
2. AP = MP 2. MP = 0

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Table 5.3. Characteristics of the Three Stages of Production
Stage I Stage 2 Stage 3
1. TP is increasing at faster 1. TP is increasing at slower 1. TP is decreasing
rate rate 2. AP and MP are decreasing
2. AP and MP are increasing 2. AP and MP are decreasing 3. AP > MP
3. AP < MP 3. AP > MP 4. MP < 0 (negative)
4. MP > 0 (positive) 4. MP > 0 (positive)

TP, MP and AP I II

70

60
TP
50

40

30

20

10
AP
0 X
1 2 3 4 5 6 7 8 9 10
- 10 MP
Figure 5.1. The Three Stages of Production.

Production Analysis with Two Variable Inputs

Production Isoquant and Isocost

Isoquant represents the various combinations of two inputs that can be used to produce
the same level of output. In this case, an isoquant shows the different combinations of capital (K)
and labor (L) which yield the same level of output as showed in Figure 5.2.

Labor (L)

0 Capital (K)

Figure 5.2. Isoquant

Characteristics of Isoquants:
1. They slope downward to the right for those combinations of inputs that firms will want to
use.
2. They do not intersect.
3. They are convex to the origin.

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Isocost line contains all combinations of inputs that the same budget can purchase at
constant prices. In this case, it shows the different combinations of capital (K) and labor (L) that
a producer can purchase or hire given his total outlay and the factor prices as showed in Figure
5.3.

Labor (L)

0 Capital (K)

Figure 5.3. Isocost

Tables 5.4 and 5.5, and Figure 5.4 will provide us an example of an isoquant and isocost
schedules and graph, respectively. The isoquant schedules presented to us the different ways to
produce different levels of outputs while varying the sets of capital and labor given. Notice that
as output levels increases, the amounts of capital and labor used to produce such quantities of
outputs also increases. Thus, when we try to produce 1000 units of Q, the combinations of K and
L also increases as compared when we produce 500 units of Q. At higher levels of outputs,
combinations of K and L also are higher.

Table 5.5, on the other hand, shows the production input combination schedule showing
each combination of capital and labor that can be purchased given the factor prices and the
budget below. Thus, the equation; I = PL. L + PK.K, must be met where I refers to the budget
or money to be used to purchased capital and labor; PK, PL refers to the prices of capital and labor,
respectively and K and L refers to the amounts of capital and labor to purchase. For instance, if
we spent all our money to buy capital alone and none of labor, then;

I = PL. L + PK.K
16, 000 = 500 (32) + 400 (0)
16, 000 = 16, 000 + 0
16, 000 = 16,000

Table 5.4. Isoquant Schedule

Q= 500 Q= 1000 Q= 1500


Labor (L) Capital (K) Labor (L) Capital (K) Labor (L) Capital (K)
9 18 16 24 20 28
10 14 20 15 21 25
16 7 25 12 23 20
25 3 35 9 36 14
28 2 45 8 48 13

Table 5.5. Production Input Combination Schedule

Given: Budget =P16,000 ; Price of Labor = P500/unit; Price of Capital = P400/unit


Labor Capital
32 0
28 5
24 10
20 15
16 20
12 25
8 30
4 35
0 40

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Producer’s Equilibrium

A producer is in equilibrium graphically when, given his total outlay and the factor prices,
the producer maximizes the production. This is shown by the point of tangency between isocost
and isoquant in Figure 5.4

Labor (L)

L*

Capital (K)

K*
Figure 5.4. The Producer’s Equilibrium

The point of tangency of the isoquant and isocost curves shows the best combination of
inputs (labor and capital) given the capital outlay of P16,000. The firm must employ 20 units of
labor (L*) and 15 units of capital (K*) in its production process. The maximum output that the
firm can produce is 1000 units. A producer is in equilibrium graphically when, given his total
outlay and the factor prices, the producer maximizes the production. This is shown by the point
of tangency between isocost and isoquant (see Figure 5.4).

References

Bello, Amelia L. et al. 2009. Economics. C and E Publishing, Inc.

Case, Karl E.; Fair, Ray C. 2005. 7TH Edition. Principles and Foundations of Economics. Pearson
Education, Inc.

Costales, Achielles C. et al. 2000. Economics: Principles and Applications. JMC Press, Inc.

Gabay, Bon Kristoffer G. et al. 2007. 1st edition. Economics: Its Concepts and Principles (with
Agrarian Reform and Taxation). Rex Book Store.

Silon, Elsa T. et al. 2009. Manual for Economics with Work Exercises

Mansfield, Edwin. 1975. Microeconomic Problems: Concepts, Cases and Test. 2nd edition. W.W.
Norton & Company, Inc.

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