Chapter Two :Theory of Production

Chapter objectives
 After successful completion of this chapter, you will be able to:
 Define production and production function
 Differentiate between fixed and variable inputs
 Describe short run total product, average product and marginal product
 Compare and contrast the three stages of production in the short run
 Explain the difference between accounting cost and economic cost
 Describe total cost, average cost and marginal cost functions
 Explain the relationship between short run production and short run cost
functions
 Theory of Production

 Raw materials yield less satisfaction to the consumer by themselves. In order to

get better utility from raw materials, they must be transformed into outputs.
 However, transforming raw materials into outputs requires inputs such as land,
labour, capital and entrepreneurial ability.
 Production is the process of transforming inputs into outputs. It can also be
defined as an act of creating value or utility.
 The end products of the production process are outputs which could be tangible
(goods) or intangible (services).
 4.1.2 Production function

 Production function is a technical relationship between inputs and outputs. It

shows the maximum output that can be produced with fixed amount of inputs
and the existing technology.
 A production function may take the form of an algebraic equation, table or
graph. A general equation for production function can, for instance, be
described as:
 Q= f(X1 ,X2 ,X3 ,...,Xn ) where,
Q is output and X1, X2, X3,…, Xn are different types of inputs.
 4.1.2 Production function

Fixed inputs are those inputs whose quantity cannot readily be changed when

market conditions indicate that an immediate adjustment in output is required.

For example, if the demand for Beer rises suddenly in a week, the brewery factories

cannot plant additional machinery overnight and respond to the increased demand.

 Buildings, land and machineries are examples of fixed inputs because their

quantity cannot be manipulated easily in a short period of time

 4.1.2 Production function

Variable inputs are those inputs whose quantity can be altered almost
instantaneously in response to desired changes in output.
 That is, their quantities can easily be diminished when the market demand for
the product decreases and vice versa.
The best example of variable input is unskilled labour.

In economics, short run refers to a period of time in which the quantity of at

least one input is fixed.
 4.1.2 Production function…….

Consider a firm that uses two inputs: capital (fixed input) and labour (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: Q = f (L)

where, Q is output and L is the quantity of labour

The production function shows different levels of output that the firm can
produce by efficiently utilizing different units of labour and the fixed capital.
 Production in the short run: Production with one variable input

Production with one variable input (while the others are fixed) is obviously a
short run phenomenon because there is no fixed input in the long run.
Assumption of short run production analysis
In order to simplify the analysis of short run production, the classical
economist assumed the following:
1. Perfect divisibility of inputs and outputs
 This assumption implies that factor inputs and outputs are so divisible that
one can hire, for example a fraction of labor, a fraction of manager and we can
produce a fraction of output, such as a fraction of automobile.
 Production in the short run: Production with one variable input

2. Limited substitution between inputs

Factor inputs can substitute each other up to a certain point, beyond which
they can not substitute each other
3. Constant technology
They assumed that level of technology of production is constant in the short
run.
Suppose a firm that uses two inputs: Capital (which is a fixed input) and labor
(which is variable input). Given the assumptions of short run production, the
firm can increase output only by increasing the amount of labor it uses.
 Production in the short run: Production with one variable input

Hence, its production function is

Q = f (L) K - being constant
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)
The production function shows different levels of output that the firm can obtain
by efficiently utilizing different units of labor and the fixed capital. In the above
short run production function, the quantity of capital is fixed. Thus output can
change only when the amount of labor used for production changes. Hence, Q is
a function of L only in the short run.
 Production in the short run: Production with one variable input

Hence, its production function is

Q = f (L) K - being constant
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)
The production function shows different levels of output that the firm can obtain
by efficiently utilizing different units of labor and the fixed capital. In the above
short run production function, the quantity of capital is fixed. Thus output can
change only when the amount of labor used for production changes. Hence, Q is
a function of L only in the short run.
 4.1.3 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.

• Marginal Product (MP): it is the change in output attributed to the addition of

one unit of the variable input to the production process, other inputs being
constant.
 4.1.3 Total, average, and marginal product…

For instance, the change in total output resulting from employing additional
worker (holding other inputs constant) is the marginal product of labour
(MPL).
In other words, MPL measures the slope of the total product curve at a given
point.
In the short run, the marginal product of the variable input first increases,
reaches its maximum and then decreases to the extent of being negative.
 4.1.3 Total, average, and marginal product…

Average Product (AP): Average product of an input is the level of output that
each unit of input produces, on the average. It tells us the mean contribution of
each variable input to the total product.
Mathematically, it is the ratio of total output to the number of the variable
input.
The average product of labour (APL), for instance, is given by:
 4.2. Production Function…cont’d
The table below illustrates the short run production function
Unit of K Unit of L TP AP MP
4 0 0 ̶ ̶
4 1 10 10 10
4 2 30 15 20
4 3 60 20 30
4 4 80 20 20
4 5 95 19 15
4 6 108 18 13
4 7 112 16 4
4 8 112 14 0
4 9 108 12 -4
4 10 100 10 -8
January 22, 2025 Microeconomics Lecture Note
4.1.3 Total, average, and marginal product…
 4.1.3 Total, average, and marginal product…

The relationship between MPL and APL can be stated as follows.

 When APL is increasing, MPL > APL.

 When APL is at its maximum, MPL = APL.

 When APL is decreasing, MPL < APL.

 Example

• Example: Suppose that the short-run production function of certain cut-flower

firm is given

by: Q=4KL-0.6K2 -0.1L2 where Q is quantity of cut-flower produced, L is labour

input and K is fixed capital input (K=5).

a) Determine the average product of labour (APL) function.

b) At what level of labour does the total output of cut-flower reach the maximum?

c) What will be the maximum achievable amount of cut-flower production?

Example
 4.1.4 The law of variable proportions

The law of variable proportions states that as successive units of a variable

input(say, labour) are added to a fixed input (say, capital or land), beyond some
point the extra, or marginal product that can be attributed to each additional unit
of the variable resource will decline.
For example, if additional workers are hired to work with a constant amount of
capital equipment, output will eventually rise by smaller and smaller amounts as
more workers are hired.
 4.1.5 Stages of production

Stage I: This stage of production covers the range of variable input levels over
which the average product (APL) continues to increase.

 It goes from the origin to the point where the APL is maximum, which is the
equality of MPL and APL (up to L2 level of labour employment in figure 4.1).

This stage is not an efficient region of production though the MP of variable input
is positive.

The reason is that the variable input (the number of workers) is too small to
efficiently run the fixed input so that the fixed input is under-utilized (not
efficiently utilized).
 4.1.5 Stages of production….
Stage II: It ranges from the point where APL is at its maximum (MPL=APL) to
the point where MPL is zero (from L2 to L3 in figure 4.1).
Here, as the labour input increases by one unit, output still increases but at a
decreasing rate. Due to this, the second stage of production is termed as the stage
of diminishing marginal returns.
 The reason for decreasing average and marginal products is due to the scarcity
of the fixed factor.
 Hence, the efficient region of production is where the marginal product of the
variable input is declining but positive.
 4.1.5 Stages of production….
Stage III: In this stage, an increase in the variable input is accompanied by
decline in the total product.
This stage is also known as the stage of negative marginal returns to the

variable input.

The cause of negative marginal returns is the fact that the volume of the variable

inputs is quite excessive relative to the fixed input; the fixed input is over-
utilized.
Obviously, a rational firm should not operate in stage III because additional
units of variable input are contributing negatively to the total product (MP of the
variable input is negative). In figure 4.1,
 The laws of production
• The laws of production describe the technically possible ways
of increasing the level of production. This can be in various
ways.
• Output can be increased by changing all factors of production
which is possible in the long run. This is called the law of
returns to scale.
• On the other hand output can be increased by changing only
the variable input while keeping the fixed inputs constant,
which is possible in the short run.
• The MP of the variable factor will decline eventually as more
and more quantities of this factor are combined with the other
constant factors.
Law of variable proportion or Law of Diminishing
Returns
• This law states that, if more and more of a variable input is applied
to a fixed input, the total output may initially increase at an
increasing rate, but beyond a certain level of output it increases at
a diminishing rate.
• In other words, if some factors are held constant and more and
more units of a variable factor are combined with the fixed factor,
the marginal product of the variable factor eventually declines.
• What we can understand is that as the use of a variable input
(labor) increases with other inputs (capital) fixed, the resulting
addition to output will eventually decreases.
• This is shown by a downward sloping MPL curve after its maximum
point (at L1).
• This principle is known as the law of variable proportion or the law
 Long run Production: Production with two variable inputs
The short-run production function in which the firm uses one variable input
(labor) and one fixed input (capital).
Now we turn to the long run analysis of production. Remember that long run is
a period of time (planning horizon) which is sufficient for the firm to change the
quantity of all inputs.
For the sake of simplicity, assume that the firm uses two inputs (labor and
capital) and both are variable.
 Laws of Returns to Scale: Long-Run Production
Analysis
• The Laws of Returns to Scale describe how output responds
to proportional changes in all inputs in the long run when
all factors of production are variable.
• Unlike the short run, where one or more inputs are fixed,
the long run provides firms the flexibility to scale up or
down their operations.
• In the long run, firms analyze the relationship between
input changes and resulting output changes. This
relationship is categorized into three phases:
 Increasing Returns to Scale (IRS)
 Constant Returns to Scale (CRS)
 Decreasing Returns to Scale (DRS)
 1. Increasing Returns to Scale (IRS)
When all inputs are increased by a certain proportion, the output
increases by a greater proportion.
• Example: Doubling both labor and capital leads to more than
double the output.
• Reasons for IRS:
• Division of Labor: Specialization increases productivity.
• Economies of Scale: Cost advantages from large-scale
production.
• Indivisibility of Inputs: Some inputs (e.g., machinery) work
more efficiently when fully utilized.
The production function can be expressed as: Q=f(aL,aK)
• If f(aL,aK)>a. f(L,K): Increasing Returns to Scale
2. Constant Returns to Scale (CRS)
When all inputs are increased by a certain proportion, output
increases by the same proportion.
• Example: Doubling both labor and capital leads to exactly
double the output.
Characteristics:
• CRS indicates that the firm operates at an optimal scale.
• It reflects a balanced and efficient use of resources without
significant gains or losses in productivity.
The production function can be expressed as: Q=f(aL,aK)
• If f(aL,aK)=a. f(L,K): Constant Returns to Scale
 3. Decreasing Returns to Scale
(DRS)
• When all inputs are increased by a certain proportion, output
increases by a smaller proportion.
• Example: Doubling both labor and capital leads to less than
double the output.
• Reasons for DRS:
• Managerial Inefficiencies: Coordination becomes challenging
in large-scale operations.
• Overutilization of Resources: Inputs may become less
effective as scale increases.
• Diseconomies of Scale: Rising costs due to operational
complexity.
• The production function can be expressed as: Q=f(aL,aK)
• If f(aL,aK)<a. f(L,K): Decreasing Returns to Scale
 Long run Production: Production with two variable inputs
The firm can now produce its output in a variety of ways by combining different
amounts of labor and capital.
With both factors variable, a firm can usually produce a given level of output by
using a great deal of labor and very little capital or a great deal of capital and
very little labor or moderate amount of both.
 In this section, we will see how a firm can choose among combinations of labor
and capital that generate the same output.
To do so, we make the use of isoquant.
 Isoquants
An isoquant is a curve that shows all possible efficient combinations of inputs
that can yield equal level of output. If both labor and capital are variable inputs,
the production function will have the following form.

Q = f (L, K)
Given this production function, the equation of an isoquant, where output is
held constant at q is

q = f (L, K)
Thus, isoquants show the flexibility that firms have when making production
decision: they can usually obtain a particular output (q) by substituting one input
for the other.
 Isoquant maps

when a number of isoquants are combined in a

single graph, we call the graph an isoquant map.
An isoquant map is another way of describing a
production function.
Each isoquant represents a different level of
output and the level of out puts increases as we
move up and to the right.
The following figure shows isoquants and
isoquant map.
 Isoquants
Fig 3.2 Isoquant and isoquant map. Isoquants show the fact that long run
production process is very flexible.
A firm can produce q1 level of output by using either 3 capital and 1 labor or 2
capital and 3 labor or 1 capital and 6 labor or any other combination of labor and
labor on the curve.
The set of isoquant curves q1 q2 & q3 are called isoquant map.
 Properties of Isoquants
Isoquants have most of the same properties as indifference curves. The biggest
difference between them is that output is constant along an isoquant whereas
indifference curves hold utility constant.
Most of the properties of isoquants, results from the word ‘efficient’ in its
definition.

1. Isoquants slope down ward. Because isoquants denote efficient combination of

inputs that yield the same output, isoquants always have negative slope. Isoquants
can never be horizontal, vertical or upward sloping. If for example, isoquants have
to assume zero slopes (horizontal line) only one point on the isoquant is efficient.
See the following figures.
 Properties of Isoquants

2. The further an isoquant lays away from the origin, the greater the level of
output it denotes.

Higher isoquants (isoquants further from the origin) denote higher combination of
inputs. The more inputs used, more outputs should be obtained if the firm is
producing efficiently. Thus efficiency requires that higher isoquants must denote
higher level of output.

3. Isoquants do not cross each other. This is because such intersections are
inconsistent with the definition of isoquants. Consider the following figure.
Properties of Isoquants

 This figure shows that the firm can produce at

either output level (20 or 50) with the same
combination of labor and capital (L* and K*).
 The firm must be producing inefficiently if it
produces q = 20, because it could produce q =
50 by the same combination of labor and
capital (L* and K*).
 Thus, efficiency requires that isoquants do not
cross each other.
 Properties of Isoquants

4. Isoquants must be thin. If isoquants are thick,

some points on the isoquant will become
inefficient. Consider the following isoquant.
Fig.3.5: Iso quants can never be thick. Points A and B are
on the same iso quant.
But point A denotes higher amount of capital and the same
amount of labor as point B.
Hence point A denotes inefficient combination of inputs and
thus it lies out of the iso quant.
The iso-quant should be thin if point A is to be excluded
from the iso quant.
 Shape of Isoquants

Isoquants can have different shapes (curvature) depending on the degree to which
factor inputs can substitute each other.

1-Linear isoquants

Isoquants would be linear when labor and capital are perfect substitutes for each
other. In this case the slope of an iso quant is constant. As a result, the same output
can be produced with only capital or only labor or an infinite combination of both.
Graphically,
 Shape of Isoquants

Linear isoquant

Capital and labor can perfectly substitute

each other so that the same output (q=100)
can be produced by using either 10k or
8K and 12L or 15L or an infinite
combinations of both inputs.
 Shape of Isoquants

2. Input output isoquant

It is also called Leontief isoquant. This assumes strict

complementarities or zero substitutability of factors of
production.

In this case, it is impossible to make any substitution among

inputs.

Each level of output requires a specific combination of labor

and capital: Additional output cannot be obtained unless more
capital and labor are added in specific proportions.

As a result, the isoquants are L-shaped. See following figure

 Shape of Isoquants
Fig. 2.7 L-shaped isoquant.
When isoquants are L-shaped, there is only one efficient way
of producing a given level of output: Only one combination of
labor and capital can be used to produce a given level of
output.
To produce q1 level of output there is only one efficient
combination of labor and capital (L1 and K1).
Output cannot be increased by keeping one factor (say labor)
constant and increasing the other (capital).
To increase output (say from q1 to q2) both factor inputs
should be increased by equal proportion.
3. Kinked isoquants

This assumes limited substitution between

inputs.
kinked isoquant in this case labor and
capital can substitute each other only at
some point at the kink (A, B, C, and D).
Thus, there are only four alternative
processes of producing q=100 out put.
4. Smooth, convex isoquants

This shape of isoquant assumes continuous substitution

of capital and labor over a certain range, beyond which
factors cannot substitute each other.
This type of isoquant is the limiting case of the kinked
isoquant when the number kink is infinite.
The slope of the iso quant decrease as we move from the
top (left) to the right (bottom) along the isoquant.
This indicates that the amount by which the quantity of
one input (capital)can be reduced when one extra unit of
another inputs(labor)is used ( so that out put remains
constant) decreases as more of the latter input (labor)is
used.
The slope of an isoquant: marginal rate of technical substitution
(MRTS)
• The slope of an isoquant (-K/L) indicates how the quantity of one input can be
traded off against the quantity of the other, while output is held constant.
• The absolute value of the slope of an isoquant is called marginal rate of
technical substitution (MRTS).
• The MRTS shows the amount by which the quantity of one input can be
reduced when one extra unit of another input is used, so that output remains
constant.
• MRTS of labor for capital, denoted as MRTS L, K shows the amount by which the
input of capital can be reduced when one extra unit of labor is used, so that
output remains constant.
• This is analogues to the marginal rate of substitution (MRS) in consumer theory.
• MRTS L,K decreases as the firm continues to substitute labor for capital (or as
more of labor is used).
The slope of an isoquant: marginal rate of technical substitution
(MRTS)
• The fact that the slope of an isoquant is decreasing makes an isoquant convex to
the origin.
• MRTS L, K (the slope of isoquant) can also be given by the ratio of marginal
products of factors. That is,

K MPL
MRTS L , K  
L MPK
 Equilibrium of the firm: Choice of optimal
combination of factors of production
• A firm is said to be in equilibrium when it employs those
levels of inputs that will maximize its profit.
• This means the goal of the firm is profit maximization
(maximizing the difference between revenue and cost).
• Thus the problem facing the firm is that of constrained profit
maximization.
• To determine the economically efficient input combination,
the following simplifying assumptions hold true:
Assumptions
Isocost line
 Maximization of output subject to cost
constraint
• Suppose a firm having a fixed cost out lay (money budget)
which is shown by its iso-cost line.
• Here, the firm is in equilibrium when it produces the
maximum possible output, given the cost outlay and prices
of input.
• The equilibrium point (economically efficient combination) is
graphically defined by the tangency of the firm’s iso-cost line
(showing the budget constraint) with the highest possible
isoquant.
• At this point, the slope of the
Mathematical derivation of the equilibrium
condition
• A rational producer seeks the maximization of its output,
given total cost outlay and the prices of factors.
• The problem can be stated as:
• Maximize X = f (L,K)..........................Objective function
• Subject to C = wL + rK..........................Constraint function
• This is a constrained optimization which can be solved by
using the lagrangian method.
• The steps are:
Numerical Example
• Solving equation (1) and (2) would give us the optimal
combination of L and K.
L=2K
5L+ 10K= 600
L=60 units and K=30 units.
Thus, the firm should use 60 units of labor and 30 units
of capital to maximize its production (output). (Check
the second order condition).
The maximum output can be found by substituting 60
and 30 for L and K in the production process.
 Factor intensity
• A process of production can be labor intensive or capital intensive or neutral process.
• A process of production is called labor intensive if it uses many labors and relatively
few capitals.
• If it uses many capitals and relatively few labor it is called capital intensive technology.
• On the other hand, if the process uses equal proportion of both it is called neutral
technology.
• The factor intensity of any process is measured by the slope of the line through the
origin representing the particular process.
• Thus, the factor intensity is the capital-labor ratio.
• The higher the capital-labor ratio is the higher the capital intensity but the lower the
capital-labor ratio is the higher labor intensity of the process.