PRODUCTION THEORY
PRODUCTION refers to the transformation of
inputs into outputs (products).
Fixed factor
Variable factor
Capital
Entrepreneur
Land
Labor
It also includes storing, shipping and packaging.
Any activity tries to add value to a product.
PRODUCTION FUNCTION
Indicates the highest output that a firm can produce
by a given amount of inputs, while holding
technology constant at some predetermined state.
Q = ( L,K )
Q = highest output
L = Labor (variable)
K = Capital (fixed)
SHORT RUN is a time period in which the quantity of
some inputs (fixed factors) cannot be increased.
Q=
L = increase or decrease in Labor
K = Capital is constant
LONG RUN is a time period in which all inputs may be
varied in which the basic technology of production
cannot be changed.
L = increase or decrease in Labor
K = increase or decrease in capital
Total, Average and Marginal Products
• Total product (TP) is the total amount that is produced
during a given period of time.
• Average product (AP) is the total product divided by the
number of units of the variable factor used to produce it.
• Marginal product (MP) is the change in total product
resulting from the use of one additional unit of variable
factor.
Table 5.1
Production of Ice Cream (Gallons per Week)
Number of
workers
TP or output in
gallons
MP
AP
1
20
20
20
2
42
22
21
3
66
24
22
4
72
6
18
5
77
5
15.4
6
80
3
13.3
7
81
1
11.6
8
81
0
10.1
9
78
-3
8.7
10
71
-7
7.1
Law of Diminishing Marginal Productivity
The law states that when successive units of a
variable input worked with a fixed input beyond
a certain point the additional product produced
by each additional unit of variable, decreases.
The message of that law is that there is a proper
combination of a variable input and a fixed input in
order to attain the maximum output. It is not
advisable to keep on increasing the number of
farmers to work. If they are many, most of them have
nothing to do. They only hamper the work of others.
3 STAGES OF
PRODUCTION
Product Curves
There are three main product curves in economic
production: the total product curve, the average product
curve and the marginal product curve.
1. The total product curve is a reflection of the firm’s overall
production and is the basis of the two other curves.
2. The average product curve is the quantity of the total output
produced per unit of a "variable input" such as hours of labor.
3. The marginal product curve is slightly different: It measures
the change in product output per unit of variable input.
Stage One
Stage one is the period of most growth in a company's
production. In this period, each additional variable input
will produce more products. This signifies an increasing
marginal return; the investment on the variable input
outweighs the cost of producing an additional product at
an increasing rate. All three curves ( TP, AP, MP) are
increasing and positive in this stage.
Stage Two
Stage two is the period where marginal returns start to
decrease. Each additional variable input will still produce
additional units but at a decreasing rate. This is because of
the law of diminishing returns. Output steadily decreases on
each additional unit of variable input, holding all other
inputs fixed. The total product curve is still rising in this stage,
while the average and marginal curves both start to drop.
Stage Three
In stage three, marginal returns start to become
negative. Adding more variable inputs becomes
counterproductive; an additional source of labor will
lessen overall production. This may be due to factors
such as labor capacity and efficiency. In this stage, the
total product curve starts to trend down, the average
product curve continues its descent and the marginal
curve becomes negative.
Entrepreneurs do not prefer to operate
within stage I and stage III. Stage II is the
suitable stage for an entrepreneur to
operate.
Productivity of the variable factor labor
and the Law of Diminishing Return
Units of Labor
Employed
Total Product
(tonnes of corn)
Marginal Product
(tonnes of Corn)
Average Product
(tonnes of CORN)
0
0
1
3
3
3
2
10
7
5
3
24
14
8
4
36
12
9
5
40
4
8
6
42
2
7
7
42
0
6
Production Stages:
The three stages of production are
characterized by the slopes, shape, and
interrelationships of the total, marginal, and
average product curves.
Stage 1
The product has a positive slope.
Marginal product is greater than average
product. Marginal product initially increases,
then decreases until it is equal to average
product at the end of Stage I.
Average product is positive and the average
product has a positive slope.
Stage II
The total product curve has a decreasing
positive slope.
Marginal product is positive and the marginal
product curve has a negative slope.
Average product is positive and the average
product curve has a negative slope.
Stage III
Production is most obvious for the
marginal product curve, but indicated by
the total product curve.
The total product curve ha a negative
slope. It has passed its peak and is
heading down.
Table Production of Tricycles
Labor (L)
Units
Total Product
(TP) Units
Marginal
Product (MP)
Units
Average
Product (AP)
Units
1
10
2
19
9
9.5
3
26
7
8.7
4
30
4
7.5
5
30
0
6
6
26
-4
4.3
7
19
-7
2.7
10.0
35
30
Output, Total Product
25
20
Total Product (TP)
15
10
5
0
1
2
Input,
Labor
3
4
5 (L)
6
Output, Marginal Product (MP)
Average Product (AP)
10
Average Product (AP)
8
Marginal Product
(MP)
6
4
2
0
1
-2
-4
-6
2
3
4
5
6
Input Labor (L)
30
25
20
15
Total Product (TP) Units
Marginal Product (MP) Units
Average Product (AP) Units
10
5
0
1
-5
2
3
4
5
6
Table 5.2 Summary of Returns to Scale
TP
MP
AP
Stage 1
Increasing
Diminishing
Decreasing
Stage 2
Maximum/constant
Zero
Decreasing
Stage 3
Diminishing
Negative
decreasing
Marginal product is negative and the
marginal product curve has a negative
slope. The marginal product curve has
intersected the horizontal axis and its
moving down.
Average product remains positive but the
average product curve has a negative
slope.
The last stage of production is where the
economic phenomenon referred to as “The Law
of Diminishing Returns” appears. In this stage, as
the non-fixed factor is added or increased (in our
example, as more employees are hired), output
ceases to increase and may even begin to
decrease. At the point where decreases in output
(i.e. marginal product) begin, the law of
diminishing returns.
Law of Diminishing Return
Diminishing Returns is said to occur when
the marginal product of labor starts to fall.
This is the stage that all companies strive
for. Somewhere at the peak of this stage is
the exact ideal spot where companies
should operate, where marginal product
and average product intersect, meaning
that a business will be able to optimize its
output. Economists say this is the stage in
which “rational” firms should operate.
Table Production of Tricycles
Labor (L)
Units
Total Product
(TP) Units
1
11
2
17
3
28
4
32
5
32
6
26
7
17
Marginal
Product (MP)
Units
Average
Product (AP)
Units
COST OF PRODUCTION
 Are defined as those expenses faced by a
business when producing goods or services for
a market.
 Cost production can be categorized as fixed
costs and variable costs.
Fixed costs
Fixed costs are expenses that does not
change in proportion to the activity of a
business.
Fixed costs include overheads (rent,
insurance-premium, interests, depreciation,
new equipment, marketing and advertising),
and also direct costs such as payroll
(particularly salaries).
Fixed cost does not change with the volume
of production.
costs
100
TFC
O
Q
Variable costs
Variable costs change in direct proportion to the
activity of a business such as sales or production
volume. In retail, the cost of goods is almost
entirely variable. In manufacturing, direct
material costs, wages, fuel costs are examples of
variable costs.
Total costs for firm X
Output TFC
(Q)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
40
20
TFC
0
0
fig
1
2
3
4
5
6
7
8
Output TFC
(Q)
100
0
1
2
3
4
5
6
7
80
60
Total costs for firm X
TVC
0
10
16
21
28
40
60
91
12
12
12
12
12
12
12
12
40
20
TFC
0
0
fig
1
2
3
4
5
6
7
8
Total costs for firm X
Output TFC
(Q)
100
0
1
2
3
4
5
6
7
80
60
TVC
0
10
16
21
28
40
60
91
12
12
12
12
12
12
12
12
TVC
40
20
TFC
0
0
fig
1
2
3
4
5
6
7
8
Total costs for firm X
100
TVC
80
Diminishing marginal
returns set in here
60
40
20
TFC
0
0
fig
1
2
3
4
5
6
7
8
Output TFC
(Q)
100
0
1
2
3
4
5
6
7
80
60
TVC
TC
Total costs for firm X
TC
0
10
16
21
28
40
60
91
12
12
12
12
12
12
12
12
12
22
28
33
40
52
72
103
TVC
40
20
TFC
0
0
1
fig
2
3
4
5
6
7
8
For a firm to maximize profit in a
competitive market, marginal revenue
and marginal cost must be balanced
with the price. At the point when total
revenue is only equal to total cost, no
profit will be made. However, there is
also no loss at this instance. This means
that the firm has a break-even in its
production. A break-even point refers
to a situation where a firm’s gain from
its economic activity equals the cost it
incurred.
TC and TR
TC
COSTS
TR
QUANTITY
Q
TFC
TVC
TC =
TFC+
TVC
1
100
10
110
2
100
14
114
3
100
17.5
4
100
5
MC =
C inTC/
Cin Q
AFC=
TFC / Q
AVC=
TVC / Q
ATC =
TC/Q
100.0
10.0
110.0
4
50.0
7.0
57.0
117.5
3.5
33.3
5.8
39.2
21.7
121.7
4.2
25.0
5.4
30.4
100
26.2
126.2
4.5
20.0
5.2
25.2
6
100
31.2
131.2
5
16.7
5.2
21.9
7
100
37.7
137.7
6.5
14.3
5.4
19.7
8
100
46.7
146.7
9
12.5
5.8
18.3
9
100
59
159
12.3
11.1
6.6
17.7
10
100
75
175
16
10.0
7.5
17.5
11
100
95
195
20
9.1
8.6
17.7
12
100
121
221
26
8.3
10.1
18.4
13
100
165
265
44
7.7
12.7
20.4
14
100
220
320
55
7.1
15.7
22.9
15
100
290
390
70
6.7
19.3
26.0
16
100
390
490
100
6.2
24.4
30.6
TR =
P xQ
MR =
Cin TR/
Cin Q
TP=
TR-TC
Q
TFC
TVC
TC =
TFC+
TVC
MC =
C inTC/
Cin Q
ATC =
TC/Q
Price
(10% markup/unit
105
150
100
2. ?
3. ?
6. ?
10. ?
15. ?
125
150
120
270
4. ?
7. ?
11. ?
200
1. ?
150
300
5. ?
1.50
1.65
275
150
275
425
8. ?
12. ?
380
150
300
450
9. ?
14. ?
PRODUCTION THEORY
lABOR
TP
MP
AP
1
505
1. ?
5. ?
2
800
2. ?
6. ?
3
1200
3. ?
7. ?
4
1600
4. ?
8. ?
1.
2.
Compute the marginal product and average product. Show your solution.
What labor that maximize your production process?
AFC=
TFC / Q
TR =
P xQ
MR =
Cin TR/
Cin Q
TP=
TR-TC
16. ?
18. ?
20 ?
17. ?
19. ?
EQUAL
ISOQUANTS
QUANTITY
DEFINITION
represents constant quantity of output.
“An Isoquant curve may be defined as a
curve showing the possible combinations
of two variable factors that can be used to
produce the same total product.” Peterson

“The Iso-product curves show the
different combinations of two resources
with which a firm can produce equal
amount of product.”Bilas
“Iso-product curve shows the different
input combinations that will produce a
given output.”- Samuelson
ISO-PRODUCT SCHEDULE
Shows the different combination of these two inputs that produce the
same level of output.
a) 1 units of labour and 15 units of capital
(b) 2 units of labour and 11 units of capital
(c) 3 units of labour and 8 units of capital
(d) 4 units of labour and 6 units of capital
(e) 5 units of labour and 5 units of capital
Iso-Product Curve:
Iso-Product Map or Equal
Product Map:
Properties of Iso-Product
Curves:
1. Iso-Product Curves Slope Downward from Left to Right:
The possibilities of horizontal, vertical,
upward sloping curves
2. Isoquants are Convex to the Origin:
3. Two Iso-Product Curves Never Cut Each Other:
4. Higher Iso-Product Curves Represent Higher Level of
Output
5. Isoquants Cannot be Parallel to Each Other:
6. No Isoquant can Touch Either Axis:
7. Each Isoquant is Oval-Shaped.
Indifference Curve Vs Isoquant Curve
1. Iso-quant curve expresses the quantity of output. Each curve
refers to given quantity of output while an indifference curve to
the quantity of satisfaction. It simply tells that the combinations
on a given indifference curve provide more satisfaction than
the combination on a lower indifference curve of production.
2. Isoquant
curve represents the combinations of the factors
whereas indifference curve represents the combinations of
the goods.
3. Isoquant curve gives information regarding the economic
and uneconomic region of production. Indifference curve
provides no information regarding the economic and
uneconomic region of consumption.
4.
Slope of an isoquant curve is
between factors of production,
whereas slope of an indifference
curve is between two commodities
consumed by the consumer.
THE ISOCOST LINE
Isocost
 “Iso” is a Greek word which means same
• is a graphical representation that shows
the combination of productive inputs that
have the same cost
• Labor – L (w)
• Capital – K (r)
K
Capital
10
8
6
4
2
O
2
4
6
8
10
Labor (L)
Example:
Producer’s total budget = P120
In order to achieve a certain level of output,
he has to spend this in two factors:
Capital and Labor with P10 and P15,
respectively.
Combinations
Units of Capital
(P15)
Units of Labor
(P10)
Total expenditure
A
8
0
120
B
6
3
120
C
4
6
120
D
2
9
120
E
0
12
120
LEAST COST FACTOR COMBINATION
- can be determined by imposing the
isoquant map on isocost line.
THE MARGINAL RATE OF
TECHNICAL SUBSTITUTION
Combination
Labor
Capital
A
1
20
B
2
10
C
3
6
D
4
3
E
5
2
F
6
1
Marginal Rate Of Technical Substitution
The measure where the reduction of one
labor unit increases the number of capital
units used in production to maintain a
constant level of output.
= 3-6
4-3
=|-3|
RETURN TO SCALE
behavior of production on returns when all productive
factors are increase proportionately and simultaneously
c= input
z= output
1. An increasing return to scale if his output is greater
than his input (z>c)
2. A decreasing return to scale if his output is less than
his input (z<c)
3. A constant return to scale is a condition where his
output is equal to his input (z=c)