CHAPTER
4
THEORY OF PRODUCTION
Principles of Economics second edition
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Ch. 5: 1
Topic Learning Outcomes
 Define production.
 Explain stages of production.
 Differentiate between fixed factor & variable factor.
 Differentiate between short-run & long-run.
 Define the Law of Diminishing Marginal Returns
(LDMR).
 Calculate TP, AP & MP.
 Sketch TP, AP & MP curve.
 Explain relationship between TP, MP & AP.
 Explain the Law of Returns to Scale
Principles of Economics second edition
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Ch. 5: 2
DEFINITION OF PRODUCTION
Definition
▪ Production means the process of using the factor of
production to produce goods and services.
▪ Production is the process of transforming inputs into
outputs.
OUTPUTS
INPUTS
Inputs refers to the
factors of production
that a firm use in the
production process.
Principles of Economics second edition
© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Processing
Refers to what we
get at the end of the
production process
that is finished
products.
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Ch. 5: 3
LAND
LABOUR
All natural resources
or gift of nature
Physical or mental
activities of human beings
CLASSIFICATION
OF FACTORS OF
PRODUCTION
CAPITAL
Part of man-made wealth
used for further production
Principles of Economics second edition
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ENTREPRENEUR
A person who combines the different
factors of production, and initiates
the process of production and also
bears the risk
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Ch. 5: 4

Business that operate at the Primary stage of
production:


Take raw materials (natural resources) from the
land, water or air
All products go through this as the 1st Stage of
Production

Business that operate at the Secondary stage of
production:


Manufacture the raw materials (natural resources)
into finished products
Most products go through this as the 2nd Stage
of Production

Business that operate at the Tertiary stage of
production:


Provide products and services to consumers,
governments and other businesses
Some products and most services go through
this as the 3rd Stage of Production
Principles of Economics second edition
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Ch. 5: 9



Primary
Secondary
Tertiary
SHORT RUN AND LONG RUN
PRODUCTION FUNCTION
Two Types of Factor Inputs
1. Fixed Input
 An input which the quantity does not change according to the amount of
output.
 Example: Machinery, land, buildings, tools, equipments, etc.
2. Variable Input
 An input which the quantity changes according to the amount of output.
 Example: Raw materials, electricity, fuel, transportation, communication, etc.
Short Run and Long Run Period

Short run period is the time frame, which at least one of the inputs (factor of
production) is fixed and other inputs can be varied.
 Long run period is the time frame which all inputs are variable.
Principles of Economics second edition
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Ch. 5: 13
Short-run vs Long-run
 Fixed input + Variable input = Short-run
 All variable input = Long-run
 Land + Labour + Capital + Entrepreneur
F
V
F
V
SR
 Land + Labour + Capital + Entrepreneur
V
V
Principles of Economics second edition
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V
V
LR
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Ch. 5: 14
SHORT RUN PRODUCTION FUNCTION
(cont.)
LAW OF DIMINISHING MARGINAL RETURNS
 It states that if the quantities of certain factors are
increased while the quantities of one or more factors
are held constant, beyond a certain level of
production, the rate of increase in output will
decrease.
OR
 “Law of diminishing marginal returns states that as
more of a variable input is used while other input and
technology are fixed, the marginal product of the
variable input will eventually decline”.
Principles of Economics second edition
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Ch. 5: 15
SHORT RUN PRODUCTION
FUNCTION (cont.)
TOTAL PRODUCT (TP)
The amount of output produced when a given amount of that
input is used along with fixed inputs.
AVERAGE PRODUCT (AP)
Divide the total product by the amount of that input
used in the production
Average Product (APL) = Total Product
Total Labour
APL = TP/ L
Principles of Economics second edition
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Ch. 5: 17
SHORT RUN PRODUCTION FUNCTION
(cont.)
MARGINAL PRODUCT (MP)
Change in the total product of that input corresponding to an addition
unit change in its labour assuming other factors that is capital fixed.
Marginal Product (MPL) = Change in Total Product
Change in Total Labour
MPL
Principles of Economics second edition
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=  TP/  L
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Ch. 5: 18
Previously…
Labour = 1
TP = 8
20
8
12
2
1
1
10
12
Now…
Labour = 2
MP = 12
TP = ?
AP = ?
Previously…
Labour = 6
TP = 54
56
54
2
7
6
1
8
2
Now…
Labour = 7
MP = ?
TP = ?
AP = 8
SHORT RUN PRODUCTION FUNCTION
(cont.)
Capital
(Fixed
input)
Labour
(Variable
input)
Total
Product
Marginal
Product
Average
Product
10
0
0
0
0
10
10
10
10
10
10
10
10
10
10
1
2
3
4
5
6
7
8
9
10
8
20
33
44
50
54
56
56
54
50
8
12
13
11
6
4
2
0
-2
-4
8
10
11
11
10
9
8
7
6
5
MP = 54 - 56
9-8
= -2
Principles of Economics second edition
© Oxford Fajar Sdn. Bhd. (008974-T) 2010
Stages of
Production
STAGE I
STAGE II
STAGE III
AP = 56
8
= 7
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Ch. 5: 21
SHORT RUN PRODUCTION FUNCTION
(cont.)
RELATIONSHIP BETWEEN TP AND MP
When MP is increasing, TP increase at an increasing rate.
When MP is decreasing, TP increase at a decreasing rate.
When MP is zero, TP at its maximum.
When MP is negative, TP declines.
60
RELATIONSHIP BETWEEN AP AND MP
When MP is above AP , AP is increasing
When MP is below AP, AP is decreasing.
When MP equals to AP, AP is at maximum.
TP MAX
STAGE II
STAGE I
STAGE III
50
40
TP
30
MP
20
AP MAX;
AP =MP
AP
10
MP=0
0
1
2
3
4
5
6
7
8
9
10
-10
Principles of Economics second edition
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Ch. 5: 22
SHORT RUN PRODUCTION FUNCTION
(cont.)
Stage I
Stage II
▪ Proportion of fixed factors are
greater than variable factors
▪ Under utilization of fixed factor
▪ Operation involves a waste of resources
▪ Called law of diminishing returns
▪ The most efficient stage of production
because the combinations of inputs are fully
utilized
STAGES OF PRODUCTION
Stage III
▪ Proportion of fixed factors is lower than variable factors
▪ Increase in variable factors decline the TP because of overcrowding
▪ A producer would not like to operate at this stage
Principles of Economics second edition
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Ch. 5: 23
There are three stages of returns to scale:



Increasing Returns to Scale (economies of scale); whereby an
increase in inputs will bring about a more than
proportionate increase in the level of output.
Constant Returns to Scale (constant economies of scale);
whereby an increase in input will bring about a
proportionate increase in the level of output.
Decreasing Returns to Scale (diseconomies of scale);
whereby an increase in input will bring about a less than
proportionate increase in the level of output.
Division of
labour
Marketing
Internal
EOS
Risk Bearing
Financial
Infrastructure
Concentration
External
EOS
Information
Marketing
Bureaucratic
problems
High
competition
Internal
DEOS
High cost to
maintain
professional
Division of
labour
Social
problems
External
DEOS
Intense
competition
Wage
differential