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THEORY OF PRODUCTION

A firm is defined as 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 (producer)
aims to maximize its profit with the use of resources (inputs) 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 process of creating goods and services using the
available inputs for production. The physical relationship between the inputs
and outputs (goods or services) at a given period of time, ceteris paribus, is called
the production function and is expressed in the mathematical form:
Q = f(X)
Where: Q = output
X = inputs (e.g. land, labor, capital, and a given technology)
F = production process

Raw Material Processing Final Product

(input) (input) (outputs)

Output refers to the goods and services that have been created/produced
using the production inputs while inputs of production refer to the factors of
production which include land, labor, capital, and technology. 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 in the short run, example; land,
top management, buildings, machineries
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, example; seeds, fertilizer, direct labor

For instance, a mangosteen farmer’s production function may include

several possible combinations of land (fixed input), labor and seedlings (variable
inputs) in the production of varying quantity of yields of mangosteen. In a similar
way, the production function of a fish-cracker maker may include combinations
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of machinery (fixed input) and workers (variable) in the production of varying

amounts of fish-crackers.

Objectives of the Producer:

1. Maximize Profit
2. Minimize Cost

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 at some points
the increases in output will become smaller and smaller and then decline. The
following concepts will be used in analyzing this principle.

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

Marginal (Physical) Product (MP). It is the additional output (Q) 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 4.1 shows the production schedule of a cardaba banana farmer given
the variable input – workers. The assumption on this given example is that there
is a fixed land planted with cardaba banana. Total, average and marginal
production in this case is measured in physical units (in tons). 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
cardaba banana 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 is called the law of
diminishing returns at work. This just means, that we cannot produce every
cardaba banana demanded by the market given a piece of land only. Further,
table 4.1 is graphically illustrated in the succeeding figures.

Table 4.1. Total production (in tons) schedule of cardaba banana with workers
employed as variable input (X).
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Units of workers Total product (TP) Marginal Average

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

TP 70

60
TP curve
50

40

30

20

10

0
0 1 2 3 4 5 6 7 8 9 10

Inputs (x)
Figure 4.1. Total Product Curve.
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MP 16
14
12
10
8
6
4 MP curve

2
0
1 2 3 4 5 6 7 8 9 10
-2
-4

Figure 4.2 Marginal Product Curve. Inputs (x)

AP 12

10
AP curve

0
1 2 3 4 5 6 7 8 9 10
Inputs (x)
Figure 4.3 Average Product Curve.

Three Stages of Production

The stage 1 of the production process is characterized by an increasing
AP. In figure 4, this occurs from the origin (0) up to x=5. 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.
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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 overwhelm any output
attributable to additional workers.

Figure 4.4 The three stages of production.

70 Stage 2 Stage 3
60 Stage 1

50
40
30
20
10
0
1 2 3 4 5 6 7 8 9 10
-10

Production Analysis with Two Variable Inputs

Production Isoquants and Isocost

Isoquants represent 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.
12
Labor (L)
10
8
6
4
2
0
2 4 6 8 10

Capital (K)

Figure 4.5 Isoquant Curve.

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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.

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.
Tables 4.2 and 4.3 and figure 4.6 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 100 units of Q. We can that
at higher levels of outputs, combinations of K and L also is higher.
Table 4.2, 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
I  PK  I  PL 
where: L= −   K and K= −  L
PL  PL  PK  PK 

16, 000 = 500 (32) + 400 (0)

16, 000 = 16, 000 + 0
16, 000 = 16,000

Table 4.2 Isoquant Schedules

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 4.3 Production Input Combination Schedule

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Labor Capital
32 0
28 5
24 10
20 15
16 20
12 25
8 30
4 35
0 40
Budget =P16,000
Price of Labor = P500/unit
Price of Capital = P400/unit

Figure 4.6 Isocost

Labor 35

30

25

20

15

10

0
0 5 10 15 20 25 30 35 40 Capital

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 and 15 units of capital 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 4.7).
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Labor
35

30

25

20
Point of tangency
15

10

0
0 5 10 15 20 25 30 35 Capital
40

Figure 4.7 Point of tangency between Isocost and Isoquant.