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THEORY OF
PRODUCTION
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.
INPUTS
OUTPUTS
Processing
Refers to what we
get at the end of the
production process
that is finished
products.
LAND
All natural resources
or gift of nature
LABOUR
Physical or mental
activities of human beings
CLASSIFICATION
OF FACTORS
OF PRODUCTION
CAPITAL
Part of man-made wealth
used for further production
ENTREPRENEUR
A person who combines the different
factors of production, and initiates
the process of production and also
bears the risk
PRODUCTION FUNCTION
Q = (K, L, M, etc.)
Where: Q = Output
K = Capital
L = Labour
M = Raw Material
Variable Input
An input which the quantity changes according to the amount of
output.
Example: Raw materials, electricity, fuel, transportation, communication,
etc.
SHORT-RUN PRODUCTION
FUNCTION
SHORT-RUN PRODUCTION
FUNCTION (cont.)
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.
TP/ L
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 (MP L)
MP L
SHORT-RUN PRODUCTION
FUNCTION (cont.)
Capital
(Fixed
input)
Labour
(Variable
input)
Total
Product
Marginal
Product
Average
Product
10
10
10
10
10
10
10
10
10
10
10
0
1
2
3
4
5
6
7
8
9
10
0
8
20
33
44
50
54
56
56
54
50
0
8
12
13
11
6
4
2
0
-2
-4
0
8
10
11
11
10
9
8
7
6
5
MP = 54 - 56
9-8
= -2
AP = 56
8
= 7
Stages of
Production
STAGE I
STAGE II
STAGE III
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
STAGE II
STAGE I
TP MAX
STAGE III
50
40
TP
30
MP
20
AP MAX;
AP =MP
AP
10
MP=0
0
-10
10
SHORT-RUN PRODUCTION
FUNCTION (cont.)
Stage I
Stage II
STAGES OF PRODUCTION
Stage III
LONG-RUN PRODUCTION
FUNCTION
ISOQUANT ANALYSIS
An isoquant or iso-product represents all the
possible combination of two factor inputs, which
gives the same level of output (total product).
Represents all the possible combinations of
variable inputs that used to generate the same
level of output (total product).
LONG-RUN PRODUCTION
FUNCTION (cont.)
ISOQUANT SCHEDULE
Production with two variable inputs
Capital
Labour
250
450
550
700
800
450
650
800
900
950
600
800
950
1050
1100
700
900
1050
1150
1200
800
950
1100
1200
1250
LONG-RUN PRODUCTION
FUNCTION (cont.)
1.
2.
3.
4.
18
18
14
12
16
10
14
12
10
Output
Factor
Y
2
2
14
12
Factor X
8
6
2
2
0
10
Q2
6
3
Q3
Q1
0
1
16
3
IC1
4
IC2
LONG-RUN PRODUCTION
FUNCTION (cont.)
Isoquant Map
Refers to a number of isoquants that are
combined in a single graph.
Can be used to estimate the maximum attainable
output from different combinations of inputs.
higher isoquant curve represents a higher level
of output.
LONG-RUN PRODUCTION
FUNCTION (cont.)
Isoquant map
6
Capital
5
4
3
Q3=1,200
Q2=800
1
0
Q1 =450
1
LONG-RUN PRODUCTION
FUNCTION (cont.)
MRTS = -
K/
MRTS
SCALE OF PRODUCTION
INCREASING RETURNS TO SCALE
All the factors of production are increased in a given
proportion, output would increase by a greater proportion.
Capital
200
100%
100
100
200
100%
SCALE OF PRODUCTION
(cont.)
CONSTANT RETURNS TO SCALE
Capital
100
IQ =20
Labour
100
200
100%
SCALE OF PRODUCTION
(cont.)
DECREASING RETURNS TO SCALE
All the factors of production are increased in a given
proportion, output would increase by a smaller proportion.
Capital
< 100%
Labour
100
200
100%
The causes of
decreasing returns to
scale are internal and
external diseconomies
of scale.