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The business firm is an entity that governs the supply

side of the market mechanism.

The firm organizes and transforms factors of

production (inputs) into goods and services

Production may be defined as a process by which

inputs are transformed into output

Inputs are resources (factors of production) which go

into the production process while outputs are goods
and services which come out of the production
Factors of production are resources or inputs which are
used in the production process.

Factors of production are usually grouped into three or four

Capital which includes equipments, machines and cash

Labour includes human capital, talents

Land includes all type of natural resources. Does not mean

soil or earths surface but includes all free gifts of nature
such as soil, minerals and air

Entrepreneur is a person who organizes other factors of

production and takes risk [the organizer, the manager, the
risk taker].
Production Function
In order to describe the relationship between
output and input, economists normally rely on the
concept of production function

A production function shows the maximum

quantity of output, Q that can be produced as a
function of the quantities of inputs, e.g. Labour,
capital etc

Short Run and Long Run Production functions

A short run production function shows the
relationship between inputs and outputs with at
least one input being fixed in quantity
A Long run production function shows the
relationship between inputs and outputs where all
inputs are allowed to vary.

Therefore, long run and short run period are just

analytical time periods and not calendar time.

The determinant of long run and short run periods

is based on whether there is existence or non-
existence of fixed input.

Assuming that there are two inputs used in the

production process, Capital (K) and Labour (L )
producing a single unit of output, Q, the
production function can be shown in equation
form as follows
Q = f(L, K)
where at least one input is fixed in the
short run and all input varying in the long
L, K are labour and capital inputs

We are interested in examining the firms

production behaviour in the short run period
where all inputs are fixed except one, labour in
our case.

First, we need to understand the following

concepts: Total Product (TP), Average Product
(AP) and Marginal Product (MP).

Total Product: is the total output produced

resulting from the efforts of all factors of
Average Product: Is the output produced per
unit of input (labour)

Marginal Product: Is the additional product
resulting from an increase in labour by one unit.
It the change in TP per unit change in the variable
factor (labour in our case)
TP, AP and MP can either be presented in a graph
or a schedule

For example
Relationship between TP, AP and MP
Total Product increases, reaches maximum and
thereafter declines
When TP is at maximum, MP is zero (slope?), and
When TP is falling, MP is negative
MP > AP when AP is increasing (because MP drives
changes in AP)
MP < AP when AP is falling (because MP drives
changes in AP)
MP = AP when AP is at maximum

Because it is the MP that drives changes in the

average product, then, when the AP is falling, the MP
must be less than the average. Likewise, when the
AP is rising, it must be due to a MP being greater
than the average. For this reason, the MP curve
intersects AP at the maximum point of the AP curve.
The Law of Diminishing Returns

As more and more of a variable input is added to the

fixed inputs, the MP will eventually decline

The law applies in the short run period where one factor is
variable while others fixed and state of technology is

As more labour is added to a fixed amount of another input,

say, capital, the productivity from the proportion of labour
to capital (labour/capital) ratio starts declining.

Note that the law refers to MP and not TP or AP because the

law may be at work even if TP and AP are increasing.

As more farm labourers are added to a given farm size, the
MP of an additional worker becomes smaller
The Three Stages of Production

Using the relationship between TP, AP and MP, we

can identify three stages of production as follows
STAGE ONE: From O to a 1

In this stage, AP still increasing but MP > AP.

Marginal Product reaches its maximum within this
stage. TP increases at an increasing rate and then
at a decreasing rate

STAGE TWO: From a1 to a2

In this stage both AP and MP decline but remain
positive. AP is at its maximum in the beginning of
this stage while MP is zero at the end of this
stage. TP is at maximum at the end of this stage.

STAGE THREE: To the right of a2

In this stage TP is declining, MP is negative. AP
continues to fall but remains positive
Economic implication of the three stages

Since no rational entrepreneur will hire an

additional amount of labour when its MP is
negative and TP declining; it is clear that stage
three is an economically meaningless region.

Since TP is still increasing and MP still positive in

stage one, the rational producer (profit
maximizing) will also not produce at this stage
because of under utilization of resources (inputs).

The rational producer will operate at stage two

where the TP is at maximum and MP of any
additional amount of labour is positive but
declining and then zero at the end of this stage.
We are interested in examining how a rational
producer will allocate the inputs efficiently for
maximum output.

Similar to the theory of consumer behaviour, we

are guided by various input combinations which
can be chosen in producing certain output but
subject to a limitation of producers budget

Isoquant: Is a curve that shows a given amount of

output Q produced by various combinations of two
inputs (Labour and Capital in our case).
Its role is similar to that of the indifference curve
in the theory of consumer behaviour

The slope of the isoquant (K/L) is called the

Marginal Rate of Technical Substitution (MRTS).

MRTS is the rate at which one input, say, L is

substituted for the other input, K but producing
the same amount of output, Q
Since output remains constant as capital is reduced
by K and labour increased by L, then

K*MPK + L*MPL = 0

By rearranging this equation, it can be shown that

___ = ____
Isocost: Is the line that shows amount of input
combinations which can be purchased with a given amount
of expenditure.

Given that input prices, P and P are given in the market


and the producer has a production budget C, then the

isocost equation is given as

P *L +P *K = C
Note that the isocost line has similar characteristics with
the budget line discussed previously in terms of intercepts,
slope, parallel shifts and pivoting.

Optimal input combinations

In the theory of CB the objective of the consumer is to
maximize utility. In the theory of production, the objective
of the producer is to minimize cost (maximize output).

Therefore, our interest is to examine how a firm minimizes

the cost of producing any level of output it wishes to

To do that we need to combine the information contained in

the isoquant and isocost
The optimal input combination should be obtained at the condition where
the slope of the isoquant and isocost are equal

This means,
___ = ____ = ___


____ = ____
Therefore, point E in the following figure is equilibrium
where the optimal input combination (Least cost condition)
is attained
What is an expansion path?

RETURNS TO SCALE: Proportionate changes in all

Let us now examine the response in output when all inputs
are varied in equal proportions.

Note that we emphasized that the law of diminishing return

applies only in the short run when some inputs are fixed.

But our focus here is to see what happens to output when

for example all inputs are varied twice? (long run period!).

So, never confuse between law of variable proportions

(diminishing returns) and returns to scale.
Depending on whether the proportionate change in output
equals; exceeds; or falls short of the proportionate change
in both inputs; a production function is classified as showing
scale respectively.

If output increases by same proportional as inputs then

there are constant returns to scale (CRS).

If output increases by less than proportional as inputs, there

are decreasing returns to scale (DRS).

If output increases by more than proportional as inputs,

there are increasing returns to scale (IRS).
For example,
If inputs are doubled and output doubled,
the firm is operating under CRT

If inputs are doubled and output is less

than double, the firm is operating under

If inputs are doubled and output is more

than double, the firm is operating under
You will learn next time about economies of scale
and long run cost curve and their linkage to returns
to scale
Special case of PF
The Cobb-Douglas PF
Assuming output Q produced by two factor
inputs, K, L
Popularized by Charles Cobb and Paul Douglas in
Functional form
Q = ALa Kb
Class discussion with examples