THE THEORY OF

PRODUCTION
• Production theory forms the foundation for
the theory of supply

• Managerial decision making involves four

types of production decisions:
1. Whether to produce or to shut down
2. How much output to produce
3. What input combination to use
4. What type of technology to use
• Production involves transformation of inputs
such as capital, equipment, labor and land
into output - goods and services

• In this production process, the manager is

concerned with efficiency in the use of the
inputs
- technical vs. economical efficiency
 Two Concepts of Efficiency
• Economic efficiency:
– occurs when the cost of producing a
given output is as low as possible

• Technological efficiency:
– occurs when it is not possible to increase
output without increasing inputs
 You will see that basic production
theory is simply an application of
constrained optimization:
the firm attempts either to minimize the cost of
producing a given level of output
or
to maximize the output attainable with a given
level of cost.

Both optimization problems lead to same rule for

the allocation of inputs and choice of technology
 Production Function
• A production function is a table or a
mathematical equation showing the
maximum amount of output that can be
produced from any specified set of inputs,
given the existing technology
Q f2(x)
f1(x)
f0(x) Improvement of technology
f0(x) - f2(x)

Q = output
x = inputs
x
 Production Function continued

Q = f(X1, X2, …, Xk)

where
Q = output
X1, …, Xk = inputs

For our current analysis, let’s reduce the

inputs to two, capital (K) and labor (L):

Q = f(L, K)
 Production Table
Units of L
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of K Employed

Same Q can be produced with different

combinations of inputs, e.g. inputs are substitutable
in some degree
 All of these outputs are assumed
to be technically efficient

• But which one is economically efficient?

– That is the question facing the DM

Short-Run and Long-Run Production

• In the short run some inputs are fixed

and some variable
– e.g. the firm may be able to vary the
amount of labor, but cannot change
the capital
– in the short run we can talk about
factor productivity
• In the long run all inputs become
variable
– e.g. the long run is the period in which a
firm can adjust all inputs to changed
conditions
– in the long run we can talk about
returns to scale
 Short-Run Changes in Production
Factor Productivity
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed

How much does the quantity of Q

change, when the quantity of L is
increased?
 Long-Run Changes in Production
Returns to Scale
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed

How much does the quantity of Q change,

when the quantity of both L and K is
increased?
 Relationship Between Total, Average,
and Marginal Product: Short-Run Analysis

• Total Product (TP) = total quantity of output

• Average Product (AP) = total product/total

input

• Marginal Product (MP) = change in quantity

when one additional unit of input used
 The Marginal Product of Labor
• The marginal product of labor is the increase in
output obtained by adding 1 unit of labor but
holding constant the inputs of all other factors

Marginal Product of L:
MPL = ∆ Q/∆ L (holding K constant)
= δ Q/δ L

Average Product of L:
APL = Q/L (holding K constant)
 Short-Run Analysis of Total,
Average, and Marginal Product

• If MP > AP then AP
is rising
• If MP < AP then AP
is falling
• MP=AP when AP is
maximized
 Law of Diminishing Returns
(Diminishing Marginal Product)
Holding all factors constant except one, the law of
diminishing returns says that:
 As additional units of a variable input are
combined with a fixed input, at some point the
additional output (i.e., marginal product) starts to
diminish
 e.g. trying to increase labor input without also
increasing capital will bring diminishing returns
 Nothing says when diminishing returns will start to take
effect, only that it will happen at some point
 All inputs added to the production process are exactly the
same in individual productivity
 Three Stages of Production in
Short Run
AP,MP
Stage I Stage II Stage III

APX

X
MPX
Fixed input grossly Specialization and
underutilized; teamwork continue to
specialization and result in greater Fixed input capacity
teamwork cause output when is reached;
AP to increase additional X is used; additional X causes
when additional X fixed input being output to fall
is used properly utilized
How to Determine the Optimal Input
Usage
• We can find the answer to this from the
concept of derived demand

• The firm must know how many units of

output it could sell, the price of the
product, and the monetary costs of
employing various amounts of the input L

• Let us for now assume that the firm is

operating in a perfectly competitive
market for its output and its input
 Example: Note: P = Product Price = $2
W = Cost per unit of labor = $10000
MRP = MP x P
TLC = X x W
MLC = ∆ TLC / ∆ X

T a b le 7 .6 C o m b in in g M a r g in a l R e v e n u e P r o d u c t (M R P ) w ith M a r g in a l
T o ta l M a rg i n aTl o ta l M a rg in a l
L a b o r T o ta l A v e ra gMe a rg in Ra le ve n uRee v e n u Le a b o r L a b o r
U n i t P ro d u cPt ro d u cPt ro d u cPt ro d u cPt ro d u c tC o s t C o s t
(X ) (Q o r T P (A ) P ) (M P ) (T R P ) (M R P ) (T L C ) (M L C ) T R P -T L M C R P -M L C
0 0 0 0 0 0 0
1 10000 10000 10000 200002000010000 10000 10000 10000
2 25000 12500 15000 500003000020000 10000 30000 20000
3 45000 15000 20000 900004000030000 10000 60000 30000
4 6 0 0 0 0 1 5 0 0 0 1 5 0 0 0 1 2 0 0 0 03 0 0 0 0 4 0 0 0 0 1 0 0 0 0 8 0 0 0 0 2 0 0 0 0
5 7 0 0 0 0 1 4 0 0 0 1 0 0 0 0 1 4 0 0 0 02 0 0 0 0 5 0 0 0 0 1 0 0 0 0 9 0 0 0 0 1 0 0 0 0
6 7 5 0 0 0 1 2 5 0 0 5 0 0 0 1 5 0 0 0 01 0 0 0 0 6 0 0 0 0 1 0 0 0 0 9 0 0 0 0 0
7 7 8 0 0 0 1 1 1 4 3 3 0 0 0 1 5 6 0 0 06 0 0 0 7 0 0 0 0 1 0 0 0 0 8 6 0 0 0 -4 0 0 0
8 8 0 0 0 0 1 0 0 0 0 2 0 0 0 1 6 0 0 0 04 0 0 0 8 0 0 0 0 1 0 0 0 0 8 0 0 0 0 -6 0 0 0
 Optimal Decision Rule:

A profit maximizing firm operating in

perfectly competitive output and input
markets will be using optimal amount of an
input at the point at which the monetary
value of the input’s marginal product is equal
to the additional cost of using that input (L)

- in other words, when MRP = MLC

 Production in the Long-Run

– All inputs are now considered to be

variable (both L and K in our case)
– How to determine the optimal
combination of inputs?

To illustrate this case we will use production

isoquants.
An isoquant is a curve showing all possible
combinations of inputs physically capable of
producing a given fixed level of output.
 Production in the Long-Run

– All inputs are now considered to be

variable (both L and K in our case)
– How to determine the optimal
combination of inputs?

To illustrate this case we will use production

isoquants.
An isoquant is a curve showing all possible
combinations of inputs physically capable of
producing a given fixed level of output.
 Example 2 Production Table
Units of L
Employed Output Quantity (Q) Isoquant
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of K Employed
 An Isoquant
Gra ph of Isoqua nt

Y
7

0
1 2 3 4 5 6 7 X
 Substituting Inputs
There exists some degree of substitutability
between inputs.
Different degrees of substitution:
Corn Natural Capital
syrup flavoring

K1 K2 K3 K4
Q

Sugar All other L1 L2 L3 L4 Labor

ingredients

a) Perfect substitution b) Perfect c) Imperfect substitution

complementarity
 Substituting Inputs continued

• In case the two inputs are imperfectly

substitutable, the optimal combination of
inputs depends on the degree of
substitutability and on the relative prices of
the inputs
 Substituting Inputs continued
• The degree of imperfection is measured
with marginal rate of technical substitution
(MRTS):

MRTS = ∆ L/∆ K

(in this MRTS some of L is removed from

the production and substituted by K to
maintain the same level of output)
 MRTS = ∆ L/∆ K = - MPL/MPK
Units of L
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of K Employed
 Optimal Combination of Inputs
• Now we are ready to answer the question stated
earlier, namely, how to determine the optimal
combination of inputs
• As was said this optimal combination depends
on the relative prices of inputs and on the
degree to which they can be substituted for one
another
• This relationship can be stated as follows:
MPL/MPK = PL/PK
(or MPL/PL= MPK/PK)
 Isocost Curves
Example 3
Assume PL =$100 and PK =$200
Table 7.11 Input Combinations
for $1000 Budget
Combination L K
A 0 5
B 2 4
C 4 3
D 6 2
E 8 1
G 10 0
 Isocost Curve and Optimal
Combination of L and K
K

100L + 200K = 1000

5

“Q52”

10 L

Isocost and isoquant curve for inputs L and K

 Optimal Levels of Inputs

• The optimality conditions given in the previous

slides ensure that a firm will be producing in
the least costly way, regardless of the level of
output

• But how much output should the firm be

producing?

• Answer to this depends on the demand for the

product (like in the one input case as well)
 Optimal Levels of Inputs continued

The earlier rule, MRP =MLC, can be

generalized:
– a firm in competitive markets should use
each input up to the point where
Pi = MRPi
where
Pi = price of input i
MRPi = marginal revenue product of input i
So in two input case, firm’s optimality
condition is
PX = MRPX and PY = MRPY

A profit maximizing firm will always try to

operate at the point where the extra
revenue received from the sale of the last
unit of output produced is just equal to the
additional cost of producing this output.
This is same as
MR = MC
 Expansion Path: the locus of points which presents the
optimal input combinations for different isocost curves

The long-run situation:

both factors variable
Units of capital (K)

Expansion path

300
TC =
£60 000
TC =
TC = £40 000 200
£20 000
100
fig
O Units of labor (L)
 Returns to Scale
• Let us now consider the effect of proportional
increase in all inputs on the level of output
produced

• To explain how much the output will increase

we will use the concept of returns to scale
 Returns to Scale continued
• If all inputs into the production process are
doubled, three things can happen:
– output can more than double
• increasing returns to scale (IRTS)
– output can exactly double
• constant returns to scale (CRTS)
– output can less than double
• decreasing returns to scale (DRTS)
 Returns to Scale continued
An Example:

Units of L
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of K Employed

In this production process we are

experiencing increasing returns to scale
 Reasons for Increasing or
Decreasing Returns to Scale:
• Often we can assume that firms experience
constant returns to scale:

– for example doubling the size of a factory

along with a doubling of workforce and
machinery should lead to a doubling of
output
– why could a greater (or smaller) than
proportional increase occur?
 Reasons for Increasing Returns to
Scale:
• Division of labor (specialization)

• Indivisibility of machinery or more sophisticated

machinery justified

• Geometrical reasons

Decreasing returns to scale can result from certain

managerial inefficiencies:
– problems in communication
– increased bureaucracy
 Measurement of Returns to Scale
– Coefficient of output elasticity

percentage change in Q
EQ = percentage change in all inputs

So if, EQ>1, increasing returns

EQ=1, constant returns
EQ<1, decreasing returns
 Measurement of Returns to Scale
continued
– Multiplying the coefficients of the production
function:

If original production function is

Q = f(X,Y)
and if the resulting equation after the multiplication
of inputs by k is

hQ = f(kX, kY)
where h presents the magnitude of increase in
production
Then, if
h>k, increasing returns
h=k, constant returns
h<k, decreasing returns
• Graphically, the returns to scale
concept can be illustrated using the
following graphs

IRTS CRTS DRTS

Q Q Q

X,Y X,Y X,Y

 Constant Returns to Scale
4

3 R
c
600
Units of capital (K)

b 500
1

0 400
0 1 a 2 3

300

200

fig
Units of labor (L)
Increasing Returns to Scale (beyond point b)
4

3 R
c
700
Units of capital (K)

2
600
b
1
500

0 400
0 1 a 2 3

300

200

fig
Units of labor (L)
 Decreasing Returns to Scale (beyond point b)
4

3 R
c
500
Units of capital (K)

b
1

0 400
0 1 a 2 3

300

200

fig
Units of labor