CONCEPT OF PRODUCTION

THEORY OF PRODUCTION
• Production theory is the study of production
or the economic process of converting
inputs into outputs.
Production

Inputs Process Outputs

Resources Used Goods or

Services that are
produce
 CLASSIFICATION OF
FACTORS OF PRODUCTION
1. Fixed Factor – remain
constant regardless of the volume
of production.
2. Variable Factor – changes in
accordance with the volume of
production
The Production Function
- states the relationship between inputs and outputs

TYPES OF PRODUCTION FUNCTIONS

1. Short-run Production Function
- at least one factor of production is fixed in
supply, and the other factors are variable in
nature.

2. Long-run Production Function

- shows relationship between inputs and
outputs under the condition that both the
inputs, capital and labor, are variable factors.
SHORT-RUN PRODUCTION
FUNCTION
HYPOTHETICAL DATA OF PRODUCTION WITH ONE VARIABLE

(1) (2) (3) (4) (5) (TP) – Total Production

Points
LAND LABOR TP APL MPL (APL) – Average Product of
A 1 0 0 0 Labor
4 • Obtained by dividing TP
B 1 1 4 4
6 by units of labor used.
C 1 2 10 5 (MPL) – Marginal Product of
8 Labor
D 1 3 18 6
6 • The difference of qty in
E 1 4 24 6 column 3 divided by the qty
4 in column 2.
F 1 5 28 5.6
2 • Additional output
G 1 6 30 5
0 produced from additional
H 1 7 30 4.29 labor
-2
I 1 8 28 3.5
-4
J 1 9 24 2.67
 THREE STAGES OF PRODUCTION
35
30
25
20
15
TP
10
5
0
0 1 2 3 4 5 6 7 8 9
10
APL
8
MPL
6
4
2
0
-2 0 1 2 3 4 5 6 7 8 9
-4
-6
The shapes TPL, MPL and APL
• In panel B, APL increases initially then reaches its
maximum and then falls continuously
• APL doesn’t reach negative because TP doesn’t have
negative values.
• MPL is plotted midway between two points because
it is the slope of the TP curve.
• When the TP curve reaches its saturation, MPL is
zero , and at the declining portion of TP, MPL is
negative.
• The falling portion of the MPL is called law of
diminishing marginal returns
The Law of Diminishing Marginal
Returns
• If the variable factor of production is increased ,
there comes a point where it will become less
productive and therefore there will eventually
be a decreasing marginal and then average
product.

• This law only applies in the short run because,

in the long run, all factors are variable.
The Three Stages of Production
• It will help us
define the quantity
of labor(or other
input) that a profit
maximizing firm
will employ.

Stage I Stage II Stage III

Return to Scale
• What will happen to output if all inputs are increased
proportionally?
1. Increasing
return to scale -
the volume of
output keeps on
increasing with
every increase in
the inputs.
2. Decreasing
return to scale -
increase in the
inputs does not
lead to
equivalent
increase in
output, the
output increases
at a decreasing
rate.
3. Constant
return to scale -
the rate of
increase/decrease
in volume of
output is same to
that of rate of
increase/decrease
in inputs.
LONG-RUN PRODUCTION
FUNCTION
Isocost
• Shows all combinations of inputs which cost the
same total amount

• To find the least cost combination of inputs to

produce a given output, we need to construct
such equal cost lines or isocost lines.
EXAMPLE
Suppose a producer has P200
and he wants to spend his entire Mathematically, an
isocost line can be
outlay on two factors – labor expressed as
and capital. Further suppose C=wL+rK
Where,
that the price of Labor is P4 per C = cost of production
unit and the price of capital is w = price of labor or
wages
P5 per unit. If the firm spends L = units of labor
r = price of capital or
its whole outlay on labor only, interest rate
he can buy 50 units of labor. K =units of capital
And, if the firm spends its entire
outlay on capital only, then he
can buy 40 units of capital.
…..
A firm can purchase only such combinations of
factor-inputs which satisfy the given equation.

For example, a producer can purchase

combinations like
25 units labor + 20 units capital
30 units labor + 16 units capital
12.5 units labor + 30 units capital

…. because all of them fulfill the equation at given

prices and outlay.
• If we join points A and B,
we get isocost line for
P200. And, the straight
line which joins points A
and B will pass through
all combinations of labor
and capital which the firm
can buy with the outlay of
P200, if it spends the
entire sum on them at the
given prices.
Shift in Isocost Line
An isocost line may shift due to two reasons. They
are :
1. Change in total outlay to be made by the firm
2. Change in price of a factor-input
CHANGE IN OUTLAY

CHANGE IN PRICE
Isoquant
• A curve which shows the different combinations
of factors which yield the same level of output.

3 CHARACTERISTICS OF ISOQUANTS
1. Negatively sloped
2. Convex to the origin
3. Do not intersect
• The negatively sloped isoquant can be explained
through the diminishing marginal rate of
technical substitution (MRTS).
• MRTS is the amount of capital that a producer is
willing to give up in exchange for labor and still
lie on the same isoquant. That is ,

• Also, MRTS is equal to ratio of marginal product

of labor to the marginal product of capital, or
• An isoquant is convex to the origin because of
the diminishing MRTS, meaning a producer is
willing to give up less and less of capital to gain
additional amount of labor.

• Isoquant curves cannot be tangent or intersect

one another. Curves that intersect are incorrect
and produce results that are invalid, as a
common factor combination on each of the
curves will reveal the same level of output,
which is not possible.
 Example
Isoquant I Isoquant II Isoquant III
Points Labor Capital Labor Capital Labor Capital
(L) (K) (L) (K) (L) (K)
A 2 22 4 26 6 30
B 1 16 3 20 5 24
C 2 10 4 14 6 18
D 3 6 5 10 7 14
E 4 4.6 6 8.4 8 12.4
F 5 3.6 7 7 9 11
G 6 3.2 8 6.4 10 10.6
H 7 3.6 9 7 11 11
Computing for MRTS
Isoquant I Isoquant II Isoquant III
Points
(L) (K) MRTS (L) (K) MRTS (L) (K) MRTS
A 2 22 … 4 26 … 6 30 …
B 1 16 … 3 20 … 5 24 …
C 2 10 6 4 14 6 6 18 6
D 3 6 4 5 10 4 7 14 4
E 4 4.6 2.6 6 8.4 1.6 8 12.4 2.4
F 5 3.6 1 7 7 1.4 9 11 1.4
G 6 3.2 0.4 8 6.4 0.6 10 10.6 1.6
H 7 3.6 9 7 11 11
Finding Producer’s Equilibrium
• A producer is 32
30

in equilibrium 28
26
graphically 24
22
when, given 20

his total outlay 18

16

and the factor 14

12
c

prices, the 10 b
8
producer 6 a

maximizes the 4
2
Isocost I Isocost II Isocost III
production. 0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
• At the points of tangency, the absolute slope of
the isoquant and isocost are equal. That is,

MRTS = PL / PK

Since MRTS = MPL / MPK, at equilibrium,

MPL = PL
MPK PK
Checking the Derived Producer’s
Equilibrium
• To check , the following conditions must be
satisfied :
𝑇. 𝑂 = 𝐾𝑂 𝑃𝐾 + 𝐿𝑂 𝑃𝐿
Where:
T.O = total outlay
KO = equilibrium capital
PK = price of capital
LO = equilibrium level of labor
PL = price of labor
Expansion Path
• An expansion path
shows the collection of
producer’s equilibrium
caused by varying total
outlay while keeping Expansion Path

factor prices
unchanged. By joining
the different producer’s
equilibrium, we get the
firm’s expansion path
given.