Theory of Production

PART I

Prepared by: Glenn H. Sadiangcolor

Economics Asst. Prof.
Describe this Photo…
Production Comes from Different
Industries…
The Theory of Production

A hen is only an egg’s way to

making another egg.

***Samuel Butler
Concept of Production

Goods Services

&

Basically, goods and services cannot be

produced without utilizing the factors of
production.
Theory of Production

 Itis the fundamental decision of the firm to

determine the amount of goods and services
to produce and how much factors of
production to apply together with other
inputs to generate an output with the highest
level of efficiency.
Definition of Firm

 A firm is the small business unit involved in

producing the profit.
 Business (company, enterprise or firm) is a
legally recognized organization designed to
provide goods or services, or both, to
consumers, business and governmental
entities.
 Businesses are predominant in capitalist
economies.
The Theory of Production

 This chapter deals with the general

discussion of production theory with the
specific case where there is one variable input
depicting :
 1. The Law of Diminishing Marginal Returns
 2. Three Stages of Production
 3. Return to Scale
Definition of Production

 Production is the transformation of inputs

into outputs.
 Inputs are the factors of production or
resources.
 Output is the result that has been created by
the inputs (in this case, when labor and
capital are combined).
 There are two types of output:
 (a) goods and (b) services
Production Output

OUTPUT

Output is the result that has been created by

the inputs (labor and capital are combined)
Production

Economic theory of firm begins with the theory

of production.
Firm

Buy Convert to Sell these

Inputs Outputs Outputs

Consumers
Factors of Production

 Land
 Labor Inputs of
 Capital Production
 Entrepreneurship
Concept of Production

The theory involves some of the most

fundamental principles of economics. These
include the relationship between the prices of
commodities and the prices of the productive
factors used to produce them and also the
relationships between the prices of commodities
and productive factors, on the one hand, and the
quantities of these commodities and productive
factors that are produced or used, on the other.
Classifications of Production Factors

Two Classifications of Factors of Production

 Fixed Factor
- Remains constant regardless of the volume of
the production.
 Variable Factor
- Changes in accordance with the volume of
production
Two Types of Output

 Goods
 Services

 The quality and quantity of labor and capital and all other
inputs have a direct impact on the quality and quantity of
outputs.
 The technology of a firm is the process by which inputs are
turned into outputs
Sample Illustration I
Sample Illustration II
Production Function

The production function shows the relationship

between quantities of various inputs used and the
maximum (technically feasible) output can be produced
with those inputs used per unit of time expressed in a
table, graph or an equation.
The Short-run Vs. Long-run Analysis of
Production
Short-run Analysis of Production
 The use of at least one factor of production
cannot be changed or there are fixed inputs.

Long-run Analysis of Production

 All factors can be changed.

Note: The difference is not based on time but on the production

inputs and the time factor is dependent across firms and
industries.
The Short-run Vs. Long-run Analysis of
Production
In the simplified case of plant capacity as the only fixed factor, a
generic firm can make these changes in the long run:

 Enter an industry in response to expected profits

 Leave an industry in response to losses
 Increase its plant in response to profits
 Decrease its plant in response to losses
The Short-run Vs. Long-run Analysis of
Production
All production in real time occurs in the short run. In the short run, a profit-
maximizing firm will:

 Increase production if marginal cost is less than marginal revenue

(added revenue per additional unit of output)
 Decrease production if marginal cost is greater than marginal value
 Continue producing if marginal variable cost is less than price per unit,
even if average total cost is greater than price
 Shut down if average variable cost is greater that price at each level of
output
The Short-run Vs. Long-run Analysis of
Production
Example:

A laundry business can be adjusted in a month or two, but

for Isuzu Motors Philippines capital adjustment could
take two or three years. However, both businesses with
no reference to time horizon still cannot adjust some of
their inputs within that time period.
 Table 5.1
Hypothetical Data of Production with One Variable

Points (1) (2) (3) (4) (5) Average

Land Labor Total Marginal Product
Product Product
A 1 0 0 0 0
B 1 1 4 4 4
C 1 2 10 6 5
D 1 3 18 8 6
E 1 4 24 6 6
F 1 5 28 4 5.6
G 1 6 30 2 5
H 1 7 30 0 4.29
I 1 8 28 -2 3.5
J 1 9 24 -4 2.67
Three Stages of Production
Take note: It is important to describe the three stages of
production because these will help us define the quantity of
labor (or any other input) that a profit maximizing firm will
employ.
Stage I of production starts at the origin until the highest portion of AP of
labor. The TP increases at an increasing rate whereas both AP of labor and
MP of labor increase.
Stage II goes from the highest portion of AP of labor until MP of labor is
zero. The TP increases at a decreasing rate and the AP of labor and the MP
of labor decrease.
Stage III of production begins where MP of labor is zero until its negative
range. The TP decreases and the AP of labor is also decreasing but still
positive while MP of labor is already negative.
Therefore, State II of production is the most favourable stage because the
MP of labor and AP of labor are both positive though declining.
 The Law of Diminishing Marginal Returns

 It states that as one input variable is

increased, there is a point at which the
marginal increase in output begins to
decrease, holding all other inputs constant.
 *The law of diminishing marginal returns describes a pattern
in most production portion in the short run . By holding one
of the inputs constant except for one (it may be capital or
labor) and continually increasing the other input, a certain
point will be arrived at wherein the rate in the increase of
output will fall. It says that output will decrease even if there is
an increase in one of the inputs.
The Law of Diminishing Marginal Returns
Returns to Scale
 Return to scale describes the rate of increase
in production relative to the associated
increase in the factors of production in the
long run. At this point, all factors of
production are variable (not fixed) and can
scale. Therefore, the scale of production can
be changed by changing the quantity of all
factors of production.
Returns to scale VS Economies of scale

 Return to scale focus only on the relation

between input and output quantities.
 Economies of scale shows the effect of an
increased output level on unit costs.
Production with Two Variable Inputs

When more than one input level is

free to be altered, a firm faces the
question of what is the best input
combination to use.
 ISOCOST
 It shows the different combinations of capital
(K) and labor (L) that producers can purchase
or hire given their total outlay and the factor
prices.
Questions???
End of Part I…

Thank you!