CHAPTER SIX

THE THEORY AND ESTIMATION OF PRODUCTION

For the manager of a profit-maximizing firm, seeking the maximum total

revenue may not ensure attaining maximum profits. Profit is the difference
between total revenues and total costs.

Total revenue depends on price and quantity.

For a given price, under competition, a successful manager should aim at

two intermediate targets leading to the final target of profit maximization:

o First, in the short run, to choose the optimal quantity of each input
o Second, in the long run, to choose the optimal size of the firm or the
production capacity that minimizes the cost

The manager will be able to tackle these targets only if he has enough
and accurate knowledge concerning the production function or the input
output relationships, and that is the focus of this chapter.

The first part of the chapter introduces the production function in short
run and long run, while the second part of the chapter is concerned with
the estimation of the production function.

The Production Function:

What level of output should the firm produce depends on the

production function it has, among other things.

The production function is the technical relationship, which shows the

maximum attainable production levels using different combinations of
input at a given state of technology within a given period of time.

Mathematically, the production function can be expressed as

Q = f (L, K, N, T, )

Where Q is level of output produced; L is the number workers (including

entrepreneurship); K is the capital; N is land; T is the state of
technology; and refers to other inputs used in the production process

The relationship between inputs and output assumes:

a. Fixed state of technology
b. Efficient use of input combinations
c. Given time period

For simplicity we will often consider a production function of two inputs:

labor and capital. Labor and capital are both composite inputs that
include all other factors of production, so, the production function is
normally written in the follows implicit form:
Q = f (L, K)

Production depends on the time-frame in which the firm is operating

(short run and long run)

The short-run production function shows the maximum quantity of

good or service that can be produced by a set of inputs when at least one
of the inputs used remains unchanged.

The long-run production function shows the maximum quantity of good

or service that can be produced by a set of inputs, assuming the firm is free
to vary the amount of all the inputs being used.

Short-Run Analysis of Total, Average, and Marginal Product

We use alternative terms in reference to inputs such as factors,

factors of production, and resources

Also alternative terms are usually used in reference to outputs

such as quantity (Q), total product (TP), and product

The relationship between output and the quantity of labor employed,

assuming fixed capital, can be described using the following three
concepts:

Total product , Marginal product , Average product

Total Product:

Total product is the total output produced in a given period.

In the short run, the total production curve shows the maximum
output produced using a certain set of variable inputs (as labor and
row materials) in addition to one or more of fixed inputs (as the
size of the plant, equipments, area of land).

However, because of our assumption for simplicity, the production

function depends only on labor and capital. Hence, to increase output
in the short run, a firm must increase the amount of labor employed.

The total product curve shows how total product changes with the
quantity of labor employed

The area below TP curve is attainable at every level of labor, while the
area are above TP is unattainable.

Example:
To understand the nature of the relation between the different
measures of production in the short run, let us take a simple example
of a small farm where capital (area of the farm, water well, and
equipments) is fixed, and the number of workers is the only variable
input.

Under these set of assumptions, total production (TP), marginal

Product (MP), and average product (AP), may be represented by the
following hypothetical values:
Number of

Total

Marginal

Average product of

Workers

Product

Product of labor

labor

(L)

(TP)

(MPL)

(APL)

0
1
2
3
4
5
6

0
8
18
29
39
47
52

--------8
10
11
10
8
5

--------8
9
9.67
9.75
9.4
8.67

7
8

56
52

4
-4

8
6.5

From the table above, you may notice that total product increases as more
workers are hired. First, total product increases at high speed making big
jumps, then it slows down but still in creasing as it approach its maximum,
then total product starts to decrease as more labor are employed.

In scientific terms we may describe the behavior of the total product in the
short run by saying that, TP increases first at an increasing rate to reach an
infliction (turning) point, after that it keeps increasing but at a decreasing
rate until it reaches its maximum level, then it starts to fall.

The following graph reflects these phases of production:

TP

Stage I
TP_, AP_,
MP_ then_,
MP > AP
a

Stage
II

Stage III

TP_, AP_,
MP_,
MP < AP
MP > 0

TP_, AP_,
MP_,
MP < AP
MP < 0

TP

AP
L
0

L1

L2
MPL

The Marginal Product:

The marginal product of labor (MPL) is the change in output (or Total
Product) that results from a one-unit change in the variable input
(quantity of labor employed), or one additional hour of work, with all
other inputs remaining the same.
MP =
L

Change in total output

= TP = Q
Change in the quantity of labor
L L

Graphically, MPL measures the slope of the total product curve.

As you see in the graph above, the slope of the TP curve starts very
close to zero at the origin, then increases (production speeds up) to
reach its
maximum at the infliction (turning) point (point a) on the TP curve, where
MPL curve reaches its maximum. The slope of TP curve decreases
gradually (production slows down) to reach zero at L 2 as MPL falls to

intersects the L axis. Total product starts to fall from there on as the slope
of the MPL curve become negative.

From the above table notice how the Marginal product of labor increases
to reach its maximum of 11, then falls after that to take a negative value
where total product starts to fall.

Almost every production process has two features: initially, increasing

marginal returns (IMR), and eventually diminishing marginal returns (DMR).

Initially increasing marginal returns

o

When the marginal product of a worker exceeds the marginal

product of the previous worker, the marginal product of labor
increases and the firm experiences increasing marginal returns.

Increasing

marginal

returns

arise

from

increased

specialization and division of labor.

Then, diminishing marginal returns

o

Diminishing marginal returns arises from the fact that

employing additional units of labor means each worker has less
access to capital and less space in which to work.

o Diminishing marginal returns will start to take effect, when MP

starts to decrease.
o Diminishing marginal returns are so pervasive that they are
elevated to the status of a law.
o The law of diminishing returns states that as a firm uses more
of a variable input with a given quantity of fixed inputs, the
marginal product of the variable input at some point will
eventually falls, where each additional unit contribute less
production than the preceded unit.
o

The law of diminishing returns is a short run concept that describes

the change in the marginal product of the variable input.

It is important to keep in mind that all units of the variable input are assumed
of equal productivity, and the only reason for variations in its marginal
product (productivity) can be attributed to its order in utilization in the
production process.

Referring to our previous example, at some early stage you may notice
increasing returns, where the MP curve has a positive slope. The reason
here is clear because the larger the number of workers is the higher the
productivity of individual workers due to specialization and teamwork
privileges.

As more workers are added to the same quantity of the fixed input, at some
point diminishing returns will be in effect due to crowdness in the work place,
and inadequacy of the fixed input, as the number of workers increase each
worker will have less fixed input.

In general:
o
o

When MP is_, firm is experiencing increasing marginal returns.

When MP is_ but positive, firm is experiencing diminishing
(decreasing) marginal returns.

When MP is_ and negative, firm is experiencing negative

marginal returns.

The Average Product:

The average product of labor (AP L) refers to the share of each worker in
the total production.

It is equal to total product divided by the quantity of labor employed. It is

the total Product per unit of input used.
APL =

TP

L
L =

Q
L

The relationship between TP and MP

Because of IMR, TP increases initially at increasing rate. Then, because of

DMR, TP increases at decreasing rate.

The point that TP change its pace from increasing at increasing rate to
increasing at decreasing rate (i.e., the point where DMR start its course) is

called the turning point. When TPL is at its turning point MPL is at its
maximum,
1. If MPL is increasing and positive, TPL is increasing at increasing rate
2. If MPL is decreasing and positive, TPL is increasing at decreasing rate
3. If MPL = 0, TPL is at its maximum
4. If MPL < 0, TPL is decreasing

The relationship between AP and MP

When MP > AP (MP Curve above AP Curve), then AP is rising

o If your marginal grade in this class is higher than your grade point
average, then your GPA is rising

When MP < AP (MP Curve below AP Curve), then AP is falling

o If your marginal grade in this class is lower than your grade point
average, then your GPA is falling

When MP = AP, (MP Curve intersect AP Curve) then AP is at its maximum

o

If your marginal grade in this class is similar to your grade point

average, then your GPA is unchanged

The Three Stages of Production in the Short Run:

The relationship between TP, MP, and AP can be used to divide the SR
production function into three stages of production.

Stage I:
o

Starts from zero units of the variable input to where AP is maximized

(where APL = MPL).

o
o

At this stage, AP is rising.

In our example, stage I ends where four workers are being hired at
L1 on the figure above.

For a profit-maximizing firm, it is irrational to limit production to any

level within the first stage. The rising AP throughout this stage
causes the average cost to fall and profits to rise as production
expands.

Stage II:

From the maximum AP to where MP=0 (or TP is maximized).

At this stage, AP declining but MP is positive.

In our example, Stage II is between L1 and L2 levels of employment.

This is the rational stage of production, over which the firm
manager has to figure out the optimal number of workers that
maximizes profits.
Stage III:
o

From where MP=0 (or TP is maximum) onwards.

At this stage, MP is negative or TP is declining.

In our example, Stage III starts at L2 (MPL = 0) and above.

o Production in this stage is also irrational because the firm incurs
o

higher costs to hire more workers; while the total revenue is falling
as TP decreases.
At which stage should the firm operate?

According to economic theory, in the short run, firms should operate in

Stage II. Specialization and team work continue to add more output
when additional variable input is used. Fixed input is being properly
utilized efficient use of resources

Why not Stage I?

o

Stage I indicates that the fixed input is underutilized since AP_ as

more and more of the variable input is used i.e., can increase output
per unit by increasing the amount of the variable input inefficient
use of resources

Why not Stage III?

o

Firm uses more of its variable inputs to produce less output. Fixed
input is over utilized or overused inefficient use of resources

Optimal level of the Variable input:

Given that Stage II is the best for profit-maximizing firm, then what is the
optimal level of variable input should the firm use? In other words, at
which point on production function should the firm operate?

The answer depends upon: how many units of output the firm can sell, the
price/ of the product, and the monetary costs of employing the variable
input.

The Optimal quantity of the variable input is the quantity that allows
the firm to maximize its profits.

The question facing the manager is: what is the optimal number of workers?

To make things easy, let us assume that the firm buys its inputs and sell its
products in competitive markets, which means, it can hire any number of
workers at the market going wage (W) and sell any quantity of its product
at the market going price (P).

Now we may present the firm profit function in the following form:
= TR TC = PXQ (FC + WL)
Where: P is the Price of the good which is assumed constant, Q is the total
product, FC is the fixed input cost, W is the labor wage which is assumed
constant, and L is the number of workers.

Now, the question is: how many workers the firm should hire in order to
maximize its profits?

P * MP = W

Which says that, the optimal number of workers is that number at which the
value of the marginal product of labor is equal to the market wage rate; or
at which the marginal revenue product of labor (MRPL) equals the
marginal labor cost (MLC).

Total revenue product (TRP) refers to the market value of the firms
output, computed by multiplying the total product by the market price (Q * P)

Marginal revenue product of labor (MRPL) is the change in the market

value of the firms output resulting from one unit change in the number of
workers used (UTRP/UL). It can be also computed by multiplying the
marginal product by the product price (MP *P)

Total labor cost (TLC) refers to the total cost of using the variable input,
labor, computed by multiplying the wage rate (which assumed to be fixed)
by the number of variable input employed (W * L)

Marginal labor cost (MLC) is the change in total labor cost resulting from
one unit change in the number of workers used

Because the wage rate is assumed to be constant regardless of number

of inputs used, MLC is the same as the wage rate (w).

If MRPL > MLC increase _ as L increase

If MRPL < MLC decrease _ as L increase

If MRPL = MLC is maximum optimal input level

In summary, A profit-maximizing firm operating in perfectly competitive

output and input markets will be using the optimal amount of an input at the
point in which the monetary value of the inputs marginal product is equal to
the additional cost of using that input (MRP = MLC) or (MRP = wage rate)

As you may notice here again we are comparing marginal revenues and
marginal cost. Therefore, the decision rule is to hire more workers as long as
the value of the production contributed by the additional worker (P*MPL)
exceeds the cost of hiring an additional unit of labor which is equal to the
wage (W) paid to worker, under competition in the labor market.

The Optimal Mix of Variable Inputs:

Suppose the firm production function has more than one variable input in
the short run. In order to maximize profits, the manager has to choose the
quantities of each input that will minimize cost.

Let the production function be as follows:

Q = f (X, Y, K),
Where X and Y are the two variable inputs

Let CX is the cost of X and CY be the cost of Y, while PQ is the price of the
firm output.

For simplicity let us assume that the firm buys its inputs and sell its product
in competitive markets, where the firm can buy or sell any quantities at a
constant price.

MPx = MPy
Cx

Cy

Thus, the optimal condition for a profit-maximizing firm employing two variable
inputs X and Y is attained where the ratio of the marginal products of the variable

inputs is equal the ratio of their costs. Or, the marginal product of X to its cost
must be equal to the marginal product of Y to its cost.

In other words, the marginal product per the amount of money spent on X
must be equal to the marginal product per the amount of money spent on Y.

To get a better understanding of this condition, let us solve the following

simple example:

Example:
o Suppose you are the production manager of a company that makes
computer parts in Malaysia and Algeria.
o

At the current production levels and inputs utilization you found that:
Malaysian marginal product of labor (MPM ) =18 Units
Algerian marginal product of labor (MPA ) = 6 Units
Wage rate in Malaysia Wm = $ 6/hr
Wage rate in Algeria WA = $ 3/hr

o In which country should the firm hire more workers?

Solution
o

Looking at the wage rates you might be tempted to hire more workers
and expand production in Algeria, where wages are relatively lower.

However, production theory suggests that the firm should not only look at
inputs cost but also to the MP of each input relative to the cost.

By examining the marginal product per dollar in each country, you will
find that:
MPM = 18 = 3 > MPA = 6 = 2 ;
$6
$3
W
W
M

Which means that: an additional dollar spent on labor in Malaysia would

yield 3 units, but would yield only 2 units if spent in Algeria.

Example:
o

Suppose labor and capital are both variable inputs and some other input
such as land is fixed, and suppose that
MPL = 12 units, MPk =24, w =$6 and r = $8,

Solution
o

MPL /w = 12/6 =2 spending one additional dollar on labor gives two

units of output

MPK /r = 24/8 = 3 spending one additional dollar on capital gives

three units of output

So use more capital and less labor since capital is cheaper per dollar
spent than labor (capital is more productive)

o Bur, as more capital is used its MP_, and as less labor is used its MP_. o
This will continue until the two ratios are equal.
o

Suppose MPL _ to 15 and MPK _ to 20, then

MPL/w = 15/6 = 2.5 and MPK/r = 20/8 = 2.5

The Long-Run Production Function

As you know by now, the long run is a period of time long enough to allow
the firm to change all its inputs. Effectively, all inputs are variable.

As the firm increases all its inputs in the long run, it actually changes the
scale of its production activity.

The total elasticity of production, the increase in production in response

to the firm proportional increase in the scale of the production process is
called returns to scale.

If all inputs into the production process are doubled, three things can
happen:
1. Output can be more than double, increasing returns to scale.

A larger scale of production allows the firm to divide tasks into more
specialized activities, thereby increasing labor productivity. It also
enables the firm to justify the purchase of more sophisticated (hence,
more productive) machinery. These factors help in explaining why
the firm can experience increasing returns to scale.
2. Output can exactly double, constant returns to scale.
3. Output can be less than double, decreasing returns to scale.

Operating on a larger scale might create certain managerial

inefficiency (e.g., communication problems, bureaucratic red tape)
and hence cause decreasing returns to scale.

Graphically, the returns to scale concept can be illustrated using the

following graphs.
Q

IRTS

CRTS
Q

X,Y

DRTS
Q

X,Y

One way to measure returns to scale is to use a coefficient of output

elasticity:
EQ =

% Q
% in all inputs

o If EQ > 1, production function shows increasing returns to scale (IRTS) o If

EQ = 1, production function shows constant returns to scale (CRTS)

o If EQ < 1, production function shows decreasing returns to scale (DRTS)

Example:

If Q = 5L + 7K; and L = 10 & K = 10 Q1

= 5(10) + 7 (10) = 120 units
Now if each input increases by 25%, then L = 12.5 & K = 12.5 Q 2
= 5(12.5) + 7 (12.5) = 150 units
%UQ = (150 - 120)/120= 25%
A 25% increase in L & K led to a 25% increase in Q CRTS

Example:
Q = 50X + 50Y +100
X = 1, Y = 1 Q 50(1) + 50 (1) +100 = 200 If X
=2, Y = 2 Q 50(2) + 50 (2) +100 = 300 %UQ =
(300 - 200)/200 = 50%
%U in all inputs = 100%
EQ = 50%/100% = 0.5 < 1 DRTS

Choosing the Optimal Capacity: (Reading)

Production levels do not depend on how much a company wants to

produce, but on how much its customers want to buy.

Although the manager may be well informed about the three stages of
production for his firm, in the short rum, he might realize that the market
demand is consistently lower than expected.

Capacity Planning: refers to the planning the amount of fixed inputs that
will be used along with the variable inputs. Good capacity planning
requires:
o

Accurate forecasts of demand

o Effective communication between the production and marketing

functions

Suppose the firm is forced to produce in the first stage as a result of the
inadequate demand in the short run. In this case the firm is underutilizing
its capacity or its fixed inputs, in other words, the firm would have excess or
idle capacity. Fixed costs are the cost of fixed inputs, that part of the firm
total cost, which is independent of the level of production. A firm producing
in stage one with some idle capacity, would have high average cost (per
unit cost), and therefore, will not maximize profits.

In the long run, such firm should consider reducing its production
capacity to the optimal size that enables it to maximize profits

By the same token, a firm facing a growing demand beyond its production
capacity should consider expanding its capacity in the long run to meet
the market demand while producing in the rational range that would allow
maximum profits.