CHAPTER THREE

3. THEORY OF PRODUCTION
3.1Introduction
In the last two chapters, we focused on the demand side of the market-the
preferences and behavior of consumers under uncertain and certain information.
Now we turn to the supply side and examine the behavior of producers. We will
see how firms can organize their production efficiently and how their costs of
production change as input prices and the level of output change. We will also see
that there are strong similarities between the optimizing decisions of firms and
those of consumers-understanding consumer behavior will help us understand
producer behavior.
3.2Technological Relationship between Inputs and Output
In the production process, firms turn inputs, which are also called factors of
production, into outputs (or products). For example, a bakery uses inputs that
include the labor of its workers; raw materials, such as flour and sugar; and the
capital invested in its ovens, mixers, and other equipment to produce such outputs
as bread, cakes, and pastries.
We can divide inputs into the broad categories of labor, materials, and capital,
each of which might include more narrow subdivisions.
Labor inputs include skilled workers (carpenters, engineers) and unskilled workers
(agricultural workers), as well as the entrepreneurial efforts of the firm's managers.
Materials include steel, plastics, electricity, water, and any other goods that the
firm buys and transforms into a final product.
Capital includes buildings, equipment, and inventories.
The relationship between the inputs to the production process and the resulting
output is described by a production function. A production function indicates the
output Q that a firm produces for every specified combination of inputs. For
simplicity, we will assume that there are two inputs, labor Land capital K. We can
then write the production function as
Q = F(K, L)
This equation relates the quantity of output to the quantities of the two inputs,
capital and labor. For example, the production function might describe the number
of personal computers that can be produced each year with a 10,000 square-foot
plant and a specific amount of assembly-line labor employed during the year. Or it
might describe the crop that a farmer can obtain with a specific amount of
machinery and workers.
The production function allows for inputs to be combined in varying proportions to
produce an output in many ways. For example, wine can be produced in a labor-
intensive way by people stomping the grapes, or in a capital- intensive way by
machines squashing the grapes. Note that equation given above applies to a given
technology (i.e., a given state of knowledge about the various methods that might
be used to transform inputs into outputs). As the technology becomes more
advanced and the production function changes, a firm can obtain more output For a
given set of inputs. For example, a new, taster computer chip may allow a
hardware manufacturer to produce more high speed computers in a given period of
time.
Production functions describe what is technically feasible when the firm operates
efficiently; that is, when the firm uses each combination of inputs as effectively as
possible. Because production functions describe the maximum output feasible for a
given set of inputs in a technically efficient manner, it follows that inputs will not
be used if they decrease output. The presumption that production is always
technically efficient need not always hold, but it is reasonable to expect that profit
seeking firms will not waste resources.
Not all firms will be producing the maximum output Q that is possible from given
inputs L and k at any point in time. There are two main reasons for that to be so:
 Some firms may be inefficient in that they incur undue costs to produce a
certain desired level of output.
 Different firms have machines and equipment of different vintages. Not all
firms will utilize the latest technology.
Thus, the more efficient firms and those using the latest technology will be
producing more output than other firms even for the same levels of measured
inputs.
A single production function cannot exist for all firms. We will consider a typical
firm and study the relationship between its inputs and output. We also consider a
given state of technology.
We will first consider a production process with a single variable input and then
consider two inputs and substitution between them subsequently.
3.3Fixed Vs. Variable Inputs and
Short run Vs. Long Run Production Periods

Input are classified into fixed inputs, the supply (quantity) of which cannot be
changed over a short period of time and variable inputs the quantity of which can
be varied in the short-run.

The most important fixed inputs in the land, capital, plant and equipment
whereas labor and raw materials are instances of variable in short-run are put in the
short-run .The short run refers to a period of time in which one or more factors of
production cannot be changed.

Factors that cannot be varied over this period are called fixed inputs. A firm's
capital, for example, usually requires time to change-a new factory must be
planned and built, machinery and other equipment must be ordered and delivered,
all of which can take a year or more. The long run is the amount of time needed to
make all Inputs variable.

In the short run, firms vary the intensity with which they utilize a given plant and
machinery; in the long run, they vary the size of the plant. All fixed inputs in the
short run represent the outcomes of previous long-run decisions based on firms'
estimates of what they could profitably produce and sell.
There is no specific time period, such as one year, that separates the short run from
the long run. Rather, one must distinguish them on a case-by-case basis. For
example, the long run can be as brief as a day or two for a child's lemonade stand,
or as long as five or ten years for a petrochemical producer or an automobile
manufacturer.

3.4 Production with a single variable input

Let’s suppose that the production of maize require land, fertilizer, water
machinery, etc.--, all fixed at certain quantities. The only input the producer can
adjust is labor. Thus, labor is the only variable input. If labor input (measured in,
say, worker/days) is 0, the output of maize is, off course 0. As we increase the
variable input (labor input), the producer will increase the output of maize. But, a
point will come where increasing labor will not increase the output of wheat at all
and, in fact, might even decrease it. This can be understood form Table 3.1 below
Units of labour Total product Average product Marginal
(Number of (Output/unit) (Output/unit) Product
workers)
0 0 - -
1 100 100 100
2 220 110 120
3 360 120 140
 4 480 120 120
5 530 106 70
6 570 95 40
7 595 85 25
8 595 74 0
9 580 64 -15
10 520 52 -60
Table 3.1 Total Product, Marginal Product, and Average Product for
Different Levels of Input (Labour)

The above tabular expression of and product concepts are depicted by way of a
diagram below:
Stage II

Stage III
Stage I

(a) 500
400
l, average and marginal products
300
200
B CC
100 TPL
0

Units of labour
1 2 3 4 5 6 7 8 9 10
MPL,
APL
MPL1
APL

APL

(b)
MPL

Units of labour
0 3 4 8 9
e Units of labour
Fig. 3.1 Relationship between TPL, APL, and MPL curves and the three stages of
production

From table 3.1 and Fig 3.1 above, the following production concepts need to be
defined:

1) Total physical product (TPPL) is the maximum quantity of output produced

and measured in physical units by the employees of the variable input,
holding all other inputs constant.

2) Average physical product (APPL) is total product divided by the units of

labour employed. Mathematically, APP = TPP/L.

3) Marginal physical product (MPPL) is the extra product resulting from one
extra units of labour input, keeping all other inputs constant. That is MPPL =
TPP/L.MPPL is the shape of the TPP curve.

Note that average product and marginal product can be defined for any input into
the production process.

Relationship between the MP and TP Curves

MPL is equal to TP/L. So graphically it is the slope of the TP curve. In general

the following relations can be established between TP and MP curves.

1) When TPP is increasing at an increasing rate, MPP is increasing. That is, if

MPP > 0, TPP will be rising as labour input (L) increases. Here, the
additional labour contributes more to output.
 2) When TPP is increasing at decreasing rate, MPPL is falling. Here too, MPP
> 0 and the additional labour odds something to output.

3) When TPP is maximum and contrast (neither increasing nor decreasing mpp
is zero. This means the additional labour does not affect output.

4) When TPP itself declines the MPPL becomes negative. Thus, MPPL< 0, and
TPP will be falling as labour input increase. The additional labour actually
reduces output.

Therefore, the total product curve reaches its maximum when MPPL = 0 and then
starts declining when MPPL< 0.

Relationship between MPPL and APPL

1) If MPPL> APPL, the latter will be rising as labour input (L) increases. This is
in stage I of production.

2) If MPPL< APPL the latter will be stage II and III of production (L) increases.
This the case in stages II and III of production.

3) If MPPL = APPL, the latter will be at its maximum. This is point e on Fig 3.2,
panel (b).
 The three stages of production

Based on the behaviour of MPPL and APPL economists have classified production
into three stages. These stages are marked on Fig 3.2, upper panel of the diagram
(panel a).

1. State I: It starts from the point where TPP is zero to the maximum point of
APPL. Here, the average product per worker increases. Two or three
workers produce more than twice as much as one worker with the same
tools. Here, total product increases at an increasing rate. This is the stage
of increasing returns to labor.
2. Stage II: Total product continues to increase, but at a diminishing, rate. In
this stage, both average and marginal products are declining.
Marginal product, being below the average product, pulls the average
product down. Indeed, marginal product reaches zero at the end of the stage
II corresponding to the maximum total product. This stage is the stage of
diminishing return to labor input.
Thus, stage II begins where MPPL and APPL are equal and ends where
MPPL is zero.
3. Stage III: Total product declines and this cause the marginal produces to be
less than zero (negative).
This stage is called the stage of negative return to labor input.
Rational Decision of Production
No profit-maximizing producer would produce in stages I or III.
 In stage I by adding one more unit of labor, the producer can increase
the average productivity of all the units. This it would be unwise on
the part of the producer to stop production in this stage. This is so too
 much fixed inputs triggering underemployment of the variable input
and underutilization of the fixed inputs. Thus, the rational producer
always has an incentive to expand employment of the variable input
and expand the level of output in stage I. Of course,
 MPPL> 0 and MPPL> APPL is stage I.

As for III, it does not pay the producer to operate in this stage because by
reducing the labor input he/she can increase total output and save the cost of a
unit of labor. In this stage, there is too much labor in relation to the fixed
inputs. Here, there is over employment of the variable input and over
utilization of the fixed inputs. Therefore, some of the workers also redundant
that they must be removed from the job in order that the firm generates more
output. I stage is characterized by MPPL< 0.

Thus, stage II is the only economically meaningful stages from the viewpoint of a
rational producer whose objective is maximizing output from the productive
inputs. This because it is the stage where labor employment brings maximum
products.

This stage is characterized or by MPPL> 0 and MPPL< APPL at latter stage of stage
II (see Fig. 4.2 panel b).
 4. The Law of Diminishing (Marginal) returns.

This is referred to as the law of diminishing marginal productivity (the law

of diminishing marginal returns). It is also called the law of variable
proportions. The law of variable proportions (the law of diminishing
marginal returns) states that if the quantity of the variable input in applied to
a fixed quantity of other inputs, output per unit of the variable input will
increase, but beyond some point, the resulting increase will be less and less,
with total output reaching a maximum before it finally begins to decline.
The law of diminishing returns commences to operate with the worker (at
point A) in Fig 3.2. This point (Point A) third is called the point of inflexion
because beyond this point, the MPPL commences to drop.

 Referring back to Table 3.1 and Fig. 3.2, there are increasing returns
to labor for the first three units of labor employed. The law of
diminishing returns sets in with the third worker. In some cases, the
law of diminishing returns is also intuitively plausible. Remember
that capital, land other inputs except labour are fixed. Eventually,
additional workers will not have a tractor, shovel, etc to works with.
Hence, they will add loss to output than earlier workers, who had
access to ample quantities of the other inputs.

It is worth nothing that the law of diminishing returns is based on the

assumption that the workers have equal efficiencies and are therefore
interchangeable. The law of diminishing (marginal) returns in exactly
symmetrical with the law of diminishing (marginal) utility in consumer theory.

4. Production with Two Variable Inputs: Production Isoquant

 a. So far we have indicated a single variable factor of production labor
consider now the case of two variable factors of production labor and
capital with two variable inputs, we have the following results:

Output is maximized when marginal products of both labour and capital are
zero. Denoting these by MPL and MPk respectively, we have MPL = MPK = 0.
Note that MPK is the increase in TP due to a one-unit increase in capital (K),
holding labour constant.
i. Price of labour = value of MPL
ii. Price of capital = value of MPK

EQUILIBRIUM OF THE FIRM: CHOICE OF OPTIMAL COMBINATION

OF FACTORS OF PRODUCTION

In the long-run, a rational producer may have two alternative goals-either

maximizing output for a given cost outlay or minimizing cost subject to a given
level of output. Both these decisions comprise cases of constrained optimization
(constrained profit maximization or cost minimization) in a single period. This is
also based on the criterion of economic efficiency.

In all the above cases it is assumed that the firms can chouse the optimal
combination of factors, that it can employ any amount of any factor in order to
maximize its profits.
In all cases we make the following assumptions:
1) The goal of the firm is profit maximization-that is, the maximization of the
difference  = R-C where:
 = Total profit
R = Total revenue
 C = Total cost

2) The price of output is given, P x

3) The prices of factors are given:
w is the given wage rate
r is the given price of capital services (rental price of machines)

Case I: Maximization of output subject to a cost constraint (financial

constraint)

Here, we assume: (a) a given production function x = f(L,K) and

(b) given factor prices, w, r, for labour and capital respectively.
The firm is in equilibrium when it maximizes its output given its total cost outlay
and the prices of the factors w and r.
The equilibrium of the producer is depicted in fig. 4.7

K2 C IQ3 (X3)
IQ2 (X2)
 IQ1 (X1)
L2 L

Fig3.7 Producer's Equilibrium

In fig. 3.7, we see that the maximum level of output the firm can produce,

given the cost constraint ( c ) , is X2 (IQ2) defined by the tangency of the isocost
line, and the highest isoquant. The optimal combination of factors of production is
K2 and L2, for prices w and r.

Higher levels of output (to the right of c) are desirable but not attainable due to the
cost constraint. Other points on LK or below it lie on lower isoquant than X 2.
Hence, X2 is the maximum attainable output under the above assumptions (of given
cost outlay, given production function, and given factor prices). At the point of
tangency (c), the slope of the isocost line is equal to the slope of the isoquant. This
constitutes the first condition for equilibrium. The second condition is that the
isoquants be convex to the origin.

In summary, the conditions for equilibrium of the producer are:

a) Slope of isoquant = slope of isocost

ΔX
ΔL Pl
=
ΔX Pk
ΔK

MP L w
=
MP K r
 MP L w
=
MRTSL,K = MP K r

b) The isoquants must be convex to the origin. If the isoquant is concave the
point of tangency of the isocost and the isoquant curves does not define an
equilibrium position.

Laws of Returns to scale: Long-run Analysis of Production

In the long-run, the expansion of output may be achieved by varying all

factors. In the long-run, all factors of production and variable. Thus, in the long-
run the firm expands production (expands the scale of its operations) by using
more of all inputs-more labour, more equipment, more space, etc.

The long-run output may be increased by changing all factors by the same
proportion or by different proportions. Traditional theory of production
concentrates on the first case-that is, the study of output as all inputs change by the
same proportion. When firm increases output by using more of all inputs, the
input-output relation is one of scale. Returns to scale refer to a property of the
production function that indicates the relationship between the proportionate
change in inputs and the resulting change in output. Returns to scale refer to the
long-run analysis of production and show how output responds to an equi-
proportionale change in all inputs.

It is crucial to note that the law of diminishing marginal returns and the law
of returns to scale are two different things. The law of diminishing marginal
returns studies the behaviour of production when only some inputs change while
other inputs are fixed in the short-run. However, the law of returns to scale
examines the effect of changes of all inputs on the level of output. Thus, while the
law of diminishing marginal returns is the sort-run phenomenon, the law of returns
to scale is the long-run scenario.

The law of returns to scale, which refers to the changes in output as all
factors change by the same proportion, can be studied under three major headings:

a) Increasing Returns to Scale

A production function is said to exhibit increasing returns to scale if a

certain percentage change in combination of inputs is accompanied by a higher
percentage change in the resulting output. For instance, if when labour and capital
double, the resulting output more than doubles, the production function displays
increasing returns to scale. Increasing returns to scale occur if a 10% increase in
labour and capital triggers more than 10% increase in output.

Causes of Increasing Returns to Scale

One possible cause of increasing returns to scale comes from higher degrees
of specialization, as Adam smith pointed out. With more labour, the firm can
subdivide tasks and thus gain efficiency of labour. Thus, because of division of
labour and specialization each worker specializes in performing a particular task
rather than engaging in different assignments and, consequently labour
productivity (average product of labour) boosts.
 Another possible cause of increasing returns to scale may be technical and/or
managerial indivisibilities. Usually, most processes can be duplicated, but it may
not be possible to halve them.

One of the basic characteristics of advanced industrial; technology is the

existence of mass-production methods over large sections of manufacturing
industry. Mass production methods (like the assembly line in the motor car
industry) are processes available only when the level of output is large. For
example, assume that we have three production Processes:

L(men) K(machines) X (in tons)

A: Small-scale process 1 1 1
B: Medium-scale process 50 50 100
C: Large-scale process 100 100 100

The K/L ratio is the same for all processes and each process can be
duplicated (but not halved). Each process has a different level of output. The
large-scale processes are technically more productive than the small-scale
processes. Clearly, if the large-scale processes were equally productive as the
small-scale methods, no firm would use them: the firm would prefer to duplicate
the smaller scale already in we, with which it is already familiar.

For X < 50 the small scale process would be used but for 50 < X < 100 the
medium scale process would be used. The switch from the small-scale to the
medium scale process gives a discontinuous increase in output (from 49 tons
produced with 49 units of L and 49 units of K, to 100 tons produced with 50men
 and 50 machines). If the demand in the market required only 80 tons, the firm
would still use the medium-scale process, producing 100 units of X, selling 80
units, and throwing away 20 units (assuming zero disposal costs). This is one of
the cases in which a process might be used inefficiently, but still relatively efficient
compared to the small scale process. Similarly, the switch from the medium-scale
to the large-scale process gives a discontinuous increase in output from 99 tons
(produced with 99 men and 99 machines) to 400 tons (produced with 100 men and
100 machines). If the demand absorbs only 350 tons, the firm would use the large-
scale process inefficiently (producing 400 units, but selling 350 units and throwing
away the 50 units). The large-scale process, even though inefficiently used, is still
more [productive (relatively efficient) compared with the medium-scale process.

b) Decreasing Returns to scale

A production function (technology) is said to display decreasing returns to

scale when a certain percentage change in the combination or inputs brings about a
lower percentage change in output. For example if when labour and capital scale up
by 15% and output less than doubles, decreasing returns to scale occurs. If a firm
gets less than twice as much output from having twice as much of each input, it is
doing something wrong.

Possible causes of Decreasing Returns to Scale

The most common causes of decreasing returns to scale are the mounting
difficulties of coordination and control as scale of operation increases. A plant with
a very large number of workers more difficult to manage than a smaller one. The
larger the number of workers, the larger becomes the number of foremen and
supervisors between the responsible plant manager and the people who actually do
the job. The ‘management’ is responsible for the coordination of the activities of the
various sections of the firm. Even authority is delegated to individual managers
(production manager scales manager, etc), the final decisions have to be taken from
the “top management” (Board of Directors). As the output (firm) grows top
management becomes eventually overburdened and hence less efficient in its rule as
coordinator and ultimate decision maker. It is a commonly observed fact that as
firms grow beyond the appropriate optimal plateau, management diseconomies
cheep in-the firm becomes unmanageable as the span of control is widened.

Another possible cause of decreasing return to scale may be sound in the

exhaustible natural resources: doubling the fishing fleet may not lead to a doubling
of fish catch.

C. Constant Returns to Scale

A production function dip day’s constant returns to s scale if a certain

percentage change in the combinative of inputs is associated with the some
proportionate change in the resulting output. Here, doubling or quadrupling of
inputs causes doubling or quadrupling of output.