Chapter 5

PRODUCTION THEORY

Christopher D. Balubayan
Instructor
University of Mindanao
2nd Term 1st Sem SY 2016-2017
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Objectives
1. Explain the production function of
the firm
2. Distinguish the relationship between
the average product and marginal
product.
3. Relate the role of Isoquants and
Isocost in the desire of the firm to
optimize production activity.
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Production theory
The study ofproduction, or the economic process
of converting inputs into outputs
Production is a process, and as such it occurs
through time and space.
Because it is aflow concept, production is
measured as a rate of output per period of time.
There are three aspects to production processes:
the quantity of the good or service produced,
the form of the good or service created,
the temporal and spatial distribution of the good or
service produced.

The most important forms of production are

Market production
Public production
household production

Cost of
ProductionTheory of
Is the theory that
the price of an object or
value

condition is determined by the sum of

thecostof the resources that went into
making it.
Thecostcan comprise any of the factors
ofproduction
Labor
Capital
Taxation

Cost
Is the value of money that has been used up
to produce something

Firms concern
To convert inputs into outputs in the most efficient manner.
Production
Through this, resources are transformed into goods and
services for consumers.
Not only manufacturing goods and services but also involves
storing, shipping and packaging.
Any activity that tries to add to a production is part of the
production process.
Production Function
Of any firm, is the given amount of inputs that can produce the
maximum amount of output utilizing the existing technology.
Why Firms want to acquire the latest technology?
Because of its ability to maximize output with a specified set of
inputs.
Through research and development activity, the development
of technology occurs.
Firms that are able to accomplish this condition attain technical
efficiency
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Firms that are able to produce a given output at the lowest

FIXED INPUTS and VARIABLE INPUTS

in
Short Run and Long Run Period

Inputs
Factors of production, which are land, labor, capital , and entrepreneurial ability.
Fixed Inputs
Are inputs which do not change in the short run.
Ex. Inputs in the machine shop: machines, equipment, machine shop place, etc.
Variable Inputs
Are inputs that change according to the plan of the firm to increase or decrease
outputs.
Ex. Electricity, unprocessed steel, and labor.
Short Run Period
A period where firm do not change fixed inputs or refuse to buy additional inputs
like machineries and the structure of the machine shop, however, they can
change the number of workers and raw materials depending on their desires.
Long Run Period
A period where a firm process and develop their product in a considerable time,
maximizing its output to be able to buy better machineries and expand the
processing plant.
NOTE:
In the short run, a firm hold their capital constant while increasing or decreasing
the number of labor they hired
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On the other hand, in the long Microeconomics
run, both labor and capital change.

The first worker has 20

gallons of ice cream
It can be noted that there
produced
are the marginal product and
Marginal
Product
The two workers
can
the average
produce
42 gallons
of icecontributed by the additional
The additional
output
input.product
cream.
The change
in total product (TP) divided by the change in inputs.
However,
the second
worker
To compute:
MP=TP
is able to contribute 22
Q
gallons of ice cream
No. Of
TP or
MP
AP

STAGES IN PRODUCTION

Average Product

workers

Output in

Example:
suppose
in an
ice
Gallons
Distributing
the total
product
to each input
equally.
cream
factory,
the
owner
1
20
To compute: TP=TP
noted
the
relationship
2
42
Q
between the numbers of
3
66
workers
hired
with
total
4
72
product output of ice cream in
gallons
in a short
period,
5
77
If combined,
threerun
workers
other
input 66
aregallons
unchanged.
produced
of ice
6
80
cream, but the third worker
7
81
See.
Table 5.124
(Page
100)
contributes
gallons
6
81
Production
Cream
greater thanof
theIce
first and
9
78
(Gallons
per Week)
the second
workers do.
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20

20.0

22

21.0

24

22.0

18.0

15.4

13.3

11.6

10.1

-3

8.7
7

Take
Note:
Production
of Ice Cream in Gallons
As the number
Figure of
5.1 Three Stages of Production
workers that a firm
(Page 101)
hired, the production
of 90
ice cream (TP) also
increases

T
P

80

Stage
1
This
depicts
the
Increasi
LAW
OF DIMINISHING
ng
60
RETURNS
Return
As
other
factors remain
50
constant, if the number ofStage 2
50 inputs increases, the Decreas
ing
contribution
of
its
40
Return
additional input decreases

Total Output

70

Stage 3
Negativ
The output
e
increases
at the
Return

decreasing rate

30

Take Note:
The
Marginal Product
10
decline as the number
0 workers hired
of
No. Of Workers
increase
-10
2
4
6 to
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20

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Microeconomics

A
P
8

M
P

THREE STAGES OF PRODUCTION

Look at Figure 5.1 (Page 101)
1st Stage
The Total Product (TP), Marginal Product (MP), and the Average Product (AP)
are all increasing.
This is a state where the increase in output is greater in proportion than the
increase in inputs.

2nd Stage
Starts when the Average Product (AP) intersects with the Marginal Product
(MP).
The Total Product (TP) is still increasing but in a decreasing rate.
The Average Product (AP) and the Marginal Product (MP) begin to decrease
until it reaches zero

3rd Stage
The last stage which is referred to as the stage of negative returns.
The Marginal Product (MP) begin to decrease.
The Marginal Product (MP) is negative which means that the additional
worker that a firm hires do not contribute anymore to the ice cream
production.
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ISOQUANTS

Suppose
desires tofrom
produce
200As shown in this table, Luigi can
The
possibleLuigi
combination
A to E
gallons
of ice
Hethat
wasin
able to
employ 10 capital and 2 workers in
as shown
herecream.
suggest
5.2 to produce 200 gallons of ice
determine the
combination
order
combination
A, possible
10 capital
andTable
2
Combination
of
and
Capital
canalso
Produce
of workers
and equipments
that
they
cream.that
He can
employ 24
workers
can produce
200Labor
gallons
of
can use
in order
to
produce
and 2 capitals to produce the
200
Gallons
of Ice Cream
ice cream.
If Luigi
gives
up
2 units200
ofworkers
of ice
cream.(Page
capital he gallons
has to hire
3 workers
and 102) 200 gallons of ice cream.
so on.
As he gives up a unit of
capital, he has to hire a
greater number of
workers. This
phenomenon follows
the
LAW OF
DIMINISHING
RETURNS
SHOWS THE POSSIBLE COMBINATION
OF TWO INTPUTS THAT CAN PRODUCE
THE SAME LEVEL OF OUTPUT

Combinati
ons
A
B
C
D
E

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Capital
(Units)
10
8
6
4
2

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Labor
(Units)
2
5
9
16
24

10

ISOQUANTS
Isoquants
1. Isoquants do not intersect
Figureis5.2
curve in shape and not a straight
just like the
indifference
Labor
and Capital
lineCombination
because it follows the principle of
curve, because the same
LDR, showing
theCream
increasing and
that
can
Produce
200
Gallons
of
Ice
amount of inputs does not
decreasing relationship between
(Page 102)
produce two different level
combinations of factors of production
of output
25

Capital

2. Isoquants is downward
slopping.
20
A
It represents the marginal
rate of technical
15substitution, where the
B
slope represents the rate
10of substitution of one input
to another.

5
3. Isoquants is convex to the
point of origin.
0It simple explains
2
6
that as4a
Labor
unit of capital is given up,
more numbers of workers
should be hired, a
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Microeconomics

D
E
8

10

11

Suppose Luigi has a budget of Php240 that he can spend

to buy capital and labor. The price of one unit of capital
is Php20 and the price of one unit of labor is Php10.

ISOCOST LINE

Table 5.3
Therefore,
he can determine
the number
units of
Combination
of Capital
and Labor
that of
Luigi
capital and labor he can buy. As this table shown the
can possible
Buy
with
His Php240 Budget
combinations of capital and labor that Luigi can
(Page 103) buy.
Combinations
Capital
Budget
(Php20/Units)
In combination
E, he can
(Php240)
buy 24 units of labor
and zero unit
A of capital
12

with his Php240 budget.

Luigi can buy
B 12 units
of capital and zero unit
of combination
labor withChisB,Php240
In
he can
budget.
This
is
buy 9 units of capital
combination
A.
D of labor
and
6 units

E
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Labor
(Php10/Units)
0
6

6DEMONSTRATES THE POSSIBLE

12
COMBINATIONS OF TWO OUTPUTS
3
18
FROM A GIVEN BUDGET

0
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24
12

Figure 5.3
The Is cost Line for Luigi
(Page 104)
25

Capital

20 A
15

10

5
0

D
2

E
10

12

Luigi observe that as the number of Labor

capital
that he bought decreases, he can hire more
units of labor.
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Capital
(Php20)

When Luigi was able to secure loan from

Figure 5.4
Marion, he was able to increase his
budget to Php300.
Shift in the Is cost
As shown in this table, the number of
(Page
units
As long
as104)
the there is no changes in
the of capital and labor that Luigi can
buy
shifted from his previous budget of
price of capital and labor, the Is cost
line
30
Php240 to Php300.
will just have a parallel shift going
rightward.
25
20
15
10

Php24
0

5
0
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Php30
0

Labor
(Php10)

10

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14

The combination of Isoquants curve and two isocosts line is shown in this table.
It means:
Luigi confronts the decision to choose
1. At point A and B Luigi can produce the 200 gallons of ice cream because it lies in
the Isoquants.
how many units of capital and labor that
2. Those combinations of capital and labor can produce 200 gallons.
he can hire given his limited budget.
3. Luigi will not choose point A because it has on the higher Is cost, meaning he has
to spend more.
Remember that he will be producing 200
4. Point B is tangent to the lower Is cost, meaning, he will be willing to produce
gallons of ice cream.
because it offers a lowest cost.
5. Luigi can produce at point C but not at the desired volume of 200 gallons.
6. He will choose point B because it is the least cost factor combination

Figure 5.5
Least Cost Factor Combination
(Page 105)
30

Capital
(Php20)

25

20
15

Php24
0

Php30
0

10
5

C
0
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Labor
(Php10)

10

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15

THE
Example:MARGINAL RATE OF
If Luigis combination of
TECHNICAL
SUBSTITUTION
labor
and capital moved

from point C to D in the

diagram, the number of
labor units increases from 3
to 4, while capital units
Combinations
decreases
from 6 to 3.
nevertheless, the different
A
combination of labor and
capital produce a constant
B
200 gallons of ice cream.

Table 5.4
(Page 103)
Labor
1

Capital
20

10

This term means as the

2
measure where the reduction
The reduction of one capital
of one labor unit 1
increases the
F
6
unit increases the number
number of capital units used in
of labor units to maintain a
production to maintain a
constant level of output.cdbalubayan@gmail.com Intoconstant
to
level of output.16
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E way around:
On the other

Microeconomics

Figure 5.5
Depicting the Marginal Rate of Technical
Substitution
(Page 106)

25
The marginal rate of technical substitution is the
absolute slope of the Isoquants at that point. This
is expressed as:

Capital

20
15

MRTS =
Change in the Number of
Capital
Change in the Number of Labor

10

Or MRTS =
L

5
0

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4
5 as regards
6
7
8
9rate of
10
Therefore,
the marginal
technical
substitution from point C to D, the
Labor
change in the number of capital (3 units 6 units)
is -3; the change
intolabor (4 3) is 1; and the
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absolute
quotient, which is the marginal rate of

QUIZ
ON
FRIDAY
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