THEORY OF PRODUCTION

Meaning of Production
 Production means transforming
inputs (labor, capital, raw material,
time etc.) into output.
 In economic sense production means
process by which resources (men,
material, money etc) are
transformed into a different and
more useful commodity or service.
 The Production Function
 A production function defines the relationship between
inputs and the maximum amount that can be produced within a
given time period with a given technology.

 Mathematically, the production function can be expressed as

Q=f(K, L)
 Q is the level of output
 K = units of capital
 L = units of labour
 f( ) represents the production technology
 The Production Function
 When discussing production, it is important to
distinguish between two time frames.

 The short-run production function describes the

maximum quantity of good or service that can be
produced by a set of inputs, assuming that at least
one of the inputs is fixed at some level.

 The long-run production function describes the

maximum quantity of good or service that can be
produced by a set of inputs, assuming that the firm is
free to adjust the level of all inputs
Production in the Short Run
 When discussing production in the
short run, three definitions are
important.
•Total Product
•Marginal Product
•Average Product
Production in the Short Run
 Total product (TP) is another name for output
in the short run.
 The marginal product (MP) of a variable input
is the change in output (or TP) resulting from a
one unit change in the input.
 MP tells us how output changes as we change
the level of the input by one unit.
Production in the Short Run
 The average product (AP) of an input
is the total product divided by the
level of the input.
 AP tells us, on average, how many
units of output are produced per unit
of input used.
Production in the Short Run
 Consider the two input production function
Q=f(X,Y) in which input X is variable and
input Y is fixed at some level.
 The marginal product of input X is defined
as
∆Q
holding input Y constant. MPX =
∆X
Production in the Short Run
 The average product of input X is
defined as
Q
APX =
X
holding input Y constant.
 Production in the Short
Run
The table below represents a firm’s
production function, Q=f(X,Y):
UnitsofY
Em ployed Output Quantity(Q)
8 37 60 83 96 107 117
7 42 64 78 90 101 110
6 37 52 64 73 82 90
5 31 47 58 67 75 82
4 24 39 52 60 67 73
3 17 29 41 52 58 64
2 8 18 29 39 47 52
1 4 8 14 20 27 24
1 2 3 4 5 6
UnitsofXEm ployed
 Production in the Short
Run
In the short run, let Y=2. The row highlighted below represents the firm’s
short run production function.

Unitsof Y
Employed Output Quantity(Q)
8 37 60 83 96 107 117 12
7 42 64 78 90 101 110 11
6 37 52 64 73 82 90 9
5 31 47 58 67 75 82 8
4 24 39 52 60 67 73 7
3 17 29 41 52 58 64 6
2 8 18 29 39 47 52 5
1 4 8 14 20 27 24 2
1 2 3 4 5 6
Unitsof XEmployed
Production in the Short Run
Variable
Input Total Produc
 Rewriting this row,
(X) (Q or TP)
we can create the
following table and 0 0
calculate values of 1 8
marginal and 2 18
average product. 3 29
4 39
5 47
6 52
7 56
 Calculation of Marginal Product

Variable Marginal
Input Total Product Product
(X) (Qor TP) (MP)
0 0 ∆Q 8
ΔX=1 ΔQ=8 = =8
1 8 ∆X 1
2 18
3 29
4 39
5 47
6 52
7 56
8 52
 Calculation of Marginal Product
Variable Marginal
Input Total Product Product
(X) (Q or TP) (MP)
0 0
8
1 8 10
2 18 11
3 29
10
4 39 8
5 47 ∆Q 5
ΔX=1 ΔQ=5 ∆X = 1 = 5
6 52
7 56 4
-4
8 52
Calculation of Average Product
Variable Total Average
Input Product Product
(X) (Qor TP) (AP)
0 0 ---
Q 88
1
1 8
8 = =8
X 11
2 18
3 29
4 39
5 47
6 52
7 56
8 52
Calculation of Average
Product
Variable Total Average
Input Product Product
(X) (Qor TP) (AP)
0 0 ---
1 8 8
2 18 9
3 29 9,67
4 39 9,75
5 47 9,4
6 52 8,67
7 56 8
8 52 6,5
Production in the Short Run
 The figures
illustrate TP,
MP, and AP
graphically.
Production in the Short Run
 If MP is positive then TP
is increasing.
 If MP is negative then TP
is decreasing.
 TP reaches a maximum
when MP=0
Production in the Short Run

 If MP > AP then
AP is rising.
 If MP < AP then
AP is falling.
 MP=AP when AP
is maximized.
 The Law of Diminishing
Returns
 Definition
 As additional units of a variable input
are combined with a fixed input, at
some point the additional output (i.e.,
marginal product) starts to diminish.
 Diminishing Returns
Variable Marginal
Input Total Product Product
(X) (Q or TP) (MP)
0 0 8
1 8 10 Diminishing
2 18 11 Returns
3 29 10 Begins
4 39 8 Here
5 47 5
6 52 4
7 56 -4
8 52
 The Law of Diminishing
Returns
 Reasons
Increasing Returns
Teamwork and Specialization
MP Diminishing Returns Begins
Fewer opportunities for teamwork
and specialization

X
MP
 The Three Stages of
Production
 Stage I
 From zero units of the variable input to
where AP is maximized
 Stage II
 From the maximum AP to where MP=0
 Stage III
 From where MP=0 on
The Three Stages of
Production
 Optimal Level of Variable
Input Usage
Consider the following short run production process.

Labor Total Average Mar
Unit Product Product Pro
(X) (Qor TP) (AP) (
0 0
Where 1 10.000 10.000 10
is 2 25.000 12.500 15
3 45.000 15.000 20
Stage
4 60.000 15.000 15
II? 5 70.000 14.000 10
6 75.000 12.500 5
7 78.000 11.143 3
8 80.000 10.000 2
Optimal Level of Variable
Input Usage
Labor Total Average Ma
Unit Product Product Pr
(X) (Qor TP) (AP) (
0 0
1 10.000 10.000 10
2 25.000 12.500 15
3 45.000 15.000 20
4 60.000 15.000 15
Stage II 5 70.000 14.000 10
6 75.000 12.500 5
7 78.000 11.143 3
Optimal Level of Variable
Input Usage

 What level of input usage within

Stage II is best for the firm?
 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.
Production in the Long Run

 In the long run, all inputs are variable.to

understand Laws of returns in long run,
we must know what is Isoquant and
Production function.
 Isoquant defines combinations of
inputs that yield the same level of
product. It is also called as production
indifference curve.
 Assumption of Isoquant Curves
 There are only two inputs – labor and
capital to produce a commodity
 Both labor, capital and product are
perfectly divisible.
 Two inputs labor and capital can
substitute each other but at
diminishing rate as they are
imperfect substitutes
 Technology of production is given.
 Isoquant
K E
5

3
A B C

2
Q3 =90
D Q2 =75
1
Q1 =55
1 2 3 4 5 L
 Marginal rate of technical
substitution (MRTS)
 MRTS refers to the slope of an
Isoquant i.e. ration of marginal
changes in inputs. It does not reveal
the substitutability of one input for
another- labor for capital – with
changing combination of inputs.

MRTS= ΔK/ΔL
Marginal rate of technical
substitution
K
(MRTS)
7

6 ΔK=3

5
MRTS = ∆K
4
ΔL=1
∆L
3 ΔK=1
ΔL=1

1 ΔK=1/3
ΔL=1

0
0 1 2 3 4 5 6 7 L
 Marginal Rate of Technical
Substitution (MRTS)
 The slope of an isoquant shows the rate at which L can
be substituted for K

K per period - slope = marginal rate of technical

substitution (MRTS)

MRTS > 0 and is diminishing for

A increasing inputs of labor
KA
B
KB
q = 20

L per period
LA LB
Production in the Long Run

 The long run production process is described by

the concept of returns to scale.
 Returns to scale describes what happens to total
output as all of the inputs are changed by the
same proportion. It means the degree by which
output changes as a result of given change in the
quantity of all inputs used in production.
 Production in the Long Run
 If all inputs into the production process
are doubled, three things can happen:
 output can more than double
 increasing returns to scale (IRTS)
 output can exactly double
 constant returns to scale (CRTS)
 output can less than double
 decreasing returns to scale (DRTS)
 Returns to Scale

Constant Increasing Decreasing

Returns to Returns to Returns to
Scale Scale Scale
Production in the Long Run
One way to measure returns to scale is
to use a coefficient of output elasticity:
Percentage change in Q
EQ =
Percentage change in all inputs

 If E>1 then IRTS

 If E=1 then CRTS
 If E<1 then DRTS
 The Theory and
Estimation of Cost
 The Short Run Relationship Between
Production and Cost
 The Short Run Cost Function
 The Long Run Relationship Between Production
and Cost
 The Long Run Cost Function
 The Learning Curve
 Economies of Scope
 Other Methods to Reduce Costs
 SR Relationship Between
Production and Cost
 A firm’s cost structure is intimately
related to its production process.
 Costs are determined by the
production technology and input prices.
 Assume the firm is a “price taker” in
the input market.
 SR Relationship Between

ProductionTotal
and Cost
 In order to illustrate Input
the relationship, (L) Q(TP) MP
consider the 0 0
production process 1 1.000 1.000
described in the 2 3.000 2.000
table.
3 6.000 3.000
4 8.000 2.000
5 9.000 1.000
6 9.500 500
7 9.850 350
 SR Relationship Between
Production and Cost
 Total variable Total
cost (TVC) is the Input TVC
cost associated with (L) Q (TP) MP (wL)
the variable input, 0 0 0
in this case labor. 1 1.000 1.000 500
Assume that labor 2 3.000 2.000 1.000
can be hired at a
3 6.000 3.000 1.500
price of w=$500 per
unit. TVC has been 4 8.000 2.000 2.000
added to the table. 5 9.000 1.000 2.500
6 9.500 500 3.000
7 9.850 350 3.500
8 10.000 150 4.000
 SR Relationship Between
Production and Cost
 Plotting TP and TVC illustrates that they are mirror
images of each other.
 When TP increases at an increasing rate, TVC
increases at a decreasing rate.
 SR Relationship Between
Production and Cost
 Total fixed cost (TFC) is the cost
associated with the fixed inputs.
 Total cost (TC) is the cost
associated with all of the inputs. It is
the sum of TVC and TFC.
 TC=TFC+TVC
 SR Relationship Between

Production and Cost

 Marginal cost (MC) is the change in total cost
associated a change in output.

∆TC
MC =
∆Q
•MC can also be expressed as the change in
TVC associated with a change in output.
∆TC ∆(TFC + TVC ) ∆TFC ∆TVC ∆TVC
MC = = = + = 0+
∆Q ∆Q ∆Q ∆Q ∆Q
 SR Relationship Between
Production and Cost
Total
 Marginal Cost
Input TVC
has been added
to the table. (L) Q MP (wL) M
 When MP is 0 0 0
increasing, MC 1 1.000 1.000 500 0,5
is decreasing. 2 3.000 2.000 1.000 0,2
 When MP is 3 6.000 3.000 1.500 0,1
decreasing, MC
is increasing. 4 8.000 2.000 2.000 0,2
5 9.000 1.000 2.500 0,5
6 9.500 500 3.000 1,0
7 9.850 350 3.500 1,4
 The Nature of Costs
 Explicit Costs : Actual expenditure
Explicit Costs : Actual expenditure
of the firm to hire, rent, or
purchase the inputs it requires in
production. It include wages to hire
a labor, the rental prices of capital,
equipment, and buildings, and the
purchase price of raw materials
and semi-finished products.
 Accounting Costs/ historical cost are
important for the firm for financial
reporting and tax purpose.
 Implicit Costs: it refers to the value of the
inputs owned and used by the firm in its own
production activity. Even though firm does not
incur any actual expenses to use these inputs,
they are not free , since the firm could sell or
rent them out to other firm. It includes the
highest salary an entrepreneur could earn in
his or her best alternative employment.
 Economic Costs :
 Alternative or Opportunity Costs
Example: A firm purchased raw material for Rs 100,
but its price subsequently fell to Rs 60. the
accountant would continue to report the cost of raw
material at its historical price of Rs. 100.
The economist , however would value the raw
material at its current or replacement value. Failure
to do so may lead to wrong managerial decision.
This would occur if the firm decided not to produce a
commodity that would lead to a loss if the raw
material were valued at its current or replacement
value of Rs. 60.the fact that the firm paid Rs 100 for
the input is irrelevant to it current production
decision since the firm would only obtain Rs 60 if it
sold the input now. The Rs40 reduction in the price
of raw material is a sunk cost that the firm should
not consider in its current managerial decisions.
 Relevant Costs: economic cost or
opportunity cost are relevant cost .
 Incremental Costs : change in the total cost
from implementing a particular management
decision , such as introduction of a new product
line, and undertaking a new advertising
campaign or production of previously
purchased component.
 Sunk Costs are Irrelevant : cost that are not
affected by the decisions are irrelevant .
Short-Run Cost Functions

Total Cost = TC = f(Q)

Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC
Short-Run Cost Functions

Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = ∆ TC/∆ Q =
∆ TVC/∆ Q
Short-Run Cost Functions
Q T F CT V C T C A F CA V CA T CM C
0 $60$0 $60 - - - -
1 6 0 2 0 8 0 $ 6 0$ 2 0$ 8 0$ 2 0
2 60 30 90 30 15 45 10
3 60 45 10520 15 35 15
4 60 80 14015 20 35 35
5 6 0 1 3 51 9 5 1 2 2 7 3 9 5 5
The Short Run Cost Function
The Short Run Cost Function
 Graphically, these results are be
depicted in the figure below.
The Short Run Cost Function
 Important Observations
 AFC declines steadily over the range of
production.
 In general, AVC, AC, and MC are u-shaped.
 MC measures the rate of change of TC
 When MC<AVC, AVC is falling
When MC>AVC, AVC is rising
When MC=AVC, AVC is at its minimum
 The distance between AC and AVC
represents AFC
 The LR Relationship
Between
Production and Cost
 In the long run, all inputs are variable.
 In the long run, there are no fixed costs
 The long run cost structure of a firm is
related to the firm’s long run production
process.
 The firm’s long run production process is
described by the concept of returns to scale.
 The LR Relationship
Between
Production and Cost
 Economists hypothesize that a firm’s long-run
production function may exhibit at first
increasing returns, then constant returns, and
finally decreasing returns to scale.
 When a firm experiences increasing returns
to scale
 A proportional increase in all inputs increases
output by a greater percentage than costs.
 Costs increase at a decreasing rate
 The LR Relationship
Between
Production and Cost
 When a firm experiences constant returns to
scale
 A proportional increase in all inputs increases
output by the same percentage as costs.
 Costs increase at a constant rate
 When a firm experiences decreasing returns to
scale
 A proportional increase in all inputs increases
output by a smaller percentage than costs.
 Costs increase at an increasing rate
 The LR Relationship
Between

Production
This graph
and Cost
illustrates the
relationship
between the long-
run production
function and the
long-run cost
function.
The Long-Run Cost Function
 Long run marginal cost (LRMC)
measures the change in long run costs
associated with a change in output.
 Long run average cost (LRAC)
measures the average per-unit cost of
production when all inputs are
variable.
 In general, the LRAC is u-shaped.
The Long-Run Cost Function
 When LRAC is declining we say that the firm is
experiencing economies of scale.
 Economies of scale implies that per-unit costs are
falling.
 When LRAC is increasing we say that the firm is
experiencing diseconomies of scale.
 Diseconomies of scale implies that per-unit costs
are rising.
The Long-Run Cost Function
 The figure
illustrates
the general
shape of
the LRAC.
 Constant returns to scale is where
long-run average total costs do not
change as output increases.
 It is shown by the flat portion of the
LRATC curve.
 Importance of Economies and
Diseconomies of Scale
 Economies and diseconomies of scale play important
roles in real-world long-run production decisions.
 The long-run and the short-run average cost curves
have the same U-shape, but the underlying causes of
these shapes differ
 Economies and diseconomies of scale account for the
shape of the long-run total cost curve.
 Initially increasing and then eventually diminishing
marginal productivity (as a variable input is added to
a fixed input) accounts for the shape of the short-run
cost curve.
 The Long-Run Cost Function
 In the short run, the firm has
a fixed level of capital
equipment or plant size.
 The figure illustrates the
SRAC curves for various plant
sizes.
 Once a plant size is chosen,
per-unit production costs are
found by moving along that
particular SRAC curve.
The Long-Run Cost Function

 Reasons for Economies of Scale

 Increasing returns to scale
 Specialization in the use of labor and capital
 Indivisible nature of many types of capital
equipment
 Productive capacity of capital equipment
rises faster than purchase price
The Long-Run Cost Function
 Reasons for Economies of Scale
• Economies in maintaining inventory of
replacement parts and maintenance personnel
• Discounts from bulk purchases
• Lower cost of raising capital funds
• Spreading promotional and R&D costs
• Management efficiencies
The Long-Run Cost Function
 Reasons for Diseconomies of
•Scale
Decreasing returns to scale
• Disproportionate rise in transportation costs
• Input market imperfections
• Management coordination and control
problems
•Disproportionate rise in staff and indirect
labor
 Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC =
∆ LTC/∆ Q
 Economies of Scope

 The reduction of a firm’s unit cost

by producing two or more goods or
services jointly rather than
separately.
 Other Methods to Reduce
Costs
 The Strategic Use of Cost
 Reduction in the Cost of Materials
 Using IT to Reduce Costs
 Reduction of Process Costs
 Relocation to Lower-Wage Countries or
Regions
 Mergers, Consolidation, and Downsizing
 Layoffs and Plant Closings
Revenue
 Total revenue – the total amount
received from selling a given output
 TR = P x Q

 Average Revenue – the average

amount received from selling each unit
 AR = TR / Q

 Marginal revenue – the amount

received from selling one extra unit
of output
 MR = TR – TR
n n-1 units
Profit
  Profit = TR – TC
 The reward for enterprise
 Profits help in the process of
directing resources to alternative
uses in free markets
 Relating price to costs helps a firm to
assess profitability in production
 Normal Profit – the minimum amount
required to keep a firm in its current line
of production
 Abnormal or Supernormal profit –
profit made over and above normal profit
 Abnormal profit may exist in situations where
firms have market power
 Abnormal profits may indicate the existence
of welfare losses
 Could be taxed away without altering
resource allocation
 Sub-normal Profit – profit below
normal profit
 Firms may not exit the market even if
sub-normal profits made if they are able
to cover variable costs
 Cost of exit may be high
 Sub-normal profit may be temporary (or
perceived as such!)
 Assumption that firms aim to
maximise profit
 May not always hold true –
there are other objectives
 Profit maximising output would be
where MC = MR
Profit maximization condition MR =
MC

C(q)

Costs, Revenue, Profit

R(q)
A

0 q0 q*
π(q)
Units/year
Profit is maximized, when MR = MC.
Costs for Decision Making
 Economic costs

 Accounting costs are historic

costs
 Historical cost is the cost incurred at
the time of procurement.
 do not incorporate opportunity costs
 Economic costs
 For business decision making we use economic costs
 explicit cost
 implicit cost
 Historic costs match to some extent explicit costs,
implicit costs are opportunity costs
 Opportunity cost is the value that is forgone in choosing one
activity over the next best alternative.

 Economic Profit = Accounting Profit – Opportunity Costs

 Costs for Decisin Making
 A cost is relevant if it is affected by a
management decision.

 A cost is irrelevant if it is not affected

by a management decision.
 Costs for Decisin Making
 A cost is relevant if it is affected by a
management decision.

 A cost is irrelevant if it is not affected

by a management decision.
 Incremental Analysis
 Incremental analysis is used to
analyze business opportunities .
 Incremental cost varies with the
range of options available in the
decision making process.
 Incremental analysis uses only
decision relevant revenues and cost
 Incremental Analysis
Process
 Incremental Analysis Process :
 Define relevant revenues and costs
 Define incremental revenues and costs
 If incremental revenues exceed
incremental costs, take the decision,
otherwise reject it
Classification of Costs
Classification of Revenues

EXPLICIT
 Examples of Incremental
Analysis
 Outsourcing opportunities for
small businesses: A quantitative
analysis