The Theory of Production

The Theory of Production

Production is the process by which inputs

are combined, transformed, and turned into
outputs.
A firm is a production unit where goods
and services are produced.
The three decisions that all firms make are:
 How much will be produced?
What combination of inputs will be used?
How much profit will be made?
 Profit and the aims of a firm
It is assumed that firms are in business to make
profit and that a firm’s behaviour is guided by the
goal of maximizing profits.
Traditional theory of the firm

The analysis of pricing and output decisions of

the firm under various market conditions,
assuming that the firm wishes to maximise profit.
Alternative theories of the firm

Theories of the firm based on the assumption

that firms have aims other than profit
maximisation.
 Short-run theory of production
There are two inputs in production:
•Fixed factor
•Variable factor
•then

o A fixed factor is an input that cannot be

increased in supply within a given time period
(e.g. buildings, land).
o A variable factor is an input that can be
increased in supply within a given time period.
(e.g. labour)
The distinction between fixed and variable factors
allows us to distinguish between the short run and
the long run.
 Long-run and short-run
production

There are two periods in production:

Short-run
Long-run

 A short-run is the period of time over which

at least one factor is fixed.
In the short run, then, output can be increased
only by using more variable factors.
 A long-run is the period of time long
enough for all factors to be varied.
In the long run, there are no fixed factors of
production.
 Short-run production function
A production function is a mathematical
expression of a relationship between inputs and
outputs. It shows units of total physical product
(TPP) as a function of units of inputs.
TPP = f (Qf , Qv)
where Qf is the quantity of fixed factors
and Qv is the quantity of variable factors
TPP = f (L, K)
This states that total physical product (i.e. the
output) over a given period of time is a function of
(i.e. depends on) the quantity of fixed land ( K) and
variable labour (L) employed.
 Average Physical Product (APP)

Average physical product is the average

amount produced by each unit of a variable
factor of production.

The APP is given by:

APP = TPP/Qv

This is output (TPP) per unit of the variable

factor (Qv).
 Marginal physical product (MPP)

Marginal physical product is the additional

output that can be produced by adding one
more unit of a specific input, holding all other
inputs constant.
The MPP is given by:
MPP = ΔTPP/ΔQv
This is the extra output (ΔTPP) produced
by employing one more unit of the variable
factor (ΔQv).
Wheat production per year from a particular farm (tonnes)
Wheat production per year from a particular farm (tonnes)
Wheat production per year from a particular farm (tonnes)
Wheat production per year from a particular farm (tonnes)
Land Labour Total Output APL MPL
5 0 0 - -
5 1 50 50 50
5 2 150 75 100
5 3 300 100 150
5 4 400 100 100
5 5 480 96 80
5 6 540 90 60
5 7 580 83 40
5 8 610 76 30
5 9 610 68 0
5 10 580 58 -30
 The law of diminishing returns
 The law of diminishing returns says that when
increasing amounts of a variable factor are
used with a given amount of a fixed factor,
there will come a point when each extra unit of
the variable factor will produce less extra
output than the previous unit.
 This means that every firm finds it
progressively more difficult to increase its
output as it approaches its capacity.
 Diminishing returns always apply in the
short-run, and in the short-run every firm
will face diminishing returns.
 Rice production per year from a particular farm
d
40
TPP
Tonnes of Rice produced per year

30 Maximum output

20

10

0
0 1 2 3 4 5 6 7 8
Number of farm workers
Rice production per year from a particular farm
40

Tonnes of Rice per year

TPP
30

20

10

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
Tonnes of Rice per year

12

10

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
Wheat production per year from a particular farm
40

Tonnes of wheat per year

TPP
30

20

10

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
Tonnes of wheat per year

12 APP = TPP / L
10

4 APP
2

0 Number of
-2
0 1 2 3 4 5 6 7 8 farm workers (L)
MPP
 The Relationship Between The
Average and Marginal Product
 If marginal product is above average
product, then average product is rising.
Thus: If MP > AP then AP is
rising.
 If marginal product is below average
product, then average product is falling.
Thus: If MP < AP then AP is
falling.
 Therefore, marginal product equals
average product when average product is
at a critical value, in this case a maximum.
 Thus MP=AP when AP is maximized.
QIf the marginal physical product (MPP) is
above the average physical product (APP):
20% 20% 20% 20% 20%
A. the MPP must be falling.
B. the MPP must be rising.
C. the APP must be falling.
D. the APP must be rising.
E. the APP could be either
rising or falling
depending on whether
the MPP is rising or
falling. A. B. C. D. E.
 Production in the long Run
 In the long run, the firm can change its
fixed inputs by building a larger factory,
acquiring bigger machines, etc.
 When the firm does these, then we say
that the firm is changing its scale of
production. There are Three possible
outcomes of the changes of the scale of
production:
 Constant Returns to Scale
 Increasing Returns to Scale
 Decreasing Returns to Scale
 Returns to Scale
 Constant Returns to Scale: A property
of a production function such that scaling
all inputs by any positive constant also
scales output by the same constant.
Constant returns to scale means that if all
factors of production are increased in a
given proportion, the output produced
would increase in exactly the same
proportion. Thus, if the quantities of
labour and capital used per unit of time
are both increased by 10%, output
increases by 10%. Also, if labour and
capital are doubled, output doubles.
 Returns to Scale
 Increasing Returns to Scale: Increasing
returns property of a production function
such that changing all inputs by the same
proportion changes output more than in
proportion. Increasing return to scale
refers to the case when all factors are
increased in a given proportion, output
increases in a greater proportion. Thus if
labour and capital are increased by 10%,
output rises by more than 10%. Also, if
labour and capital are doubled, output
more than doubles
 Returns to Scale
 Decreasing Returns to Scale: A property
of a production function such that changing
all inputs by the same proportion changes
output less than the change in inputs in
proportion. In other words, we have
decreasing returns to scale if output
increases in a smaller proportion than the
increase in all inputs. This may result
because as the scale of operation increases,
communication difficulties may make it
more and more difficult for the entrepreneur
to run a business effectively.
 It is generally believed that at very
small scale of operation, the firm faces
increasing returns to scale
Short-run Costs
 Measuring costs of production

There are two costs involved in production:

Explicit costs
Implicit costs

 Explicit costs are the payments by firms to

outside suppliers of inputs.
Implicit costs: The opportunity costs
of using resources owned by the
firm. One important implicit cost is
the forgone interest of investing the
owner’s own capital into the
business and the forgone salaries of
a business owner managing his own
business.
To the economists, total cost is the
sum of Explicit and Implicit cost
 Assume that a firm already owns a machine
Q
with a total life of 10 years. The cost of using
the machine for one year to produce good X
is:
A. a tenth of what the firm paid for
the machine in the first place. 20% 20% 20% 20% 20%
B. a tenth of what it would cost to
replace the machine.
C. the value of one year’s output of
X.
D. the scrap value of the machine
at the end of its life.
E. the maximum the machine
could have earned for the firm
in some alternative use during
the year in question. A. B. C. D. E.
 Short-run costs

 Total Fixed costs (TFC) are total costs that do not

vary with the amount of output produced. These

costs are incurred even if the firm is producing
nothing. But there are no fixed costs in the long-
run.

 Total Variable costs (TVC) are total costs that do

vary with the amount of output produced.

 Total Cost (TC) is the sum of total fixed costs and

total variable costs. TC = TVC + TFC

 Short-run Per Unit costs

 Average fixed cost (AFC) is the total fixed

cost per unit of output: AFC = TFC/Q.
 Average variable cost (AVC) is the total
variable cost per unit of output: AVC =
TVC/Q.
 Average total cost (ATC) is the total cost
(fixed plus variable) per unit of output:
AC = TC/Q = AFC + AVC.
 Marginal cost (MC) is the cost of producing
one more unit of output: MC = ΔTC/ΔQ.
Q
Which one of the following is a fixed cost
for a handmade furniture manufacturer?
20% 20% 20% 20% 20%
A. The cost of wood
B. Labour costs
C. The rent on the
workshop

D. The cost of glue and

screws

E. The cost of electricity

for running the
machines A. B. C. D. E.
 Output TFC
Total costs for firm X
100 (Q) (GH¢)

0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20

0
0 1 2 3 4 5 6 7 8
 Output TFC
Total costs for firm X
100 (Q) (£)

0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20

TFC
0
0 1 2 3 4 5 6 7 8
 Output TFC TVC
Total costs for firm X
100 (Q) (GH¢) (GH¢)

0 12 0
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20

TFC
0
0 1 2 3 4 5 6 7 8
 Output TFC TVC
Total costs for firm X
100 (Q) (GH¢) (GH¢)

0 12 0 TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20

TFC
0
0 1 2 3 4 5 6 7 8
 Output TFC TVC TC
Total costs for firm X
100 (Q) (GH¢) (GH¢) (GH¢)

0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
0 1 2 3 4 5 6 7 8
 Output TFC TVC TC
Total costs for firm X
100 (Q) (GH¢) (GH¢) (GH¢) TC
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
0 1 2 3 4 5 6 7 8
 Total costs for firm X
100 TC
TVC
80

60

40

20

TFC
0
0 1 2 3 4 5 6 7 8
Relationship between marginal and total cost
curves

MCs reflect changes in variable costs because

fixed costs do not change when output changes
in the short-run.
When MC is declining, TVC increases but at a
decreasing rate.
When MC increases, TVC continues to increase
but at an increasing rate. Thus, the TVC curve
gets steeper.
 The TVC curve always has a positive slope.
The TC curve is simply the TVC curve shifted
vertically upwards by the amount of the FC.
Marginal cost and the law of diminishing
returns

 The shape of the MC curve follows directly

from the law of diminishing returns. As
more of the variable factor is used, extra
units of output cost less than previous
units. MC falls. This corresponds to the
rising portion of the MPP curve.
 Beyond a certain level of output,
diminishing returns set in. Thereafter MC
rises as MPP falls. Additional units of
output cost more and more to produce,
since they require ever increasing amounts
of the variable factor.
 Marginal cost
MC
Costs (£)

Output (Q)
 Average and marginal costs
MC
AC

AVC
Costs (£)

x
AFC

Output (Q)
Relationship amongst MC, ATC, AVC
and AFC

• If MC is less than ATC, ATC must be falling.

• If MC is greater than ATC, ATC must be
rising.
• The MC crosses the ATC at its minimum point.
Since all marginal costs are variable, the same
relationship holds between MC and AVC.
• AVC and ATC get closer together as output
increases, but the two lines never meet
because as AFC falls with output, an ever-
declining amount is added to AVC.
• AFC falls continuously since total fixed costs
 Q If the marginal cost is below
the average cost, then:
A. the marginal cost must be
falling. 20% 20% 20% 20% 20%

B. the marginal cost must be

rising.
C. the average cost must be
falling.
D. the average cost must be
rising.
E. the average cost could be
either rising or falling
depending on whether the
marginal cost is rising or A. B. C. D. E.
falling.