Theory of Production-1

THE THEORY OF
PRODUCTION
• Production involves transformation
of inputs such as capital,
equipment, labor, and land into
output - goods and services
• In this production process, the

manager is concerned with
efficiency in the use of the inputs
- technical vs. economical efficiency
1
Two Concepts of Efficiency
• Economic efficiency:
– occurs when the cost of producing a
given output is as low as possible
• Technological efficiency:
– occurs when it is not possible to
increase output without increasing
inputs
2
You will see that basic production
theory is simply an application of
constrained optimization:
the firm attempts either to minimize

the cost of producing a given level
of output
or
to maximize the output attainable
with a given level of cost.
Both optimization problems lead to

same rule for the allocation of
inputs and choice of technology
3
Production Function
• A production function is purely technical
relation which connects factor inputs &
outputs. It describes the transformation of
factor inputs into outputs at any particular
time period.
Q = f( L,K,R,Ld,T,t)
where
Q = output R= Raw Material
L= Labour Ld = Land
K= Capital T = Technology
t = time
For our current analysis, let’s reduce the

inputs to two, capital (K) and labor (L):
4
Q = f(L, K)
Production Table
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed
Same Q can be produced with different combinations of
inputs, e.g. inputs are substitutable in some degree
5
Short-Run and Long-Run
Production
• In the short run some inputs are
fixed and some variable
– e.g. the firm may be able to vary the
amount of labor, but cannot change
the amount of capital
– in the short run we can talk about
factor productivity / law of variable
proportion/law of diminishing returns
6
• In the long run all inputs
become variable
– e.g. the long run is the period
in which a firm can adjust all
inputs to changed conditions
– in the long run we can talk
about returns to scale
7
Short-Run Changes in
Production
Factor Productivity
Units of K
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed
How much does the quantity of Q change,

when the quantity of L is increased? 8
Long-Run Changes in
Production
Returns to Scale
Units of K
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed
How much does the quantity of Q change, when

the quantity of both L and K is increased?
9
Relationship Between Total,
Average, and Marginal Product:
Short-Run Analysis
• Total Product (TP) = total quantity

of output
• Average Product (AP) = total

product per total input
• Marginal Product (MP) = change

in quantity when one additional
unit of input used 10
The Marginal Product of
Labor
• The marginal product of labor is the
increase in output obtained by adding
1 unit of labor but holding constant the
inputs of all other factors
Marginal Product of L:
MPL= Q/L (holding K constant)
= Q/L
Average Product of L:
APL= Q/L (holding K constant)
11
Law of Diminishing
Returns
(Diminishing Marginal
Product)
The law of diminishing returns states that when more
and more units of a variable input are applied to a
given quantity of fixed inputs, the total output may
initially increase at an increasing rate and then at a
constant rate but it will eventually increases at
diminishing rates.
Assumptions. The law of diminishing returns is based
on the following assumptions: (i) the state of technology
is given (ii) labour is homogenous and (iii) input prices
are given.
12
Short-Run Analysis of Total,
Average, and Marginal Product
• If MP > AP then
AP is rising
• If MP < AP then
AP is falling
• MP = AP when
AP is
maximized
• TP maximized
when MP = 0
13
Three Stages of Production in
Short Run
AP,MP
Stage I Stage II Stage III
APX
•TPL Increases at MPX X

•TPL Increases at
Diminshing rate. • TPL begins to
increasing rate.
•MPL Begins to decline. decline
•MP Increases at
decreasing rate. •TP reaches maximum •MP becomes
level at the end of negative
•AP is increasing stage II, MP = 0.
and reaches its •APL declines
•AP continues to
maximum at the decline 14
end of stage I
Three Stages of Production
Stages
Labor Total Average Marginal of
Unit Product Product Product Production
(X) (Q or TP) (AP) (MP)
1 24 24 24
2 72 36 48 I
3 138 46 66 Increasing
4 216 54 78 Returns
5 300 60 84
6 384 64 84
7 462 66 78
8 528 66 66 II
9 576 64 48 Diminishing
10 600 60 24 Returns
11 594 54 -6 III
12 552 46 -42 Negative Returns
15
Application of Law of
Diminishing Returns:
• It helps in identifying the rational

and irrational stages of
operations.
• It gives answers to question –
How much to produce?
What number of workers to apply
to a given fixed inputs so that the
output is maximum?
16
Production in the
Long-Run
– All inputs are now considered to
be variable (both L and K in our
case)
– How to determine the optimal
combination of inputs?
To illustrate this case we will use

production isoquants.
An isoquant is a locus of all
technically efficient methods or all
possible combinations of inputs for
producing a given level of output. 17
Production Table
Units of KK
Units of
Employed
Employed Output Quantity (Q) Isoquant
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of
of KL Employed
18
Isoquant
Graph of Isoquant
Y
7
0
1 2 3 4 5 6 7 X
19
Types of Isoquant
There exists some degree of
substitutability between inputs.
Different degrees of substitution:
Sugar
Natural
Cane Capital
flavoring
syrup
K4
K1 K2 K3
Q
Sugar All other L1 L2 L3 L4 Labor

ingredients
b) Input – Output/ L- c) Kinked/Acitivity
a) Linear Isoquant Shaped Isoquant
(Perfect substitution) (Perfect Analysis Isoquant –
complementarity) 20
(Limited substitutability)
Marginal Rate of Technical
Substitution MRTS
• The degree of imperfection in
substitutability is measured with
marginal rate of technical
substitution (MRTS- Slope of
Isoquant):
MRTS = L/K
(in this MRTS some of L is removed

from the production and substituted
by K to maintain the same level of
output)
21
Properties of Isoquants
• Isoquants have a negative slope.
• Isoquants are convex to the origin.
• Isoquants cannot intersect or be tangent to

each other.
• Upper Isoquants represents higher level of

output 22
Isoquant Map
• Isoquant map is a set
Figure : Isoquant Map
of isoquants
Y
presented on a two
dimensional plain.
Capital Y
Each isoquant shows IQ3
IQ4
various combinations IQ1

IQ2
of two inputs that can O Labour X X
be used to produce a
given level of output.
23

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THE THEORY OF

• In this production process, the

the firm attempts either to minimize

Both optimization problems lead to

For our current analysis, let’s reduce the

How much does the quantity of Q change,

How much does the quantity of Q change, when

• Total Product (TP) = total quantity

• Average Product (AP) = total

• Marginal Product (MP) = change

•TPL Increases at MPX X

• It helps in identifying the rational

To illustrate this case we will use

Sugar All other L1 L2 L3 L4 Labor

(in this MRTS some of L is removed

• Isoquants are convex to the origin.

• Isoquants cannot intersect or be tangent to

• Upper Isoquants represents higher level of

various combinations IQ1

of two inputs that can O Labour X X

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