Microeconomics: Chapter 5
Theory of Production
Definition
– Production means the process of using the factor of production to produce goods and
services.
– Production is the process of transforming inputs into
INPUTS OUTPUTS
Inputs refers to the Processing Refers to what we get
factors of production at the end of the
that a firm use in the production process
production process. that is finished
products.
CLASSIFICATION OF FACTORS OF PRODUCTION
LAND - All natural resources or gift of nature. Eg land surface, water, seas, forest.
LABOUR - Physical or mental activities of human beings. Eg doctors, lecturers, farmers, lawyer.
CAPITAL -Part of man-made wealth used for further production. Eg building, machinery,
money.
ENTREPRENEUR - A person who combines the different factors of production, and initiates
the process of production and also bears the risk.
PRODUCTION FUNCTION - is a statement of the functional relationship between inputs and outputs,
where it shows the maximum output that can be produced with given inputs.
Q = ¦(K, L, M, etc.)
Where: Q = Output
K = Capital
L = Labour
M = Raw Material
SHORT-RUN AND LONG-RUN PRODUCTION FUNCTION
Two Types of Factor Inputs
– Fixed Input
• An input which the quantity does not change according to the amount of output.
• Example: Machinery, land, buildings, tools, equipment, etc.
– Variable Input
• An input which the quantity changes according to the amount of output.
• Example: Raw materials, electricity, fuel, transportation, communication, etc.
Short-run and Long-run Periods
– Short run period is the time frame, which at least one of the inputs (factor of production)
is fixed and other inputs can be varied.
– Long run period is the time frame which all inputs are variable.
SHORT-RUN PRODUCTION FUNCTION
In the short run, we assume that at least one of the inputs is fixed that is capital.
Therefore, in the short run the production function can be written as:
Q = ¦( K , L)
Where: Q = Output
L = Labour
K = Capital (fixed)
LAW OF DIMINISHING MARGINAL RETURNS
– It states that if the quantities of certain factors are increased while the quantities of one or
more factors are held constant, beyond a certain level of production, the rate of increase
in output will decrease.
OR
– “Law of diminishing marginal returns states that as more of a variable input is used while
other input and technology are fixed, the marginal product of the variable input will
eventually decline”.
TOTAL PRODUCT (TP)
– The amount of output produced when a given amount of
– That input is used along with fixed inputs.
AVERAGE PRODUCT (AP)
– Divide the total product by the amount of that input
– used in the production
Average Product (APL) = Total Product
Total Labour
MARGINAL PRODUCT (MP)
Change in the total product of that input corresponding to an addition unit change in its labour
assuming other factors that is capital fixed.
Marginal Product (MPL) = Change in Total Product
Change in Total Labour
MPL = D TP/ D L
RELATIONSHIP BETWEEN TP AND MP
When MP is increasing, TP increase at an increasing rate.
When MP is decreasing, TP increase at a decreasing rate.
When MP is zero, TP at its maximum.
When MP is negative, TP declines.
RELATIONSHIP BETWEEN AP AND MP
When MP is above AP , AP is increasing
When MP is below AP, AP is decreasing.
When MP equals to AP, AP is at maximum.
Total Product Marginal Product Average Product
Stage I Increases Increases
(Increases at an increasing rate)
Stage I Reaches a maximum and Continues to increase
(Increases at a diminishing rate) begins to diminish
Stage II (Continues to increase at a Continues to diminish Reaches maximum and begins to
diminishing rate) diminish
Stage II (Reaches maximum) Becomes zero Continues to diminish
Stage III Becomes negative Continues to diminish but must
(Diminishes) always be greater than zero
Stage I
Proportion of fixed factors are greater than variable factors
Under utilization of fixed factor
Operation involves a waste of resources
Stage II
Called law of diminishing returns
The most efficient stage of production because the combinations of inputs are fully utilized
Stage III
Proportion of fixed factors is lower than variable factors
Increase in variable factors decline the TP because of overcrowding
A producer would not like to operate at this stage
LONG-RUN PRODUCTION FUNCTION
ISOQUANT ANALYSIS
– An isoquant or iso-product represents all the possible combination of two factor inputs,
which gives the same level of output (total product).
– Represents all the possible combinations of variable inputs that used to generate the
same level of output (total product).
Properties of an isoquant curve
1. The iso-quant curve is negatively sloped, which means, in order to have a same
level of production, the more use of units of one input factor is to be offset with
the lesser units of another input factor.
2. The iso-quant curve is convex to the origin because of the MRTP effect. This
shows that factors of production are substitutable for each other and with the
increase in one factor the other has to be reduced to have the same level of
production.
3. Iso-quant curves cannot intersect or be tangent to each other. If these intersects,
then the results will be incorrect. A common factor combination on both the
curves will show the same level of output, which is not feasible.
4. Upper iso-quant curves yield higher outputs. This is possible because, at a
higher curve, more factors of production are employed either the capital or the
labor, which results in more production.
Exercises
Question 1
Refer to the table below and answer the following questions:
Land Worker Total Product Average Product Marginal Product
10 1 40
10 2 50
10 3 126 36
10 4 37.5
10 5 165
10 6 9
10 7 168
(a) Complete the above table. (10 marks)
(b) Sketch the Total Product, Average Product and Marginal Product in the same diagram. Indicate the
stage of production. (5 marks)
(c) At what number of worker does total product is maximized? (2 marks)
(d) At what stage of production will a rational producer choose to produce? State the range of the worker.
(3
marks)
