THEORY OF

PRODUCTION
Concept of Production
 Production
 creation of goods or service for the purpose of selling
to buyers.
 Creation of outputs by business firms, by government
agencies and by nonprofit institutions like school and
hospitals.
Examples of Production Activities
 The farmer producing vegetables
 The psychiatrist producing specialized service
 The songwriter producing new song
 The DPWH producing roads
 A mother producing meals for her children
 Suzuki Corp, producing motorcycles
Transforming Inputs to Outputs
 Production is an activity where inputs are
transformed into outputs. To be able to do it, the
following are required
 Assembling the necessary inputs
 Transforming the inputs through a recipe and
technological process into outputs of goods and
services
What are the INPUTS
 Capital - including raw materials ingredient,
supplies, tools, machinery, equipment and physical
facilities.
 Labor – which combines and process the various
materials
 Land - where the space allotted for processing is
located
 Entrepreneurial or Managerial talent – which
performs function like supervision, planning,
control, coordination and leadership
Categories of Production Activities
 Unique- product production
 This type of production activity has as its output
“made to order” products and services.
 High demands on skill and craftsmanship
 Low volume of production is not uncommon but high
volume can be achieve by increasing the size of the
workforce.
 Rigid Mass Production
 This production activity involves the manufacture of
uniform products in large quantity using a well define,
proven and usually inflexible technology.
 The tools, materials and parts used are standardized
which make movements and outcomes highly
economical.
 This makes possible mass production in short periods
of time.
 Flexible Mass Production
 In this type of production activity, processing is done
in two stages.
 The first stage involves mass production of standardized
components
 Components are assembled into final products that appear
different from one another.
 This type of production clearly has cost efficiency
advantage in addition to its ability to cater to consumer
needs.
 Process or Flow Production
 A continuous flow of output is the feature of process or
flow production
 Integrated technology is employed to move a
continuous flow of raw materials inputs through the
system.
 This production activity is highly automated and
mechanized, resulting to high production efficiency
when operated at capacity
Production Function
 Relationship between the amount of inputs required and
the amount of output that can be obtained.
 A schedule ( a table or mathematical equation) showing
the maximum amount of outputs that can produced from
any specified sets of inputs given the existing technology.
 Example: the number of college graduate a school can
produce. School administrators know that the
quantity and quality of college graduate will depend
on the quality and quantity of teachers and students;
number and types of buildings, library and
laboratory facilities.
Marginal Product
Influences this trend and is define as the product due to
the additional or last unit of the variable resource input
and measured as follows
MP = ∆Q
∆I
Where: MP = marginal product or output
Qp = Total Product or Output
I = Resource Input
∆ = change
Production Function Table
Labor Total Product/ Marginal Average
(Manhours) Output Product Product
(Units) (Units)
1 5 5 5 Stage 1
2 10 5 5 Stage 1
3 16 6 5.3 Stage 1
4 21 5 5.2 Stage 2
5 24 3 4.5 Stage 2
6 24 0 4 Stage 2
7 21 -3 3 Stage 3
8 16 -5 2 Stage 3
9 10 -6 1.1 Stage 3
10 5 -5 0.5 Stage 4
11 2 -3 0.2 Stage 4
 At Stage 1, every additional input of labor churns out a
bigger chunk with a higher Marginal Product (MP) to
accelerate (TP)
 At Stage 2, additional inputs churns out a smaller chunk
with lower MP to still increase but decelerate TP. MP
continues to decline to negative levels
 At Stage 3, where additional labor inputs has negative
returns and decrease T
 Average Product is output per unit of the variable resource
input and measure as follows
AP = Q/I
* The decline in TP at last stage obviously decrease AP but
only to the level of zero
Law of Diminishing Returns
 The production function shows that stretching the use
of variable resources against the limits of fixed
resources decreases additional product (MP)
 Having too much of one resources and too little of
another can even result in a resources imbalance that
decreases production capacity with a negative MP at
stage 3
 Stretching resource use to the point of imbalance or
overusing breeds counterproductive conditions which
directly cause diminishing or even negative returns.
Lessons of Diminishing Returns
 The size of a resource, given the rest as fixed,
should not go beyond its product maximizing point.
 Plant capacity can only increase with more
resources combined unless technology changes.
 Resources are complementary, a resource is as
indispensable as any other in production.
Isoquant – Isocost Model
 This model illustrates more dynamically how
different plant sizes and resource combinations
determine different levels of resource efficiency
and plant capacity.
 ISOQUANT – combinations of resource input that
produce the same level of output.
ISOQUANT
Labor Input Capital Input Marginal Rate of
Substitution
1 30 -
2 26 4
3 22.5 3.5
4 19.5 3
5 17 2.5
6 15 2
7 13.5 1.5
8 12.5 1
9 12 0.5
10 12 0
ISOQUANT Figure
This figure shows inverse
relationship exists between the
resources as the capacity
foregone by using less of one is
regained by using more of the
other .

Marginal Rate of Substitution (MRS) is define as how much of one

resource is given up in order to use an additional unit of other, given
fixed capacity.
Isoquant and Diminishing Returns
 The Law of Diminishing Returns influences the
behavior of the marginal rate of substitution (MRS)
as latter shapes the isoquant.
 An efficient resource cannot be given up in
exchange for an inefficient one to maintain output.
Hierarchy of Isoquants
 Is an array of isoquants which correspond to
different levels of resource inputs and plant
capacity.
All the points of Q1 move upward to
form a higher isoquant Q2 as more
capital and labor combines increases
plant capacity
Isocost Curve and its Hierarchy
 Isocost – combinations of production resources that
a given budget can buy
Table – ISOCOST and Hierarchy
Budget 10,000 Budget 20,000
Capital Labor Capital Labor
5 0 10 0
4 4 8 8
3 8 6 16
2 12 4 24
1 16 2 32
0 20 0 40
Price of Capital = 2,000
Price of Labor = 500
MRS (capital/ labor) =0.25
Table shows the isocost curve with capital and labor as resource inputs.
Between one point and another along the curve, one resource is given up in
exchange for the other because of a FIXED BUDGET.
Figure of Isocost

Hierarchy of isocost curves which

corresponds to different budget and
cost levels. In table shows that the
purchase of both capital and labor
increases proportionally with the
budget for every combination.

A bigger budget forms higher isocost

curve but with the same MRS because
of constant prices and their ratio.
Isoquant and Isocost Combination
 The isoquant represents what can be produce while
isocost curve defines the cost and budgetary limits
of production
 The optimum resource combination for a given
plant capacity is a least cost condition.
Figure – Isoquant and isocost
The budget of isocost curve B2 meets
an alternative resource need of
isoquant Q1 at point B or C or where
Capital B two curves meet.

Budget can purchase a certain

resource combination to build up a
A C certain plant capacity.
Q
Least cost and optimum combination
B1 B2
is at point A where the isoquant is
Labor tangent to the lowest isocost curve
that meet its production requirement
Change in Resource Mix
 Resource mix or combination
 Is define as how much of one resource is used per unit
of the other.
 Optimum combination changes with relative resource
price and efficiency.
Figure
The figures shows that the isocost
curve becomes steeper from B1 to
B2 as labor becomes costlier while
Capital B capital cheapens.

Output decreases because only less

A of costlier labor inputs can
Q1
complement the same capital
inputs with same budget.
B2 B1
Labor
Productivity
 Productivity
 Is the efficiency and therefore, the power of inputs to
produce
 Measure as output per unit
 P = Q/I where Q = output and I = input
 Marginal Productivity
 Efficiency of additional inputs and measure as their
average output which is also
 Marginal Productivity = ∆Q/ ∆I
2 types of Productivity
 Technical Efficiency – capitalizes on the output
 Cost Efficiency – gives emphasis to the cost of
inputs.
Relative Resource Efficiency
 Production resources are complementary not only
in function but also in efficiency
 Resources do not become more internally efficient
at the same time, but every improvement
contributes to the overall productivity pictures.
 Productivity improvement can alter the optimum
combination of resources which result the TP, AP
and MP to move upward
Basic Ways to Improve Resource
Efficiency
 Change the nature of the resource through
innovation.
 Change the external condition of resources such as
the organization of work
 More balanced resource combination
 Using the resource saving technology
Trend in Computer Technology
 Technology only has a dramatic impact on output
in the computer producing sector.
 This manufacturing sector continually produces
faster and better computers even at lowest cost.
Return to Scale and Productivity
 Measures how output changes relative to resource
inputs a