Chapter 6:

Theory of Production
Terms to Remember:
• Marginal Product – additional product brought about adding an
additional resource output.
• Diminishing Returns – the point where marginal product
decreases despite an increase to resource input.
• Isoquant – combination of resource input that produce the same
level of output.
• Isocost – combination of production resources that a given budget
can buy.
• Productivity – the ratio o output over input
• Returns to Scale – measures how an output changes relative to
resource inputs.
Production
 The process of transformation of resources (like land, labour,
capital and entrepreneurship) into goods and services of
utility to consumers and/or producers.

 Theory of production is an analysis of output-input

relationship.
 Production Function

A production function is a table or a

mathematical equation showing the
maximum amount of output that can be
produced from any specified set of inputs,
given the existing technology. The total
product curve for different technology is
given below:
Q

Q = output
x = inputs

x
 Production Function
 Also termed as law of variable proportion

 It is the short term production function

 Total product is a function of labour:

 Average Product (AP) is total product per unit of variable
input

 Marginal Product (MP) is the addition in total output per

unit change in variable input
 Marginal Product is defined as the product due to additional
or lost unit of the variable resource input and measured as follows

 As the quantity of the variable

factor is increased with other fixed
factors, MP and AP of the variable
factor will eventually decline.
 Therefore law of variable  Average Product
proportions is also called as law of is output per
diminishing marginal returns. unit of the
variable resource
input and
measured as
follows:
EXAMPLE :

 The decline of TP at the last stage

obviously decreases AP but only to
the level of zero. There is no such
thing as negative output, although a
negative MP only shows decrease in
output.
Law of Diminishing Returns
 States that production function shows that stretching the use of
variable resources against the limits of fixed resources decreases
the marginal product.

 Furthermore having too much of one resource and too little of one
another can even result in a resource imbalance that decreases
production capacity with a negative marginal product.

Lessons of Law of Diminishing Returns

 The size of the resource  Capacity can only increase  Resources are
should not g beyond its with more resources basically
product-maximizing point. combined with unless complementary.
technology changes.
Isoquant-Isocost Model
Illustrates more dynamically how different resource combinations
determine different levels of resource efficiency and capacity.

There are infinite combinations of resource inputs which determine

the same capacity, these combinations form the product indifference
curve or ISOQUANT
Marginal Rate of Substitution (MRS) – how much of one resource is
given up in order to use an additional unit of other, given a fixed
capacity.
Where:
K- Capital
L- Labor
 The table shows that less and less of capital
inputs (K) are given up in order to use an
additional unit of labor (L) as MRS decreases
down.

The graph shows the downward pointing arrow as the capital and rightward pointing
arrow as the labor.
The shortening vertical arrow decreases as the ratio of the horizontal arrow which is the
trend of the MRS as L substitutes K.
This trend shapes that the isoquant as convex to the graph’s point of origin.
Heirarchy of Isoquants
• It is an array of isoquants • This means that any point in
which corresponds to different the graph is a resource
level of resource inputs. combination of an isoquant.
• All points of Q1 move upward
to form a higher isoquant
which is the Q2 as more
capital and labor increases
capacity.
• This overall change is actually
the upward and rightward
shift in the production
function curve.
• There is an infinite number of
isoquants as there are infinite
levels of the capacity in the
hierarchy.
 Isocost and Its Heirarchy
• There are infinite
combinations of
production resources that
a given budget can buy.
• These combination form
isocost curve.
• The table and the graph
illustrates 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 other
because of a fixed budget.
 Returns to Scale
 Returns to Scale show the degree by which the level of
output changes in response to a given change in all the
inputs in a production system.
Constant Returns to Scale : When a proportional
increase in all inputs yields an equal proportional
increase in output
Increasing Returns to Scale : When a proportional
increase in all inputs yields a more than
proportional increase in output
Decreasing Returns to Scale : When a proportional
increase in all inputs yields a less than proportional
increase in output
 Return to Scales
Measures how output changes relative to resource
inputs in the long run and indicates how overall
resource efficiency changes:

Where:
Q – output
I – Resource Input
 Stages of Law of Production
First Stage: Increasing return

 TP increase at increasing rate until the end of the stage.

 AP also increase and reaches at highest point at the end of the stage.

 MP also increase at it become equal to AP at the end of the stage.

 MP>AP
Second Stage: Diminishing return
 TP increase but at diminishing rate and it reach at highest at the end of the
stage.
 AP and MP are decreasing but both are positive.
 MP become zero when TP is at Maximum, at the end of the stage
 MP<AP.

Third Stage: Negative return

 TP decrease and TP Curve slopes downward
 As TP is decrease MP is negative. AP is decreasing but positive.