Theory of production, in economics, an effort to explain the principles by which

a business firm decides how much of each commodity that it sells (its “outputs”
or “products”) it will produce, and how much of each kind of labour, raw
material, fixed capital good, etc., that it employs (its “inputs” or “factors of
production”) it will use. The theory involves some of the most fundamental
principles of economics. These include the relationship between the prices of
commodities and the prices (or wages or rents) of the productive factors used to
produce them and also the relationships between the prices of commodities
and productive factors, on the one hand, and the quantities of these
commodities and productive factors that are produced or used, on the other.

Production is a process of transformation of the factors of production into the

economic goods. So in term of production analysis we are dealing with the
physical relationships between inputs and outputs (i.e. we are observing the
dependence of physical production volume on physical quantity of the inputs).
Picture 34: Inputs and outputs of production process Explanation of the basic
concepts mentioned in the picture no. 34 is following:

• The factors of production (inputs): labor (mental or physical, its price is a

wage), soil (or natural resources; its price is a rent) and capital (equipment,
buildings, machinery and other tangible resources usable in production; its
price is an interest).

• The economic goods have to be produced to be available. They have a

characteristic of an economic scarcity which consists in limited resources and
utility of a good. We can occupy ourselves with production process in the
different periods. Basic partition is based on the distinction between short and
long run:

• In a short run (SR) a range of at least one input, which thereby is creating a
limitation for a whole production process, cannot be changed. Inputs, which
amount cannot be changed in a short run, are called fixed inputs. Inputs,
whose quantity cannot be changed in a short run, are called the variable
inputs.

• In a long run (LR) an amount of all inputs can be changed. Common time line
between a short and long run cannot be determined because it depends on the
nature of production (industry). In case of electric power station or airlines a
short run may take few years and in case of hairdressing a short run can be
question of few months. According to a number of variable factors we
distinguish the following types of the production functions:
• Single-factor production function can be expressed as q=f(L), where q is a
volume of production and L is a number of variable input (in this case a labor).
This function indicates that volume of production varies with amount of one
input but even fixed factors certainly enter production (but due to their
unchanging amount they do not enter argument of the function).

• Two-factor production function can be expressed as q=f(K, L), where q is a

volume of production and K and L are numbers of variable inputs (K is capital
and L is labor). In case that a firm uses only these two factors to produce, it is
a production function usable for modeling of a firm’s production in a long run.

• Multi-factor production function can be expressed for example as q = f (K1,

K2, …, KN, L), where q is a volume of production, K1…KN may be the
individual production resources, L is an amount of labor. Volume of production
is in this case function of quantity of more variable factors. Following
production analysis is based on the assumption that a firm uses in production
only two factors of production – labor (L) and capital (K). In a short run we
consider that capital is a fixed input while labor is variable input. From this
perspective we can model in a short run a production process by single-factor
production function (q=f(L)). In a long run we can model a production process
by two-factor production function because production volume will vary with
varying amount of both factors of production (q=f(K,L)) as it is already indicated
above. Production analysis in a short run During analysis of production in a
short run we will assume that production volume varies with the number of
single (variable) factor. As a variable factor we will thus consider a labor, a
capital will be fixed factor of production. Total approach created by the given
procedures is called as a total product (TP). Total product is expressed in
physical units and its curve shows the different levels of maximum achievable
output that can be produced by combinations of the different amounts of
variable input with a constant quantity of fixed input. Picture 35: Production
function in a short run Curve of total product (TP) separates reachable
amounts of output from the unreachable amounts. All points above the curve
are unreachable, points below the curve are indeed reachable but factors are
used inefficiently.

In mathematical optimization and decision theory, a loss function or cost

function is a function that maps an event or values of one or more variables
onto a real number intuitively representing some "cost" associated with the
event. An optimization problem seeks to minimize a loss function.