The Theory and Estimation of Production

Farrukh Wazir Khan

 Definition of Production
Production is the process in which inputs (factors of production)
are transformed into outputs.
The production function is a statement of the relationship between a firm’s scarce
resources (i.e., its inputs) and the output that results from the use of these
resources. In mathematical terms, the production function can be expressed as:
Q = f(X1, . . . , Xk) where Q = Output
X1, . . . , Xk = Inputs used in the
production process
For purposes of analysis, let us reduce the whole array of inputs in the production
function to two, X and Y.
Q = f(X, Y ) where Q = Output, X = Labor,Y = Capital

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The production function

A production function defines the relationship between inputs and

the maximum amount that can be produced within a given period
of time with a given level of technology.

A short-run production function shows the maximum quantity of a good or

service that can be produced by a set of inputs, assuming the amount of at least
one of the inputs used remains unchanged.

A long-run production function shows the maximum quantity of a good or

service that can be produced by a set of inputs, assuming the firm is free to vary
the amount of all the inputs being used.

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The Production Function

A Short-Run Analysis of Total, Average, and Marginal Product

• The Law of Diminishing Returns

• The Three Stages of Production in the Short Run

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 Q = f ( X, Y )

A Short-Run Analysis of Total, Average, and Marginal Product

Before we go on to a more detailed analysis of the production function, certain

key terms employed throughout this chapter should be clarified. First, economists
use a number of alternative terms in reference to inputs and output:

Inputs Output
Factors Quantity (Q )
Factors of production Total product (TP )
Resources Product

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A Short-Run Analysis of Total, Average, and Marginal Product

In the short-run analysis of the production function, two terms besides the quantit
y of output are important measures of the outcome. They are marginal product
(MP) and average product (AP). If we assume X to be the variable input, then

Marginal product of X = MPX = ΔQ/ΔX, holding Y constant

Average product of X = APX = Q/X, holding Y constant

In other words, the marginal product can be defined as the change in output or
total product resulting from a unit change in a variable input, and the average
product can be defined as the total product (TP) per unit of input used.

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 Q = f ( X, Y )

The production function

A hypothetical production function with two inputs is displayed in the following

Table. The numbers in the matrix indicate the amount of output that would result
from various combinations of X and Y.

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A Short-Run Analysis of Total, Average, and Marginal Product
Q = f(X, Y )

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 Production in the Short Run

• Rewriting the row, we can create the

following table and calculate values of
marginal and average product.

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 Production in the Short Run : Pages 183 - 184

Variable
Example 1 Input Total Product
(X) (Q or TP)
Assume following data 0 0
1 8
Calculate values of marginal product
2 18
and average product. 3 29
4 39
5 47
6 52
7 56
8 52

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Example 1 – Contd/-
Calculation of Marginal Product
Variable Marginal
Input Total Product Product
(X) (Q or TP) (MP)
0 0
Q 8
1ΔX=1 ΔQ=8
8  8
X 1
2 18
3 29
4 39
5 47
6 52
7 56
8 52

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 Example 1 – Contd/-

Calculation of Marginal Product

Variable Marginal
Input Total Product Product
(X) (Q or TP) (MP)
0 0
8
1 8
10
2 18
11
3 29
10
4 39
8
5 47 Q 5
ΔX=1 ΔQ=5  5
6 52 X 1
7 56 4
8 52 -4

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 Example 1 – Contd/-

Calculation of Average Product

Variable Total Average
Input Product Product
(X) (Q or TP) (AP)
0 0 ---
Q

88  8
11 88
2 18
X 1
1

3 29
4 39
5 47
6 52
7 56
8 52

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Example 1 – Contd/-
Calculation of Average Product
Variable Total Average
Input Product Product
(X) (Q or TP) (AP)
0 0 ---
1 8 8
2 18 9
3 29 9.67
4 39 9.75
5 47 9.4
6 52 8.67
7 56 8
8 52 6.5

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 Production in the Short Run : Pages 184 - 189

Production in the Short Run

• The figures illustrate
TP, MP, and AP
graphically.

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 Production in the Short Run
• If MP is positive then
TP is increasing.
• If MP is negative then
TP is decreasing.
• TP reaches a maximum
when MP=0

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Production in the Short Run
• If MP > AP then
AP is rising.
• If MP < AP then
AP is falling.
• MP=AP when AP
is maximized.
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The Law of Diminishing Returns

The key to understanding the pattern of change in Q, AP, and MP is the

phenomenon known as the law of diminishing returns. This law states:

Definition :

As additional units of a variable input are combined with a fixed

input, at some point the additional output (i.e., marginal product)
starts to diminish.

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 Diminishing Returns
Variable Marginal
Input Total Product Product
(X) (Q or TP) (MP)
0 0
1 8 8
2 18 10 Diminishing
11 Returns
3 29 Begins
4 39 10 Here
5 47 8
6 52 5
7 56 4
8 52
-4
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 The Law of Diminishing Returns
• Reasons
Increasing Returns
Teamwork and Specialization
MP Diminishing Returns Begins
Fewer opportunities for teamwork
and specialization

X
MP
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 The Three Stages of Production
• Stage I
– From zero units of the variable input to where AP
is maximized
• Stage II
– From the maximum AP to where MP=0
• Stage III
– From where MP=0 on

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 Three Stages of Production in the Short Run

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 Optimal Level of Variable Input Usage – Page 190-191

Example 2

• Consider the following short run production

process. Labor
Unit
Total
Product
Average Marginal
Product Product
(X) (Q or TP) (AP) (MP)
0 0
1 10,000 10,000 10,000
Where is 2 25,000 12,500 15,000
3 45,000 15,000 20,000
Stage II? 4 60,000 15,000 15,000
5 70,000 14,000 10,000
6 75,000 12,500 5,000
7 78,000 11,143 3,000
8 80,000 10,000 2,000

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 Optimal Level of Variable Input Usage

• What level of input usage within Stage II is

best for the firm?
• The answer depends upon how many units
of output the firm can sell, the price of the
product, and the monetary costs of
employing the variable input.

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 Optimal Level of Variable Input Usage

• In order to determine the optimal input

usage we assume that the firm operates
in a perfectly competitive market for its in
put and its output.
– Product price, P=$2
– Variable input price, w=$10,000

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 Optimal Level of Variable Input Usage

• Define the following

– Total Revenue Product (TRP) =

– Marginal Revenue Product (MRP) =
– Total Labor Cost (TLC) =
– Marginal Labor Cost (MLC) =

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 Optimal Level of Variable Input Usage
• Define the following
– Total Revenue Product (TRP) = Q•P
– Marginal Revenue Product (MRP) =
TRP (Q  P) P  Q
   P  MP
X X X
– Total Labor Cost (TLC) = w•X
– Marginal Labor Cost (MLC) = TLC
w
X

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 Optimal Level of Variable Input Usage – Page 190-191

Example 2 – Contd/- Product price, P=$2 Variable input price, w=$10,000

Total Marginal Total Marginal
Labor Total Average Marginal Revenue Revenue Labor Labor
Unit Product Product Product Product Product Cost Cost TRP- MRP-
(X) (Q or TP) (AP) (MP) (TRP) (MRP) (TLC) (MLC) TLC MLC
0 0 0 0 0
1 10,000 10,000 10,000 20,000 20,000 10,000 10,000 10,000 10,000
2 25,000 12,500 15,000 50,000 30,000 20,000 10,000 30,000 20,000
3 45,000 15,000 20,000 90,000 40,000 30,000 10,000 60,000 30,000
4 60,000 15,000 15,000 120,000 30,000 40,000 10,000
? 80,000 20,000
Stage 5 70,000 14,000 10,000 140,000 20,000 50,000 10,000 90,000 10,000
II ? 6 75,000 12,500 5,000 150,000 10,000 60,000 10,000 90,000 0
7 78,000 11,143 3,000 156,000 6,000 70,000 10,000 86,000 -4,000
8 80,000 10,000 2,000 160,000 4,000 80,000 10,000 80,000 -6,000
MRP = MP x P
TLC = X x W
Farrukh Wazir Khan MLC = ∆TLC / ∆X
 Optimal Level of Variable Input Usage

• A profit-maximizing firm operating in

perfectly competitive output and input markets will
be using the optimal amount of an input at the point
at which the monetary value of the input’s marginal
product is equal to the additional cost of using that
input.

• Where MRP=MLC.

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 Optimal Level of Variable Input Usage – Page 190-191

Example 2 – Contd/-
Total Marginal Total Marginal
Labor Total Average Marginal Revenue Revenue Labor Labor
Unit Product Product Product Product Product Cost Cost TRP- MRP-
(X) (Q or TP) (AP) (MP) (TRP) (MRP) (TLC) (MLC) TLC MLC
0 0 0 0 0
1 10,000 10,000 10,000 20,000 20,000 10,000 10,000 10,000 10,000
2 25,000 12,500 15,000 50,000 30,000 20,000 10,000 30,000 20,000
3 45,000 15,000 20,000 90,000 40,000 30,000 10,000 60,000 30,000
4 60,000 15,000 15,000 120,000 30,000 40,000 10,000 80,000 20,000
5 70,000 14,000 10,000 140,000 20,000 50,000 10,000 90,000 10,000
Stage
6 75,000 12,500 5,000 150,000 10,000 60,000 10,000 90,000 0
II
7 78,000 11,143 3,000 156,000 6,000 70,000 10,000 86,000 -4,000
8 80,000 10,000 2,000 160,000 4,000 80,000 10,000 80,000 -6,000

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 Three Stages of Production : Partial Elasticity of Production

Example 3

Hint : Stage 1 – Between L=0 and L where AP is maximized

Stage 2 - Between L where stage 1 ends and L where MP = 0
Stage 3 – L where stage 2 ends onwards

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 Optimal Level of Variable Input Usage – Page 192-193

• When the firm employs multiple variable inputs,

the firm should choose the level of the inputs whic
h equates the marginal product per dollar across
each of the inputs. Mathematically,

MP1 MP2 MPk

 
w1 w2 wk

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 Optimal Level of Variable Input Usage – Page 192-193

Example 4

A firm produces parts in Country A and Country B.

At current production levels and input utilization :
Country A MPa=18units Wage Rate Wa=$6/hr
Country B MPb=6units Wage Rate Wb=$3/hr

In which country should the firm hire more workers ?

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 Production in the Long Run
• In the long run, all inputs are variable.
• The long run production process is described
by the concept of returns to scale.
• Returns to scale describes what happens to
total output as all of the inputs are changed
by the same proportion.
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 Production in the Long Run

• If all inputs into the production process are doubled,

three things can happen:
– output can more than double
• increasing returns to scale (IRTS)
– output can exactly double
• constant returns to scale (CRTS)
– output can less than double
• decreasing returns to scale (DRTS)

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 Production in the Long Run
Economists hypothesize that a firm’s long run production function may exhibit
at first increasing returns, then constant returns, and finally decreasing
returns to scale.

Returns to scale can also be described

using the following equation
hQ=f(kX,kY)

• If h>k then IRTS

• If h=k then CRTS
• If h<k then DRTS

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 Production in the Long Run

• Graphically, the returns to scale concept

can be illustrated using the following
graphs.
IRTS CRTS DRTS
Q Q Q

X,Y X,Y X,Y

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 Production in the Long Run
One way to measure returns to scale is to
use a coefficient of output elasticity:
Percentagechange in Q
EQ 
Percentagechange in all inputs

• If E>1 then IRTS

• If E=1 then CRTS
• If E<1 then DRTS
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 Production in the Long Run - Returns to Scale : Page 194-195

Prod Example 5n t
he Long Run

a. What is output ?
b. Assume inputs increase by 25%, do you observe
increasing, decreasing or constant returns to scale?

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 Cobb Douglas Production Function

• Cobb Douglas
b 1-b or c
Q = aL K
– b+c > 1 IRTS
– b+c = 1 CRTS
– b+c < 1 DRTS

– Short Run Analysis: MPK = c Q/K &

MPL = b Q/L
– b & c are Elasticities of K & L factors

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 Cobb Douglas Production Function : Pages 198-200

Example 6

Cobb Douglas

Assume Q = aL0.25K0.75

Do you observe Increasing, Constant or Decreasing Returns to Scale ?

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Reading Assignment

Managerial Economics: Economic Tools for Today’s Decision Makers

By Paul G. Keat, Philip K. Y. Young, Stephen E. Erfle

Chapter 6

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