MICROECONOMICS

Lesson 7. Production Theory

1. Production Function
2. Production Costs
3. Economies of Scale

Duration: 3 hours

Introduction
Production theory illuminates us into understanding the behavior of the
business firm. The goal of producers or business firms is to maximize profit. This is
attained thru an efficient management of production costs.

Learning Objectives/ Competencies

At the end of the lesson, the student should be able to

1. Understand the constraints of production.
2. Explain the profit maximizing condition
3. Exhibit skills in computing the firms’ costs of production

Content/ Lesson Proper

Production is the process of altering resources or inputs so they satisfy more
needs and wants (Reynolds 2010). It is the transformation of inputs or resources into
outputs of goods and services. In another definition, it is the process of combining
inputs to make outputs (Hall and Liebermann 2004). Natural resources are
transformed into numerous things that we use every day. Oil is processed to produce
gasoline. Plants are studied and made into digestible medicines. Labor is harnessed
to produced goods and services that society avail and enjoy. Inputs used in the
production of goods includes land, labor, capital and entrepreneurship. Production
inputs are classified as variable and fixed. A variable input is an input whose usage
can change as the level of output changes. A fixed input on the other hand is an input
whose quantity must remain constant, regardless of how much output is produced
(Hall and Liebermann 2004). Fixed inputs cannot be changed in the short run.
Examples are land, plant size or government regulation.
Analysis on production may be done in the short-run or long-run. In the short
run, the use of at least one factor of production cannot be changed, or there are fixed
inputs. In the long-run, all factors can be changed. In other words, all inputs are
variable. For example, a firm producing export quality sugar may add laborers or
machineries to increase production in the short run. However, the sugarcane
plantation cannot expand in a few years. A firm decides on what and how much
resources it employs to reach a level of output.

Understanding the Firm

A business firm operates to deliver goods and services to the consuming public.
Some firms or stores operate to give a particular service out of benevolence or
advocacy. They are called non-profit institutions. However, from the standpoint of
1
 MICROECONOMICS

economics, all firms operate because of one thing: profit. The rationale of producing
a good is to gain revenues. Revenues are the payment for the output sold. Firms also
face production costs. As you have learned in the first units of this module, every
resource has a price, or a payment. In producing rice, you need payment for labor
(wage) and land (rent). You also pay for capital (interest). Profit is gained from the
difference of revenues and costs. It is expressed in the equation:
Profit = Total Revenues – Total Costs
𝜋 = 𝑇𝑅 − 𝑇𝐶
Revenues are computed by multiplying the quantity of the good sold with the
price of one unit of the good. It is expressed in the equation:
𝑇𝑅 = 𝑃 𝑥 𝑄 or 𝑇𝑅 = 𝑃𝑄

A firm’s total cost (TC) is computed by summing the costs of variable inputs
(TVC) and cost of the fixed input (TFC). It is expressed in the equation:

𝑇𝐶 = 𝑇𝑉𝐶 + 𝑇𝐹𝐶
As explained above, firms incur costs because of it pays for the factors of
production it utilizes. We discussed costs at the latter part of this lesson.

Production Function
The production function shows the relationship between quantity of inputs used
to make a good and the quantity of output of that good (Mankiw, 2009, p. 271). It can
be expresses as an equation, table or graph showing the maximum output of a
commodity that a firm can produce per period of time with each set of inputs. Inputs
and outputs are measured in physical units and not in monetary units. The production
function is expressed as
𝑄 = 𝑓( 𝐿, 𝐾)
Where Q is output, L is the input labor and K is the input capital. This equation
is under the assumption that the firm only chooses between two factors of production:
labor and capital. For example, to produce more clothes for the upcoming Christmas
season, a garments factory may either hire more skilled workers or buy more
machines. The most efficient combination of quantities of labor and capital will yield
the maximum profit. This entails a proper understanding of productivity of the
production inputs.

PRODUCTION WITH ONE VARIABLE INPUT

TOTAL, AVERAGE AND MARGINAL PRODUCT
Let us start the analysis of business firms with only one input. Total Product
(TP) is the output produced by using different quantities of an input with fixed quantities
of the other. It is the market value of the inputs used in production (Mankiw, 2009, p.
268). Average Product (AP) is the output divided by the variable input used. Marginal
Product (MP) is the change in TP per unit change in the variable input used (citation).
Let us take the garments factory to illustrate these measures. Suppose the factory
only uses labor as the variable input. The total product is the quantity of the output of
all the laborers. Output increases with every additional input of labor. More workers
produce more clothes. Average product is the output of each worker on the average.
2
 MICROECONOMICS

If there are 5 workers and their total product is 10 units, each worker is producing 2
units on the average. Marginal product of labor measures the additional output of the
additional worker. Marginal product is important as it helps firm decides whether hiring
another worker is efficient for the firm. MP and AP are expressed in the equations
below:
𝑀𝑃 = ∆𝑄/∆𝐿, 𝑀𝑃 = ∆𝑄/∆𝐾
𝐴𝑃𝐿 = 𝑇𝑃𝐿 /𝑄

Table 1 below shows a hypothetical data of garments production using labor. Notice
the trend of the values of the Output, MP and AP with the additional labor employed.
Table 1. Production of Garments Factory
Labor Output Marginal Product Average Product

1 2 2 2
2 6 4 3
3 16 10 5.3
4 29 13 7.3
5 43 14 8.6
6 55 12 9.2
7 58 3 8.3
8 60 2 7.5
9 59 -1 6.6
10 56 -3 5.6

Figure 1 shows the TP curve. Notice that the TP slowly increases, peaks and
then declines as the firm employs more labor. Hiring more inputs will not always result
to more output. This means that the marginal product of each additional worker gets
smaller. The stage of declining TP and MP exhibits the Law of Diminishing Returns.

LAW OF DIMINISHING MARGINAL RETURNS

3
 MICROECONOMICS

As you have observed in Table 1 and Figure 2, marginal product rises, reaches
a peak then declines as additional inputs are hired. This trend is called the Law of
Diminishing Marginal Returns. It is the “property whereby the marginal product of an
input declines as the quantity of the input increases” (Mankiw, 2009 ,p273). Holding
all other factors fixed except from one (e.g. labor), additional output declines as input
increases. Imagine the garments factory, management may hire additional workers
but cannot expand the factory or the work area. This may result to too much workers
operating in a limited space, which will affect their productivity.
Figure 2 shows the patterns of MP and AP. Rising AP of labor is within the

Stage 1 of production, where TP also increases. The point of declining AP and zero
MP is on the Stage 2 of production. The final stage or Stage 3 is where MP is negative.
This is the area of diminishing marginal returns, when MP and TP both declines with
additional labor (or other input) employed. It is least efficient to produce at Stage three
as TP, AP and MP are all negative. (Gabay et. Al., 2012, pp 75-76) The firm may hire
additional workers as long as AP and MP are positive.

OPTIMAL USE OF ONE VARIABLE INPUT

After understanding productivity, our next task is to know the amount of inputs
and level of production that is most efficient for the firm. A firm with a single-input
operation, like our garment factory example, will be at most efficient when the marginal
revenue product is equal with the marginal resource cost. Marginal revenue product
is the revenue form the sale of the extra output produced. It is the marginal product
multiplied with the marginal revenue (equivalent to price). It is expressed in the
equation,
MRP = MP*MR = MP*P
Marginal resource cost (MRC) is the increase in total cost resulting from hiring
an additional unit of the variable resource. If we hire additional labor, MRC will be the
additional wage of the additional worker. As long as MRP > MRC, it pays for the firm
to expand use of variable input. The optimal use of variable input is expressed in the
equation below.
Optimal use of variable input: MRP = MRC
Table 2. Hypothetical MRP and MP of a Firm
4
 MICROECONOMICS

L M𝑷𝑳 MR = P MR𝑷𝑳 MR𝑪𝑳

2 5 100 500 300
3 4 100 400 300
4 3 100 300 300
5 2 100 200 300
6 1 100 100 300

If you look at Table 2, the optimal use of variable input is when L=4, where MRP
= MRC. The wages of the 5th and 6th workers cost more than the amount of their work.

PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS

Business firms will eventually need to change more than one factor of
production. Let’s say that the firm only employs two factors as variable: capital and
labor. The firm needs to employ the combination of these two factors that will yield the
highest output. Remember that the firm’s goal is to maximize profit. Producer’s
equilibrium is therefore the point that produces the highest level of output with the
given level of inputs, labor and capital.

ISOQUANT
The isoquant shows the various combinations of two inputs that the firm can
use to produce a specific level of output. Any point in the isoquant yields the same
level of output (citation). Economic region of production is given by the negatively
sloped segment of the isoquant. Similar to the appearance of the indifference cures,
isoquants have the same properties. They are negatively sloped, convex to the origin
and do not intersect.

MARGINAL RATE OF TECHNICAL SUBSTITUTION

5
 MICROECONOMICS

The MRTS is the amount of capital that a producer is willing to give up in

exchange for labor. It is the slope of the isoquant. The convex shape of the isoquant
illustrates the willingness of the producer to give up one unit of input for another. The
producer is less willing to give up the remaining unit of one input (e.g. labor) for an
additional unit of another input (e.g. capital).

ISOCOST
The isocost line is a set of combinations of labor and capital that yield the same
total cost for the firm (Besanko and Braeutigam, 2011, p.255). It shows the various
combinations of inputs that a firm can purchase or hire at given costs. Figure 4 shows
an example of the isocost. Figure 5 shows a rightward shift of the isocost. This shows
an increase in the firm’s capital outlay. A leftward shift indicates a decrease in capital
outlay.

PRODUCER’S EQUILIBRIUM

6
 MICROECONOMICS

Producer equilibrium is the tangency of the isocost and the isoquant. It

maximizes production at the given outlay and prices of capital and labor (Gabay 2011,
78). Figure 6 shows the tangency of isocosts and isoquants at points A and B. At
Point B, there is more amount of capital and labor employed by the firm at a larger
capital outlay compared with the Point A.
The slopes of isoquant and isocosts are equal. Hence the equation
𝑀𝑃𝐿 𝑃
= 𝑃𝐿
𝑀𝑃𝐾 𝐾

EXPANSION PATH

7
 MICROECONOMICS

Expansion path is a line that connects the cost minimizing input combinations
as the quantity of output, Q varies, holding input prices constant (Besanko and
Braeutigam, 2011, p. 264). It connects the equilibrium points of isoquants and
isocosts. The movement from equilibrium points A to B and to C shows the firm’s
employment of more quantities of K and L as it produces more output.

8
 MICROECONOMICS

COST ANALYSIS
As we have discussed in the earlier part of this unit, profit maximization is done
thru the optimal use of the firm’s input. Firms incur costs by using inputs. Examples of
costs are wages, interest payments, rent and taxes.

Box 1. Types of Costs

TOTAL FIXED COST (TFC) – These are costs that do not vary with output.
Examples of these costs are depreciation of buildings and machineries,
rent expenses on leased plant, and interest payments on borrowed capital

TOTAL VARIABLE COSTS (TVC) these are costs that vary with output.
Examples are raw materials, wages, tax payments, and operating
expenses (electricity, fuel and water)

Total Cost (TC) – it is the sum of total fixed costs and toral variable costs
𝑇𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶
Average Fixed Costs (AFC) This refers to the total fixed costs divided by
the number of output produced
𝑇𝐹𝐶
𝐴𝐹𝐶 =
𝑄
Average Variable cost (AVC) This refers to the total variable costs divided
by the number of output produced
𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑄
Average Total Cost (ATC) This refers to the total output divided by the
number of output produced.
𝑇𝐶
𝐴𝑇𝐶 =
𝑄
Marginal Cost (MC) Refers to the change in total cost divided by the
change in output produced. It is the additional cost incurred from producing
additional unit of output.
∆𝑇𝐶
𝑀𝐶 =
∆𝑄

Sources:
Gabay, B. et al (2012). Economics: Concepts and Principles. 2nd edition. Manila: Rex
Bookstore Inc.
Mankiw, G. (2009). Microeconomics. Ohio:: Southwestern Cengage Learning.

Costs are treated differently by accountants and economists. Economists sees

costs thru the notion of opportunity costs. Accountants only count the explicit costs of
the firm. Explicit costs are input costs that require an outlay of money by the firm.
9
 MICROECONOMICS

These are the costs of inputs that producers are willing to pay at market prices. On the
other hand, implicit costs are costs that do not need the outlay of money by the firm.
These are the opportunity costs of buying inputs. This includes the alternative cost of
investment, time or rate of return. Both explicit and implicit costs are analyzed by the
economist (Mankiw,2009). Economic profit is therefore smaller than accounting profit.
Box 1 lists the different types of costs that a firm has.

SHORT RUN COSTS

Analysis of short run costs holds one input constant. The most efficient scale of
production is when average total cost is at its minimum. Table 3 contains the cost
schedules of Firm A. We see that TFC is fixed at Php 20,000. TVC and TC rise with
the increase in output.

Table 3. Hypothetical Cost Schedules of Firm A (in thousand pesos)

Q TFC TVC TC AFC AVC ATC MC
0 20 - 20 - - - -
1 20 10 30 20 10 30 10
2 20 15 35 10 7.5 17.5 5
3 20 18 38 6.67 6 12.67 3
4 20 30 50 5 7.5 12.5 12
5 20 50 70 4 10 14 20

Figure 8 shows the TC, TVC and TFC curves from the data in Table 3. The TFC
is constant in the short-run, reflected by the horizontal line. The curved part of the TVC
exhibits diminishing returns. Variable cost rises with the increase in output (by
increasing input), rises with a smaller increment then steadily rise past the TFC.

The average cost curves and the marginal cost curve are in Figure 9. Notice
the U-shaped ATC. AFC declines while AVC rises with the increases in output. The
rising AVC is due to the diminishing marginal product of the input. Marginal cost curve
intersects with all the average costs. MC intersects with ATC at its lowest point. The
average cost curves exhibit a U-shape like pattern because of diminishing marginal

10
 MICROECONOMICS

product. Many firms exhibit a rise in marginal product followed by a diminishing

marginal product (Mankiw 2009).

LONG RUN COST ANALYSIS

In the long-run, all inputs are variable. Firms can expand plant size or may
multiply investment. The long run average cost curve is tangent to the lowest point of
the firm’s average total cost curves. The firm may decide to choose its production size
or output along the LAC. In Figure 10, the lowest point of LAC 3 determines the most
efficient production size for the firm. The bottom of the U-shaped curve LAC, or when
the LAC is flatter shows that the firm is operating under constant returns to scale.
Larger firms with more output may opt to produce along the tangency of SAC 6 and
LAC.

LONG RUN AVERAGE COST AND LONG RUN MARGINAL COST

Average cost and marginal cost exhibit display similar relationship in the short-
run or long-run. At points where average cost is decreasing while output is increasing,
11
 MICROECONOMICS

average cost is greater than the marginal cost. When both average cost rises with
quantity, average cost is less than the marginal cost. At the point of the intersection
between average cost and marginal cost, or at AC=MC, average cost is constant
whether output increases or decreases (See Figure 11).

PROFIT MAXIMIZATION: MARGINAL REVENUE = MARGINAL COST

Firms earn profits when the value of 𝜋 = 𝑇𝑅 − 𝑇𝐶 is positive. The firm

maximizes profits when the difference between TR and TC is the largest (See Box
2). Graphically, this is shown as the point where the gap between the TR and TC
curves are at its widest (See Figure 12).

Box 2. FIRM’S TOTAL REVENUE AND TOTAL

COST

TR > TC = PROFIT

TR < TC = LOSS

TR = TC =BREAKEVEN

12
 MICROECONOMICS

Figure 12. Short run profit of a firm

Image retrieved from economicsonline.co.uk

The price and quantity that yields the highest profit is the point of intersection
of the marginal revenue and the marginal cost. Marginal revenue is the revenue
gained from the additional output sold. Firm earns profits as long as marginal
revenue is greater than marginal cost. Figure 13 shows the profit maximization of a
perfectly competitive firm. Marginal revenue is equivalent to price. The condition
where P=MR=MC is at quantity 𝑄0 , and at price 𝑃𝑂 . Profit is graphically shown from
extending AC at quantity 𝑄0 , until price 𝑃𝑂 . Average cost is lower than the price. If
the firm’s average total cost is equivalent to price, the firm is at break-even.
Revenues are only allotted for payments to inputs. The firm’s shutdown condition is
when average variable cost (AVC) is greater than marginal revenue. This means that
the firm’s revenue can only pay for its variable costs. The firm cannot pay its fixed
costs.

Figure 13. Profit maximization in a Competitive Firm

(Image retrieved from California State University website at www.csun.edu)

13
 MICROECONOMICS

RETURNS TO SCALE
Returns to scale describes the relationship of output to every proportional
increase in inputs. If the firm’s output changes by the same proportion as the inputs,
the firm is operating within constant returns to scale. For example, if the firm doubled
the quantity of capital, the quantity of output will also double. The firm may also
experience a rise in output with a larger proportion than the additional inputs. This
production scale is called increasing returns to scale or economies of scale This
may result from specialization or technological advancements. Employing more highly
skilled laborers or using a new IT system may increase productivity and would and
thus would produce more output. Lastly, when the firm’s output changes by smaller
proportion than inputs, the firm is operating under decreasing returns to scale,or
diseconomies of scale Besanko and Braeutigam, 2012; Mankiw 2009).

REFLECTION. Express your opinion in a clear and concise manner.

The recent pandemic due to COVID-19 made governments implement

quarantine measures to mitigate the spread of the virus.
1.In what ways do business firms get affected by these measures?
2.How would the costs of these business firms change?
3.Do you think they are more affected with lesser revenues, or with larger costs?
Explain.
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________

14