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Module 2 – Theories of Consumer Behavior and Production

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Module 2 – Theories of Consumer Behavior and Production

Lesson 2:
Theory of Production

SPECIFIC LEARNING OUTCOMES

In this lesson you should be able to:
1. describe the four factors of Production and the Production Function;
2. describe the concept of Law of Diminishing Returns;
3. explain ways to improve production; and
4. identify successful businesses in the Philippines that uses resource efficiency.

PRE-ASSESSMENT
True or False. Write T if the statement is correct and F if the statement is wrong.
__________1. Productivity is the output produced by a unit of factor input during a given span of time.
__________2. The theory of production describes the functional relationships of output and economic
resources, assuming these are of fixed size.
__________3. A production function illustrates the varies combinations of inputs at the same level of
capacity.
__________4. The law of Diminishing Returns describes the tendency at some point for each
succeeding addition to output to become smaller as the firms add succession units of
variable input to some fixed inputs.
__________5. Computers and computerized machineries are means of improving overall efficiency
by utilizing resource-saving technology.
__________6. Capital includes machines, equipment, buildings, factories, roads, etc.
__________7. Diseconomies of scale are the negative sloping portion of a long-run average cost
curve.
__________8. Returns to scale are the indicator of plant-size change of a given business firm.
__________9. Improvement in productivity can be seen if the ratio of output over input increases
since a unit of input can produce more of the same output.
__________10. The natural resources, represents the gift of nature to our productive processes.
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Module 2 – Theories of Consumer Behavior and Production

LESSON MAP

The Production
Function
-Total Product
-Average Product
-Marginal Product

Production
Theory of -Land
-Labor
Production -Capital
-Entrepreneurship

Law of
Diminishing
Returns
-Contant returns
-Increasing returns
-Decreasing returns

The map above shows the important factors in the Theory of Production that are relevant in determining
production functions and to understand the concept of law of diminishing returns.

CORE CONTENTS

ENGAGE: PICTURE ANALYSIS

Activity 1: Picture Analysis

1. What does the picture imply?
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Module 2 – Theories of Consumer Behavior and Production

2. What do you think is the concept being demonstrated in the picture?

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EXPLORE: READING CONCEPTS

PRODUCTION
Production refers to any economic activity, which combines four factors of production to form an
output that will give direct satisfaction to consumers. It includes material goods (food, shirts, shoes, cars,
etc.) or provision of any services (haircut, massage, hotel service, etc.) that satisfy the wants of people.

Four factors of production:

➢ Land
➢ Labor
➢ Capital
➢ Entrepreneurship

When we talk about production, inputs and outputs will always be discussed. When we speak of
Inputs, these are commodities and services that are used to produce goods and services.
1. Land
• The natural resources, represents the gift of nature to our productive processes.
• It includes those above and under the earth like forest products (e.g., timber) and mineral ores
(e.g., copper and iron ore).
2. Labor
• The mental and physical ability used in the production of goods and services.
• Thousands of occupations and tasks, at all skill levels, are performed by labor (from the creation
of microchips to the building of space stations and skyscrapers.
3. Capital
• The goods that are used in the production of other goods and services.
• It includes machines, equipment, buildings, factories, roads, etc.

Outputs are the various useful goods and services that result from the production process and are
either consumed or employed in further production.
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Module 2 – Theories of Consumer Behavior and Production

1. Final Goods – goods and services that are ultimately consumed like RTW clothes, notebooks, etc.
2. Intermediate Goods – include tires used in the production of cars, sugar in the making of cakes, and
candies, etc.

❖ An economy (such as the Philippines) or firm (like San Miguel Corporation) uses its existing
technology to combine inputs to produce outputs.

Technology: Labor Intensive or Capital Intensive

Technology is the body of knowledge applied to how goods are produced. In other words, technology
is the production process employed by the firms in creating goods and services. Technology can be
classified into two broad categories:
▪ Labor-intensive technology utilizes more labor resources than capital resources. Is usually
employed by the economies where labor resources are abundant and cheap. In the Philippines,
industries that are considered labor-intensive include the agricultural sector and some
manufacturing sub-sectors like garments.
▪ Capital-intensive technology utilizes more capital resources than labor resources in the
production process. Is employed by industrialized economies since capital resources in these
economies are cheaper than labor. Countries such as Germany, Japan, Korea, and the United
States are considered capital-intensive economies.

THE PRODUCTION FUNCTION

Having defined production, inputs, and outputs, we can now describe how inputs are transformed into
outputs using a concept called production function.
• Production Function is the functional relationship between quantities of inputs used in production
and outputs to be produced.
• Production Function specifies the maximum output that can be produced with a given quantity of
inputs given the existing technology of a firm.
• For example: You want to produce a T-shirt, its production function may appear as follow:

Output t-shirt = f (fabrics, sewing machine, sewer, thread, buttons, etc.)

In our present time where millions of products are produced, there is also literally millions of different
production functions – one for each and every product or service produced.
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Module 2 – Theories of Consumer Behavior and Production

TOTAL, AVERAGE, AND MARGINAL PRODUCTS

Starting from a firm’s production function, we can determine three important production concepts:
total, average, and marginal products.

1. Total Products
• Refers to the total output produced after utilizing the fixed and variable inputs in the production
process.
• Fixed inputs are components of production which do not change, like machineries and
equipment.
• Variable inputs are the changeable resources in the production, such as raw materials and
number of laborers.
• Total product is designated in physical units like cavans of rice, number of rubber shoes, number
of t-shirts, etc.

For example: See table 1 below

In the example, we can see how total product responds as the amount of labor applied is increased
in the production of T-shirts. The total product starts at zero for zero labor and then increases as
additional labor is employed, reaching a maximum of 82 units of T-shirts when 10 units of labor are
used.

2. Marginal Products
• Recall that the term marginal means ‘extra’ or ‘additional’.
• The marginal product of an input is the extra output produced by 1 additional unit of that input
while other inputs are held constant.
• Assume that we are holding land, machinery, and all other inputs constant in the production of T-
shirts. Then, labor’s marginal product is the extra or additional output obtained by adding 1 unit of
labor.

For example: See table 1 below

In the third column of the example calculates the marginal product of each labor added in the
production of T-shirt. We can derive the marginal product using the following equation.
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As a firm increases its number of employees by one, which is a marginal increase, there is a change
in the total product. The marginal product of labor is the change in total product when one more unit of
labor is employed, with the amounts of other inputs remaining the same.

3. Average Product
• Derived by dividing total products to the total units of inputs used.
• In the table below, it shows the average product of labor: 8 units per worker with one worker, 10
units per worker with two workers, and so forth.

TP
AP=
I
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Module 2 – Theories of Consumer Behavior and Production

Sample solution: Solve for the AP with two (2) labors. See table below

Table 1
Hypothetical Production Schedule of T-shirts
Input TP
TP MP AP AP=
(Labor) I
0 0 0 0
1 8 8 8 20
=
2 20 12 10 2
3 37 17 12
AP= 10

Table 1
Hypothetical Production Schedule of T-shirts
Input (Labor) TP MP AP
0 0 0 0
1 8 8 8
2 20 12 10
3 37 17 12
4 57 20 14
5 72 15 14
6 80 8 13
7 85 5 12
8 88 3 11
9 86 -2 10
10 82 -4 8
The table shows the total amount of T-shirts that can be produced for different inputs of labor when other inputs and
the state of technical knowledge are held constant. From total product, we can derive important production concepts
like the marginal and average products.

Output and Revenue of the Firm

As firms aim to increase profit, a consideration of its employed factors of production must also be
reviewed. A firm needs to weigh the cost against the benefit of acquiring each unit factor in order for
them to know up to when they will increase their inputs for as long as it is profitable to do so.
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Module 2 – Theories of Consumer Behavior and Production

Using our previous table above on the hypothetical production schedule of T-shirts, we can determine
the production and revenue of the firm when the price of a good is given. If the price is P10.00, we
can derive the total revenue and the marginal revenue product of the firm by using the following
formula:
Total Revenue – Price (P) x Quantity (Q)

It is also important to know about Marginal Revenue Product. The MRP is the change in revenue
resulting from the output produced by one additional unit (MPP) of the variable input. MRP is the
additional revenue generated by employing an additional factor input.

MRP=Total Revenue2 – Total Revenue1

MP is the marginal product is computed as the change in quantity of output divided by the change in
the quantity of the factor input.
Table 2
Production and Revenue Schedule of T-Shirts
Marginal
Total
Input (Labor) TP(Q) MP Price Revenue
Revenue
Product
0 0 0 10 0 0
1 8 8 10 80 80
2 20 12 10 200 120
3 37 17 10 370 170
4 57 20 10 570 200
5 72 15 10 720 150
6 80 8 10 800 80
7 85 5 10 850 50
8 88 3 10 880 30
9 86 -2 10 860 -20
10 82 -4 10 820 -40
The table shows the Marginal Revenue Product which helps in the marginal analysis in studying the effects of variable
inputs (Labor). As Labor increases, the revenue decreases at a certain point by each additional unit.
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Module 2 – Theories of Consumer Behavior and Production

Notice the decline in the MRP? This is because the marginal productivity of the factor input, which
according to the law of diminishing marginal returns, will eventually decline, and because MP will also
decline at a certain point, therefore the MRP will eventually diminishing or go to same downward
direction.

THE LAW OF DIMINISHING RETURNS

▪ In the schedule of product and revenue above, we can observe that the average product rises as
more workers are added up to the fifth worker. However, when the sixth worker is added, the average
product starts to decline. The conditions that we have just presented bring us to what is referred to as
the Law of Diminishing Returns. It states that:

The Law of Diminishing Returns holds that we will get less and less extra output
when we add additional doses of an input while holding other inputs fixed.

▪ This law expresses a very basic relationship. As successive units of a variable resource (in our
example the sewer) are added to a fixed set of resources (say the sewing machine), beyond some
point the extra, or marginal product attributable to each additional unit of the variable resource will
decline.
▪ Thus, as more sewers are added to sew T-shirts using a single sewing machine, the sewing machine
gets more crowded so that the marginal product of the additional sewer declines.
▪ Example 1: See table 2 above
The 10th sewer added contributes less than all the other sewers since his marginal product is negative
4 units of T-shirts. What does this imply? This simply tells us that as more and more variable inputs
are used to a fixed input, the contribution of the extra unit of variable input added declines.
▪ Example 2:
Suppose you have a small party at home for which you hired a temporary cook in addition to your
regular cook. Obviously, two cooks are better than one which technically means that Total Product
(TP) increases with more resource input. But more cooks now begin to overuse the same kitchen
facility and breed counterproductive conditions like confusion, delays, and mishandling of utensils.
o As a result, the additional cook is not as efficient as the regular cook when the latter does the
regular kitchen chores.
o Technically, this means that the Marginal Product (MP) decreases despite the increase in TP.
o Neither is every cook as efficient as any one of them when doing the regular kitchen chores
alone with the decrease in Average Product (AP).
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Module 2 – Theories of Consumer Behavior and Production

Increasing Marginal Returns

▪ This will happen when the marginal product of an additional worker exceeds the marginal product of
the previous worker.
▪ We can also say that there is increasing marginal returns when a small number of workers are
employed and arise from increased specialization and division of labor in the production process.
▪ For example: if you are a manager of a garments factory employing just one worker, that person must
learn all aspects of making T-shirts: from cutting to delivery. That single person must perform all
tasks. If you hire a second person, the two workers must have specialization in different aspects of
the production process.
▪ As a result, two workers produce more than twice as must as one worker. We can therefore say that
the marginal product of the second worker is greater than the marginal product of the first worker. In
this case, marginal product is increasing.

Decreasing Marginal Returns

▪ Occurs when the marginal product of an additional worker is less than the marginal product of the
previous worker hired to do the same task.
▪ Arise from the fact that more and more workers use the same equipment and work space. Thus, as
more and more workers are employed, there is less and less that is produced for the additional
worker.
▪ For example: if you are a manager of a garments factory employing just one worker, that person must
learn all aspects of making T-shirts: from cutting to delivery. That single person must perform all
tasks. If you hire a second person, the two workers must have specialization in different aspects of
the production process.
▪ As a result, two workers produce more than twice as must as one worker but if the second worker
does not exceed the marginal product of the first worker, which is the case where marginal product is
decreasing.

Returns to Scale
▪ Diminishing returns and marginal products refer to the response of output to an increase of a single
input when all other inputs are held constant.
▪ We noted in the previous example that increasing the number of sewers, while holding sewing
machine constant would increase T-shirt production by ever small increments. But sometime, we are
interested in the effect of increasing all inputs.
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▪ There are three important cases that should be distinguished:

o Constant Returns to Scale indicates a case where change in all inputs leads to a proportional
change in output. Example: If farm land, number of farmers, and other inputs are doubled, then
we can assume that under this condition rice production would also double.
o Increasing Returns to Scale (Economies of Scale) happen when an increase in all inputs leads to
a more-than-proportional increase in the level of input. Example: A farmer will generally find that
increasing the inputs of labor, irrigation, fertilizers, and pesticides to 10% will increase his total
rice production by more than 10%.
o Decreasing Returns to Scale occur when a balanced increase in all inputs lead to a less-than-
proportional increase in increase in total output. In many processes, scaling up may eventually
reach a point beyond which inefficiencies sets in. This may arise because the cost of
management or control becomes large.

PRODUCTIVITY
Productivity is the efficiency and therefore the power of inputs to produce. This section confines
discussion to resource inputs which are basic to production. Productivity is measured as output per unit of
input which is illustrated below as the average productivity wherein the efficiency of inputs taken as a whole
and is measured as their average output.

Productivity = Q/I

On the other hand, marginal productivity is the efficiency of additional inputs and it is measure as their
marginal output which is also illustrated below.

Marginal Productivity = ∆Q/∆I

Where:
Q = Output
I = Input
∆ = Change

Productivity Improvement means more output per unit of input as the increase in the efficiency ratio
(Q/I) indicates. It also means less input for output as the decreases in the ratio’s inverse (I/Q) indicates.
Therefore, efficiency is not a matter of size. A bigger plant is not necessarily more efficient than its smaller
counterparts. To use a simple analogy, a class may best the rest in a school fund drive by the sheer
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Module 2 – Theories of Consumer Behavior and Production

number of soliciting members. But the most efficient class has the biggest amount solicited by every
member which reflects on individual initiative.
▪ The profitable improvement in overall resource efficiency in the going is categorized as an increase in
economic efficiency. This form of efficiency is measured as output per monetary unit of input with the
latter expressed as monetary cost in the basic productivity ratio (Q/I).
▪ Economic efficiency balances or reconciles the effects of two other types of productivity.
▪ Technical efficiency capitalizes the on the output, while
▪ Cost efficiency gives emphasis to the cost of inputs.

Usually, output and cost are conflicting to attain economic efficiency. Thus, the technical efficiency of
a machine is not necessarily profitable if it is too costly. To strike a balance, its additional monetary returns
should outstrip its cost. However, technological advancement can optimize both output and cost to readily
fit the picture of economic efficiency.

RELATIVE RESOURCE EFFICIENCY

▪ Production resources are complementary not only in function but also in efficiency.
▪ A better machine also enables its operator to work faster or the other way around.
▪ Resources do not become more internally efficient as the same time, but improvement contributes to
the overall productivity picture.
▪ The time lag between productivity improvements can alter the optimum combination of resources.
▪ For example: replacing old machines with modern and more efficient ones improves work and shifts
the TP, AP, and MP upward. But plant expansion (long run) favors the use of more efficient capital
than less efficient labor. The shift is economically efficient since every peso of labor given up, which is
additionally spent for capital, yields a net increase in output.

Basic Ways to Improve Resource Efficiency

How much a plant overall efficiency can be improved to increase output depends on the amount of
wasted resources and time that could otherwise be used productively. Ways to improve resource
efficiency:
1. Change the nature of the resource through innovation.
One example is work specialization, which concentrates on job requirements instead of diffusing
efficiency. Thus, a worker in a car assembly plant does more in tightening bolts than other jobs like
mounting wheels.
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Module 2 – Theories of Consumer Behavior and Production

2. Change the external condition of resources.

A simple example is increasing the number of customers served in a drug retail outlet by temporarily
reassigning resources to augment the sales group during peak hours. This set up minimizes
imbalances in work distribution and labor idle time.

3. More balanced resource combination.

Increasing the size of constraining resources also makes the constrained resources more efficient
and minimizes diminishing returns. For example: investment in an irrigation system (capital) enables
the rice farmer to plant and harvest three times a year with the same land area. But without irrigation,
capital is at a minimum and land is only productive once a year.

4. Using resource saving technology.

For example, computers have become more powerful and cost efficient and resource combination in
industrialized economies favors their use to save on scarce and costly labor resources.

EXPLAIN: GOING DEEPER

1. Identify a good that you currently have now (shoes, shirt, etc.) and present its production function.
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2. Based on the second example for law of diminishing returns, what would happen if nine additional cooks
were hired for the party? Give at least 5.

Effects of
Adding 9
more cooks
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Module 2 – Theories of Consumer Behavior and Production

3. What are the ways to improve production? Explain briefly.

4. Give at least two (2) successful businesses in the Philippines that use resource efficiency and briefly
discuss how these businesses applied resource efficiency.

TOPIC SUMMARY
In this lesson, you learned that:
▪ Production refers to any economic activity, which combines four factors of production such as land,
labor, capital and entrepreneurship.
▪ A labor-intensive technology utilizes more labor resources that capital resources.
▪ Capital intensive technology utilizes more capital resources than labor resources in the production
process.
▪ A production function is the functional relationship between quantities of inputs used in production
and outputs to be produced.
▪ Total product refers to the total output produced after utilizing the fixed and variable inputs in the
production process.
▪ The marginal product on an input is the extra out produced by 1 additional unit of that input while
other inputs are held constant.
▪ The average product equals the total product divided by total units of inputs fixed.
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Module 2 – Theories of Consumer Behavior and Production

▪ Law of diminishing returns state that the use of variable resources against the limits of fixed
resources or describes the tendency at some pint for each succeeding addition to output to become
smaller as the firms add succession units of variable input to some fixed inputs.
▪ Constant returns to scale indicate a case where a change in all inputs leads to a proportional
change in output.
▪ Economies of scale will happen when an increase in all inputs leads to a more-than-proportional
increase in the level of output.
▪ Decreasing returns to scale occur when a balanced increase in all inputs leads to a less-than-
proportional increase in total output.

REFERENCES
▪ Avila-Bato et al, Microeconomics Simplified: National Book Store, 2016 M221
▪ Gabay et al, Economics, Concepts and Principles: Rex Book Store, Inc., 2012
▪ Manapat et al, Economics, Taxation and Agrarian Reform: C & E Publishing, Inc., 2014
▪ Retrieved at: https://businessmirror.com.ph/2019/08/05/household-spending-wont-slow-anytime-
soon/. Retrieved on: August 19, 2020.