Theory of the Firm

Production & Cost of Production

Theory of the Firm
A microeconomic concept that states that a firm exists and makes
decisions to maximize profits.

Production - a process and methods employed in the transformation of

tangible inputs (raw materials, semi-finished goods, and sub-assembles)
and intangible inputs (ideas, information, and know-how) into goods and
services.
Production Function
It is an equation that expresses the relationship between the quantities of
productive factors (such as labor and capital) used and the amount of
product obtained. It states the amount of product that can be obtained from
every combination of factors, assuming that the most efficient available
methods of production are used. There are several ways of specifying the
production function.

In a general mathematical form, a production function can be expressed as:

Q = ( 1, 2, 3, …, 𝑛)

Quantity of Output = Factor Inputs

Production Function

One formulation is as a linear function:

Q= + 1 + 2 + 3…..

where a, b, c, and d are parameters that are determined empirically.

a, b, c, d = signifies the amount by which change in x must be
multiplied to give the corresponding average change in y.
Production Function
Another is a Cobb-Douglas production function (multiplicative):
Developed by American economist Paul Douglas (1892-1976) and
mathematician Charles W. Cobb.

Q= ← Output Elas city

where Q is the Total Production, L denotes Labor, K represents Capital,

and A is the Total Factor Productivity. In addition, a and b are the output
elasticities of capital and labor.
Production Function
Output elasticity measures the responsiveness of output to a change in
levels of either labor or capital used in production, ceteris paribus. For
example, if α = 0.15, a 1% increase in labor would lead to approximately a
0.15% increase in output.

Further, if:

+ =1 → The production function has constant returns to scale.

That is, if L and K are each increased by 20%, Y increases by 20%.

+ <1 → returns to scale are decreasing

+ >1 → returns to scale are increasing

Returns to Scale
Constant Returns to If output increases by that same proportional
Scale (CRS) change.
Ex. If a manufacturing firm doubled its total output.
+ =1
Decreasing Returns to If output increases by less than that
Scale (DRS) proportional change.
Ex. If a manufacturing firm doubles its total input but gets only a
+ <1 40% increase in output

Increasing Returns to If output increases by more than that

Scale (IRS) proportion
Ex. If the manufacturing firm increased its output by 120%, the
+ >1 manufacturer experienced increasing returns to scale.
Production Periods
A Short-run Period is a period (fixed plant) too brief for a firm to alter its
plant capacity, yet long enough to permit a change in the degree to which
the fixed plant is used. The firm’s plant capacity is fixed in the short run.
However, the firm can vary its output by applying larger or smaller
amounts of labor, materials, and other resources to that plant. It can use its
existing plant capacity more or less intensively in the short run.

Long-run is a period long enough for it to adjust the quantities of all the
resources that it employs, including plant capacity. From the industry’s
viewpoint, the long run also includes enough time for existing firms to
dissolve and leave the industry or for new firms to be created and enter the
industry. While the short run is a “fixed plant” period, the long run is a
“variable plant” period.
Short-run Production Relationship
There are three general terms included in this concept: Total Product (TP),
Marginal Product (MP), and Average Product (AP).

- Total Product (TP) is the total quantity, or total output, of a particular

good or service produced.

- Marginal Product (MP) is the extra output or added product associated

with adding a unit of a variable resource, in this case labor, to the
production process.

- Average Product (AP) also called labor productivity, is output per unit
of labor input:
Law of Diminishing Marginal Returns
This law assumes that technology is fixed and thus the techniques
of production do not change. It states that as successive units of a variable
resource (say, labor) are added to a fixed resource (say, capital or land),
beyond some point the extra, or marginal, that can be attributed to each
additional unit of the variable resource will decline.

For example, if additional workers are hired to work with a constant

amount of capital equipment, output will eventually rise by smaller and
smaller amounts as more workers are hired.
Seatwork Activity
(Individual)