Chapter 4

PRODUCTION PROCESS AND COST ANALYSIS

LESSON 1
PRODUCTION ANALYSIS

LEARNING OBJECTIVES
After reading and studying this chapter, the reader should be able to:

-identify Production Theory

-define Production Function;
-determine the difference between Short-run and Long-run Function; and
-identify Total, Average, and Marginal Product;-describe Return to Scale

Production Theory
Most products we enjoy as consumers underwent some form of processing. The patty in burger you
enjoyed for lunch was processed from meat, the bun came from wheat; the cheese came from
cow's milk, and such. The juice you drank was from fruit extract that was mixed with sugar and
perhaps flavoring and coloring. Can you imagine the process of raw materials undergo to become
finished products we now enjoy as consumers?
Production is the process of converting input into output. It is represented by the figure below:

Fig. 4.1: The Production Process

INPUT PROCESS OUTPUT

Just think of things a baker needs to bake a loaf of bread. The baker will need raw materials such as
eggs, milk, flour, eggs, baking powder, sugar, salt, water, among others. He will also need an oven
or a stove, rolling pin, baking trays and the like and he might also need the services of an assistant
baker. The raw materials that the baker needs to produce a loaf of bread could be considered, in
the model as input. Before it became a loaf of bread, it was kneaded and baked hence, with such
methods of preparation are considered as the process in the model we presented. Finally, the loaf
of bread that we are enjoying during breakfast or at snack time considered as output. Therefore,
production paves the way for the creation of utility or usefulness of a product or service.
Imagine the amount of work that has to be done just to produce a loaf of bread. A baker has to put
resources together in the most efficient manner to minimize wastage and to be profitable.
Therefore, there is a need of managers to understand the production process and the costs
involved.
It is important to note that the level of technology also plays a role in the production process. It is
assumed that technological progress enables firms to produce more efficiently. Can you imagine
preparing a research paper for school using a typewriter as opposed to using a word processor you
are now accustomed to?

Production Function
The production function expresses the amount of output that can be produced given certain
amounts of input. Recalling the circular flow diagram, the economic resources of land, labor, capital
and entrepreneurship shall be utilized as input to produce goods and services.
In general, the production function can be expressed as:
Q = f (L,K)
where: Q is the level of output
L is the number of units of labor
K is the number of units of capital

In the production function presented, labor (L) and capital (K) are treated as input. Mathematically,
they are also the arguments of the function or independent variables. On the other hand, Q is the
output level or dependent variable that states the firm's quantity of output depends on the quantity
of input.
In modern times, firms are now able to incorporate technology to produce more output. With
technology, more output is produced with less time. This is a sharp contrast to firms that still
manufacture manually. Furthermore, output tends to be more standardized; products such as
computers or flat screen TVs tend to be capital intensive while products such as clothing tend to be
labor intensive.

Cobb Douglas Production Function:

This is a function that defines the maximum amount of output that can be produced with
a given level of inputs. Let us assume that all input factors of production can be grouped into two
categories such as labor and capital (K).The general equilibrium for the production function is Q
= f (K, L)

Short-Run Production Function

Production in the short-run, treats one of the inputs as fixed or meaning the amount or level of
capital tends to be fixed. In the real world, capital tends to be fixed in the short-run. Firms cannot
easily vary the size of their production facilities, such as the plant or purchase a new parcel of land
or sell the same. Hence, the short-fun production function is given by:
Q = f(L)
where: Q is the level of output
 L is the number of units of labor
In the short-run, a firm can easily hire people than expand or decrease its capital requirements. This
justifies why only L appears as an argument of the said production function.
Long-Run Production Function
A firm can vary both its labor and capital requirements hence, both L and K appear as arguments
(independent variables) of the production function. Firms, in the long run, can freely expand its
production facilities, as well as its labor requirements.
Total, Marginal and Average Product
Total product (Q) is measured in physical units and is also known as total physical product while,
marginal product refers to the extra product or output produced by an extra unit of input, say labor
(or capital) while other input say capital (or labor) is held constant hence, we have marginal product
of labor (MPL) and the marginal product of capital (MPK). Average product is simply the ratio of the
total output to total units of input. If we divide the total product y the number of units of labor, we
have the average product of labor (APL) and if we divide the total product by the number of units
of capital, we have the average product of capital (APK).
The given table shows the summary of the formulas needed when determining the marginal
product and average product:

Marginal Product Average Product

∆𝑄 𝑄
Labor MPL = ∆𝐿 APL = 𝐿

or (Q2-Q1) / (L2-L1)

𝜕𝑄
or 𝜕𝐿
∆𝑄 𝑄
Capital MPK = ∆𝐾 APK = 𝐾

or (Q2-Q1) / (K2-K1)

𝜕𝑄
or 𝜕𝐾

The Law of Diminishing Returns

In the combination of input factors when one particular factor is increased

continuously without changing other factors the output will increase in a diminishing manner.
Let us assume that a person preparing for an examination continuously prepares without any
break. The output or the understanding and the coverage of the syllabus will be more in the
beginning rather than in the later stages. There is a limit to the extent to which one factor of
production can be substituted for another. The total production increases up to an extent and
it gets saturated or there won’t be any change in the output due to the addition of the input
factor and further it leads to negative impact on the output. That means the marginal
production declines up to an extent and it reaches zero and becomes negative. The point at
which the MP becomes zero is the maximum output of the firm with the given set of input
factors. This law is applicable in all human activities and business activities.
For example with two sewing machines and two tailors, a firm can produce a maximum of 14
pairs of curtains per day. The machines are used only from 9 AM to 5 PM and the machines lie
idle from 5 pm onwards. Therefore the firm appoints 2 more tailors for the second shift and
the production goes up to 28 units. Then adding two more labor to assist these people will
increase the output to 30 units. When the firm appoints two more people, then there won’t
be any change in their production because their Marginal productivity is zero. There is no
addition in the total production. That means there is no use of appointing two more tailors.
Therefore, there is a limit for output from a fixed input factors but in the long run purchase of
one more sewing machine alone will help the firm to increase the production more than 30
units.

The Law of Returns to Scale

In the long run the fixed inputs like machinery, building and other factors will change
along with the variable factors like labor, raw material etc. With the equal percentage of
increase in input factors various combinations of returns occur in an organization.

Returns to scale: the change in percentage output resulting from a percentage change in all the
factors of production. They are increasing, constant and diminishing returns to scale.

Increasing returns to scale may arise: if the output of a firm increases more than in
proportionate to an increase in all inputs. For example the input factors are
increased by 50% but the output has doubled (100%).

Constant returns to scale: when all inputs are increased by a certain percentage the
output increases by the same percentage. For example input factors are increased by
50% then the output has also increased by 50 percentages. Let us assume that a laptop
consists of 50 components we call it as a set. In case the firm purchases 100 sets they
can assemble 100 laptops but it is not possible to produce more than 100 units.

Diminishing returns to scale: when output increases in a smaller proportion than the
increase in inputs it is known as diminishing return to scale. For example 50%
increment in input factors lead to only 20% increment in the output.

From the graph given below we can see the total production (TP) curve and the
marginal production curve (MP) and average production curve (AP). It is classified into
three stages; let us understand the stages in terms of returns to scale.

Stage I: The total production increased at an increasing rate. We refer to this as

increasing stage where the total product, marginal product and average production are
increasing.
Stage II: The total production continues to increase but at a diminishing rate until it
reaches the next stage. Marginal product, average product are declining but are positive.
The total production is at the maximum level at the end of the second stage with a zero
marginal product.

Stage III: In this third stage total production declines and marginal product becomes
negative. And the average production also started decline. Which implies that the
change in input factors there is a decline in the overall production along with the
average and marginal.