PRODUCTION THEORY

THE THEORY OF THE FIRM

A firm is a technical unit in which commodities
are produced. It hires the services of the factors
of production to produce goods and services.
The concept of a firm ranges from a sole
proprietor to a big enterprise. An input is
anything a firm uses in the production process
and an output is anything that a firm produces
for sale or consumption. The management
production decisions can be grouped into four
categories.
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(i) How much shall be spent on the purchase
of inputs.
(ii) How shall the inputs be divided among
the various types of inputs
(iii) How much of each type of in-put will be
allocated to each type of output. This is
relevant to a firm producing different types of
commodities.
(iv) How much of each final product shall the
firm produce
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So, production theory seeks to analyze the input
and output relations and answer the following
questions.
(i) If all the inputs are simultaneously increased or
decreased at a certain rate will the output increase
or decrease in the same proportion?
(ii) Supposing there are more than one processes of
producing a commodity, how will the output
change in response to change in factor proportion?
(iii) How can the least cost combination of the
inputs be achieved. This is a very vital question
because the main objective of the firm is to
maximize profits by minimizing costs.

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 ASSUMPTIONS IN PRODUCTION
THEORY
(i) A firm sells all its output
(ii) Sales revenue is equal to the value of
goods.
(iii) The firm produces each output as cheaply
as possible given the technology used.
(iv) All units of each factor of production are
equally efficient
(v) The price of each FOP is given i.e.,
constant

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BASIC CONCEPTS OF PRODUCTION
THEORY
The production function (PF)
The PF describes the technological
relationship between inputs and output in
physical terms. It is the relationship between
the quantities of various used per period of
time and the maximum quantity that can be
produced in that time. It represents the ability
of the firm to convert inputs into output given
the technology.

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2021
(i) It may take the form of a table
Labour Quantity
10 30
20 70
30 100
40 90

(ii) It may be in a form of an equation.

Q = Q(L, K) K - given capital
Q = a + bL L - variable labour
Q = LbKa Q - output
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(iii) It may also take the form of a curve or a
graph.
Output

Total Output

O Variable Input
The standard economic assumption which affects the shape
of the production function is the Law of Diminishing
Returns: As more and more of a variable input X is employed
on a fixed factor total output increases at an increasing rate and
later at a decreasing rate until a point is reached where
additional quantities of input X will yield diminishing marginal
returns assuming all other factors constant.
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Labour Quantity MP = Q/X AP Q/X
10 30 4 3
20 70 3 7/ 2
30 100 3 10/ 3
40 90 -1 9/ 4
Average Production
This is simply defined as total output divided
by total units of the variable factor. Generally
as more of the Variable factor is used average
product first rises and then later on falls. The
point where the AP reaches maximum is called
a point of diminishing average productivity.
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Marginal Product

This is a change in total product

resulting from the use of one
more unit of a variable factor.
The level of output where the MP
reaches maximum is called point
of diminishing marginal returns.
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 The Production Function, Marginal Product and
Average Product Curves
Q TP = 0
I
TV II
III TP
0
MP AP Var L/p

AP
0
Variable input
MPL/p
The boundary between stage II and III shows
the level at which all fixed resources are fully
used.
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It would be irrational to limit
operations in Stage I because the
variable input is not fully utilized that
means that the average product is still
increasing in Stage III it is rational to
limit operations because you cannot
continue adding an input when the
total product is decreasing and the MP
is negative unless the input is
obtained at a negative cost.
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It is also irrational to
continue adding a variable
input when the fixed input
are fully utilized therefore
the best stage of production
is Stage II when both the
MP and AP are falling.
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ISOQUANT
showing a combinations of resources
required by a firm to produce a given
level It is a curve of output. Its shape
and slope depends on the rate at which
one factor can be substituted for
another to produce the same level of
output. This rate of substitution is
called the marginal rate of technical
substitution.
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 Isoquant
K

Isoquant

0 L

- Down ward sloping

- A curve above the other shows a higher level of
output
- It is convex to the origin
- Doesn’t touch any of the axes
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 EQUILIBRIUM OF THE FIRM
K
Isocost
Cost of combination of inputs that
maximize output other than Labour

K1 e

Isoquant line
ISOCOST LINE
0
L1
The firm will opt for that point of tangency where the higher
isoquant is tangent to the Isocost line. At point e the
equilibrium position of the firm is defined as the level of
maximum output subject to the cost constraint and is always
shown when the Isocost line is tangent to the isoquant.
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2021
 Have A Pleasant

WEEKEND

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2021