THEORY OF PRODUCTION

Module: Principles of Economics

Code: AIU 07303
BA-IT II

By; Mr. Hyera D (MPM)- IAA

Mobile: 0752899785
Office: Papa Building – PA 1
 Meaning of production
• Production is the creation of goods and
services to satisfy human wants. Or
• Production is the process in which the inputs
are converted in to outputs.
• Inputs: These are what a firm buy ie
productive resources such land, labor, capital
• Output: These are what a firm sells ie goods
and services.
 Purpose of production
• Creation of utility to satisfy human
wants, production is not complete until
the final goods and services produced
reach the final consumer.
• To increase people welfare ie the general
standard of living of the people.
 Levels of production
1. Primary production
This refers to the extraction of basic raw
materials from their material form for
use as inputs for the production of other
goods and services. It is sometimes
referred to as extractive industry.
 Cont..
2. Secondary production
This involves the transformation of
extracted raw materials into finished
products eg furniture, food processing,
textile manufacturing.
 Cont..
3. Tertiary production
This is the level of production which deal
with the creation and distribution of
services to the final consumer.
 Factors of production
• Factors of production have been traditionally
classified as land, labor, capital and
organization (entrepreneurship)
1. Land
In economics land as a factor refers to the all
gifts of nature found below, on and above the
earth surface that facilitate production such
as soil, minerals, water, sunshine
 Cont..
2. Labor
This refers to all mental and physical
efforts undertaken for the purpose of
production. It includes the services of
factory work as doctor, teacher, engineer
etc
 Cont..
3. Capital
Refers to all man made resources. It
includes mobile resources such as
tools, machinery, means of transport
like roads, railways
 Cont..
4. Organization
Refers to the service of an entrepreneur
who controls, organizes and manages the
policy of a firm, innovations and
undertakes all risks.
Through organization it brings together
land, labor and capital.
 Production Inputs
• The factors of production that carry out the
production is called inputs.
• The inputs are divided into two categories;
1. Fixed inputs
These are the factors whose costs do not
change with the change in output such as
machinery and buildings. The cost of fixed
inputs is called fixed cost.
 Cont..
2. Variable inputs
These are the factors where
quantities and costs change with the
change in output such as raw
materials. The cost of variable inputs
is called Variable Cost
 Time period in Production
1. Very short run
This is a very short period during which
output can not increase through the
production process. Firms can bring to
the market only what is in a such small
period.
 Cont..
2. Short run
This is a short period within which firms
can only vary the variable factors of
production to increase output some
factors remain fixed and therefore the
law of diminishing returns is likely to be
experienced after a certain level of
output.
 Cont..
3. Long run
This is a period that is long enough for a
firm to expand output by varying all
factors of production. If there is
expansion the firm experiences
diseconomies of scale.
 Cont..
4. Very long run
This is a very long period of time when
the firm can expand in size and change
the technology to produce new or high
quality products. The very long time
enables the firm to carry out research
and development.
 Output Variation in the Production.

1. A fixed factor
This is an input which remains constant
at any level of out put ( even zero
output in the short run)
2. A variable factor
This is an output which varies with
changes in out put eg labor, raw
materials
3. Total product
This is total output resulting from the
utilization of all the factor of
production.
TP=AP*L
where L unit of variable ie labor
 Cont..

• Average Product
The quantity of goods that on average is produced
per hour worked or per unit of capital (L, K).
APL =
Where: APL = Average product of Labour
Q = Output
L = Number of Labour
APK =
Where: APL = Average product of Labour
Q = Output
L = Amount of Capital
• Marginal Product
The additional output produced by an additional unit of
labour, while all other input remain constant.
This measures how much extra quantity can be produced if
a firm increases one unit of either labour or capital, keeping
the other one constant.
MPL =

MPK =
The expression Marginal Product will become more and
more exact, the smaller one chooses either or .
NB: We will largely be dealing with the short run basis and
hence whenever we mention MP it will be Marginal Product
of Labour since Capital is fixed.
• Up to now we have examining the term marginal by
simply finding a change of one thing in terms of the
other. However change (marginality) can also be
measured (found) by using derivatives (differentiation).
• Thus if we have a production function that is given as:
Y=f(X) then, the marginal product of input ‘i’ is given by:
MPi =, where Y is output.

For instance if Q= f (L,K), Then

MPL=and MPK=
 Example:
• IAA CO. LTD production function is described by
Q= 60L – L2
Whereby Q = units of output and L= Labour
Find (i) Average Product function
(ii) Marginal Product function
(iii) Number of workers to be employed at maximum
output.
(iv) What is maximum Total product.
 LAWS OF PRODUCTION
• Laws of production includes;
1. The law of variable factor
proportions (Law of diminishing
returns)
2. Law of returns to scale
 Law of variable factor proportions
(Law of diminishing returns)
• This is the law which states that “As you add units of
a variable factor to a fixed factor, the marginal
product (MP) of the variable factor increases up to
certain point and then decreases. OR
• Ceteris paribus “As additional units of a variable
factor are added to a given quantity of a fixed factor,
total output will initially increase at an increase rate
but beyond a certain level of output it will increase
at a declining rate and will eventually fall.
 Cont..
• The law of variable factor proportions
assumes that production takes place in
the short run where at least one factor is
variable and there is one variable factor
of production, assumes constant level of
technology and homogeneous factor of
production.
 Stages of production
• Stages of production implied in the
law of diminishing returns can be
illustrated in the following diagram.
Production Stages
 Cont..
• STAGE 1
In this stage there are increasing returns to the
variable factors. Total production is increasing at
an increasing rate while the marginal and average
product are also rising with marginal product
higher than average product at any point. This is
an indication of the increasing efficiency of the
proportions in which the factors are combined
since fixed factors are still under utilized and
there is room for greater specialization.
 Cont..
• STAGE 2
This stage represents decreasing returns to
the variable factors, total product is increasing
at a decreasing rate. Marginal product and
average product are positive but falling during
this stage with the average product higher
than the MP. This stage goes from where the
AP of a labor is maximum to the point where
the MP of labor is zero. Stage 2 is the only
stage of production for the rational producers.
 Cont..
• STAGE 3
The stage represent the stage of negative
returns to the variable factor. At this stage
marginal product is negative and as the result
product is declining.
It represents a stage of extreme inefficient
when factors of production are probably
getting into each others way. No producer will
operate at this stage.
 Example:
• IAA CO. LTD production function is described by
Q= 60L – L2
Whereby Q = units of output and L= Labour
Find (i) Average Product function
(ii) Marginal Product function
(iii) Number of workers to be employed at maximum
output.
(iv) What is maximum Total product.
 Relationship Between Total, Average, and
Marginal Product:
• When the APL is going up the MPL is always higher than the AP.
(When average product increases the marginal product remains
higher than the average product)
• When the AP reaches maximum the MP just cuts the AP at that
particular point. So at the point of maximum the AP=MP. (When
the maximum point of average product curve intersects with the
marginal product that is at its maximum, the value of average
product equals that of marginal product)
• As the AP product starts to fall (going down) the marginal product
is always less than the AP. (When the average product decreases
the marginal product remains lower than the average product).
Applications of Law of diminishing returns

• Helps the producer to determine the

way of combining factors of
production to get maximum output.
• A rational producer will combine
inputs up to a point where the
marginal product of labor is equal to
the price of that factor MP(L)= P(L)
 Limitation of the law of variable factor proportion

• It assumes short run period when there is

fixed factor, when all factors are variable the
law does not applies.
• Assumes constant technology, if there is
change in technology the MP of a variable
factor can increase beyond the point of
diminishing.
• It assumes homogeneous factor of production
which is not always the case.
 THE LAW OF RETURNS TO SCALE
Production in the long-run
• The law of returns to scale describes input – output
relationship in long run when all inputs are variable.
• In the long-run firm has the freedom to vary all of
its inputs.
• in the long run a firm must decide on the proportion
of inputs to use and also the firm must determine its
scale of operation.
The decisions can be addressed through the concept
of returns to scale
 Cont..
• RETURNS TO SCALE; measures the percentage
change in outputs resulting from the
percentage change in inputs. There are three
important cases:
• This can be looked at in three cases/ways;
1. Increasing returns to scale
2. Constant returns to scale
3. Decreasing return to scale
Returns to scale
 1. Increasing returns to Scale
• This is where output increases proportionally more than
the increase in inputs eg when inputs are doubled output
more than doubles. This trend is due to specialization and
economies of scale which are enjoyed by the expanding
firm.
• Occurs when a given percentage increase in all inputs
results in a greater percentage increase in output. For
instance 10 percent increase in all inputs results in a 20
percent increase in output.
• In practical case by increasing its scale a firm can be able to
use new production methods that were infeasible at the
smaller scale.
 2. Constant Returns to Scale
• This is where output increases proportionately as
increase in inputs eg when inputs are doubled
outputs also doubles.
• Occurs when given percentage increase in all inputs,
cause an equal percentage increase in output. For
example when inputs increase by 10 percent the
resultant output is also increased to 10 percent.
• In practical case a firm can find that it can double it
output by replicating it current plant and labour
force, for instance by building another plant beside
the old one.
 3. Decreasing returns to Scale
• Occurs when a given percentage increase in all input
results in a smaller percentage increase in output.
• This is where output increases proportionately less than
increase in inputs eg when inputs are doubled, output
less than double. This is due to the disadvantages of
over expansion of the firm (diseconomies of scale)
e.g. 10 percent increase in all inputs results in either 2, 5, 7
percent increase in output.
• In practical case as the size of a firm increase from being
a small to a larger one there comes organizational
challenges so it becomes difficult to coordinate and
monitor many management functions.
 Cont..
• Increasing returns is illustrated by
the downward sloping part of the AC
curve. Constant returns by the
horizontal part of the AC curve and
decreasing returns by the upward
sloping part of the AC curve.
 Output Elasticity
• Is the percentage change in output resulting from a one
percentage increase in all inputs.

• For Constant returns to scale; the output elasticity is 1.

• For Increasing returns to scale; the output elasticity is
greater than 1.
• For Decreasing returns to scale; the output elasticity is less
than 1.
 Production in the Long-run cont…
• In the long run both labour and capital are variable
inputs, this means that the quantity produced is a
function of both L and K. where both of them can be
changed.
• It is usually the case that the same quantity can be
produced with different combination of labor and
capital. Workers can be substituted to some extent
by machines and vice versa.
• The idea can be illustrated by a graph that is very
similar to indifference curves in consumer theory.
• Isoquant (“iso” = same/similar; “quant” = quantity)
is a curve that shows different combinations of
inputs (L,K) that produce the same quantity of a
single good when production is efficient.

CHARACTERISTICS OF ISOQUANTS
• Sloping downward from left to right (negative slope)
• It is convex to the origin because of diminishing
marginal rate of technical substitution.
• Isoquants cannot intersect or be tangent to each
other
• Upper Isoquants represents higher level of output
Capital
ISOQUANT

Isoquant

labour
Marginal Rate of Technical Substitution

• Is the slope of an isoquant.

• MRTS measures the rate at which one input
can be substituted for another without
changing the amount of output produced.
MRTS =
• The slope is a negative number, however for
simplification purpose we are going to treat
it as an absolute value.
 Isocost
• Is the curve showing all combinations of
inputs that cost the same.
• If the price (cost) of labour is wage (w) and
the price for capital is rental r (r), An isocost
line is defined as all combinations of L and K
that cost the same. From the figure below: What can be the
slope? Borrow the concept from how
we obtained the Slope of a Budget Line.

c/r
c/w L
 THE PRODUCTION FUNCTION
• A production function refers to the
relationship between the output of a
commodity and the input factor of
production used to make that
commodity.
• It is a mathematical relationship between
output which is dependent variable and
inputs of production which are
independent variable
 Cont..
• Production function;
Q=f(L, K)
• That is output is a function of labor given
capital K which is fixed factor of
production.
• It assumes that commodities produced
are homogeneous, constant state of
technology and units of factors of
production are homogeneous.
 Cont..
• A function that indicates the maximum amount of
output a firm can produce over some period of time
from each combination of inputs.
• A production function summarizes technical
constraints of the firm’s production decision.
• A production function considers a firm producing a
single product out of many inputs.
• The quantity producer will produce of a single good
depends on a number of working hours L (L =
Labour), and the amount of K (K=Capital) that she
uses.
• Thus, output is a function of L and K
51
• This can be written as:

Q= f (L, K)
• The letter f in the expression means that we have a function of L and
K. The function could mean:
Q= f (L + K)
Q= f (L * K)
Q= f (L0.5 * K0.5)

Just to show the possible combinations of L and K. Which function is

appropriate it depends on the technology that is employed in producing
that good or service.

52
• In the whole production process we
assume that production is done in the
most efficient way possible. E.g. if it is
possible to produce 40 units of a good
and we produce 39 units using the
combination of L and K, that
production cannot be efficient since
there is a waste of resources that could
be used to produce one more unit.
53
 Production Function properties
• It is continuous i.e. This ensures that small
changes in inputs leads to small changes in
output produced.
• It is strictly increasing. i.e. employing more
input results in more output, ceteris
paribus.
• It is strictly quasi concave. This implies some
complementarity in factors of production.
54
Production and Cost of Production
• A production function specifies the maximum
amount output that can be produced for a
given amount of output.
• The production function shows the minimum
quantity of input necessary to produce given
level of output.
• Production functions are also determined
technology available any improvement in
technology enhance worker productivity
results in a new production function.
 Cont…
Assumptions:
• Assume some given state of art in the production technology (any
innovation would cause relationship between input and output to
change).
• Assume whatever input or output combinations are included in a
particular function the output resulting from their utilization is at the
maximum level.

• The two assumptions gives us the following definition.

• A production function defines the relationship between inputs and
the maximum amount that can be produced within a given period of
time with a given level of technology.
• Can be written as
• Where:
Q= Output
X1, …Xn= Inputs
 Factors affecting/Determining the
production function
• State of technology
• The size of the firm
• Prices/costs of the factors of production
• Availability of quantity and quality of inputs
needed in production process
• Nature and efficiency of firms organization
 Complete the following table
Average Product (AP) Marginal Product (MP)
Units of labor
(units) (units)

1 8 -

2 10 -

3 10 -

4 9 -

5 8 -

6 7 -
 AP = TP/Q, MP= ChangeTP/ChangeL, TP = AP x Q

Marginal
Total product Average Product
Units of labor Product (MP)
(TP) (AP) (units)
(units)

1 8 8 8

2 20 10 12

3 30 10 10

4 36 9 6

5 40 8 4

6 42 7 2
 Question

i. Identify different phases of the Law of

Variable Proportion from the following
schedule.
ii. Graphically present the schedule given.
iii. Give reasons for your answer.
 Cont..
Total Product (TP) Marginal Product (MP)
Units of labor
(units) (units)

1 4 4

2 9 5

3 13 4

4 15 2

5 12 -3
 End

Thank you