ECO 1003 –

Microeconomics
Lecture 10
Theory of production
Outline
• Explain the role of firms in the economy
• Describe and differentiate between the types of inputs in the production
process
• Introduce the production function
• Differentiate between short-run decisions and long-run decisions
• Calculate Total Product and derive Average Product and Marginal
Product
• Identify the maximum production with efficient use of input
• Relate the law of diminishing return (DMR) to the short-run production
costs
 What is Production?
• Production is the process that a firm
uses to transform inputs into outputs,
i.e. the goods or services the firm
wishes to sell, using a given level of
technology.

• Inputs refer to the factors of production

that a producer uses in the production
process
• Labour, capital raw materials, entrepreneurship
• Output is the goods or services the firm
wishes to sell
• Output is the Quantity produced (Q) or Total
Product (TP).
Factors of production or factor inputs
• Land: all natural resources or gift of
nature
• Oil, farming land, gas, wood, …
• Labour (L): physical or mental
activities of human beings
• All types of work
• Capital (K): Man-made things used for
production
• Machines and equipment, roads, bridges,
trains
• Entrepreneurship: combining “land,
labour and capital”
• Ideas, recipes, management, new ideas
in production (product and method)
 Profit, Revenue and Cost
• The goal of firms is to maximise profits through
increasing Total Revenue and reducing the Total Cost of
production.
• Total Profit = Total Revenue – Total Cost
• Total Profit = (P X Q) - (ATC X Q)
• Total profit = (P - ATC) * Q
• P is the price and ATC is the cost per one unit of output
• Profit maximisation include strategies:
• Choosing the optimal level of production at lowest input cost
(ATC)
• Setting the optimal price (P)
• Expanding into new geographic markets or new product lines (Q)
• Buying other firms or merging with other firms (Q)
Concept check
• Anca owns a bakery called Anca’s Italian Bakery. Which of the following
best represents the capital used in the production of bread and pastries
for Anca’s restaurant?
A. The money used by Anca to start her bakery.
B. The oven used to bake the bread and pastries.
C. The salaries of the employees and the cost of materials like flour and
sugar.

• Which of the following describes the production process?

A. Anca’s bakery distributed higher profit to its owners in 2022.
B. The government issues new regulations for restaurants.
C. The employees of Anca’s Restaurant combine flours, water and salt to
make fresh bread.
 Types of inputs

Types of input

Fixed input Variable input

An input whose quantity does
not change with the amount
output.
Example: machinery, land,
buildings, tools, equipment, etc.
An input whose quantity
changes with the amount of
output.
Example: raw materials, labour,
transportation, communication,
 Production periods: hypothetical periods (They
are NOT calendar periods

Short-run (SR) and long-run (LR) periods

Short-run period is the time

frame, in which at least one
input is fixed and other
inputs are variable
(Labour is variable but
Plant capacity is fixed)
Long-period is the time frame in
which all inputs are variable
(Firms can enter or leave the
industry and increase their size)
 Production analysis: managers make
production decisions in the SR and LTR
Short-run production decision Long-run production decision

• In the short-run, some of the inputs • In the long-run, all inputs

are fixed and others are variable.
• The firm’s plant capacity (fixed assets) are variable.
is fixed. • The long-run includes
• The firm can change its output by enough time for existing
applying larger or smaller amounts of
labour, materials, and other resources. firms to leave the industry
• In the short-run, production depends
or for new firms to enter the
on only ONE variable input (L, industry.
Labour) whereby others (such as K, If Emirates buys a new
capital) are fixed. plane(s), and install
If Emirates hires 10 new extra equipment in existing planes,
workers for one of its flight, we are then we are referring to the
speaking of the short-run decision. long-run decision.
 Activity
• Which of the following are short-term decisions
about input, and which are long-run decisions about
input?
A. Anca’s Flowers builds a new restaurant
B. Toyota hires 200 more production workers
C. A farmer increases the amount of fertiliser used on
his corn crop
D. Emirate Aluminium plant adds a third shift of
workers
 Production function in the short-run
• Production question:
• How much output (Q) can a firm produce if it has a certain
“number of” workers?
• How many workers (L) shall a firm employ to produce the
maximum amount of output (Q)?
• To answer, we need find Total product (TP), Average
Product (AP), and Marginal Product (MP)
Total Product, average product, and marginal
product
• Total Product (TP) is the total quantity, or total output, of a
particular good or service produced using fixed and variable
inputs
• Q = f(L)
• Q = Output or Total Product (TP); L = Labour
• Average Product (AP) refers to the productivity of labour
calculated as output per labour input
Average Product = AP=
Total Product 𝑇𝑃
=
Total Labour 𝐿

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

associated with adding one unit of labour to the production
process.
• MP is the slope of the Total Product curve
Marginal
 Example with a pizza shop
• Your firm produces and sells pizzas.
• Assume that your capital (K) is fixed in the short run
• K includes machines and equipment you use in the making and
selling pizzas.
• Now, you want to decide how many workers (Labour, L) you
will employ in the shop. The optimal number of workers is the
one that maximises your outputs (TP or Q)
• Let’s use the concepts of TP, AP and MP to determine the
number of workers that maximises output
• Assume that we have 10 pizza workers with the following IDs:

Name Ahmad Abdulla Jassim Marwa Sara Mariam Khaled Laila Omar David
ID A B C D E F G H I J
Total Product table
Labour Total Explanation Stages of production
product (TP)
0 0 If you do not employ (L= 0) there is no production (TP=0) Stage I
15 If you employ one worker (L=A, Ahmad), Ahmad produces output L between 0 and 3  TP is
1 increasing at a faster (or
Q = 15 pizzas
increasing) rate
34 If you employ (L = A and B), Ahmad and Abdulla together will
2
produce a total of output Q = 34 pizzas
51 If you employ (L = A, B and C), Ahmad, Abdulla and Jassim will
3
produce a total of output Q = 51 pizzas
4 65 Stage II
74 L between 3 and 7  TP is
5 increasing at a decreasing
6 80 rate and reached maximum
of 83
7 83
8 82 Stage III
79 L between 7 and 10  TP is
9 decreasing
10 74
Total product Curve (TP) and three stages of production
Total product
90
80 80 83 82 79
74 74
70
65
60
50 51
40
34
30
20
15
10 Labour
0 0
0 1 2 3 4 5 6 7 8 9 10 11
Increasing Marginal return (IMR)

Stage I: TP is increasing Stage II: TP is increasing Stage III: TP is decreasing

at an increasing rate at a decreasing rate
Average Product table
Lab Total Average Product (AP) Stages of AP
our product
(TP)
0 - If you do not employ (L=) there will be no L between 0 and 3 
0
production (AP = 0) AP is increasing and
1 15 15 / 1 = 15 per worker If you employ one worker (L=1), AP is 15 pizzas reaches a maximum
of 17 pizzas per
34 34 / 2 = 17 per worker If you employ L=2, Each of them will produce 17 worker
2
pizzas on average
3 51 51 / 3 = 17 per worker
4 65 65 / 4 = 16.25 per worker L between 3 and 10
74 74 / 5 = 14.80  AP is decreasing
5 but does not turn
6 80 80 / 6 = 13.33 into negative
7 83 83 / 7 = 11.86
8 82 82 / 8 = 10.15
9 79 79 / 9 = 8.89
10 74 74 / 10 = 7.40
Marginal Product table
Labour Total product (TP) Marginal Product (MP) Comment Stages of MP
0 0 - L =0  TP and MP = 0 Stage I:
MP is increasing and
15 ( 15 -0) / (1 – 0) = 15 If you employ Ahmad only (L=1), he reaches a maximum of
1
produces 15 pizzas 17 pizzas per worker
34 ( 34 -15) / (2 – 1) = 19 If you employ another worker Abdulla (with
2 Ahmad), Abdulla produces 19 pizzas
(TP = 15 + 19 = 34)
51 ( 51 -34) / (3 – 2) = 17 If you employ Jassim (with Ahmad and
3
Abdulla), Jassim produces 14 pizzas
65 ( 65 -51) / (4 – 3) = 14 If you employ Marwa (with Ahmad, Abdulla Stage II
4 and Jassim), Marwa produces 14 pizzas (TP = MP is decreasing and
15 + 19 + 17 + 14 = 65) reaches 0 between
74 ( 74 -65) / (5 – 4) = 9 L=7 and 8
5
6 80 ( 80 -74) / (6 – 5) = 6
7 83 ( 83 -80) / (7 – 6) = 3
8 82 ( 82 -83) / (8 – 7) = -1 Stage II
MP crosses 0 and
9 79 ( 79 -82) / (9 – 8) = -3 becomes negative
10 74 ( 74 -79) / (10 – 9) = -5
TP, AP and MP table
Total product Average product Marginal Product
Labour (TP) (AP) (MP) Stages of MP
0 0 - Stage I: Increasing Marginal Returns
TP is increasing
1 15 15 15 MP > AP, and both increasing and intersect
2 34 17 19 at L=3
3 51 17 17
4 65 16.25 14 Stage II: Diminishing Marginal Returns
TP is increasing at a decreasing rate and
5 74 14.80 9 reaches a maximum of 83
6 80 13.33 6 MP is lower than AP and reaches 0 between
7 and 8
7 83 11.86 3
8 82 10.15 -1 Stage III: Negative Marginal Return
TP is decreasing
9 79 8.78 -3 MP crosses 0 and becomes negative
10 74 7.4 -5

Now, you need to decide in what stage you should produce? (number of L and size of Q)
 Average Product curve (AP), Marginal
Product curve (MP) and three stages of
production
AP and MP
25

20 19
17 17 16
15 15 14 15
13
12
10 10 AP
9 9
7
5 6
3 MP
0
0 1 2 3 4 5 6 7 8-1 9 10 Labour
11
-3
-5 -5
Increasing Marginal return (IMR) Diminishing Marginal return (DMR)
-10 Negative Marginal return (NRS)

Stage I: AP and MP are Stage II: AP and MP are decreasing Stage III: between L 7 and 8, MP
increasing and intersect at L=3 and MP is below AP becomes negative
Total product curve (TP), Average Product curve (AP), Marginal
Product curve (MP) and three stages of production
90
80Total product (TP) 80 83 82 79
70 74 74
65
60 Increasing
50 51
40 Marginal Negative Marginal return (NMR)
30 return 34
Diminishing Marginal return (DMR)
20 (IMR)
15
10
0 0
0 1 2 3 4 5 6 7 8 9 10 11
Labour

25 AP and MP
20 19
17 17 16
15 15 14 15 13 12 10
10 9 9 AP
6 7
5
3 MP
0
0 1 2 3 4 5 6 7 8 -1 9 -3 10 Labour11
-5 -5
-10Stage I: AP and MP are increasing and Stage II: AP and MP are decreasing Stage III: after L=7, MP is negative
intersect at L=3 and MP is below AP
 Summary of the three stages of Total Product
Stages of TP
Stage I: Stage II:
Increasing Marginal Diminishing
Returns Marginal Returns
• TP is increasing at a • TP is increasing at a
increasing rate. decreasing rate.
• MP is positive and • MP is positive but
increasing diminishing (or falling or
 extra units of labour are decreasing)
adding larger amounts to  Each additional unit of
Total Product labour adds less amounts to
Total Product than did the
previous unit
Stage III:
Negative Marginal
Returns
• TP reaches maximum level
and then starts falling.
• MP is zero at the maximum
TP, then becomes negative
as TP declines
 Each additional unit of
labour is having a negative
impact on TP
The law of diminishing marginal returns
• A law which states that “holding capital and
technology fixed, if the variable input, Labour,
increases beyond a certain point, the rate of
increase in output will decrease”
• This means that “ if the variable input increases
beyond a certain point, marginal product of the
labour will decline”
Activity
• Complete the following table by calculating Average
product (AP) and marginal product (MP)
• Plot the total product in one graph and explain its
shape
• Plot the AP and MP in one graph and explain their
shapes.
• Explain “When marginal product is rising, marginal
cost is falling”
Exercise: Complete the table and identify the
stages of production in a graph (TP, AP, MP)
Labour Total product (TP) Marginal Product (MP) Average Product (AP) Stages of production
0 0 -
1 8
2 20
3 33
4 44
5 50
6 54
7 56
8 56
9 54
10 50
Exercise: Complete the table and identify the
stages of production in a graph (TP, AP, MP)
Labour Total product (TP) Marginal Product (MP) Average Product (AP) Stages of production
0 0 -
1 4
2 10
3 17
4 23
5 28
6 31
7 32
8 32
9 30
10 25