Chapter 6

The Theory
and
Estimation of Production

Dr. khaled Abdella Mohamed Chapter Six

 Overview
2

The production function

Short-run analysis of average and
marginal product
Long-run production function
Importance of production function in
managerial decision making

Dr. khaled Abdella Mohamed Chapter Six

 Learning objectives
3

define the production function

explain the various forms of production functions

provide examples of types of inputs into a

production function for a manufacturing or service
company

Dr. khaled Abdella Mohamed Chapter Six

 Learning objectives
4

 understand the law of diminishing returns

 use the Three Stages of Production to explain why a

rational firm always tries to operate in Stage II

Dr. khaled Abdella Mohamed Chapter Six

 Factors of Production
5

 Land
 Labor
 Capital
 Entrepreneurship

Dr. khaled Abdella Mohamed Chapter Six

 Production function
6

 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

Q=f(X1, X2, ..., Xk)

Q = level of output
X1, X2, ..., Xk = inputs used in
production

Dr. khaled Abdella Mohamed Chapter Six

 Production function
7

 we can consider some of the

 basic variations, assuming the general form in (5.1)
with two inputs:
 Q = aL + bK Linear
 Q = aL + bK + c Linear plus constant
 Q = aL + bK + cLK Linear plus interaction term
 Q = aL² + bK² + cLK Quadratic
 Q = aLK + bL²K + cLK² + dL³K + eLK³ Cubic
 Q = aLᵅKᵝ Power
Dr. khaled Abdella Mohamed Chapter Six
 Production function
8

 For simplicity we will often consider a production

function of two inputs:

Q=f(X, Y)
Q = output
X = labor
Y = capital

Dr. khaled Abdella Mohamed Chapter Six

 Short-run analysis of Total,
Average, and Marginal product
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 Alternative terms in reference to inputs

 ‘inputs’
 ‘factors’
 ‘factors of production’
 ‘resources’

 Alternative terms in reference to outputs

 ‘output’
 ‘quantity’ (Q)
 ‘total product’ (TP)
 ‘product’

Dr. khaled Abdella Mohamed Chapter Six

 Production function
10

 Short-run production function shows the maximum

quantity of output that can be produced by a set of
inputs, assuming the amount of at least one of the
inputs used remains unchanged

 Long-run production function shows the maximum

quantity of output that can be produced by a set of
inputs, assuming the firm is free to vary the amount
of all the inputs being used

Dr. khaled Abdella Mohamed Chapter Six

 Input Output Table
11

Dr. khaled Abdella Mohamed Chapter Six

 Short Run Production
12

 Total Product: It gives maximum of output that can

be produced at different levels of one input, assuming
that the other input is fixed at a particular level.
 Marginal Product: Change in the output resulting
from a very small change in one factor input ,
keeping the other factor inputs constant.
 Average Product: Total production for per unit of
output.

Dr. khaled Abdella Mohamed Chapter Six

 Short Run Production
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 Marginal product (MP) = change in output (Total

Product) resulting from a unit change in a variable
input
MPL= Q/L (holding K constant)
= Q/L
 Average product (AP) = Total Product per unit of
input used
APL= Q/L (holding K constant)
Dr. khaled Abdella Mohamed Chapter Six
 Total, Average, and Marginal product
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No. of workers Total Product Marginal Average Stage of

(1) (2) Product product production
(3) (4) (5)
1 24 24 24
2 72 48 36 I
3 138 66 46
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66
8 528 66 66
II
9 576 48 64
10 600 24 60

11 594 -6 54 III

Dr. khaled Abdella Mohamed Chapter Six

15 Dr. khaled Abdella Mohamed Chapter Six
 Short-run analysis of Total,
Average, and Marginal product
16

 if MP > AP then
AP is rising
 if MP < AP then
AP is falling
 MP=AP when
AP is maximized
 MP=0 when TP
is maximized

Dr. khaled Abdella Mohamed Chapter Six

 Short-run analysis of Total,
Average, and Marginal product
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 Law of diminishing returns: states that with a given state of

technology if the quantity of one factor input is increased , by

equal increment , the quantities of other factor inputs remaining

fixed , the resulting increment of total product will first increase

but decreases after a particular point.

Dr. khaled Abdella Mohamed Chapter Six
 Assumptions
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 State of technology is given.

 One factor of production must always be kept

constant at a given level.

 The law is not applicable when two inputs are

used in a fixed proportion.

Dr. khaled Abdella Mohamed Chapter Six

 Short-run analysis of Total,
Average, and Marginal product
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 The Three Stages of Production in the short run:

 Stage I: from zero units of the variable input to

where AP is maximized (where MP=AP)
 Stage II: from the maximum AP to where MP=0
 Stage III: from where MP=0 on

Dr. khaled Abdella Mohamed Chapter Six

 Short-run analysis of Total,
Average, and Marginal product
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 Total revenue product (TRP) = market value of the

firm’s output, computed by multiplying the total
product by the market price

TRP = Q · P

Dr. khaled Abdella Mohamed Chapter Six

 Short-run analysis of Total,
Average, and Marginal product
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 Marginal revenue product (MRP) = change in the

firm’s TRP resulting from a unit change in the number
of inputs used

TRP
MRP = MP · P =
X

Dr. khaled Abdella Mohamed Chapter Six

 Short-run analysis of Total,
Average, and Marginal product
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 Total labor cost (TLC) = total cost of using the

variable input labor, computed by multiplying the
wage rate by the number of variable inputs
employed
TLC = w · X

 Marginal labor cost (MLC) = change in total labor

cost resulting from a unit change in the number of
variable inputs used
MLC = w

Dr. khaled Abdella Mohamed Chapter Six

 Short-run analysis of Total,
Average, and Marginal product
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A profit-maximizing firm operating in perfectly

competitive output and input markets will be using the
optimal amount of an input at the point at which the
monetary value of the input’s marginal product is equal
to the additional cost of using that input

 MRP = MLC

Dr. khaled Abdella Mohamed Chapter Six

 Example
24

 Suppose P= 75 , W = 400 , FC = 1500

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 Example
25

Dr. khaled Abdella Mohamed Chapter Six

 Solution
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Dr. khaled Abdella Mohamed Chapter Six

 Short-run analysis of Total,
Average, and Marginal product
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 Multiple variable inputs

 Consider the relationship between the ratio of the
marginal product of one input and its cost to the
ratio of the marginal product of the other input(s)
and their cost

MP1 MP2 MPk

 
w1 w2 wk

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 Example
28

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 Solution
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Dr. khaled Abdella Mohamed Chapter Six

 Long-run production function
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 In the long run, a firm has enough time to change

the amount of all its inputs

 The long run production process is described by the

concept of returns to scale

Returns to scale = the resulting increase

in total output as all inputs increase

Dr. khaled Abdella Mohamed Chapter Six

 Long-run production function
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 If all inputs into the production process are doubled,

three things can happen:
 output can more than double
 ‘increasing returns to scale’ (IRTS)

 outputcan exactly double

 ‘constant returns to scale’ (CRTS)

 output
can less than double
 ‘decreasing returns to scale’ (DRTS)

Dr. khaled Abdella Mohamed Chapter Six

 Long-run production function
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 One way to measure returns to scale is to use a

coefficient of output elasticity:

Percentagechange in Q
EQ 
Percentagechange in all inputs

if EQ > 1 then IRTS

if EQ = 1 then CRTS
if EQ < 1 then DRTS

Dr. khaled Abdella Mohamed Chapter Six

 Elasticity of Production
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 The elasticity of production, also called output elasticity,

is the percentage change in the production of a good by
a firm, divided the percentage change in an input used
for the production of that good, for example, labor or
capital.
 The elasticity of production shows the responsiveness of
the output when there is a change in one input.

Dr. khaled Abdella Mohamed Chapter Six

 Long-run production function
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 Returns to scale can also be described using the

following equation

hQ = f(kX, kY)

if h > k then IRTS

if h = k then CRTS
if h < k then DRTS

Dr. khaled Abdella Mohamed Chapter Six

 Long-run production function
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 Graphically, the returns to scale concept can be

illustrated using the following graphs

IRTS CRTS DRTS

Q Q Q

X,Y X,Y X,Y

Dr. khaled Abdella Mohamed Chapter Six
 Estimation of production functions
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 Examples of production functions

 power function: exponential for one input

Q = aLb
if b > 1, MP increasing
if b = 1, MP constant
if b < 1, MP decreasing

Advantage: can be transformed into a linear

(regression) equation when expressed in log terms

Dr. khaled Abdella Mohamed Chapter Six

 Estimation of production functions
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 Examples of production functions

 Cobb-Douglas function: exponential for two inputs

Q = aLbKc

if b + c > 1, IRTS
if b + c = 1, CRTS
if b + c < 1, DRTS

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Dr. khaled Abdella Mohamed Chapter Six