CHAPTER 4
THE THEORY OF PRODUCTION AND COST
• Firms are buyers of factors of production (or resources) and
sellers of goods & services.
• Firms buy factors of production & transform them into goods &
services; and this process is called Production.
• Theory of production thus shows how economic resources are
combined to produce commodities/products.
• Raw materials yield less satisfaction to the consumer by
themselves.
• Production is basically an activity of transformation, which
connects factor inputs and outputs.
Basic Concepts of Production Theory
• An input is a good or service that goes into the
production process. As economists refer to it, an
input is simply anything which a firm buys for
use in its production process.
• An output, on the other hand, is any good or
service that comes out of a production process.
• Inputs are considered variable or fixed depending
on how readily their usage can be changed.
Cont….
• Fixed input– An input for which the level of usage cannot readily be
changed when market conditions indicate that an immediate
adjustment in output is required.
• Example, capital
• Variable input are- those inputs whose quantity can be altered
almost instantaneously in response to desired changes in output.
– It is the one whose supply in the short run is elastic, example, labor, raw
materials, and the like. Users of such inputs can employ a larger quantity in
the short run.
Short run Vs. Long run production
• Short run
– At least one input is fixed
– All changes in output achieved by changing
usage of variable inputs.
• Long run
– All inputs are variable
– Output changed by varying usage of all inputs
Production function
• It describes the technical relationship between inputs and output in physical
terms.
• It may take the form of a schedule, a graph line or a curve, an algebraic
equation or a mathematical model.
• It refers the maximum amount of output that can be produced from any
specified set of inputs, given existing technology.
• Look the following production function:
Q = f(Ld, L, K, M, T, t)
• Where Ld = land and building; L = labour; K = capital; M = materials; T =
technology; and, t = time.
• For sake of convenience, economists have reduced the
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number of variables used in a production function to only
two: capital (K) and labour (L).
• Therefore, in the analysis of input-output relations, the
production function is expressed as:
Q = f(K, L)
• Increasing production, Q, will require K and L, and whether
the firm can increase both K and L or only L will depend on
the time period it takes into account for increasing
production, that is, whether the firm is thinking in terms of
the short run or in terms of the long run.
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• Economists believe that the supply of capital (K) is
inelastic in the short run and elastic in the long run.
• Thus, in the short run firms can increase production only by
increasing labour, since the supply of capital is fixed in the
short run.
• In the long run, the firm can employ more of both
capital and labour, as the supply of capital becomes elastic
over time.
Short run production
• In the short run, capital is fixed– Only changes in the variable labor
input can change the level of output
• Short run production function Q = f ( L,K ) = f ( L )
• ………………………………………………………...
• Total Product (Q): It gives maximum of output that can be produced at
different levels of one input (L), 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 variable input (L), keeping the other factor inputs
constant.
MPL = ΔQ/ΔL
• Average Product: the ratio of total production to the number of
variable input (L). AP = Q/L
Example
The Law of variable proportion (LDMR)
• The law of variable proportions states that as successive units of a variable
input(say, labour) are added to a fixed input (say, capital or land), beyond some
point the extra, or marginal, product that can be attributed to each additional
unit of the variable resource will decline (MPL declines).
• As more and more of an L is added (combined with a fixed amount of K), total
output initially largely increase but eventually smaller increments; and then the
additions to total output will tend to diminish; LDMR.
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Relationships b/n TP, MP & AP curves
• At the point O, all the three curves, TP, AP and MP starts from the
origin since L = 0.
• As long as TP curve is convex, MP is increasing. When TP curve is
Concave, MP is decreasing.
• The point A on TP curve is called as point of inflexion. MP will be
maximum corresponding to this point of the TP curve.
• AP is maximum at the point B, and also AP = MP
• Corresponding to the maximum point of the TP curve, point C, MP
is equal to Zero.
• To the left of Point C, TP is increasing & MP is positive. To the
right of point C, TP curve is decreasing & MP is negative.
• Since the MP curve is must be decreasing when the AP is maximum,
the MP curve reaches maximum before the AP curve.
Cont…
When AP is rising, MP is greater than AP
When AP is falling, MP is less than AP
When AP reaches it maximum, AP = MP
The Three Stages of Production
Stage I: Stage of Increasing Returns:
• AP is increasing and the MP is greater than the AP. Up to point B on
the TP curve Stage I exist.
• AP is increasing, but MP is increasing first up to point A then
decreasing.
Stage II: Stage of Decreasing Returns
• Both AP and MP is decreasing. But MP is positive.
Stage III: Stage of Negative Returns
• The portion of TP is diminishing and the MP is negative.
In which stage would the rational producer like to operate?
• In Stage I, MP and AP both are rising, and the MP is more
than AP.
• A given increase in variable factor leads to a more than
proportionate increase in the output.
• The producer is not making the best possible use of the
fixed factor. A particular portion of fixed factor remains
unutilized.
• In Stage III, MP of variable factor is negative and the TP
is also decreasing.
• MP is negative because of overcrowded working
environment i.e., the fixed input is over utilized.
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• In Stage II, MP and AP both are falling and MP through
positive, is less than AP. This is efficient region. B/se:
• There is less than proportionate change in output due to
change in labor force.
• Hence at this stage the producer will employ the variable
factor in such a manner that the utilization of fixed factor
is most efficient.
• Hence, the efficient region of production is where the
marginal product of the variable input is declining but
positive.
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Tips;
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