Production Theory

Understanding the relationships between inputs & outputs Production Theory

- Production refers the economic process of converting inputs into outputs
-The level of production depends on level of inputs (investments) provided. Can
be described as output Y = f(x1 / x2 x3 x4 xn). Where x can be variable or
fixed inputs, in this case x1 is the variable input.
-E.g. for a farm output Y = f(cost of feterlizer / cost of land, labour costs,
machineries,..)
-E.g. for a boarding facility, output Y = f(cost of foods provided / cost of caging
to set up accommodation, electricity costs, water costs.)
-The relationship between output and inputs can be :
- Constant return
- Increasing return
- Diminishing return

This section is relevant

only because a lot of
activity projected for
business plan depended
on the inner workings of
production theory

Production Theory
Understanding the relationships between inputs & outputs Production Theory
-Central to the production theory is the firm.
-Measurements affected by whether businesses planned for a long run or short
run production.
A. Short Run Production Function
- a time period where at least one factor of production is in fixed supply.
- Typically associated with start-ups or initial production stage where demand
is still an estimate. Capped by law of diminishing return
- Assumes that FC (e.g. machinery & production plants are fixed) and that
production can be changed by adjusting variable inputs such as labour, raw
materials thus incurring variable costs.
- Time for a short run differs from industry to industry. E.g. short run for
Nasi lemak stalls could be just in days/weeks in time to lease a stall space
or none at all ! versus setting up a dairy farm which could be in months or
years.
- Important for determination of marginal output and product functions !

Production Theory
Understanding the relationships between inputs & outputs Production Theory
-Central to the production theory is the firm.
-Measurements affected by whether businesses planned for a long run or short
run production.
B. Long Run Production Function
- a time period where all factor of production are variable.
- Typically associated with how a business returns to scale
- Assumes that FC (e.g. machinery & production plants are NOT fixed) and
that production can be changed by adjusting variable inputs such as labour,
raw materials thus incurring variable TOTAL COSTS.
- Associated with the term economies of scale or diseconomies of scale
when cost factors are included.
- Economies of scale indicate that long run average cost DECREASES which
corresponds to increasing return to scale in production, e.g. it cost RM
0.65/pack to produce the 100 Nasi Lemak, but this cost become RM
0.55/pack if we produce 200 Nasi Lemak in one production run.

Production Theory
Understanding the relationships between inputs & outputs Production Theory
-Central to the production theory is the firm.
-Measurements affected by whether businesses planned for a long run or short
run production.
B. Long Run Production Function
- Dieconomies of scale indicate that long run average cost INCREASES
which corresponds to decreasing return to scale in production, e.g. it cost
RM 0.65/pack to produce Nasi Lemak when we operate within the optimal
production capability of the operator, but this cost will increase if we
employ an additional person but maintaining the SAME level of production.
- BEAR In mind that return to scale (ROS) refers to production where as
economies of scale refers to cost aspects of ROS !
- Return to scale should not be confused with marginal functions described in
short run production scenarios

Production Theory
Production Theory : Economies vs Diseconomies of scale
-Central to the production theory is the firm.

Cost
Economies of
scale

Diseconomies
of scale

Optimal scale of production

point for a firm
Level of output

Production Theory
Understanding the relationships between inputs & outputs
-The relationship between output and inputs can be :
- Constant return returns are consistent and linear with inputs invested
-Invested units

Output units

10

12 (diff = 2)

14 (diff = 2)

16 (diff = 2)

18 (diff = 2)

- Follows Y=ax+b

Outputs are not limited to goods, but also to services and consumption.

Production Theory
Understanding the relationships between inputs & outputs
-The relationship between output and inputs can be :
- Increasing return increasing returns with increasing inputs
- Invested units

Output units

12

16 (diff = 4)

22 (diff = 6)

30 (diff = 8)

40 (diff = 10)

-Diminishing return

Production Theory
Understanding the relationships between inputs & outputs
-The relationship between output and inputs can be :
- Diminishing return decreasing return with increasing inputs
-Invested units

Output units

12

18 (diff = 6)

23 (diff = 5)

26 (diff = 3)

27 (diff = 1)

-Typically occur after an inflection point (a point where a concavity or

curve changes inflects or changes sign (+ve to ve, -ve to +ve) or
direction. Due to Laws of Diminshing Returns (LDR)
- Major concern of productivity

Production Theory
Understanding Marginal Product Vs Average Product
-These two quantities described how output level is related to their inputs.
-Average product (AP) is the quantity of total output produced per unit of a
variable input, holding all other inputs fixed. Equals total product divided by the
quantity of the variable input. A.k.a. average physical product (APP).
- e.g. 2 tonnes of feed accounts for 10000 eggs, APP = 10000 eggs/2 tonnes
or 5000 eggs per tonne, therefore each egg requires 0.2 kg of feeds.
-Marginal product (MP) or Marginal Physical Product is the change in the
quantity of total product resulting from a unit change in a variable input,
keeping all other inputs unchanged. Equals the change in total product by the
change in the variable input.
-Marginal product is the very foundation of the analysis of short-run production
and the subsequent explanation of the law of supply and the upward-sloping
supply curve, using the law of diminishing marginal returns.

Production Theory
Understanding Marginal Product Vs Average Product
-Marginal product (MP) or Marginal Physical Product equals the change in total
product by the change in the variable input.
-e.g. 3 tonnes of feed accounts for 13000 eggs, MPP = output/ input
- therefore MPP = (13000-10000) eggs / (3-2) tonnes or 3000 eggs per
tonne, each additional eggs after 10000th egg needs 0.333 kg feed to
produce.
- MPP and APP can be related in the following ways :
- when MPP < APP, then APP declines.
- when MPP > APP, then APP increases.
- when MPP = APP, then APP stays.
- these relationships are important to adjust profitable size of operation, length
of time to market (e.g. length of time to harvest chickens) etc

Production Theory
Understanding Marginal Product Vs Average Product
-Simulated relationships in units
Input

Output

APP

MPP

14

21

26

6.5

30

33

5.5

35

36

4.5

36

can be translated into a curve..

Production Theory
Understanding MPP, APP & Total Output
Total Output
Curve

Decreasing
Return

Output

Inflection
point

II

III

Increasing
Return
Constant
Return

APP

Input

MPP

Production Theory
Understanding Marginal Product Vs Average Product Vs Total Ouput
-Region I = MPP > APP, profitable to keep on increasing inputthe enterprise
has huge potential to grow. Started from point of inflection.
-Region III = MPP<APP, increasing inputs are causing issues.e.g. increasing
energy intake of chickens through excessive feedings cause deterioration of egg
production and quality
- Region II = rational region, enterprise still achieve profitable operation but at
diminishing output, MPP is reducing but still in positive region.
- Having understand this the next challenge is to obtain output and input prices
to arrive at a level where we get optimal input increment this is a point where
an operation will get maximum profitability. This will be used to evaluate
production efficiencies.and to decide to expand, to sell or to consider shut
down operations.
- it is often assumed that Value of MPP, or MPP x Output cost = Input costso
maximum profitability is when MPP = Input Cost/Output Cost

Working On A Specific Activity

Exercise (Week 3 & 4)
Using the spread sheet given to you earlier,
Identify :
1.

Capital costs (or overlays)

2.

Operating costs (what are the elements ?)

3.

Work out principal activities that are responsible to bring in revenues (or
incomes) & their projections for a period of your choice (at least 3 years).
Projections should be based on realistic assumptions for the activity of your
choice.