Production Theory

Members:
Blanca, Azalea Shelley
Bongcasan, Justine Marie
Buntag, Jemar Balsomo
Buquiran, Mary Joy Morales
Cajulao, Lera Jean Salveron
Production Theory Learning Outcomes:

▪ Identify the types of inputs and timely

production
▪ Define production function
▪ Describe long run and short run production
▪ Illustrate and explain the Law of Diminishing
Returns
▪ Examine production function isoquants and
define isocost curves 2
Identifying the Types of
Inputs and Timely
Production
Four Major Factors of Production

▪ Labor
refers to human effort
▪ Capital
refers to machinery, equipment, and factories
▪ Land
refers to resources taken from the earth
▪ Entrepreneurial skills
refers to skills related to innovation and risk evaluation
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Variable and Fixed Inputs

▪ Variable Inputs ▪ Fixed Inputs

are inputs whose quantities are inputs whose quantities
can be readily changed in can't be readily changed in
response to changes in market. response to market conditions.

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Short run and Long run Production

▪ Short run ▪ Long run

In the short run, some inputs In the long run, all inputs can
are fixed and some inputs are be changed and thus are
variable. variable.

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Defining the Production
Function: What Goes in
Must Come Out
Production
function
specifies the relationship
that exists between
inputs and outputs for
a given technology.

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 q= f (x1 , x2 , … , xn)
X1 through Xn represents the various inputs in

the production process.

q represents the quantity of output produced.

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If you only have two inputs in the production process:

q= f ( L, K )
L -represents for labor
K -represents for capital

q= 2L + 5K
A linear relationship between both labor and output
and capital and output.
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Cobb-Douglas Function
-this commonly used production function.
-it assumes some degree of substitutability between
inputs, but not perfect substitutability.

q= 4L0.5K0.5

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Using Single Input
Production Functions
Single Input
Production Functions
▪ one variable input
▪ all other inputs in the
production process are
fixed inputs.
▪ you can’t change the
quantity of the fixed
inputs.
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Distinguishing between average product and marginal
product

▪ Total product
refers to the entire quantity of output produced from a given set of
inputs.

Example: q represents total product

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Distinguishing between average product and marginal
product

▪ Average product
refers to the output per unit of input.
Example:

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Distinguishing between average product and marginal
product
▪ Marginal product
it is the change in total product that occurs when one additional
unit of a variable input is employed.
Example:
-The marginal product of the 100th acre of
land is 102 bushels of corn.
-The total product of 99 acres is 11,255
bushels and total product for 100 acres is
11,357 bushels.
-The difference or change between the two
is 11,357-11,255 or 102 bushels of corn.
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Diminishing returns

▪ This law states that ceteris paribus, as the quantity employed

of an input increases, eventually a point is reached where the
marginal product of an additional unit of that input decreases.

It indicates that after some period, additional units of a

variable input aren't as productive as preceding units of
the input.

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Making Production More
Realistic with Multiple
Input Production Function
▪ Although single-input functions are useful in illustrating
many concept, usually they're too simplistic to represent
a firms production decision. Therefore, it is useful for
you to understand the firms employment decision when
the quantities employed of two or
more inputs are changed. In short you are dealing
with two more variableinputs

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▪ Consider the production function q = f(L,K), which
indicates the quantity of output produced is a function
of the quantities of labor, L, and capital, K, employed.
The specific form of this function may be the following
Cobb-Douglas function.

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Production Isoquants

▪ Shows all possible combinations of

two inputs that produce a given
quantity of output

▪ Table 6-2 shows various combinations of

labor and capital that produce 3,200
units of output.

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Defining isocost curves: All input combinations cost
the same
▪ illustrates all possible combinations of two inputs that
result in the same level of total cost. The isocost curve
is presented as an equation

C = a constant level of cost

pL = the price of labor
L = the quantity of labor employed
pK = the price of capital
K = the quantity of capital employed.
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Defining isocost curves: All input combinations cost
the same
▪ On a graph, the isocost curve’s slope equals the price of
the input on the horizontal axis divided by the price of
the vertical axis input.

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Defining isocost curves: All input combinations cost
the same
Example:
Assume your total cost is $4,000 a day, and labor costs $20
per hour, and capital costs $5 per machine-hour. Given this
information, your isocost curve equation is

Given: C= 4,000, PL = 20, Pk = 5

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This are some of the possible combinations of
labor and capital that you can employ for a total
cost of 4000.

Labor Capital
50 600
100 400
150 200

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 1st Combination
C= 4,000 PL = 20 L = 50 PK = 5 K= 600

C = (Pₗ X L) + (Pₖ X K)
4,000 = (20 X 50) + (5 X 600)
4,000 = 1,000 + 3,000

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 2nd Combination
C = 4,000 PL = 20 L = 100 PK = 5 K =400

C = (Pₗ X L) + (Pₖ X K)
4,000 = (20 X 100) + (5 X 400)
4,000 = 2,000 + 2,000

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 3rd Combination
C = 4,000 PL = 20 L = 150 PK = 5 K = 200

C = (Pₗ X L) + (Pₖ X K)
4,000 = (20 x 150) + (5 x 200)
4,000 = 3,000 + 1,000
4,000 = 4,000

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Figure 6-3:
An isocost curve showing
possible combinations of
labor and capital you can
employ for $4,000.

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Shift in Isocost Line

An isocost line may shift due to two reasons:

▪ Change in total outlay to be made by the firm
▪ Change in Price of a factor-input

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Change in total outlay to be
made by the firm
- When the firm decides to
increase or decrease the total
money to be spent
on purchase of inputs while
prices of the inputs remain the
same.

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Change in Price of a factor-
input
- When price of-factor input
changes the isocost line
swings or rotates.
The direction in which the
isocost line will swing depends
upon the factor whose price
has changed.

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Figure 6-4:
Lower input price on the
horizontal axis.

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Lower input price on the
horizontal axis
▪ If the input in the horizontal axis
becomes cheaper , the isocost curve
rotates out on that axis.

Decrease in price of labor

= rightward shift

Increase in price of labor

= leftward shift.

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Figure 6-5:
Lower input price on the
vertical axis

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Lower input price on the
vertical axis
▪ If the input on the vertical axis
becomes cheaper , the isocost curve
rotates

Decrease in price of capital

= rightward shift

Increase in price of capital

= leftward shift

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Making the most with the least: Cost minimization

▪ The costs of producing a given quantity of output are

minimized at the point where the production isoquant is
just tangent — or, in other words, just touching — the
isocost curve. This point is illustrated as point A in
Figure 6-6. The cost-minimizing combination of labor
and capital are the quantities L0 and K0.

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Figure 6-6:
Cost-minimizing input
combination.

At the point where you

minimize costs, the
production isoquant and
isocost curve are tangent.

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40
▪ Economists call the preceding
concept the least cost criterion, and
it’s an application of
the equimarginal principle. To produce
goods with the lowest possible
production cost, you equate
the marginal product per dollar spent.

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 Figure 6-6:
Isoquant Curve Cost-minimizing
input combination

▪ is a concave-shaped line on a graph,

used in the study of microeconomics,
that charts all the factors, or inputs,
that produce a specified level of
output. This graph is used as a metric
for the influence that the inputs—most
commonly, capital and labor—have on
the obtainable level of output or
production.

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Recognizing That More
Isn't Always Better with
Long-Run Returns to Scale
Returns to scale

▪ In the long run, all inputs can be

changed. If you change all inputs
by the same percentage or
proportion, you need to know the
amount output will change by.
Economists call this relationship
between output and all
inputs returns to scale.
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Returns to scale

▪ refers to the changes in output that occur when the scale of

production changes. Changes in the scale of production
indicate a proportional change in the quantity employed of all
inputs.

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3 Kinds of
Returns to
scale:
▪ Increasing returns to scale
▪ Decreasing returns to scale
▪ Constant returns to scale
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➢ Increasing returns to scale
Indicate that doubling the quantity employed of all inputs results in the quantity of
output produced more than doubling. Increasing returns to scale can be caused by
greater specialization within your company, or perhaps doubling your inputs allows
you to build one large factory that’s more efficient than two small factories. This is
shown in the following example.

The table shows that the input is increasing by 100%, on the other hand the output is
increased by 150%.

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Causes of Increasing Returns to scale

▪ Indivisibilities: Indivisibility means that certain factors are available

only in some minimum sizes.

▪ Greater Specialization: As the scale of production increases, the

efficiency of labour increases due to division of labour and
specialization of labour. Similarly, when the scale of production
increases, it becomes possible to use specialised machines and the
services of specialized and expert management.

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➢ Decreasing returns to scale
Indicate that doubling the quantity employed of all inputs results in the quantity of
output produced less than doubling. Decreasing returns to scale may result from the
fact that larger business enterprises are harder to coordinate than smaller
businesses. The following example will explain decreasing returns to scale.

This shows that inputs increased to 100% but the increase output is only 50%.

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Causes of Decreasing Returns to scale

▪ Complexity of management: Increase in the scale of production on

beyond a point may create the problem of proper management,
leading to a decrease in managerial efficiency. As a consequence of all
these, the overall efficiency of management decreases.

▪ Entrepreneur is a fixed factor: According to some economist

decreasing returns to scale arise because entrepreneur is a fixed and
indivisible factor.

▪ Exhaustibility of Natural Resources: Another factor responsible for the

diminishing returns in some activities is the limitation of natural
sources.

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➢ Constant returns to scale
Indicate that doubling the quantity employed of all inputs results in output also
doubling. In the case of constant returns to scale, increasing and decreasing returns
to scale essentially offset each other.

Similarly, chain of dry cleaners can increase its volume of service by increasing its
number of outlets (with designated number of workers per outlets). This can be
explained in the following example.

This shows that as the inputs increased

to 100%, output also increased to
100%

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Causes of Constant Returns to scale

▪ Limits of Economies of scale: Increasing returns to scale cannot go on

indefinitely. There is a limit to these economies of scale When the
economies of scale are exhausted and diseconomies are yet to start,
there may be a briefs phase of constant returns to scale.

▪ Economies of Scale: It refers to the situation which increases in the

scale of production give rise to certain benefits to the producers.

▪ Divisibility of Inputs: Constant returns to scale may occur in certain

productive activities where the factors of production are perfectly
divisible.

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“ Diminishing marginal
returns vs. returns to scale
Diminishing marginal returns primarily looks at changes in
variable inputs and is therefore a short-term metric. Variable
inputs are easier to change in a short time horizon when
compared to fixed inputs. As such, returns to scale is a measure
focused on changing fixed inputs and is therefore a long-term
metric.

Both metrics show that an increase in input will increase output

up until a point, the main difference between the two is the time
horizon and therefore the inputs that can be changed: variable or
fixed.

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Determining Output
Elasticity
Output Elasticity

▪ is the percentage change in output that results from a one-

percent change in the quantity employed of all inputs. This is
therefore related to returns to scale. If the output elasticity is
greater than one, increasing returns to scale exist. An output
elasticity equal to one indicates constant returns to scale, while
an output elasticity of less than one indicates decreasing
returns to scale.

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Output Elasticity

Consider the Cobb-Douglas production function

If you increase the quantity employed of both labor and capital by one
percent, then

Rearranging the equation results in

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Output Elasticity

▪ Therefore, a one-percent increase in

both labor and capital results in a one-
percent increase in output, as
represented by the (1.01) in the
equation. This situation indicates
constant returns to scale.
▪ One special feature of Cobb-Douglas
production functions is that they always
have constant returns to scale.
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References:

Graham, R. (2013). Managerial Economics for Dummies. John Wiley & Sons, Inc.

https://wikieducator.org/Returns_to_Scale?fbclid=IwAR0EBSxvXw-lFZfl-
avQp1o6pZdIQJEVB7g4bxepT0Sg64t2VkvPp5wyI9w

https://www.investopedia.com/ask/answers/033015/whats-difference-
between-diminishing-marginal-returns-and-returns-scale.asp

https://drive.google.com/file/d/1-
XzlKjl_ISHOwgJVeRUY7rxhS4QyFFTc/view?fbclid=IwAR2fIiYmRmAiXbr_GgPjT4
RI9hDDF6dhInm84gmj4RhES8s-XCUdwCYFJ_g
THANK YOU VERY
MUCH!
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