MODULE BASIC MICROECONOMICS

CHAPTER 5: THEORY OF PRODUCTION

Objectives:

1. Describe the concept of Law of Diminishing Returns.

2. Explain ways to improve production.
3. Show how productivity is measured via formula
4. Point out successful business in the Philippines that uses
resource efficiency.

INTRODUCTION

The theory of production is an analysis of output-input relationship. As such, discussions

touch on the relation of output to the size, combination, and efficiency of resources. The
fundamental concepts in this chapter are the Law of Diminishing Returns and returns to scale,
which explain the output function in different resource conditions.

PRODUCTION FUNCTION

Plant size and the efficiency of its resources (land, labor, and capital) determined plant
capacity (maximum output). Resources are fixed in the short run, which is generally described as
a period when conditions have not changed yet. But as plant size and resource efficiency change
in the long run, so is production capacity. In addition, material inputs change with output
regardless of the time frame, i.e., within fixed or changing plant capacity.

Description

Alternative plant sizes and resource combinations (choice) determine different levels of
resource efficiency and production capacities in the long run. The production function only
illustrates one side of this combination but drives home fundamental concept of diminishing
returns. As a practical model and tool of analysis, its one-variable-resource assumption basically
reflects on the dynamics of a multi-resource condition.

The marginal product influences this trend and is defined as the product due to the
additional or last unit of the variable resource input and measured as:
𝛥𝑄
𝑀𝑃 =
𝛥𝐼
Where: MP = Marginal Product or Output

Qp = Total Product or Output

I = Resource Input

Δ = Change
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Lastly, average product (AP) is output per unit of the variable resource input and measured
𝑄
as: 𝐴𝑃 = , AP follows the trend of MP, following the law of averages. In other words a change
𝐼
∆𝑄 𝑄
in MP ( ) causes the AP ratio ( ) to change in the same direction. There is no such thing
∆𝐼 𝐼
as a negative output, although a negative MP simply means a decrease in output.

The Law of Diminishing Returns

Diminishing returns, also called law of diminishing returns or principle of diminishing

marginal productivity, economic law stating that if one input in the production of a commodity is
increased while all other inputs are held fixed, a point will eventually, be reached at which
additions of the input yield progressively smaller, or diminishing, increases in output.

In the classic example of the law, a farmer who owns a given acreage of land will find that
a certain number of laborers will yield the maximum output per worker. If he should hire more
workers, the combination of land and labor would be less efficient because the proportional
increase in the overall output would be less than the expansion of the labor force. The output per
worker would therefore fall. This rule holds in any process of production unless the technique of
production also changes.

Early economists, neglecting the possibility of scientific and technical progress that would
improve the means of production, used the law of diminishing returns to predict that
as population expanded in the world, output per head would fall, to the point where the level of
misery would keep the population from increasing further. In stagnant economies, where
techniques of production have not changed for long periods, this effect is clearly seen. In
progressive economies, on the other hand, technical advances have succeeded in more than
offsetting this factor and in raising the standard of living in spite of rising populations.

The Lessons of Diminishing Returns

The Law of Diminishing returns has two important lessons. First, the size of a resource,
given the rest as fixe, should not go beyond its product-maximizing point. This means that the
maximum labor inputs should only correspond to where the output is maximized to determine
plant capacity. Resource imbalance and diminishing returns are at their worst as production
capacity (maximum output) decreases with a bigger but overtaxed plant.

Therefore, the other lesson is that plant capacity can only increase with more of all
resources unless technology changes. From this two lessons can be drawn the third that
resources are basically complementary. Differently put, a source is as indispensable as any other
in production.

The Isoquant-Isocost Model

This model illustrates more dynamically how different plant sizes and resource
combination determine different levels of resource efficiency and plant capacity. As a dynamic
tool of analysis, it also factors in the cost and budgetary limits of production.
 MODULE BASIC MICROECONOMICS
THE ISOQUANT

An isoquant is a firm's counterpart of the consumer's indifference curve. An isoquant is a

curve that shows all the combinations of inputs that yield the same level of output.
'Iso' means equal and 'quant' means quantity. Therefore, an isoquant represents a constant
quantity of output.

Theoretically, there are infinite combinations of resource inputs which determine the same
plant capacity (maximum output). In a two-variable resource system, these combinations form the
product indifference curve or isoquant with the capital and labor resource inputs.

But resource input foregone is not necessarily equal to resource input gained to maintain
plant capacity and their rates of substitution are not even constant along the curve. Their marginal
rates of substitution (MRS) are defined as how much of one resource is given up in order to use
an additional unit of the other, given a fixed capacity. To use the isoquant, the MRS is measured
as follows.

𝛥𝑌 𝑎𝑥𝑖𝑠
𝑀𝑅𝑆 =
𝛥𝑋 𝑎𝑥𝑖𝑠

Where additionally: Δ = Change

The Isoquant and Diminishing Returns

Table 13: Isoquant

Marginal Rate of The Law of Diminishing

Labor Input Capital Input Substitution Returns influences the
Δ Capital / Δ Labor behaviour of the marginal rate
1 30 - of substitution (MRS) as the
latter shapes the isoquant.
2 26 4
In the same example of Table
3 22.5 3.5
13, marginal product of labor
4 10.5 3 ∆𝑄
( ∆𝐿 ) decreases from more
5 17 2.5
∆𝑄
6 15 2 use, while that of capital ( )
∆𝐾
7 13 1.5 increases from less use with the
opposite effect of diminishing
8 12 1
returns. It follows that more
9 12 0.5 labor inputs (L) are needed to
produce an additional unit of
10 12 0
outputs as the inverse of its
 MODULE BASIC MICROECONOMICS
∆𝐿
marginal product ( ) increases. But less capital inputs (K) are only given up to reduce output
∆𝑄
∆𝐾
by the same unit as the inverse of its marginal product ( ) decreases. To go back to their
∆𝑄
∆𝐾
MRS formula, ( ), more and more labor is used (ΔL) to regain the same output foregone by
∆𝐿
giving up less and less of capital inputs (ΔK). Thus, the MRS ratio decreases as labor is
substituted for capital. Clearly, less capital is given up in exchange for more and more of labor as
the former becomes more efficient from less use while the latter becomes less efficient from more
use. To stress the point, an efficient resource cannot be given up in exchange for an inefficient
one to maintain output.

Hierarchy of Isoquants

A hierarchy of isoquants is
an array of isoquants which
corresponds to different levels of
resource inputs and plant
capacity. In Figure 40, all the
points of Q₁ move upward to form
the higher isoquant Q₂ as more
capital and labor combined
increase plant capacity. This
overall change is actually the
upward and rightward shifts in the
production function curve in
Figure 40 where all resources
increase plant size and capacity.

In addition, there is an
infinite number of isoquants as there are infinite levels of plant capacity in the hierarchy. This
means that any point in the graph is a resource combination of an isoquant. The isoquant shown
in the graph are just two of the infinite numbers in the hierarchy.

Again, the assumption of infinity serves to highlight relevant tendencies in reality. For
example, technological research can explore the possibility of designing a plant that is neither too
small nor too big for a certain market size.

The Isocost Curve and Its Hierarchy

Theoretically, there are infinite combinations of production resources that a given budget
can buy. In a two-variable resource system, these combinations form isocost curve, Figure 41
based on Table 14 illustrates the isocost curve with capital and labor as resource inputs. Between
one point and another along the curve, one resource is given up in exchange for the other because
of a fixed budget.
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The same figure and table show that each budget is split between the resources at varying
purchase combinations. But as resource prices and their ratio are constant, so is the marginal
rate of substitution down the curve. Marginal rate of substitution (MRS) is defined as how much
of one resource should be given up in order to buy an additional unit of the other, given a fixed
budget.

Figure 41: Hierarchy of Isocost

The (MRS) of capital

(K) to labor (L) in the example
is computed as follows:

𝛥𝑌 𝑎𝑥𝑖𝑠
𝑀𝑅𝑆 =
𝛥𝑋 𝑎𝑥𝑖𝑠

𝛥𝐾
𝑀𝑅𝑆 =
𝛥𝐿
Alternatively, the
MRS of capital to labor is
equal to the inverse of its
given price ratio. Given a
fixed budget, the cost (price)
of buying an additional unit of
labor (L) is the capital input
(K) that the price of labor or
𝛥𝐾
. Thus, MRS is the capital input (K) that the price of a unit of labor (L) could otherwise buy or:
𝛥𝐿
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐿
.
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐾

Likewise there is a hierarchy of isocost curve which corresponds to different budget and
cost levels. Table 14 shows that the purchase of both capital and labor increases proportionally
with the budget for every combination. Therefore, a bigger budget forms a higher isocost curve in
Figure 41 but with the same marginal rate of substitution (MRS) because of constant prices and
their ratio. Rather, volume and cost spell the difference between the isocost curves in the
hierarchy.

Lastly, there is also an infinite number of isocost curves as there are infinite budget levels
in the hierarchy. As in the isoquant map, any point in the graph is a purchase combination of
resource inputs of a budget and its isocost curve. The curves in Figure 41 are among the infinite
number in the hierarchy.

The Isoquant-Isocost Combination

Isoquant Curve – represents what can be produced.

 MODULE BASIC MICROECONOMICS
Isocost Curve – defines the cost and budgetary limits of production.

The optimum resource combination for a given plant capacity is a least-cost condition.

Table 14: Isocost and its Hierarchy

The optimum resource combination follows the principle of the equi-marginal condition of
consumer’s behaviour. In the foregoing optimum condition, one resource is as marginally efficient
as the other. Therefore, any deviation from the optimum point results in a resource imbalance that
diminishes returns and decreases production capacity.

Change in Resource Mix

Resource mix or combination is defined as how much of one resource is used per unit
of the other. Optimum combination changes with relative resource price and efficiency. Optimum
resource combination favours the use of cheaper and more efficient inputs to maximize
production. This explains why industrialized countries use capital-intensive technology to solve
their problem of scarce and expensive labor resources. The same principle explains why
developing countries use labor –intensive technology to take comparative advantage of their
abundant and cheap labor.

Capital-intensive technology - production requires more equipment and machinery to produce

goods; therefore, require a larger financial investment.

Labor-intensive technology - refers to production that requires a higher labor input to carry out
production activities in comparison to the amount of capital required.
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PRODUCTIVITY

Productivity – is the efficiency and therefore the power of inputs to produce. It is

commonly defined as a ratio between the output volume and the volume of inputs. In other words,
it measures how efficiently production inputs, such as labour and capital, are being used in an
economy to produce a given level of output. Productivity is measured as output per unit of input
which is illustrated below:
𝑄
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 = where: Q = output I = Input
𝐼

The forgoing, which is average productivity is the efficiency of inputs taken as a whole and
is measured as their average output (as in the above formula). On the other hand, marginal
productivity is the efficiency of additional inputs and it is measured as their marginal output which
is also illustrated below:
𝛥𝑄
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 = where additionally: Δ = Change
𝛥𝐼

Advantages:

Productivity improvement means more output per unit of input as the increase in the
𝑄
efficiency ratio ( ) indicates. It also means less input for output as the decrease in the ratio’s
𝐼
𝐼
inverse ( ) indicates.
𝑄

Therefore, efficiency is not a matter of size. Bigger plant is not necessarily more efficient
than its smaller counterpart.

However, productivity is not an end but means to compete and survive in the free market.
The profitable improvement in overall resource efficiency in the foregoing is categorized as an
increase in economic efficiency. This form of efficiency is measured as output per monetary unit
𝑄
of input with the latter expressed as monetary cost in the basic productivity ratio ( ). Therefore,
𝐼
economic efficiency balances or reconciles the effects of two other types of productivity.

Technical efficiency – capitalizes on the output.

Cost efficiency – gives emphasis to the cost of inputs.

Usually, output and cost are conflicting to attain economic efficiency. Thus, the technical
efficiency of a machine is not necessarily profitable if it is too costly. To strike a balance, its
additional monetary returns should outstrip its cost. However, technological advancement can
optimize both output and cost to readily fit the picture of economic efficiency. For example,
computers have become more powerful and cheaper to do more work at a lower cost.
 MODULE BASIC MICROECONOMICS
RELATIVE RESOURCE EFFICIENCY

Production resources are complementary not only in function but also in efficiency. A
better machine also enables its operator to work faster or the other way around. Resources do
not become more internally efficient at the same time, but every improvement contributes to the
overall productivity picture.

In addition, the time lag between productivity improvements can alter the optimum
combination of resources. For example, replacing old machines with modern and more efficient
ones improves work and shifts. But plant expansion (long frun) favors the use of more efficient
capital than less efficient labor. The shift is economically efficient since every peso of labor given
up, which is additionally spent for capital, yields a net increase in output.

Basic Ways to Improve Resource Efficiency

One way to improve the plant’s overall resource efficiency is to change the nature of the
resource through innovation. One example is work specialization, which concentrates on job
requirements instead of diffusing efficiency.

Another way to improve resource efficiency is to change the external condition of

resources such as the organization of work. A simple example is increasing the number of
customers served in a drug retail outlet by temporarily reassigning resources to augment the sales
group during peak hours. This set-up minimizes imbalances in work distribution and labor idle
time.

Another external change that can improve resource efficiency is a more balanced resource
combination. Increasing the size of constraining resources more efficient and minimizes
diminishing returns.

Still another way to improve plant overall resource efficiency is by using resource saving
technology.

Returns to Scale and Productivity

Returns to scale measures how output changes relative to resource inputs in the long run
and indicate how overall resource efficiency depending on plant size and condition. Returns to
scale are measured as follows:

%(𝛥𝑄)
𝑅=
%(𝛥𝐼)

Where: R = Returns to Scale

Q = Output
I = Resource Input
Δ = Change
% = Percentage
 MODULE BASIC MICROECONOMICS
𝑄
Resource ( ) increases when R is greater than I because Q increases faster than I. The
𝐼
opposite is true when R is less than one.

To capture the effect of plant expansion on resource efficiency, the measure assures
constant percentage use of plant capacity and excludes the distorting effect of diminishing returns.
Otherwise, the measure can misrepresent, say, a decline in plant efficiency form overusing
resources due to diminishing returns of scale.

Therefore, the measure of R truly reflects the relation between size and efficiency only
when the degree of plant use is constant. Assume a simple case of plant expansion with no effect
on efficiency yet with constant returns to scale. This expansion is like enlarging your photo with
the same body proportions. Therefore, output increases proportionally with resource inputs in the
production function for the same capacity use.

Table 15: Returns to Scale

Returns to Scale Marginal Productivity Average Productivity

Returns
R = %(ΔQ) / %(ΔI) ΔOutput / ΔInput Output / Input
Greater than 1 Increaing Increases Increases
Equal to 1 Constnat Constant Constant
Less than 1 Decreasing Decreases Decreases
Less than Zero or Decreasing and
Negative Decreases
Negative Negative

Table 15 summarizes the different stages of plant expansion in relation to overall resource
efficiency. The first stage has increasing returns to scale with R is greater than 1. Output increases
faster than resource inputs as the latter becomes more and more efficient. The c=second stage
has constant returns to scale with R is equal to 1. Output increases as fast as resource inputs as
the efficiency of resource inputs is constant. The third stage has decreasing returns to scale with
R less than 1. This time, output lags behind resource inputs as the latter becomes less and less
efficient. The last stage, output decreases despite plant expansion as resources become more
and more efficient.

Reasons for Returns to Scale

The early part of plant expansion conditions resource specialization and division of labor
which increase returns to scale. This stage is characterized by the efficiency of size or economies
of scale. In a small plant, a resource may be assigned different functions because no job is
extensive enough to be its monopoly. But large-scale production enables resources to
concentrate on job requirements instead of diffusing efficiency.

However, further expansion breeds the problem of control and decreases returns to scale.
This stage is characterized by the decreasing efficiency or even the efficiency of size, which is
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also called diseconomies of scale. The reason is that the problem of control makes coordination
and directing difficult because of delays, decision lapses or even inaction.

Overcoming Decreasing and Negative Returns

I the real world, size is not handicap after all when innovations are made to overcome the
causes of decreasing and negative returns.

Advances in information technology can solve the once insurmountable problems of

communication and control in large organizations. The fast processing and transmittal, as well as
the efficient storage of large volume of complex information make technology an indispensable
tool of management decision-making.

However, innovation also applies to organizational structure and culture and not only to
its physical aspect. They are called the “hard” and “soft” of the organization, respectively. A current
trend in structural innovation is decentralization toward self-managed teams. Corresponding the
foregoing structural innovation is the chopping off of a big organizations into smaller but
autonomous and manageable parts. Self-managed team are most efficient in these decentralized
units where the scope of decision-making is more focused and communication is more fluid.

Finally, the general trend in corporate culture is toward a people-oriented organization.

This culture reconciles organizational and individuals goals to create a synergy beneficial to both
sides. It is the force behind the organizational drive to survive and excel in this competitive world.

SUMMARY

Two Concepts in theory of Production

1. Law of Diminishing Returns – states the use of variable resources against the limits of fixed-
resources or describes the tendency at some point for each succeeding addition to output to
become smaller as the firms add succession units of variable input to some fixed inputs.

Two lessons:

a) Size of a source, given the rest as fixed, should not go beyond its product
maximizing point.
b) Plant capacity can only increase with more resources combined unless technology
changes.

2. Returns to scale measure how output changes relative to resource inputs in the long run and
indicate how overall resource efficiency changes with plant size.

Economies of scale cost advantages that a business can use by expanding their scale of
production.

Diseconomies of scale occur when business grows so large that costs of unit go up and are
characterized by the decreasing efficiency or even inefficiency of size.
MODULE BASIC MICROECONOMICS

For more knowledge, please follow the link provided;

https://www.youtube.com/watch?v=lT8eSU9pxcw
https://www.youtube.com/watch?v=7qozjIj_xoo
https://www.youtube.com/watch?v=qW9QqlLc42Y