Production Theory

1. Production
a. It refers to transformation of resources into outputs of goods and services over a
given period of time
b. It is a flow concept or has a time dimension
c. Organization of Production
i. Firm
1. It is an organization that combines and organizes resources for the
purpose of producing goods and services for sale at a profit
d. Classification of Inputs
i. Labour or Human resources
ii. Capital or investment goods
iii. Land or natural resources
iv. Fixed or variable
1. Fixes Inputs
a. Those that cannot be varied or can be varied only with
excessive cost during the time period under consideration.
2. Variable Inputs
a. Those that can be varied easily and on shot notice during
the time period under consideration
e. Time period
i. Short Run
1. Time period during which at least one input is fixed
ii. Long Run
1. Time period during which all the inputs are variable
2. One variable unit
a. Dealing with short run
b. Production function
i. It is a unique relationship between inputs and outputs.
c. Average Product of labour (APL)
i. APL = TP/L
d. Marginal Product of Labour (MPL)
i. MPL = ΔTP/ ΔL
e. Graphically
i. AP
1. At any point of TP Curve is equal to the slope of a straight line drawn
from the origin tot that point on the TP Curve
ii. MP
1. Between any two points on TP Curve, is equal to the slope of TP
between those points
 iii. MP Curve reaches its maximum point before AP curve
iv. Till AP curve is rising: MP curve is above it
v. MP curve intersect AP curve when AP is maximum
vi. MP curve is below AP curve when AP curve is declining
f. Law of Diminishing Returns
i. It postulates that as more units of a variable input are used with a fixed
amount of other inputs, after a point, a smaller and smaller return will accrue
to each additional unit of the variable input
ii. In other words, marginal product of the variable input eventually declines
3. Two variable inputs
a. Isoquants
i. It shows the various combinations of two inputs that can be used to produce
a specific level of output

b. TR Curve from Isoquant Curve

4. Shape of Isoquants
a. Characteristics
i. Cardinal
ii. Negatively sloped
1. If the firm wants to reduce the quantity of capital used in the
production, it must increase the quantity of labour in order to
continue to produce the same level of output
iii. Convex to the origin
iv. Do not intersect
1. Intersection would mean that two different levels of output of the
same commodity could be produced with the identical combination.
This is impossible under our assumption that the most efficient
production techniques are always used
v. Marginal Rate of Technical Substitution (MRTS)
1. Absolute value of slope of isoquant curve
MRTSLK = -ΔK/ ΔL
2. It measures the amount of capital that the firm can give up by using
one additional unit of labour and still remain on the same isoquant

3. Also, MRTSLK = MPL/MPK

b. Economic Region of Production
i. A firm would not operate on the positively sloped portion of isoquant
because it could produce the same level of output with less capital and less
labour.
 ii. Ridge Lines
1. They separate the relevant (negatively-sloped) from the irrelevant
(positively-sloped) portions of the isoquants
c. Fixed Proportion Production Function

i. In general, the smaller the curvature of isoquants, the more easily inputs can
be substituted for each other in production.
ii. The greater the curvature (the closer are isoquants to right angles), the
more difficult is substitution
5. Returns to scale
a. Constant Returns to Scale
i. Refers to the situation where output changes by the same proportion as
inputs
b. Increasing Return to Scale
i. Refers to the case where output changes by a larger proportion than inputs.
ii. As scale of operation increase, a greater division of labour and specialization
takes place, more specialized and productive machinery can be used
c. Decreasing Returns to Scale
i. Refers to the situation where output changes by a smaller proportion than
inputs
ii. As scale of operation increases, it becomes more difficult to manage the
firm effectively and coordinate the various operations and division of the
firm
6. Technological Progress and International Competitiveness
a. Technological Progress
i. Refers to the development of new and better production techniques, to
make a given, improved, or an entirely new product.
b. Innovations
i. Product Innovations
1. Refers to the introduction of new or improved products
ii. Process Innovations
1. Refers to the introduction of new or improved production processes
iii. Most innovations are incremental
7. Innovation Model
a. Closed Innovation Model
i. Companies generally developed and commercialized for the most part of
their own ideas, innovations, or technological breakthroughs
b. Open Innovation Model
i. This involves, the commercialization of both company’s ideas and
innovations as well as the innovations of other firms and deploying external
as well as internal, or in-house, pathways to market