LESSON 5: The Theory of Production

Production Theory in Economics

Production theory in economics refers to how businesses decide the quantities of
outputs to produce in response to demand. The firm produces goods or commodities
with limited resources, and this means that even if it somehow knows people are willing
to buy whatever quantity of goods it produces, it just can't instantly make an unlimited
quantity of goods.

The resources firms use in production are called the factors of production, and they are
also known as inputs.

Theory of Production Function

Since the production theory is about deciding how much output to make, the
production function helps by showing how the output will change when a variable
input changes. For example, how many products will the company make if it employs
two more employees?

From the production schedule in Table 1 above, we can see that the total product
changes with each added worker. This change is what economists call the marginal
product. The marginal product is the change in output resulting from the addition of an
extra unit of input.
The marginal product is the change in output resulting from the addition of an extra unit
of input.

Average product is a term used in the field of economics that refers to the average
output per unit of the variable input. By definition, average product is the average
amount of output (product) a company produces for every input unit.

Table 1 shows that the total product continues to rise until the 10th worker is added. If
more than 9 workers are added, then the total product starts to fall. This is because
production follows the law of diminishing marginal returns, which states that adding
extra units of inputs results in smaller increases in output.

The law of diminishing marginal returns states that adding extra units of inputs results in
smaller increases in output.

This can be confirmed by looking at the column for marginal product. It increases at the
beginning, then begins to drop until it reaches negative values!

The production function is presented in Figure 1 below. It shows the total product on the
vertical axis and the number of workers or quantity of variable input on the horizontal
axis.
The Theory of Production Stages

Because of the law of diminishing marginal returns, production has three main stages.

Let's take a look at Figure 2 below, which is based on Table 1.

Looking at Figure 2 above, we observe a period of heavy rise (Stage I), followed by a
period of slower rise (Stage II), which is then followed by a period of decline (Stage III) of
the total product. These are the three stages of production. The three stages are
characterized by increasing marginal returns, decreasing marginal returns, and
negative marginal returns.

The theory of production Stage I

This is the stage of increasing marginal returns, where the marginal product of each
additional worker increases. In this stage, the addition of each worker means the
workers are able to use the company's equipment more effectively. For instance, the
first worker had a marginal product of 5, whereas the next worker had a marginal
product of 10. This continues until the sixth worker is added. The firm will continue to hire
more workers since it is benefiting greatly by adding a worker each time.

The theory of production Stage II

This is the stage of decreasing marginal returns. Here, the marginal product is still
increasing, but the marginal product of the added worker is less than that of the
previous worker. This stage comes as the company continues to employ workers in
Stage I. In this stage, the total product is still increasing, and the company sees no
reason to stop hiring. In Figure 2, this stage ends with the ninth additional employee.
Soon, the company enters the third stage.

The theory of production Stage III

This is the stage of negative marginal returns. As the company continues to hire, there
will be too many workers in the company. For instance, if one machine can only be
operated by 2 people and there are 4 workers, this means there are two extra workers
distracting the other workers and slowing things down. Therefore, the company begins
to see negative marginal returns. This begins with the addition of the tenth employee as
seen in Figure 2.

Short Run Theory of Production

The short run is the period where only the variable inputs can be changed. Usually, this
variable input is labor, and the fixed inputs are usually capital and land. In more
practical terms, the company can easily hire more workers in this period, but things like
machines and the company office cannot be changed.

Let's say the firm uses labor and land as its two resources to make the goods. At any
point in time, the firm can increase or decrease the number of workers it employs in
response to an increase or decrease in demand. Since the number of workers is so easy
to change at any point in time, economists refer to it as a variable factor of production
or input. On the other hand, since land cannot be changed so easily, it is often called a
fixed input. This means that any change in output must be a result of a change in the
variable input.
Long Run Theory of Production

The opposite of the short run is the long run - a period that is long enough, allowing for
all inputs to be changed. For instance, if a company increases the number of workers,
the company may be doing so well that it will add more machines in the future as it
can make more money this way.

The Theory of Production - Key takeaways

• Production theory in economics refers to how businesses decide the quantities of

outputs to produce in response to demand. Factors of production are the
resources firms use in production. The production function is a figure illustrating
the changes in output when a single variable input changes.
• The marginal product is the change in output resulting from the addition of an
extra unit of input. The law of diminishing marginal returns states that adding
extra units of inputs results in smaller increases in output.
• The three stages of production are characterized by increasing marginal returns,
decreasing marginal returns, and negative marginal returns.
• The short run is the period where only the variable inputs can be changed. The
long run is a period that is long enough, allowing for all inputs to be changed.

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