THEORY OF PRODUCTION

A production function shows a technical relationship between inputs and outputs. Supposing that the
production of good X requires input of capital, labour and land using functional notation we can write
Qx=f (K, L, LD)
Where:
Qx=output of x per time period
F=the functional relationship
K,L,LD=Services of capital labor and land

The short and long run

The short run is that period of time over which the input of at least one factor of production cannot
be varied. Those factors which can be varied in the short run (labor, raw materials and fuel) are called
variable factors. Those which cannot be varied (capital and land are called fixed factors). The long
run is that period of time over which the input of all factors is variable factors in the long run.

NB: The actual length of the long run does not correspond precisely to any particular time period.
Short run changes in production. As a firm increases its level of production in the short run, it
eventually comes up against “the law of diminishing returns.”

Illustration
Consider farmer growing maize in 1 acre of land and with a given quantity of capital and assume that
neither the land nor the capital can be varied in the short run. Assume also that the state of technology
is constant and that labor is homogeneous i.e. Each worker is exactly like any other worker.

The production function can be written as:-

QM=f (L, K, LD)

No. of workers Total Product(TP) Average product MP

(AP)
1 4 4 4
2 14 7 10
3 25.5 8.5 11.5
4 40 10 14.5
5 60 12 20
6 72 12 12
7 77 11 5
8 80 10 3
9 81 9 1
10 75 7.5 -6

P=TP
L
MP=the change in total product resulting from the employment of an additional worker.
MP=ΔTP
ΔL
It is apparent that MP of a labor is at a maximum when five workers are employed, the 5th worker
adds 20 tones to the total maize output. After this point the MP of labor declines. The result that both
the average and the marginal product of labor eventually declines as more and more units of labor
are added to a fixed amount of other factors in an illustration of the” law of diminishing returns .”

Theory of Production – NOTES @DOUGLAS Page 1

The law of diminishing return states that as additional units of a variable factor are added to a given
quantity of fixed factors, with a given state of technology, the average and the marginal products of
the variable factor will eventually decline.

Average and
Marginal
Products

AP

MP

NO. Of workers

The AP and MP are smooth because of the discrete nature of the data. If we had used continuous data
so that the labor input could be increased in very small quantities, we would have obtained smooth
curves for AP and MP

Average

And

Marginal

Product A B

O Number of workers

MP reaches maximum at point A. This is known as the point of diminishing marginal returns.
Similarly the point at which AP reaches maximum is B and is known as the point of diminishing
average returns

NB - AP begins to fall before AP does. In fact the MP cuts the AP at maximum point on the AP

Theory of Production – NOTES @DOUGLAS Page 2

LONG RUN CHANGES IN THE PRODUCTION

In the long run all factors of production are variable. Firms wishing to maximize their profits
therefore will attempt to produce their chosen output by employing combination of capital labor and
land which minimize their production costs.

We can illustrate this cost minimization graphically with the use of isoquants and isocost lines. These
also enable us to trace out the path along which a firm can expand in the long run.

ISOQUANTS

Consider the production of good x and suppose that only two factors of production, labor and capital
are employed. Suppose further that it is always possible to substitute capital for labour and labour
for capital continuously in the production process.

Given these assumptions it follows that a given quantity of good x can be produced using different
combinations of capital a d labour .This is shown in the following figure.

Capital

Isoquant map for good x

K1 A C F Q3

D Q2

K2 B Q1

L1 L2

Labor

The vertical axis unit of capital per time period K and the horizontal axis measures units of labor (L).
Point A on Isoquant Q1 represents just one possible combination of capital and labor OK 1 units of
capital and OL1 units of labour. Which can be used to produce Q1 units of Output. There are in fact an
infinite number of other points on the isoquant Q1 all of which represents different combination of
capital and labour which can be used to produce Q1 units. An output q2 units (bigger than Q1) can be
produced using any of the combination of capital and labour represented by points along the isoquant
labeled q2 e.g. points c and d. Similarly an output Q3 (bigger than Q2) can be produced using any of
the combination of capita l and labour represented by points along the isoquant labeled Q3 e.g. E and
F.

Theory of Production – NOTES @DOUGLAS Page 3

Definition

An isoquant sometimes called an isoproduct is a contour line which joins together the different
combination of two factors of production that are just physically able to produce a given quantity of
a particular good.

PROPERTIES OF ISOQUANTS

1. They cannot intersect

Consider a case where isoquants intersect

H Q2

Q1

Point H represents combination of capital and labor which when used efficiently can apparently
produce two different quantities of good x, Q1 and Q2 .This absurd result confirms the statement that
isoquants cannot intersect

2. Isoquants are negatively sloped.

If both capital and labour have positive marginal products (so that employment of extra units
increases the total output), then it follows that to maintain a given level of output when the quantity
of one factor is reduced, the quantity of the other must be increased.

3. Isoquants are convex to the origin

If labor and capital are substitutes for each other, though not perfect substitutes then isoquants will
be curves which are convex to the origin. As bigger quantities of labour and smaller quantities of
capital are employed to produce a given level of output, labour becomes less and less capable of
substituting for capital. Similarly as bigger quantities of capital and smaller quantities of labour are
employed to produce the same level of output, capital becomes less and less capable of substituting
for labor.

ISOCOST LINES

On the same labour and capital axes, we cannot an isocost line which join together all those factors
which have the same cost .This together with the isoquant map enables as to identify the cost
minimizing combination of factors that a profit maximizing forms will employ to produce its chosen
output level .

Theory of Production – NOTES @DOUGLAS Page 4

Definition

An isocost line illustrates all the combinations of capital and labour that can be bought for a given
monetary outlay

Example

Suppose price of capital=1sh per unit and

Price of labour= 2sh per unit
The combination of two factors that can be bought for an outlay or cost of 20/- is

Labour Capital
Price=2/- Price=1/-
10 0
8 4
6 8
4 12
2 16
0 20

The combinations can be plotted in the following figure

Capital

40 A1

20 A

10 A11

O B11 B B1
5 10 20 labour
Notice that the slope of the line (OA/OB=2) represents the relative factor price ratio. In fact it is the
price of labour in terms of capital.
a) The cost line for an outlay of 40 is plotted as A1B1.It is parallel to AB and lies to the right.
b) Similarly the isocost line for an outlay of ksh 10 is A11B11 is parallel to AB but lies on its left
c) A change in the relative factor price ratio will change the slope of the isocost lines.

COST MINIMIZATION
To produce a given output of good x say Q1 at minimum cost, a firm will produce at the point where
isoquant Q1 is just touching or is tangent to an isocost line .This is the isocost line nearest to the origin
that can be achieved. Point C represent the cost of point minimization All other combination of capital
and labour along the isoquant Q1 would involve the firm in a larger monetary outlay.

Theory of Production – NOTES @DOUGLAS Page 5

Capital

Expansion Path

C Q2
Q1

O L1 Labour

As the firm expands in the long run it will continue to attempt to minimize its costs. Thus, production
of output Q2 would be at point D and production of output q3 would be at point E. The locus of points
CDE is referred to as the firm’s long run expansion path.

COSTS OF PRODUCTION

Short run costs

Total costs can be broken down into fixed costs and variable costs. Fixed costs = those costs
associated with fixed factors .They have to be paid whether or not the firm produces e.g. rents and
rates of buildings, interests rates on loans and license fees. Variable costs-changes as the level of
output varies costs of raw materials component.

The shape of MC curve is related to the behavior of MP curve. The MC curve cuts the AVC and ATC
curves at their minimum points for arithmetical reasons similar to ones which meant that MP curve
cut the AP curve at maximum point.

Long run cost

Theory of Production – NOTES @DOUGLAS Page 6

Profit-maximizing firms wish to minimize their costs of production. Elementary economics theory
has traditionally assumed when deriving long run average costs (LRAC) curve that the firm can build
an infinite number of plants of different capacities. An LRAC curve indicates the minimum possible
average cost of producing any level of output on the assumption that all factors are variable factors.

The LRAC cost curve reaches a minimum when q2 units of output are produced. Up to this level of
output LRAC curve is declining. The firm is experiencing economies of scale. As output is increased
above q2, the LRAC curve rises, indicating that the firm is facing diseconomies of scale. With fixed
factor prices, this is because of these levels of output the firm has decreasing returns of scale.

NB - Having built a plant appropriate to minimum long run average cost to a given level of output,
if the firm varies its output, it will move along the short run average cost (SRAC) curve. There is a
SRAC curve at a tangent at every point along the LRAC curve. Each SRAC curve lies above the LRAC
curve except at the point at which it is a tangent. For this reason, the LRAC is sometimes known as an
envelope curve.

Exercise.

What are the factors that influence the shape of LRAC curve?

Theory of Production – NOTES @DOUGLAS Page 7

ECONOMIES OF SCALE

They can either be internal or external

INTERNAL
They are those factors which bring about reduction in average cost as the scale of production of an
individual firm rises. Economies of scale can help to explain the trend towards larger production
units in some industries .The following are internal economies
Technical economies

a) Increased specialization –The larger is the scale of production, the greater is the scope of
specialization of both labour and machinery. By performing the same action repeatedly,
labour can become very skilled and perform with skill and dexterity. If the production process
is broken down into many stages, much can be designed specifically for each stage.
b) Economies of increased dimensions-If internal dimensions of a container are increased, the
cubic capacity increases more than proportionately. This means that the unit storage or
transport cost of liquids or gasses may fall as larger containers are used.
c) Factor indivisibility-Certain pieces of capital equipment have to be of certain minimum size
capacity to justify their manufacture. By using the indivisible pieces of capital, larger firms
may be able to achieve lower average costs than small firms.
d) Principle of multiples-If a production process involves the use of different types of machinery,
a larger firm can arrange to have more of the same machine with a small output and fewer of
machines with high output, thus achieving a high utilization rate. A small firm on the other
hand ,with only one of each type of machine would find the high capacity machines standing
idle for much of the time
e) Research and development-A large firm may be able to support its own research and
development program which can result in cost reducing innovations.

Financial economies
Large firms are normally able to obtain finance at lower rates of interests than small firms. Large
firms can often provide more collateral as security for loans. The administrative cost of arranging a
large loan will not be twice those of arranging a loan half as large. Large companies have the option
of making a new share issue on the stock exchange

Marketing economies
A company selling a large volume may be able to use more expensive but more cost effective
advertising. Large firms normally receive quantity discount in the purchase of raw materials. Large
firms have a strong bargaining position as they can threaten to start production of the components
themselves. The distribution and administrative cost of an order for 1000 units are likely to be 10
times the cost of an order for 100 units

Risk- bearing economies

A large company that has diversified into several markets is likely to be better placed to withstand
adverse trading conditions in one particular market. A company has to hold stocks in order to meet
fluctuations in orders. Stocks have to be financed and also have to incur storage costs. As the volume
of orders increases because of an increased number of customers, the company will find that the

Theory of Production – NOTES @DOUGLAS Page 8

required volume of stock will increase less than proportionately as individual changes in orders will
tend to offset one another

EXTERNAL ECONOMIES

They are available to all firms in the industry no matter what their size. When an industry is
concentrated in a particular area, all firms can benefit from the specialist services that develop. This
include the specialist company for supplying and repairing machinery the provision of relevant
training courses by local colleges and the facilities of the financial institution. The specific labor skills
developed in the industry will encourage new firms entering the industry to locate in the same region.
The expansion of an industry lead to establishment of many firms specializing in particular stages of
the production process. This is termed disintegration.

DISECONOMIES OF SCALE

As the organization becomes larger, managerial functions become difficult to perform effectively. In
large organizations, there are likely to be several departments so that more time and effort have to
be devoted to communication and consultation. This may lead to delays in decision making .In areas
where the consumers taste change rapidly ,small firms which can make decision quickly may take
an advantage over a large firm. If production is concentrated in one or more production units, the
average transport cost of raw materials, components and finished articles are likely to increase.
There is evidence that large production units suffer from more strikes and labour disputes. This is
because a worker in a larger firm feels himself to be a co machine with no individual identity. A
worker in a large manufacturing plant is likely to be removed firm the center of the decision making
and is unlikely to feel highly committed to the firm. Industrial disputes involving only a few workers
may lead to a complete half production, as all the stages in the production process are
interdependent.

Theory of Production – NOTES @DOUGLAS Page 9