Department of Agribusiness

ISABELA STATE UNIVERSITY

Echague, Isabela

_______________________________________________________________________________

THEORY OF PRODUCTION

INTRODUCTION
Among the important decisions that a producer has to make are the choice of inputs and input
combinations as well as output optimization. This chapter covers input-output relationships both in
the short run and long run, and other important production concepts and theories which are useful in
understanding costs and profits in the succeeding modules.

OBJECTIVES
After completing this module, you should be able to:
1. Sketch and explain product curves.

2. Compute and explain marginal and average product

3. State and explain the principle of Diminishing Marginal returns
4. Define isoquant and explain its characteristics
5. Discuss the different returns to scale
6. Apply cost minimization rule

LESSON PROPER
Production may be defined as the process of transforming inputs into the desired output . It
may also refer to the units of output produced by a firm for sale. As a process, it refers to the series
of steps undertaken by the producer in producing the desired product using a given level of
technology and a certain combination of inputs. An input is anything used by a firm in the
production process. Inputs , also called resources, can be categorized as either variable or fixed. A
variable input is a resource, the quantity of which can be adjusted even in the short run. A fixed
Input is a resource, the quantity of which can not be changed or adjusted in the short run. In farming
for instance, within a short period of time, the farmer may be unable to change the quantities of all the
inputs used. Some inputs say fertilizer, labor and pesticides are variable inputs because their
quantities can be easily adjusted even within a short period of time. The quantity of other inputs like
land, farm buildings and heavy machinery may not be as easy to change, and are therefore usually
fixed in the short run.
The technical or physical relationship between a firms’ input of resources and its output of
goods and services per unit of time is referred to as a production function. It specifies the maximum

AGRI GE ELEC 2 Agricultural Economics & Marketing 12

 Department of Agribusiness
ISABELA STATE UNIVERSITY
Echague, Isabela

_______________________________________________________________________________

output that can be produced for a given amount of input, and can be expressed in the form of an
equation, a table or a graph. Below is an example of a production function:
Y = 1.5X where X = input =fertilizer (in bags)
Y = output = palay (in metric tons)

Production periods
Long- Run – planning period of the firm that is long enough to allow the firm to vary the
quantities of all inputs.
Short-Run – planning period of the firm that is so short that the firm is unable to adjust or change
the quantity of some resources. Hence, some resources are fixed while other
resources are classified variable.

A. PRODUCTION IN THE SHORT RUN(One variable input)

Elements of Production Function

Total Product – the output produced out of a given combination of resources.
Y=f(x) where:
Y = output
X = input in producing output (y)

Average Product – the output produced per unit of variable input

Y TP
AP = -------- or AP = ------------
X X

Marginal Product – the change in total output resulting from a unit change in the input level.

ΔY ΔT.P.
M.P. = ------- or M.P. = -------
ΔX ΔX

AGRI GE ELEC 2 Agricultural Economics & Marketing 12

 Department of Agribusiness
ISABELA STATE UNIVERSITY
Echague, Isabela

_______________________________________________________________________________

Note:
Stage 1 : Total output (TP) is increasing at an increasing rate
Average product(AP) is increasing
Stage II: Total Product is still increasing but at a decreasing rate
Average product is decreasing

AGRI GE ELEC 2 Agricultural Economics & Marketing 12

 Department of Agribusiness
ISABELA STATE UNIVERSITY
Echague, Isabela

_______________________________________________________________________________

Marginal product (MP) is falling but positive

Stage III : TP falls
MP becomes negative

Principle of Diminishing Marginal Returns – a principle in Economics stating that if the quantity of
one input is increased by equal increments, while the quantities of other inputs are
assumed constant, total output will at first increase but beyond some point, the
resulting output increases become smaller and smaller.

ISOQUANTS AND ISOCOSTS (Production in the long run)

Isoquant – a graph showing the different combinations of inputs that produce the same level
of output.

Characteristics of isoquants:

1. they are typically downward sloping. This suggests the substitutability of inputs, that is to
produce the same level of output, a producer can reduce the quantity of one input but has to
increase the quantity of the other input.

2. They are convex to the origin. This suggests that inputs are not perfect substitutes. As labor
is substituted to capital, it takes increasing amounts of labor to substitute one unit of capital.
The rate at which labor and capital can substitute for each other is called the Marginal Rate
of Technical Substitution(MRTS). MRTS is the rate at which the producer can substitute
between two inputs and maintain the same level of output.

AGRI GE ELEC 2 Agricultural Economics & Marketing 12

 Department of Agribusiness
ISABELA STATE UNIVERSITY
Echague, Isabela

_______________________________________________________________________________

Law of diminishing marginal rate of substitution – states that as less of one input is
used, increasing amounts of another input must be employed to produce the same
output level. Alternatively it can be stated as: as input B is substituted for input A,
and as less of B is used, the quantity of B the producer is willing to substitute for Input
A becomes less and less

3. The higher or farther away the isoquant is from the vertex, the higher the output level. In
the graph below, point R is at a higher isoquant while Pt. S lies on the lower isoquant.
Note that Point R shows a combination of more capital and more labor input than Point S.
The assumption is the more inputs used, the higher also is the level of production.
Therefore the higher isoquant represents a higher production level.

AGRI GE ELEC 2 Agricultural Economics & Marketing 12

 Department of Agribusiness
ISABELA STATE UNIVERSITY
Echague, Isabela

_______________________________________________________________________________

4. Isoquants can not intersect. This is because it violates the transitivity principle. No single point
could produce 2 different levels of output. In the graph below for instance, point B (that is 4
units of capital and 2 units of labor ) can not possibly produce both Q =100 and Q=200

AGRI GE ELEC 2 Agricultural Economics & Marketing 12

 Department of Agribusiness
ISABELA STATE UNIVERSITY
Echague, Isabela

_______________________________________________________________________________

COST MINIMIZATION
The isoquants and isocosts may be used to determine the input usage that minimizes the
production costs. The objective of the producer is to maximize profit by producing the highest
possible output with the least possible cost. Alternatively, this can also be stated as given a certain
output level to produce, his interest is in finding the optimum combination of inputs that will give
him the least cost.
An isocost is a line that represents the combinations of inputs that will cost the producer the same
amount of money.

Example: If the producer’s total outlay (C or TO) is P3,000 , Price of capital K, ( r ) is P500
per unit and price of labor, (w) is P300 per unit, the isocost can be drawn as
follows:

Least cost combination(LCC)

In the graph below, the optimum combination, or the least cost combination is
given by point B, where the isocost or budget line is tangent to the highest isoquant. At
point B, the optimum level of output is 100. To produce this level of output, the firm uses
4 units of capital K
and 2 units of labor.

AGRI GE ELEC 2 Agricultural Economics & Marketing 12

 Department of Agribusiness
ISABELA STATE UNIVERSITY
Echague, Isabela

_______________________________________________________________________________

Cost -minimizing Input Rule

Equivalently, to minimize the cost of production, a firm should employ inputs such
that the MRTS is equal to the ratio of prices.
MRTSKL = PL/PK

Returns to Scale
Constant Returns to Scale – a production situation where if all factors of production are increased in a
given proportion, the output produced would increase in exactly the same proportion.

% change in output = % change in inputs

Increasing Returns to Scale - a case where if all factors are increased in a given proportion, output
increases in a greater proportion.

% change in output > % change in inputs

Decreasing Returns to Scale – a case where if all factors are increased in a given proportion, output
increases in a small proportion.

% change in output < % change in inputs

AGRI GE ELEC 2 Agricultural Economics & Marketing 12

 Department of Agribusiness
ISABELA STATE UNIVERSITY
Echague, Isabela

_______________________________________________________________________________

Theory of Production

SELF -ASSESSMENT QUESTIONS

NAME_________________________________ SCORE______

Part A. Fill the blanks with the correct words/terms.

1. _________________________ is a type of input whose quantity can be adjusted even in the short run.
2. In stage _________________ of production, Total output begins to decline and marginal product falls below
zero, as more of the variable input is utilized..
3. The change in total output resulting from an additional unit of variable input used is called
___________________________________.
4. The output produced per unit of variable input is referred to as____________________
5. A factory employs 20 workers to produce electronic parts for radios. If the average product is 5 pieces per
day, then daily production would be equal to ____________________.

Refer to the isoquant map below. J and K are products produced by the firm. I1, I2, I3 are the isoquants. Lines
ab and ac are the isocosts.

AGRI GE ELEC 2 Agricultural Economics & Marketing 12

 Department of Agribusiness
ISABELA STATE UNIVERSITY
Echague, Isabela

_______________________________________________________________________________

6. ____If the budget line or isocost shifts from ab to ac the:

A. price of K has decreased. D. consumer's money income has fallen.
B. price of K has increased. E. not among the choices
C. price of J has increased.

7. ____ The marginal rate of technical substitution is

A. the slope of the isocost.
B. the slope of the isoquant curve.
C. the slope of the utility possibilities curve.
D. the slope of the indifference curve.
E. not among the choices

Part B. Fill the table with the correct answers:

Labor (mandays) Total product TPL) Average Product Marginal product

Land (ha) (APL) (MPL)
1 0 0
1 1 10
1 2 25
1 3 45
1 4 60
1 5 70
1 6 75
1 7 75
1 8 70

AGRI GE ELEC 2 Agricultural Economics & Marketing 12

 Department of Agribusiness
ISABELA STATE UNIVERSITY
Echague, Isabela

_______________________________________________________________________________

AGRI GE ELEC 2 Agricultural Economics & Marketing 12