Concept of Production

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Productivity – is a measure which
compares the quantity of goods and / or
services produced (output) to the quantity
of resources employed in producing them.
• The knowledge applied to resources
through human work.
• The quantity of goods and services
produced from each hour of a worker’s
time.
Production – Is the creation of goods and
services to satisfy human wants.

Inputs of Production – Factors of

production (land,labor, capital,
entrepreneur)

Outputs of Production – The goods and

services that have been created by the
inputs.
Economic Goods – Goods produced by
man.

Free Goods – Goods produced by nature.

These are the goods produced without
costs.
2 Classifications of Factors of Production
1. Fixed Factor (Fixed Input)
- Remains constant regardless of the volume
of production.
- This means whether you produce or not,
the factor of production is unchanged. Ex.
Land and Capital.
2. Variable Factor (Variable input)
- It changes in accordance with the
volume of production. No production
means no variable factor. More production
means more variable factors. Ex. Labor and
Entrepreneur.
Theory of Production – The process of
transforming both fixed and variable
inputs into finished goods and services.
• The quantity and quality of goods and
services being produced depend on the
“state of technology.”
The Production Function
- It shows the relationship between quantities
of various inputs used and the maximum
(technically feasible) output that can be
produced with those inputs per unit of time
expressed in a table, graph, or an equation.
The Short-Run versus Long-Run Analysis of Production
- In the production theory, it is often important to
distinguish the long-run from the short-run period of
production.
- The difference is not based on time but on the
production inputs.
- In the short-run, the use of at least one factor of
production cannot be changed, or there are fixed
inputs.
- In the long-run, all factors can be changed. The time
factor is dependent across firms and industries.
Example. A laundry business can be adjusted in a
month or two, but for Isuzu Motors Philippines, capital
adjustment could take two or three years.
Production with One variable Input
- To introduce the concept, consider the first
three columns in table 6 as a hypothetical
short-run production function in producing
rice.
- Land is measured in hectares, labor in months,
and total production (TP) in cavans.
- Consider a homogenous product in terms of
quality. The average product of labor (AP˪)
given in column 4 which is defined as output
per labor, is obtained by dividing TP (column 3)
by its corresponding units of labor used
(column 2).
- We get marginal product of labor (MP˪) given
in column 5 by finding the differences of
successive quantities in column 3 divided by
the successive quantities in column 2.
- Marginal product of labor (MP˪) is the
additional output produced from employing
additional unit of labor (or capital as the
case may be).
- Consider point E, AP˪ = 6, it means that each
employed labor is producing an average of 6
units of output, while MP˪ = 6 means that the
last labor employed produced an additional 6
units of output.
- Total product, Average product, and Marginal product schedules of Table 6
are plotted in Figure 6.
The Shapes of TP, MP˪, and AP˪
-While keeping capital constant and labor varied, Figure
6 shows the behavior of TP, MP˪, and AP˪.
-Observe in Panel B that AP˪ increases initially then
reaches its maximum and then falls continuously.
-AP˪ does not reach negative because TP does not have
negative values.
-MP˪ is plotted midway between two points because it is
the slope of the TP curve.
-Like the AP˪, it usually rises at first, reaches its
maximum (before AP˪ does), then begins to decline.
-When the TP curve reaches its saturation, MP˪ is zero,
and at the declining portion of TP, MP˪ is negative. The
falling portion of the MP˪ is the so called law of
diminishing returns.
Law of Diminishing Returns
-It is also known as the “law of diminishing
marginal productivity.”
- It is a basic law of economics and
technology. (The law states that when
successive units of a variable input (like
farmers) work with a fixed input (like one
hectare of land), beyond a certain point the
additional product (output) produced by
each additional unit of a variable input
decreases.
Law of Diminishing Returns
-It describes a pattern in most production
portion in the short-run.
-By holding one of the inputs constant
except for one (it may be capital or labor)
and continually increasing the other input,
a certain point will be arrived at wherein
the rate in the increase of output will fall.
-Explaining it more simply, it says that
output will decrease even if there is an
increase in one of the inputs.
Message of the Law
• The message of the law is that there is a
proper combination of a variable input and a
fixed input in order to attain the maximum
output.
The Three Stages of Production
- It is important to describe the three stages of
production because these will help us define the
quantity of labor (or any other input) that a
profit-maximizing firm will employ.
- Stage 1 of production starts at the origin until
the highest portion of the AP˪.
- The TP increases at an increasing rate whereas
both AP˪ and MP˪ increase.
- Stage 2 goes from the highest portion of the AP˪
until MP˪ is zero.
- The TP increases at a decreasing rate and the
AP˪ and the MP˪ decrease.
- Stage 3 of production begins where MP˪ is
zero until its negative range.
- The TP decreases and the AP˪ is also
decreasing but still positive while MP˪ is
already negative.
- From these three stages, at what stage can
the producers maximize their profit?
- Producers will not operate in Stage 3
because at negative MP˪, they can produce
more even if they withdraw some units of
labor and still increase the output.
- Similarly, Stage 1 is not an optimum stage
because it is symmetric with Stage 3 (the MP
of land is negative).
- Therefore, Stage 2 of production is the most
favorable stage because the MP˪ and AP˪ are
both positive though declining.(see figure 6).
Production with Two Variable Inputs
- When more than one input level is free to be
altered, a firm is faces the question of what is
the best input combination to use.
- This section examines the various alternatives
the firm faces when deciding how to produce
each particular level of output.

Isocost - It shows the different combinations

of capital (K) and labor (L) that producers can
purchase or hire given their total outlay and
the factor prices.
An Isocost that shifts to the right indicates an
increase in total outlay, while a leftward shift
denotes a decrease in total outlay.
Example. If the price of capital is 2 pesos, the
price of labor is 1 peso, the total outlay of the
producer is 20 pesos per time period and all is
spent on both inputs.
-The isocost line is given by line DE in figure 6.3.
If the producer spends all his outlay on
purchasing or hiring capital, he could purchase
10 units of it (20 pesos/2 = 10 pesos).
-This is point D. If total outlay is spent on
purchasing or hiring labor, he could purchase
20 units of labor (20 pesos/1 peso = 20). This
is point E. By joining both points, we can now
define the isocost line DE.
Isoquant - Is a curve which shows the
different combinations of capital (K) and labor
(L) which yield the same level of output.
-On a particular isoquant that is given in
Figure 6.4, any combination of capital
and labor that lies on it will result to
the same level of production.
-A shift of an isoquant to the right
means that there is an increase in
production, while a shift to the left
denotes a decline in production.
•Isoquants have three characteristics:
1. Negatively sloped,
2. Convex(curving outward) to the
origin, and
3. Do not intersect.
-The negatively sloped isoquant can be
explained through the diminishing marginal
rate of technical substitution (MRTS).
Marginal Rate of Technical Substitution (MRTS)
- It is the amount of capital that a producer is
willing to give up in exchange for labor and still
lies on the same isoquant.
-A isoquant is convex to the origin because of
the diminishing MRTS, meaning a producer is
willing to give up less and less of capital to gain
additional amount of labor.
*The less remaining capital makes it more
valuable than additional labor.
- Figure 6.5 illustrates why isoquants do not
intersect.
- In Isoquant 1, point G and point H create the
same level of production.
- In Isoquant 2, point G and point I also
produce the same level of production.
- It follows that point H and point I have equal
level of production even though the producer
is using different levels of capital and labor.
Cost of Production – It refers to the total
payments by a firm to the owners of the
factors of production like land, labor,
capital, and entrepreneur.
• For a firm to remain in business, it has to
earn an income which is greater than its
expenses. This means the firm is making
profit.
1. Total Cost – Is the sum total cost of
production. It is composed of wages, rents,
interests, and normal profits.
- These are also known as factor payments:
wages for labor, rent for land, interest for
capital, and normal profit for the
entrepreneur.
Revenue – it is the income side of the firm.
TC = TFC + TVC
Normal Profit – is therefore part of the
total cost of production.
•It is an amount which is sufficient to
encourage an entrepreneur to remain
in business.
Pure Profit – It is an amount which in
excess of the cost of production.
2. Fixed Cost – Is a kind of cost which
remains constant regardless of the
volume of production. Even if there is
no production, there is still cost.
Ex. The Expenditures on machines and
buildings are examples of fixed cost,
whether you use these factors of
production or not, you have paid for
them.
3. Variable Cost – Is a kind of cost
which changes in proportion to
volume of production. If there is no
production, there is no cost. More
production means more costs.
Ex. Wages, raw materials, and oil
products.
4. Average Cost – This is also called
unit cost. It is equivalent to total cost
divided by quantity.
AC = TC/Q
5. Marginal Cost – Is the additional
or extra cost brought about by
producing one additional unit. It is
obtained by dividing change in total
cost by change in quantity.
MC = Δ TC/ Δ Q
6. Explicit Cost – This also called
“expenditure cost.” These are
payments to the owners of the
factors of production like wages,
interests, electric bills, and so forth.
7. Implicit Cost – Another term for this
cost is “non-expenditure cost.” The
factors of production belong to the
users. So, they do not pay. You do not
pay rent to your own land.
8. Opportunity Cost – Is a foregone
opportunity or alternative benefit.
- The amount of benefit that a firm or
individual is willing to forgo in
exchange to another benefit.
9. Total Fixed Costs (TFC) – Costs that
do not vary with output.
Ex. Depreciation of buildings and
machineries, salaries of top
management, rent expenses on
leased plant, and interest payments
on borrowed capital.
10. Total Variable Costs (TVC) – Costs
that vary with output.
Ex. Payment for raw materials,
wages, tax payments, operating
expenses (light, fuel, and water).
11. Average Fixed Costs (AFC) – total
fixed costs divided by the number of
output produced (Q).
AFC = TFC/Q
12. Average Variable Costs (AVC) –
total variable costs divided by the
number of output produced (Q).
13. Average Total Costs (ATC) – total
costs divided by the number of
output produced (Q). Also defined as
the “cost per unit of output.”
ATC = TC/Q
Short Run and Long Run
•Variable Factors or inputs like labor,
raw materials, electricity, oil, and so
forth take a shorter time in adjusting
them to the production process.
These can be increased or decreased
to fit the requirements of production.
•In the case of Fixed Factors or inputs
like machines, buildings, heavy
equipment, or manufacturing plant
capacities, it takes a longer period of
time for their adjustments in
accordance with the needs of
production. It is not easy to increase
or decrease such fixed inputs to suit
business conditions.
Short-Run – It refers to a period of time
which is too short to allow an enterprise to
change its plant capacity, yet long enough
to allow a change in its variable resources.
• Output can be increased or decreased by
applying the corresponding number of
workers, raw materials, and other inputs to
the plant.
• The number of goods to be produced
depends on the full capacity of the plant. A
firm can not produce goods beyond such
capacity.
Long – Run – It refers to a period of
time which is long enough to permit a
firm or enterprises to alter all its
resources or inputs (both fixed and
variable factors).
•Under this period, some existing
enterprises dissolve and leave the
industry while new firms are
organized and enter the industry.
•There is no specific number of
months or years in determining
short-run and long-run periods. In
small scale industries, it takes a
shorter time to make adjustments in
their plant capacities than in large
scale industries.
Economies of Scale – Economies of
growth resulting from expansion of
the scale of productive capacity of a
firm or industry, leading to increases
in its output and decreases in its cost
of production per unit of output.
2 Classifications:
1. External Economies of Scale – It
refers to those which are outside the
firm or enterprise, but they contribute
to the efficiency of the latter in terms of
increased output and decreased unit
cost of production.
Ex. Government policies, electrification,
and transportation and communication
facilities.
2. Internal Economies of Scale – These are the
factors inside the firm or enterprise which
contribute to the efficiency of the latter.
Ex. Division of labor, human resources
development, managerial specialization,
proper use of machines and equipments,
modern techniques of production, effective
utilization of by-products etc...
•It is important to note that those firms which
enjoy both external and internal economies
of scale have become very efficient and big.
They have survived competition and
therefore have remained in the industry.
Appropriate Techniques of Production
Labor Intensive Technology – This
means more labor inputs and less
capital inputs.
•The more plentiful resources should
be utilized because these are cheaper.
•Capital inputs (machines and
equipments) are imported, and
these are usually expensive. Poor
countries can hardly afford to
purchase them with their small
foreign exchange earnings.
Capital – Intensive Technology – This means
more capital inputs and less labor inputs.
•Capital is cheaper in Western Countries
while labor is expensive.
•Under a short-term period, a firm has both
fixed cost and variable cost. Under what
conditions would a businessman operate or
shut down his firm? The rule is: “If Total
revenue is greater than variable cost,
operate; If Total Revenue is less than
variable cost, Shut Down.
Example. The Fixed Cost of the firm is P
10,000 and its variable cost is P 5,000.
Total Cost is therefore P 15,000. Supposing
Total Revenue is P 7,000. This is greater
than the variable cost but less than the
Total cost. If the Firm operates, its loss is P
3,000. But if it closes down, its loss is P
10,000 which is its fixed cost. A firm under
a short – run incurs a fixed cost whether it
operates or not. So, it is better to operate
because the loss is only P 3,000. This is
much better than losing P 10,000.
• In the Long-Run, all costs are available.
This means total cost is equivalent to
variable cost. When does a firm under a
Long-run period operate or close down?
The Rules are:
 
• TR > TC : Produce more
• TR < TC : Stop Production
• TR = TC : Maintain production
Sources of Productivity:
1. Advances in knowledge
2. Technology and Productivity
Technology – it comes from the greek
word “technologia”
- It is the application of knowledge,
including scientific knowledge to
practical purposes.
3. Inventions to innovations
Invention – consists of a new and
bright idea about a new project.
- a new method of producing the same
commodity.
- a new way of organizing the
production process.
- a new source of raw materials, or a
new market for the same product.
Innovation – is the process by which
an invention is translated into the
actual product of process brought
into effective use.
- it involves the economic exploitation
of an invention.