Theory of production, in economics, an effort to explain the principles by

which a business firm decides how much of each commodity that it sells (its
“outputs” or “products”) it will produce, and how much of each kind of
labour, raw material, fixed capital good, etc., that it employs (its “inputs” or
“factors of production”) it will use. The theory involves some of the most
fundamental principles of economics. These include the relationship
between the prices of commodities and the prices (or wages or rents) of the
productive factors used to produce them and also the relationships between
the prices of commodities and productive factors, on the one hand, and the
quantities of these commodities and productive factors that are produced or
used, on the other.

The various decisions a business enterprise makes about its productive

activities can be classified into three layers of increasing complexity. The
first layer includes decisions about methods of producing a given quantity of
the output in a plant of given size and equipment. It involves the problem of
what is called short-run cost minimization. The second layer, including the
determination of the most profitable quantities of products to produce in any
given plant, deals with what is called short-run profit maximization. The
third layer, concerning the determination of the most profitable size and
equipment of plant, relates to what is called long-run profit maximization.

Minimization Of Short-Run Costs

The production function

However much of a commodity a business firm produces, it endeavours to

produce it as cheaply as possible. Taking the quality of the product and the
prices of the productive factors as given, which is the usual situation, the
firm’s task is to determine the cheapest combination of factors of
production that can produce the desired output. This task is best understood
in terms of what is called the production function, i.e., an equation that
expresses the relationship between the quantities of factors employed and
the amount of product obtained. It states the amount of product that can be
obtained from each and every combination of factors. This relationship can
be written mathematically as y = f (x1, x2, . . ., xn; k1, k2, . . ., km).
Here, y denotes the quantity of output. The firm is presumed to use nvariable
factors of production; that is, factors like hourly paid production workers
and raw materials, the quantities of which can be increased or decreased. In
the formula the quantity of the first variable factor is denoted by x1 and so on.
The firm is also presumed to use m fixed factors, or factors like fixed
machinery, salaried staff, etc., the quantities of which cannot be varied
readily or habitually. The available quantity of the first fixed factor is
indicated in the formal by k1 and so on. The entire formula expresses the
amount of output that results when specified quantities of factors are
employed. It must be noted that though the quantities of the factors
determine the quantity of output, the reverse is not true, and as a general rule
there will be many combinations of productive factors that could be used to
produce the same output. Finding the cheapest of these is the problem of
cost minimization.

00:0304:03

The cost of production is simply the sum of the costs of all of the various
factors. It can be written:

Get unlimited ad-free access to all Britannica’s trusted

content.Start Your Free Trial Today

in which p1 denotes the price of a unit of the first variable factor, r1 denotes
the annual cost of owning and maintaining the first fixed factor, and so on.
Here again one group of terms, the first, covers variable cost (roughly“direct
costs” in accounting terminology), which can be changed readily; another
group, the second, covers fixed cost (accountants’ “overhead costs”), which
includes items not easily varied. The discussion will deal first with variable
cost.

The principles involved in selecting the cheapest combination of variable

factors can be seen in terms of a simple example. If a firm manufactures
gold necklace chains in such a way that there are only two variable factors,
labour (specifically, goldsmith-hours) and gold wire, the production
function for such a firm will be y = f (x1, x2; k), in which the symbol k is
included simply as a reminder that the number of chains producible by x1feet
of gold wire and x2 goldsmith-hours depends on the amount of machinery
and other fixed capital available. Since there are only two variable factors,
this production function can be portrayed graphically in a figure known as
an isoquant diagram (Figure 1). In the graph, goldsmith-hours per month are
plotted horizontally and the number of feet of gold wire used per month
vertically. Each of the curved lines, called an isoquant, will then represent a
certain number of necklace chains produced. The data displayed show that
100 goldsmith-hours plus 900 feet of gold wire can produce 200 necklace
chains. But there are other combinations of variable inputs that could also
produce 200 necklace chains per month. If the goldsmiths work more
carefully and slowly, they can produce 200 chains from 850 feet of wire; but
to produce so many chains more goldsmith-hours will be required, perhaps
130. The isoquant labelled “200” shows all the combinations of the variable
inputs that will just suffice to produce 200 chains. The other two isoquants
shown are interpreted similarly. It is obvious that many more isoquants, in
principle an infinite number, could also be drawn. This diagram is a graphic
display of the relationships expressed in the production function.

Theory of production
QUICK FACTS
 View Media Page

RELATED TOPICS

 Economics

Marginal cost
Two other concepts now become important. The average variable cost,
written AVC(y), is the variable cost per unit of output. Algebraically,
AVC(y) = VC(y)/y. The marginal variable cost, or simply marginal
cost [MC(y)] is, roughly, the increase in variable cost incurred when output
is increased by one unit; i.e., MC(y) = VC(y + 1) - VC(y). Though for
theoretical purposes a more precise definition can be obtained by regarding
VC(y) as a continuous function of output, this is not necessary in the present
case.

The usual behaviour of average and marginal variable costs in response to

changes in the level of output from a given fixed plant is shown in Figure 3.
In this figure costs (in dollars per unit) are measured vertically and output
(in units per year) is shown horizontally. The figure is drawn for some
particular fixed plant, and it can be seen that average costs are fairly high for
very low levels of output relative to the size of the plant, largely because
there is not enough work to keep a well-balanced work force fully occupied.
People are either idle much of the time or shifting, expensively, from job to
job. As output increases from a low level, average costs decline to a low
plateau. But as the capacity of the plant is approached, the inefficiencies
incident on plant congestion force average costs up quite rapidly. Overtime
may be incurred, outmoded equipment and inexperienced hands may be
called into use, there may not be time to take machinery off the line for
routine maintenance; or minor breakdowns and delays may disrupt
schedules seriously because of inadequate slack and reserves. Thus the AVC
curve has the flat-bottomed U-shape shown. The MC curve, as might be
expected, falls faster and rises more rapidly than the AVC curve.

Figure 3: Average variable costs (AVC) and marginal variable costs (MC) in relation to output. Encyclopædia
Britannica, Inc.

SIMILAR TOPICS
 Consumption
 Income and employment theory
 Location theory
 Efficiency
 Price
 Wage theory
 Input–output analysis
 Postindustrial society
 Quantity theory of money
 Diminishing returns

Maximization Of Short-Run Profits

The average and marginal cost curves just deduced are the keys to the solution of
the second-level problem, the determination of the most profitable level of
output to produce in a given plant. The only additional datum needed is
the price of the product, say p0.

The most profitable amount of output may be found by using these data. If the
marginal cost of any given output (y) is less than the price, sales revenues will
increase more than costs if output is increased by one unit (or even a few more);
and profits will rise. Contrariwise, if the marginal cost is greater than the price,
profits will be increased by cutting back output by at least one unit. It then
follows that the output that maximizes profits is the one for which MC(y) = p0.
This is the second basic finding: in response to any price the profit-maximizing
firm will produce and offer the quantity for which the marginal cost equals that
price.

Such a conclusion is shown in Figure 3. In response to the price, p0, shown, the
firm will offer the quantity y* given by the value of y for which the ordinate of
the MC curve equals the price. If a denotes the corresponding average variable
cost, net revenue per unit will be equal to p0 - a, and the total excess of revenues
over variable costs will be y*(p0 - a), which is represented graphically by the
shaded rectangle in the figure.

Marginal cost and price

The conclusion that marginal cost tends to equal price is important in that it
shows how the quantity of output produced by a firm is influenced by the market
price. If the market price is lower than the lowest point on the average variable
cost curve, the firm will “cut its losses” by not producing anything. At any
higher market price, the firm will produce the quantity for which marginal cost
equals that price. Thus the quantity that the firm will produce in response to any
price can be found in Figure 3 by reading the marginal cost curve, and for this
reason the marginal cost curve is said to be the short-run supply curve for the
firm.

The short-run supply curve for a product—that is, the total amount that all the
firms producing it will produce in response to any market price—follows
immediately, and is seen to be the sum of the short-run supply curves (or
marginal cost curves, except when the price is below the bottoms of the average
variable cost curves for some firms) of all the firms in the industry. This curve is
of fundamental importance for economic analysis, for together with the demand
curve for the product it determines the market price of the commodity and the
amount that will be produced and purchased.

One pitfall must, however, be noted. In the demonstration of the supply curves
for the firms, and hence of the industry, it was assumed that factor prices were
fixed. Though this is fair enough for a single firm, the fact is that if all firms
together attempt to increase their outputs in response to an increase in the price
of the product, they are likely to bid up the prices of some or all of the factors of
production that they use. In that event the product supply curve as calculated will
overstate the increase in output that will be elicited by an increase in price. A
more sophisticated type of supply curve, incorporating induced changes in factor
prices, is therefore necessary. Such curves are discussed in the standard literature
of this subject.

Marginal product
It is now possible to derive the relationship between product prices and factor
prices, which is the basis of the theory of income distribution. To this end, the
marginal product of a factor is defined as the amount that output would be
increased if one more unit of the factor were employed, all other circumstances
remaining the same. Algebraically, it may be expressed as the difference
between the product of a given amount of the factor and the product when that
factor is increased by an additional unit. Thus if MP1(x1) denotes the marginal
product of factor 1 when x1 units are employed, then MP1(x1) = f(x1 +
1, x2, . . . ,xn; k) - f(x1, x2 . . . ,xn; k). The marginal products are closely related to
the marginal rates of substitution previously defined. If an additional unit of
factor 1 will increase output by f1 units, for example, then one more unit of
output can be obtained by employing 1/f1 more units of factor 1. Similarly, if the
marginal product of factor 2 is f2, then output will fall by one unit if the use of
factor 2 is reduced by 1/f2 units. Thus output will remain unchanged, to a good
approximation, if 1/f1 units of factor 1 are used to replace 1/f2 units of factor 2.
The marginal rate of substitution is therefore f2/f1, or the ratio of the marginal
products of the two factors. It has already been shown that the marginal rate of
substitution also equals the ratio of the prices of the factors, and it therefore
follows that the prices (or wages) of the factors are proportional to their marginal
products.

This is one of the most significant theoretical findings in economics. To restate it

briefly: factors of production are paid in proportion to their marginal products.
This is not a question of social equity but merely a consequence of the efforts of
businessmen to produce as cheaply as possible.

Further, the marginal products of the factors are closely related to marginal costs
and, therefore, to product prices. For if one more unit of factor 1 is employed,
output will be increased by MP1(x1) units and variable cost by p1; so the marginal
cost of additional units produced will be p1/MP1(x1). Similarly, if additional
output is obtained by employing an additional unit of factor 2, the marginal cost
will be p2/MP2(x2). But, as shown above, these two numbers are the same;
whichever factor i is used to increase output, the marginal cost will be pi/MPi(xi)
and, furthermore, the firm will choose its output level so that the marginal cost
will be equal to the price, p0.

Therefore it has been established that p1 = p0MP1(x1), p2 = p0MP2(x2), . . ., or the

price of each factor is the price of the product multiplied by its marginal product,
which is the value of its marginal product. This, also, is a fundamental theorem
of income distribution and one of the most significant theorems in economics. Its
logic can be perceived directly. If the equality is violated for any factor, the
businessman can increase his profits either by hiring units of the factor or by
laying them off until the equality is satisfied, and presumably the businessman
will do so.

The theory of production decisions in the short run, as just outlined, leads to two
conclusions (of fundamental importance throughout the field of economics)
about the responses of business firms to the market prices of the commodities
they produce and the factors of production they buy or hire: (1) the firm will
produce the quantity of its product for which the marginal cost is equal to the
market price and (2) it will purchase or hire factors of production in such
quantities that the price of the commodity produced multiplied by the marginal
product of the factor will be equal to the cost of a unit of the factor. The first
explains the supply curves of the commodities produced in an economy. Though
the conclusions were deduced within the context of a firm that uses two factors
of production, they are clearly applicable in general.

Maximization Of Long-Run Profits

Relationship between the short run and the long run

The theory of long-run profit-maximizing behaviour rests on the short-run theory

that has just been presented but is considerably more complex because of two
features: (1) long-run cost curves, to be defined below, are more varied in shape
than the corresponding short-run cost curves, and (2) the long-run behaviour of
an industry cannot be deduced simply from the long-run behaviour of the firms
in it because the roster of firms is subject to change. It is of the essence of
long-run adjustments that they take place by the addition or dismantling of fixed
productive capacity by both established firms and new or recently created firms.

At any one time an established firm with an existing plant will make its short-run
decisions by comparing the ruling price of its commodity with cost curves
corresponding to that plant. If the price is so high that the firm is operating on
the rising leg of its short-run cost curve, its marginal costs will be high—higher
than its average costs—and it will be enjoying operating profits, as shown
in Figure 3. The firm will then consider whether it could increase its profits by
enlarging its plant. The effect of plant enlargement is to reduce the variable cost
of producing high levels of output by reducing the strain on limited production
facilities, at the expense of increasing the level of fixed costs.

In response to any level of output that it expects to continue for some time, the
firm will desire and eventually acquire the fixed plant for which the short-run
costs of that level of output are as low as possible. This leads to the concept of
the long-run cost curve: the long-run costs of any level of output are the
short-run costs of producing that output in the plant that makes those short-run
costs as low as possible. These result from balancing the fixed costs entailed by
any plant against the short-run costs of producing in that plant. The long-run
costs of producing y are denoted by LRC(y). The average long-run cost of y is
the long-run cost per unit of y[algebraically LAC(y) = LRC(y)/y]. The marginal
long-run cost is the increase in long-run cost resulting from an increase of one
unit in the level of output. It represents a combination of short-run and long-run
adjustments to a slight increase in the rate of output. It can be shown that the
long-run marginal cost equals the marginal cost as previously defined when the
cost-minimizing fixed plant is used.

Long-run cost curves

Cost curves appropriate for long-run analysis are more varied in shape than
short-run cost curves and fall into three broad classes. In constant-cost industries,
average cost is about the same at all levels of output except the very lowest.
Constant costs prevail in manufacturing industries in which capacity is expanded
by replicating facilities without changing the technique of production, as a cotton
mill expands by increasing the number of spindles. In decreasing-cost industries,
average cost declines as the rate of output grows, at least until the plant is large
enough to supply an appreciable fraction of its market. Decreasing costs are
characteristic of manufacturing in which heavy, automated machinery is
economical for large volumes of output. Automobile and steel manufacturing are
leading examples. Decreasing costs are inconsistent with competitive conditions,
since they permit a few large firms to drive all smaller competitors out of
business. Finally, in increasing-cost industries average costs rise with the volume
of output generally because the firm cannot obtain additional fixed capacity that
is as efficient as the plant it already has. The most important examples are
agriculture and extractive industries.

Criticisms Of The Theory

The theory of production has been subject to much criticism. One objection is
that the concept of the production function is not derived from observation or
practice. Even the most sophisticated firms do not know the direct functional
relationship between their basic raw inputs and their ultimate outputs. This
objection can be got around by applying the recently developed techniques
of linear programming, which employ observable data without recourse to the
production function and lead to practically the same conclusions.
On another level the theory has been charged with excessive simplification. It
assumes that there are no changes in the rest of the economy while individual
firms and industries are making the adjustments described in the theory; it
neglects changes in the technique of production; and it pays no attention to the
risks and uncertainties that becloud all business decisions. These criticisms are
especially damaging to the theory of long-run profit maximization. On still
another level, critics of the theory maintain that businessmen are not always
concerned with maximizing profits or minimizing costs.

Though all of the criticisms have merit, the simplified theory of production does
nevertheless indicate some basic forces and tendencies operating in the economy.
The theorems should be understood as conditions that the economy tends toward,
rather than conditions that are always and instantaneously achieved. It is rare for
them to be attained exactly, but it is just as rare for substantial violations of the
theorems to endure.

Only the simplest aspects of the theory were described above. Without much
difficulty it could be extended to cover firms that produce more than one product,
as almost all firms do. With more difficulty it could be applied to firms whose
decisions affect the prices at which they sell and buy (monopoly, monopolistic
competition, monopsony). The behaviour of other firms that recognize the
possibility that their competitors may retaliate (oligopoly) is still a theory of
production subject to controversy and research.