CHAPTER THREE

THEORY OF PRODUCTION
Production of goods and services involves transforming economic resources (such as labor, raw
material, etc) into finished products. The productive resources, such as labor and capital
equipment, that firms use to manufacture goods and services are called inputs or factors of
production, and the amount of goods and services produced is the firm’s output.

Production Function describes technical relationship between input and output. In particular,
production function tells us the maximum quantity of output the firm can produce from given
input, mathematically,
Q = f (L, K)

Where Q – The quantity of output

L – The amount of Labor used
K – The quantity of capital employed

Short Run Production Function

Short-run is a period of time at least one of the firm’s inputs (usually capital) quantities is fixed.
Some inputs are fixed in the short-run while others are variable. Inputs that cannot be varied in
the short-run are called Fixed Input (for example: capital /like machinery, building, etc). Inputs
that can be varied in the short are called variable Input (for example: labor is variable in the short-
run). The short-run production functions look like:

Q = f (L, K) Where K- is constant

Let’s consider a clothing plant where capital is fixed but labor is variable. In the short-run, output
could change only as labor change. Let the firm have ten units of capital but with variable labor
as follows.

 Marginal product of labor is the extra product or output produced as a result of extra unit
of labor, i.e.
MPL = TP/ L = Q/L
 Average product of labor is output per unit of labor, i.e.
APL = Q/L

Compiled by Dechassa G. and Milkessa D. (Msc in Economics) 2017 Microeconomics (Econ 201) 1
 Capital (K) Labor (L) Total Product Average Marginal
(Q) Product (APL) Product (MPL)
10 0 0 - -
10 1 10 10 10
10 2 30 15 20
10 3 60 20 30
10 4 80 20 20
10 5 95 19 15
10 6 108 18 13
10 7 112 16 4
10 8 112 14 0
10 9 108 12 -4
10 10 100 10 -8

Graphical reading of relationship among TP, AP and MP is explained as follows:

o TP increases as an increasing rate up to point b, and increases at a decreasing rate up to point c
and reaches maximum at point d, and then starts to decline as more of the variable input is
used.
o Diminishing Marginal Returns to Labor occurs when an increase in the quantity of labor
increases the total output at a decreasing rate. Diminishing Marginal Returns to labor is set in
when the firm exhausts its ability to increase productivity through specialization of workers. .
o Specialization enhances the marginal productivity of workers because it allows them to
concentrate on tasks for which they are most productive.
o Diminishing total returns to labor occurs when an increase in the quantity of labor decreases
total output. Diminishing total Returns occurs because of the fixed size of the fabricating
plant. That is, the quantity of labor used becomes too large; workers will not have enough
space to work effectively.
o The law of diminishing Returns or the law of variable proportion states as the use of variable
input (Labor) increases while the use of other input is fixed (capital), a point will eventually be
reached at which output diminishes as the input increases.
o The slope of the TP at any point depicts the MP. Thus, MP increases up to point b and starts
falling thereafter. Hence point b is the highest MP. AT point d, where TP is maximum, MP is
zero thereafter MP is negative. MP is always positive when output (TP) is increasing, and it is
negative when output (TP) is decreasing.
o AP increase up to point c and starts to decline thereafter. Hence point c is the highest AP.

o At point c, where the intersection of the two curves, MP and AP are equal. So MP intersects
AP at the maximum of AP.

Compiled by Dechassa G. and Milkessa D. (Msc in Economics) 2017 Microeconomics (Econ 201) 2
o

Production beyond the input level when MP is zero is not technically efficient since output is
declining.

Stages of Production
1. Stage I- it starts from the point where TP is zero to the maximum point of AP L. Here, the
average product per worker increases, here total product increases at an increasing rate. This
stage also known as Increasing Returns to Labor.
2. Stage II- Total product increases but at a decreasing rate. In this stage both AP L and MPL are
declining MP reaches zero at the end of the stage II corresponding to the maximum total
product. This stage is also known as diminishing returns to labor. Thus, stage two begins
where MPL and APL are equal and ends where MPL is zero. This stage is the only
economically meaningful from the view point of a rational producer.
3. Stage III – Total product began to decline and MP is negative. It’s also known as negative
returns to labor.

Laws of Returns to Scale

Compiled by Dechassa G. and Milkessa D. (Msc in Economics) 2017 Microeconomics (Econ 201) 3
In the long-run expansion of output may be achieved by varying all factors (input). In the long-
run all inputs are variable. The law of returns to scale refers to the effect of scale relationship.
In the long-run output may be increases by changing all factors of production by the same
proportion, or by different proportion. The traditional theory of production concentrates on the
same production.
The term returns to scale refers to changes in output as all factors change by the same proportion.
Suppose the initial level of input and output:
Q0 = f (L, K)
And let’s also suppose that we increase all inputs by the same proportion, say λ. We will clearly
obtain a new level of output, say Q*, higher than the initial level of output (Q 0).
Q* = f (λL, λK)
If Q* increases by the same proportion (λ) as the input, we say that there is constant Returns to
scale.
If Q* increases less than proportionality with the increases in input, we say there is Decreasing
Returns to Scale.
If Q* increase more then proportionality with the increase in input, we say there is Increasing
Returns to scale.
If we factor out λ, then the new level of output can be expressed as a function of λ (to any
power V) and the initial level of output.
Q* = λVf (L, K)
Q* = λVQ0-such production function is called homogeneous. If λ cannot be factored out,
the production function is non-homogeneous.
A homogeneous function is a function such that if each of the input is multiplied by λ,
then λ can be completely factored out. The power V of λ is called the Degree of homogeneity of
the function, and is a measure of returns to scale:
If V=1, we have constant returns to scale
If V<1, we have decreasing Returns to scale.
If V>1, we have Increasing Returns to sale.
Example: Consider a Cobb-Douglas production function:
Q = Alb1, Kb2
Returns to scale are measured by:
V = b 1 + b2
L and K are increased by λ. The new level of output is
Q* = f(λL, λk)

Compiled by Dechassa G. and Milkessa D. (Msc in Economics) 2017 Microeconomics (Econ 201) 4
 Q* = A(L λ)b1. (k λ) b2
= A. Lb1, λb1.Kb2, λb2
= A Lb1 Kb2 λb1+b2
= Q λb1+b2
Where b1 + B2 = λ
Numerical Example
1. Q = K2L
Measure the Returns to scale
L = λL
K = λK
Q*= (λL)( λK)2
= λ3.L.K2
= λ3.Q
Since V=3, and V>1-Increasing returns to scale.
Exercise: Measure the returns to scale for the following production function
a. Q = 10K + 5L
b. Q = KL
c. Q= 0.5L 0.1K0.6
Long-run Production Function
In the long-run expansion of output can be achieved by varying all factors, since in the long-run
all inputs are variable. The expansion of output in the long-run can be explained by using
Isoquant.
Isoquant- is a curve that shows various combination of input that will yield the same amount of
output. A set of isoquant known as Isoquant Map.
Firms can produce specific level of output by using various combinations of inputs and this is
shown by an Isoquant. Graphically, it can be shown as follows:

Compiled by Dechassa G. and Milkessa D. (Msc in Economics) 2017 Microeconomics (Econ 201) 5
Properties of Isoquant
1. Isoquant curves are downward sloping and convex to the origin. The slope of Isoquant curve
is known as the Marginal Rate of Technical substitution, which measured the rate at which
input can be substituted another input along the Isoquant curve. Mathematically,
K dK
MRTSL,K = =
L dL
dQ dQ
MPL = and MPx =
dL dK

MPL dQ dQ dQ dK dK
= = , 
MPK dL DL dL. dQ dL

Thus
dK MPL
MRTS L, K 
dL MPK
2. The farther away an Isoquant from, the origin, the larger the output will be, i.e.
Q3>Q2>Q1
3. Isoquant curve do not intersect each other
4. As we more form one point to another along the Isoquant, the reduction of one input must be
compensated by the increase in another input to produce the same amount of output.

Compiled by Dechassa G. and Milkessa D. (Msc in Economics) 2017 Microeconomics (Econ 201) 6
Choice of Optimal Combination of Factors of Production: Equilibrium of the Firm
In order to determine optimum (best) combination of inputs, we make the following 3
assumptions.
1. the goal of the firm is profit maximization
Π = TR-TC
Where Π – profit
TR – Revenue
TC – Cost
2. The price of output is given
3. The price of input is given.
w – Wage rate- the price of labor

Compiled by Dechassa G. and Milkessa D. (Msc in Economics) 2017 Microeconomics (Econ 201) 7
 r – Rental price of capital – the price of capital
For graphical presentation of the equilibrium of the firm, we will use the Isoquant and Isocost
curve.

The Isocost line is defined by the equation

C = wL + rK
Where w - Wage rate (price of labor)
r - Rental price of capital (price of capital)
C - Total expenditure (total cost)
The Isocost line is a locus of point defined by different combination of input that yields the same
cost.
The slope of Isocost is w/r
The maximum output a firm produce is defined by at point of tangency between the Isoquant and
Isocost line. At the point of their tangency their slope will become equal,
The slope of Isoquant = the slope of Isocost

MPL w
MPK = r

Compiled by Dechassa G. and Milkessa D. (Msc in Economics) 2017 Microeconomics (Econ 201) 8
Compiled by Dechassa G. and Milkessa D. (Msc in Economics) 2017 Microeconomics (Econ 201) 9