Theory of production

The theory of production is an analysis of relationship between output (goods and

services) and input (resources used in production).

The conditions of production underlie the theory of supply.

The short-run and the long-run

The short –run is a period of time during which at least one input is fixed while the others
are variable. Resources that can be varied in the short-run are called variable inputs while those
that cannot be changed are called fixed inputs.

The long-run is a period of time that is sufficiently long for all the inputs to be varied,
enabling supply to have great flexibility.

1. Short-Run in Production. Time period is short enough that not all factors of production
can be adjusted. Typically, plant size is fixed.
2. Long-Run in Production. Time period is long enough, so all factors of production can
be adjusted.

Factors of Production
The success of production depends on the effective organizations of the four factors of
production namely: land, labor, capital and entrepreneurship.

Land
In economics, land – sometimes called natural resources – includes not only the surface
of the globe but also what is under and above the surface. It embraces the natural environment –
the oceans, rivers, soil, climate, mineral deposit and all other gifts of the nature.

It is the basis of all production, because from land comes all the wealth of man. The raw
materials utilized in the production come from land.

Labor
This is next to land in degree of importance as a factor of production. It is defined as the
exertion of human effort, physical and mental, to earn an income. Land without labor is useless;
exertion is necessary to make a living.
Capital
The third factor of production is that part of wealth, other than land and personal services,
which is used as an aid to further production. Capital includes machinery, tools and raw
materials. Money is called cash capital.

Three Requirements of Capital

1. It must be a product of past industry of man.

2. It must be wealth.
3. It must be used to produce more value.

Distinction Between: 1) Explicit Costs and Implicit Costs, 2) Economic Profit and
Accounting Profit, and 3) the Short-Run and the Long-Run Production

1. Explicit Costs. Payments by a firm to purchase productive resources.

2. Implicit Costs. Opportunity costs of a firm’s use of resources that it owns. These costs
do not involve direct payments.

3. Economic Profit. Difference between firm’s total revenue and total cost.

4. Accounting Profit. Firm revenue minus expenses over given time period. Does not take
implicit costs into account.

Entrepreneurship
An entrepreneur is often called the “captain” of the industry because he is the one who
initiates and organizes the business and puts them together in te right and optimum proportion.

Theory of production
An organized body of knowledge that puts together the rationale for production situation.

Production function
It is therefore important that combinations of inputs present in the functions of production
must be materially and technically efficient. A resource input combination is said to be efficient
is lesser quantity of any one or more of the inputs induces the reduction of the number of output.
Law of Diminishing Returns
The law of diminishing return in productivity states that is some inputs are held constant
while others are allowed to vary, marginal productivity will decline at some point as a result of
adding more units of that inputs that were allowed to vary.

Table 5.1
Law of Diminishing Returns in Productivity
500 square meters of furniture factory
Labor Total Margina Average
Input Product l Product
Product
2 4 0 2
4 8 2 2
6 16 4 2.66
8 28 6 3.5
10 44 8 4.4
12 64 10 5.33
14 80 8 5.71
e16 92 6 5.75
18 100 4 5.55
20 104 2 5.2
22 104 0 4.72
24 100 -2 4.16

Production in the short-run is influenced by the Law of Diminishing Returns. The Law
states that as successive units of variable resources (inputs), say labor, are added to fixed
resources, say land, beyond some point, the extra or marginal product attributable to each unit of
the variable resources, will decline.

1. Total Product (TP) is the total amount produced during some period of time by all the
factors or production employed over that time period.

2. Average Product (AP) is the total product per unit of variable input.
 TP
AP=
LI
 3. Marginal Product (MP) is the change in the total product per unit change in quantity of
the variable input.
∆ TP TP 2−TP 1
MP= =
∆ LI L 2−LI

Marginal Product shows the change in total output associated with each additional input
of labor. Different levels reflect increasing returns. Beginning with the other level, marginal
product diminishes continuously and, actually becomes negative with the next level of workers.

Stages in Diminishing Productivity

1. Increasing returns. TP increases; AP increases and reaches maximum; MP increases
and reaches maximum and decreases; MP is greater than AP, except when AP is
maximum; boundary of I and I is the intersection AP and MP; AP intersects MP, at its
maximum point.

2. Decreasing Increase in Return. AP begins to decline; TP increases and reaches

maximum; AP decreases and becomes zero; MP zero; TP maximum.

3. Negative Returns. TP decreases; AP decreases; MP negative.

Figure 5.1. The Cost Curve Relationship

Figure 5.2. Diminishing Return in Productivity Trend Based on Table 5.1 with Stages of Diminishing Return in
Productivity

The Law of Diminishing Returns and its Impact on a

Firm’s Costs
Law of diminishing Returns to a factor of Production

As more and more units of a variable input are combined with a fixed amount of
another input, the additional of the variable input will yield increased output at a
decreasing rate.
 The shapes of the Short-Run Marginal Cost, Average Variable Cost, Average Fixed
Cost, And Average Total Cost:

1. Once you have reach a level of output where diminishing returns occur, larger and
larger additions of the variable factor are necessary to increase output by one more
unit.

2. Result is MC of the additional output increase. So long as MC is below ATC,

producing additional units of output will bring down the ATC curve.

3. At some point, however, MC will raise enough to exceed ATC.

4. After the point where MC = ATC, additional units of output will raise ATC causing
the ATC curve at its minimum point.

Production Isoquant
It is a varying combination or is mixed in the utilization of resource input corresponding
to the same level of output.

The points along the isoquant curve represent a different combination of capital and labor
input corresponding to a particular plat capacity. Between any points to another, an inverse
relationship exists between these resources as the output that production foregoes by utilizing
less of one regained by utilizing more of the other.

Table 5.2 relationship of Capital Input and Labor Input that Results to MRS (Marginal
Rate of Substitution)

LI KI MRS
1 30 -
2 26 4

3 22.5 3.5
4 19.5 3
5 17 2.5
6 15 2
 7 13.5 1.5
8 12.5 1
9 12 .5
10 12 0

Figure 5.3. LI + MRS Relationships (production Isoquant Curve and MRS Curve)

The cost of Production

One of the determinants of supply is cost of production. Producers have unquestionable
pursuit to supply a product of lower cost for production. As mentioned earlier, inputs or
resources are needed in the production of goods. The prices of such inputs are determined by
demand and supply. Resources which are scarce, and there is a great demand for them to
command higher prices. This means higher cost of production that result to a higher price of
productions.

Cost has a relative effect both to producers and consumers. Since an upswing disturbance
in the increase of prod-

uction cost consequently increases the price of products, the tendency of buyers is to lessen their
purchases. Such reaction of buyers is in reference with the law of demand. For this reason,
producers seem to be in continuous search of ways and means to cost cutting scheme. Less cost
means less price. Less price means more sales – and more profits. Particularly speaking, the
Philippines is far from being competitive in this respect because of factors that are inherent with
high costs.
 The presence of abundant resources makes it cheaper to produce. In less developed
countries, labor is abundant while capital (machines) is scarce and expensive. It is the reverse in
other western developed countries where labor is expensive and capital is cheap. In the United
States, it is cheaper to use robots than to hire workers. Only the very rich can afford to employ
household helper. In the Philippines, wages are sometimes below subsistence level. Thus, even
some of the corporate employees of a company are willing to be a D.H. (domestic helper) of
other countries.

Economic Costs
1. Total Cost. The sum total of cost of production. It is composed of wages, rents,
interests and normal profits. These are also known as factor payments: wage for
labor, rent for land, interest for capital, and normal profit for the entrepreneur.
Normal profits are therefore part of the total cost of production. It is the amount
which is sufficient to encourage an entrepreneur to remain in business. In the case of
pure profit, it is an amount which is in excess of cost of production. Total cost is also
equivalent to fixed cost plus variable cos.
2. Fixed Cost. A kind of cost which remains constant regardless of the volume of
production. Even if there is no production, there is still cost. Examples are the
expenditures on the machines and buildings. Whether you use these factors of
productions or not, you have to pay for them.
3. Variable Cost. A kind of cost which changes in production to volume of production.
If there is no production, there is no cost. More productions means more costs.
Examples are ages, raw materials and oil products.
4. Average Cost. This is also called unit cost. It is equivalent to total cost divided by
quantity.

TC
AC=
Q

5. Marginal Cost. The additional or extra cost caused by producing one additional unit.
It is obtained by dividing change in total cost by change in quantity.

∆ TC
MC=
∆Q
 6. Explicit cots. This is also called expenditure cost. These are payments to the owners
of the factors of production like wage, interests, electric bills, and so forth.

7. Implicit Cost. Another tern 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 land.

8. Opportunity Cost. This is the foregone opportunity or alternative benefit. For

example, the super powers are spending more than $1 trillion dollars a year for arms
race, sand such amount is more than enough to erase global poverty from the face of
the earth. So hunger and poverty still prevail around the world.

Figure 5.4. Hypothetical, Total, Fixed and Variable Costs

Production Cost Formulas:

∆ TC
TC=TFC +TVC MC=
∆Q

TFC
AFC= TR=PRICE x OUTPUT
Output

TC
ATC= Profit∨Loss=TR−TC
Output

TVC
AVC=
Output
Types of Production Responses
1. When slope of TP curve is the same to that of the next points

2. When slope of TP curve continues to increase but on a decreasing pattern

 3. When slope of TP curve reflects a continuous increase in an inter mitten pattern

Figure 5.7. Accelerated Increase

Economics and Diseconomies of Scale

Possibilities and the Relationship of Each to the Shape of a firm’s
Long-Run Average Total Cost Curve
1. Economies of scale. Reductions in firm’s per unit costs as all factors of production
are increased in an optimal way.

Possible Reasons:

a. Mass production

b. Specialization of factors of production

c. Learning by doing scale economies

2. Diseconomies of Scale. Increases in firm’s per unit costs as all factors of production
are increased in an optimal way.

Possible Reasons:

a. Coordination inefficiencies

b. Increasing difficulties in conveying information

c. Increased principal-agent problems

3. Constant Returns to Scale. No change in firm’s per unit costs as all factors of
production are increased in an optimal way.
Figure 5.8. Economies and diseconomies of Scale

Factors that cause cost curves to shift

1. Prices of resources. Increase in price of resources used (inputs to production)
will cause a firm’s cost to shift upward.

2. Taxes. Increased taxes shift up a firm’s cost curves. Tax on variable input shifts
MC, AVC, and ATC. Fixed tax shifts AFC and ATC.

3. Technology. Cot-reducing technological improvements will lower a firm’s cost

curves in which these curves depend on whether technology affects fixed or
variable costs.

The Basic Framework for Break-Even Analysis

The break-even analysis is the heart of the modern management accounting system. It is
used as the firm’s guide in making critical business decisions, such as how much to produce
(volume of production) and how much to sell the product (pricing).

The basic equation goes as follows:

TR=TC

P x Q=TFC +TVC

Hence, to set the break-even volume:

TFC +TVC
Q be =
P
And, to get the break-even price:

TFC +TVC
Pbe=
Q

Example 1:

Given:

P = P10/unit

TFC = P350,000

TVC = P500,000

Find:

Qbe = ?

Solution:

TFC +TVC
Qbe=
P

350,000+500,000
Qbe=
10

Qbe=85,000units

Example 2:

Given:

TFC = P350,000

TVC = P600,000

Q =100,000

Solution:

TFC +TVC
Pbe=
Q
 350,000+ 600,000
Pbe=
100,000

Pbe=P 9.50 /unit