Chapter 5

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2013 5– 1

CHAPTER 5
THEORY OF
PRODUCTION

DEFINITION OF PRODUCTION
 Definition
– Production means the process of using the factor of
production to produce goods and services.
– Production is the process of transforming inputs into
outputs.
INPUTS
OUTPUTS
Inputs refers to the
factors of Refers to what we
production get at the end of the
Processing
that a firm use in production process
the that is finished
production process. products.

LAND LABOUR
All natural resources Physical or mental
or gift of nature activities of human beings
CLASSIFICATION
OF FACTORS
OF PRODUCTION
CAPITAL ENTREPRENEUR
Part of man-made wealth A person who combines the different
used for further production factors of production, and initiates
the process of production and also
bears the risk

PRODUCTION FUNCTION
 A production function is a statement of the functional

relationship between inputs and outputs, where it shows
the maximum output that can be produced with given
inputs.
Q = (K, L, M, etc.)
 Where: Q = Output
K = Capital
L = Labour
M = Raw Material

SHORT-RUN AND LONG-RUN
PRODUCTION FUNCTION
 Two Types of Factor Inputs
– Fixed Input
• An input which the quantity does not change according to the amount
of output.
• Example: Machinery, land, buildings, tools, equipment, etc.
– Variable Input
• An input which the quantity changes according to the amount of
output.
• Example: Raw materials, electricity, fuel, transportation, communication,
etc.
 Short-run and Long-run Periods
– Short run period is the time frame, which at least one of the inputs (factor of
production) is fixed and other inputs can be varied.
– Long run period is the time frame which all inputs are variable.

SHORT-RUN PRODUCTION
FUNCTION
 In the short run, we assume that at least one of
the inputs is fixed that is capital.
 Therefore, in the short run the production
function can be written as:
Q = ( K , L)
Where: Q = Output
L = Labour
K = Capital (fixed)

FUNCTION (cont.)
 LAW OF DIMINISHING MARGINAL RETURNS
– It states that if the quantities of certain factors are
increased while the quantities of one or more factors
are held constant, beyond a certain level of
production, the rate of increase in output will
decrease.
OR
– “Law of diminishing marginal returns states that as
more of a variable input is used while other input and
technology are fixed, the marginal product of the
variable input will eventually decline”.

FUNCTION (cont.)
TOTAL PRODUCT (TP)
The amount of output produced when a given amount of
That input is used along with fixed inputs.
AVERAGE PRODUCT (AP)

Divide the total product by the amount of that input
used in the production
Average Product (AP L) = Total Product

Total Labour
AP L = TP/ L

FUNCTION (cont.)
MARGINAL PRODUCT (MP)

Change in the total product of that input corresponding to an addition
unit change in its labour assuming other factors that is capital fixed.
Marginal Product (MP L) = Change in Total Product

Change in Total Labour
MP L =  TP/ L

FUNCTION (cont.)
Capital Labour Total Marginal Average Stages of
(Fixed (Variable Product Product Product Production
input) input)
10 0 0 0 0
10 1 8 8 8
10 2 20 12 10 STAGE I
10 3 33 13 11
10 4 44 11 11
10 5 50 6 10
10 6 54 4 9
STAGE II
10 7 56 2 8
10 8 56 0 7
10 9 54 -2 6
STAGE III
10 10 50 -4 5
MP = 54 - 56 AP = 56
9-8 8
= -2 = 7
FUNCTION (cont.)
RELATIONSHIP BETWEEN TP AND MP RELATIONSHIP BETWEEN AP AND MP
When MP is increasing, TP increase at an increasing rate. When MP is above AP , AP is increasing
When MP is decreasing, TP increase at a decreasing rate. When MP is below AP, AP is decreasing.
When MP is zero, TP at its maximum. When MP equals to AP, AP is at maximum.
When MP is negative, TP declines.
60 TP MAX
STAGE I STAGE II STAGE III
50
40
30 TP
MP
20
AP MAX;
AP =MP AP
10
MP=0
0
1 2 3 4 5 6 7 8 9 10
-10
FUNCTION (cont.)
Stage I Stage II
Proportion of fixed factors are Called law of diminishing returns


greater than variable factors The most efficient stage of production

Under utilization of fixed factor because the combinations of inputs are fully

Operation involves a waste of resources utilized


STAGES OF PRODUCTION
Stage III
Proportion of fixed factors is lower than variable factors

Increase in variable factors decline the TP because of overcrowding


A producer would not like to operate at this stage



LONG-RUN PRODUCTION
FUNCTION (cont.)
Marginal Rate of Technical Substitution

The technique to estimate the amount of capital input to be

replaced by labour input without increasing or decreasing output.
MRTS = - Change in Capital

Change in Labour
MRTS = - K/ L


SCALE OF PRODUCTION
INCREASING RETURNS TO SCALE

 All the factors of production are increased in a given
proportion, output would increase by a greater proportion.
Capital
When labour and capital are doubled

(100 units to 200 units), output
increases from 20 units to 60 units,
which is more than double.
200
The causes of increasing returns
IQ = 60 to scale are specialization,
100%
technical economies,
> 100%
100
IQ =20
managerial economies which
are also known as economies
Labour of scale.
100 200
100%

SCALE OF PRODUCTION
(cont.)
CONSTANT RETURNS TO SCALE
proportion, output would increase by same proportion.
Capital
When labour and capital are

doubled (100 units to 200 units),
output increases from 20 units to 40
units.
200
IQ = 40
100%
100%
100
IQ =20
Labour
100 200
100%

SCALE OF PRODUCTION
(cont.)
DECREASING RETURNS TO SCALE
proportion, output would increase by a smaller proportion.
Capital
When labour and capital are doubled

(100 units to 200 units), output
increases from 20 units to 30 units,
which is less than double.
200
The causes of decreasing
IQ = 30 returns to scale are internal
100%
and external diseconomies
100
< 100% of scale.
IQ =20
Labour
100 200
100%


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PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 5– 1

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

 A production function is a statement of the functional

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

AVERAGE PRODUCT (AP)

Average Product (AP L) = Total Product

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

MARGINAL PRODUCT (MP)

Marginal Product (MP L) = Change in Total Product

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Operation involves a waste of resources utilized

Increase in variable factors decline the TP because of overcrowding

A producer would not like to operate at this stage

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Marginal Rate of Technical Substitution

replaced by labour input without increasing or decreasing output.

MRTS = - Change in Capital

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

INCREASING RETURNS TO SCALE

When labour and capital are doubled

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

When labour and capital are

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

When labour and capital are doubled

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

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