CHAPTER 4

THE THEORY OF
PRODUCTION
12/12/2024 By: Debebe D. 1
 Introduction
 Production may be defined as the act of
creating those goods/services which have
exchange value for sale (not for personal
consumption).
 Raw materials yield less satisfaction to the
consumer by themselves. In order to get utility
from raw materials, first they must be transformed
into output.
 However, transforming raw materials into final
products require factor inputs such as land,
labor, and capital and entrepreneurial ability.
 Thus, no production (transforming raw material into
output) can take place without the use of inputs.

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 Fixed Vs Variable Inputs

Fixed inputs are those inputs

whose quantity can not readily
be changed when market
conditions indicate that an
immediate change in output is
required. may be fixed during an
immediate requirement.
Buildings, machineries and
managerial personnel are examples
of fixed inputs because their quantity
can not be manipulated easily in
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 Cont’d..

Variable inputs, on the other

hand, are those inputs whose
quantity can be changed
almost
instantaneously(rapidly) in
response to desired changes
in output. The best example of
variable input is unskilled
labor.
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 Short run Vs. long run

short run refers to that period of

time in which the quantity of at
least one input is fixed
Long run is that time period
(planning horizon) which is
sufficient to change the
quantities of all inputs. Thus
there is no fixed input in the
long -run.
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 4. 2. Production In The Short Run:
Production With One Variable
Input
Production with one variable input
(while the others are fixed) is
obviously a short run
phenomenon because there is no
fixed input in the long run.
Assumption of short run
production analysis
In order to simplify the analysis of
short run production, the classical
economist assumed the following:
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 Cont’d…
1. Perfect divisibility of inputs and outputs
 This assumption implies that factor inputs and
outputs are so divisible that one can hire, for
example a fraction of labor, a fraction of
manager and we can produce a fraction of
output, such as a fraction of automobile.
2. Limited substitution between inputs
 Factor inputs can substitute each other up to a
certain point, beyond which they can not
substitute each other
3. Constant technology
 They assumed that level of technology of
production is constant in the short run.

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 Short Run Production Function
 Suppose a firm that uses two inputs: Capital
(which is a fixed input) and labor (which is
variable input).
 Given the assumptions of short run production,
the firm can increase output only by increasing
the amount of labor it uses.
Hence, its production function is
Q = f (L) K - being constant
 Where Q is the quantity of production (Output)

L is the quantity of labor used, which is

variable, and K is the quantity of capital (which is
fixed)

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 Cont’d…
 The production function shows different
levels of output that the firm can obtain by
efficiently utilizing different units of labor
and the fixed capital.
 In the above short run production function,
the quantity of capital is fixed.
 Thus output can change only when the
amount of labor used for production
changes.
 Hence, Q is a function of L only in the
short run.
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 4.3 Total Product, Marginal
Product And Average Product
Total product: is the total amount
of output that can be produced by
efficiently utilizing a specific
combination of labor and capital.
 The total product curve, thus,
represents various levels of
output that can be obtained from
efficient utilization of various
combinations of the variable
input, and the fixed input.
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 Cont’d..
 It shows the output produced for
different amounts of the variable
input, labor.
 Any ways, increasing the variable
input (while some other inputs are
fixed) can increase the total
product only up to a certain point
 Even as we employ more and more unit
of the variable input beyond the
carrying capacity of a fixed input,
out put may tends to decline.
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Cont’d…
Thus increasing the variable input
can increase the level of output only
up to a certain point, beyond which
the total product tends to fall as
more and more of the variable input
is utilized.
This tells us what shape a total
product curve assumes.
The shape of the total variable
curve is nearly S-shape
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 Marginal Product (MP)

The change in total output resulting from

using this additional worker (holding
other inputs constant) is the marginal
product of the worker.
If output changes by q when the number
of workers (variable input) changes by ∆L,
the change in out put per worker or
marginal product of the variable
input, denoted as MPL is found as

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 Cont’d…

• Thus, MPL measures the slope of

the total product curve at a
given point.
That is, as we continue to combine
more and more of the variable
inputs with the fixed input, the
marginal product of the variable
input increases initially and then
declines.

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 Average Product (AP)

 The AP of an input is the ratio of total

output to the number of variable inputs.

 the average product of labor first increases

with the number of labor (i.e. TP increases
faster than the increase in labor), and
eventually it declines.
 Graphing the short run production curves
 The following figures shows how the TP, MP
and AP of the variable (labor) input vary with
the number of the variable input.

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Total, Average and Marginal
Products curve

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 Cont’d…
 MP curve measures the slope of the TP. The
slope of the TP curve increases (MP
increases) up to L1, it decreases from L1 to
L3 and it becomes negative beyond L3.
 The average product curve increases up to
L2, beyond which it continuously declines.
 The AP curve can be measured by the
slope of rays originating from the origin to
a point on the TP curve.
 For example, the APL at L2 is the ratio of
TP2 to L2. This is identical to the slope of
ray a.
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The relationship between MPL and APL can be stated as
follows:

For all number of workers (Labor)

below L2, MPL lies above APL.
At L2, MPL and APL are equal.
 Beyond L2, MPL lies below the
APL
Thus, the MPL curve passes
through the maximum of the
APL curve from above
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The Law Of Diminishing Marginal Returns
(LDMR): short –run law of production

 The law of variable proportions states that as successive

units of a variable input(say, labour) are added to a fixed
input (say, capital or land), beyond some point the extra,
or marginal, product that can be attributed to each
additional unit of the variable resource will decline
 The law starts to operate after the marginal
product curve reaches its maximum (this
happens when the number of workers
exceeds L1 in figure 4.1).
 This law is also called the law of
diminishing returns.
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 Three stages of short run
production
Stage I – ranges from the origin to
the point of equality of the APL and
MPL.
Stage II – starts from the point of
equality of MPL and APL and ends at
a point where MP is equal to
zero.
Stage III – covers the range of labor
over which the MPL is negative.
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 Cont’d…
 firm should not operate in stage III because in
this stage additional units of variable input are
contributing negatively to the total product
(MP of the variable input is negative)
because of over crowded working
environment i.e., the fixed input is over
utilized.
 Stage I is also not an efficient region of
production though the MP of variable input is
positive.
 The reason is that the variable input (the
number of workers) is too small to efficiently
run the fixed input; so that the fixed input is
under utilized (not efficiently utilized)
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Cont’d…
 Thus, the efficient region of production is
stage II.
 At this stage additional inputs are
contributing positively to the total
product and MP of successive units of
variable input is declining (indicating that
the fixed input is being optimally used).
 Hence, the efficient region of production is
over that range of employment of variable
input where the marginal product of the
variable input is declining but positive.

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 4.6 Long run Production:
Production with two variable
inputs
 long run is a period of time (planning
horizon) which is sufficient for the firm to
change the quantity of all inputs. For the
sake of simplicity, assume that the firm uses
two inputs (labor and capital) and both are
variable.
 The firm can now produce its output in a
variety of ways by combining different
amounts of labor and capital
 how a firm can choose among combinations
of labor and capital that generate the
same output?
 To do so, we make the use of isoquant.
12/12/2024 By: Debebe D. 23
 Isoquants

An isoquant is a curve that shows all

possible efficient combinations of
inputs that can yield equal level of
output. If both labor and capital are
variable inputs, the production function
will have the following form. Q = f
(L, K)
Given this production function, the
equation of an isoquant, where
output is held constant at q is
q = f (L, K)
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 Cont’d…
Thus, isoquants show the flexibility
that firms have when making
production decision: they can usually
obtain a particular output (q) by
substituting one input for the
other.
As employment of one factor
increases, the employment of the
other factor must decrease to
produce the same quantity efficiently.
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 Isoquant maps:
when a number of isoquants are
combined in a single graph, we
call the graph an isoquant map.
Each isoquant represents a different
level of output and the level of out
puts increases as we move up
and to the right
Isoquants show the fact that long run
production process is very flexible.

12/12/2024 By: Debebe D. 26

 Cont’d…
A firm can produce q1 level of
output by using either 3 capital
and 1 labor or 2 capital and 3
labor or 1 capital and 6 labor or
any other combination of labor
and labor on the curve.
The set of isoquant curves q1 q2
& q3 are called isoquant map.

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Isoquant curve and map

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 Properties of isoquants

Most of the properties of isoquants,

results from the word ‘efficient’ in
its definition.
1. Isoquants slope down ward.
Because isoquants denote
efficient combination of inputs
that yield the same output,
isoquants always have negative
slope.
 Isoquants can never be horizontal,
vertical or upward sloping.
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Cont’d…

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 Cont’d…

• 2. The further an isoquant lays away

from the origin, the greater the level
of output it shows
• 3. Isoquants do not cross each other.

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 Cont’d…

4. Isoquants must be thin. If

isoquants are thick, some points on
the isoquant will become inefficient.
Consider the following isoquant.

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 Shape of isoquants

i. Linear isoquants - perfect

substitutes
same output can be produced with
only capital or only labor or an infinite
combination of both

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 Cont’d…

ii. Input output isoquant-

 This assumes strict complementarities or
zero substitutability of factors of production.
 Additional output cannot be obtained
unless more capital and labor are added
in specific proportions.
 As a result, the isoquants are L-shaped
 Output cannot be increased by keeping one
factor (say labor) constant and increasing the
other (capital).
 To increase output (say from q1 to q2) both
factor inputs should be increased by equal
proportion
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Cont’d…

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 Cont’d…

iii. Kinked isoquants

This assumes limited substitution
between inputs.
Inputs can substitute each other
only at some points.
 Thus, the isoquant is kinked and
there are only a few alternative
combinations of inputs to
produce a given level of output.
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Cont’d…

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 Cont’d…
iv. Smooth, convex isoquants
This shape of isoquant assumes
continuous substitution of capital and
labor over a certain range,
The slope of the isoquant decrease as
we move from the top (left) to the right
(bottom) along the isoquant
This indicates that the amount by which
the quantity of one input (capital)can be
reduced when one extra unit of another
inputs(labor)is used

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Cont’d…

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The Slope of an Isoquant: marginal rate
of technical Substitution (MRTS)

 The slope of an isoquant = (-K/L)

-> indicates how the quantity of one input
can be traded off against the quantity of
the other, while out put is held constant.
 The absolute value of the slope of an
isoquant is called marginal rate of
technical substitution (MRTS).
 MRTS of labor for capital, denoted as
MRTSL,K shows the amount by which the
input of capital can be reduced when
one extra unit of labor is used, so that
output remains constant.
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 Cont’d…

MRTSL,K (the slope of isoquant) can

also be given by the ratio of
marginal products of factors.
That is,

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 Factor intensity

A process of production can be labor

intensive or capital intensive or neutral
process
 The factor intensity of any process is
measured by the slope of the line
through the origin.
 Thus, the factor intensity is the capital-labor
ratio.
 The higher the capital-labor ratio is the
higher the capital intensity but the lower
the capital-labor ratio is the higher labor
intensity of the process.
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 Cont’d…

Fig 3.10 Process A uses k1 and L1 units of labor and capital to

produce x amount of output.
The factor intensity of this process can be measured by the
slope of OA, which equals AL1/OL1 =
OK1 K1

OL1 L1

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 Cont’d…
The upper part of the isoquant
includes more capital intensive
processes and the lower part,
labor intensive techniques.
let’s illustrate the above concepts
with the most popular and applicable
form of production function, Cobb-
Douglas production function
The Cobb- Douglas production
function is of the form
b1
x b0 L K b2

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from this production function

x b0 Lb1 K b 2

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 Cont’d…
4. Factor intensity is measured by
the ratio
The higher the ratio, the more labor
intensive the technique. The lower the
ratio the more capital intensive the
technique
5. The efficiency of production is
measured by the coefficient b0. The
more efficient firm will have a
larger b0 than the less efficient one.
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 4.9 Laws of returns to scale:
long run analysis of
production
In the long run; Expansion of output
may be achieved by varying all factors
of production by the same proportion
or by different proportions
The term returns to scale refers to
the change in output as all factors
change by the same proportion.
Suppose initially the production
function is X0 = f (L, K)

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 Cont’d…
 If we increase all factors by the same
proportion t, we clearly obtain a new level
of output X* where, X* = f (tL, tK)
 If X* increases by the same proportion
t or if X* = tX0, we say that there is
constant returns to scale.
 If X* increases less than proportionally
with the increase in the factors (or if X*
increases by a proportion less than t),
we have decreasing returns to scale.

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 Cont’d…
IfX* increases more than
proportionally with the increase
in the factors (by a more than t
proportion), we have increasing
returns to scale

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Returns to scale and homogeneity
of production function
Suppose we increase both factors of the
function X0=f(L,K) by the same
proportion ‘t’, and we get the new level
of output
X = f (tL, tK)
If t can be factored out (that is, may
be taken out of the brackets as a
common factors), then the new level of
output X* can be expressed as a function
of t (to any power V) and the initial
level of output, and the production
function is said to12/12/2024
be homogeneous.
By: Debebe D. 50
 Cont’d…
X* = f (L ,K) or X* = X0
If t can not be factored out, the
production function is non-
homogeneous.
 Thus, a homogeneous function is a
function such that if each of the
input is multiplied by t, then t can
be completely factored out of the
function.
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 Cont’d…

 The power V of t is called degree of

homogeneity of the function and is
measure of returns to scale.
 If V=1, we have constant returns to
scale. This production function is some times
called linear homogeneous
 If V<1, decreasing return to scale
prevails
 If V>1, increasing return to scale
prevails

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 Cont’d…

For a Cobb-Douglas production function

 X = b0Lb1 Kb2, V = b1 +b2 and it is a
measure of returns to scale.
 Proof: Let L and K increase by t. The new
level of output is
X* = b0 (tL) b1 (tk) b2
X* = b0 tb1 lb1 tb2kb2
X* = b0Lb1Kb2 tb1+b2
X* = X (t b1+b2)
 Thus V = b1+b2

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Equilibrium of the firm: Choice of
optimal combination of factors of
production
Different combinations of labor and
capital on a given isoquant yield the
same level of out put.
However, the cost of these different
combinations of labor and capital could
differ because the prices of the inputs
can differ.
Thus, isoquant shows only
technically efficient combinations
of inputs, not economically
efficient combinations.
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 Cont’d…
Economic efficiency seeks to find
the least cost (in monetary
terms) combination of inputs
among the various technically
efficient combinations
To determine the economically
efficient input combinations we
need to have the prices of
inputs.

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 Cont’d…
 Assumptions
I. The goal of the firm is
maximization of profit ¶=R-C
II. The price of the product is given
and it is equal to Px .
III. The prices of inputs are given
(constant).
IV. Price of a unit of labor is ‘w’ and
that of capital is ‘r’.

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 Iso-cost line

 Itis the locus points denoting all combination

of factors that a firm can purchase with a
given monetary outlay, given prices of
factors.

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Cont’d…

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 Cont’d…
The equilibrium point (economically
efficient combination) is graphically
defined by the tangency of the firm’s
Iso-cost line (showing the budget
constraint) with the highest possible
isoquant

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Cont’d…

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Cont’d…

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Cont’d…

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Cont’d…

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 The end

Thank
you !!
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