Chapter 5
Theory of
Production
Chapter 5
Prof. Dr.
Mohamed I. Migdad
Professor of Economics
2015
Main Questions
Production decisions concentrate
on the following questions:
1. What goods to produce;
2. How to produce them; that include
the technology.
3. For whom to produce, that
determine the quality and price.
4. The costs of production;

Assumptions
We assume all firms to try to produce
efficiently at the lowest cost.
 Or they try to produce the maximum
level of output for a given level of inputs.
 We also assume firms to try to maximize
economic profits.

Definition
A firm is an organization that comes into
reality when a person or a group of
people decide to produce a good or a
service in order to meet a perceived
demand.
 Most firms exist to make a profit but
production is not limited to firms; many
important differences exist between
firms.

Production Process
Production is simply the conversion of
inputs to outputs.
 It is an economic process that uses resources
to create commodities that are suitable for
exchange.
 Some economists define production broadly as
"the act of making things, creating things,
producing things, and, in particular, the act of
making products that will be traded or sold
commercially".

Continue
For those economists, this can include
manufacturing, storing, shipping, and
packaging.
 They see every commercial activity, other
than the final purchase, as some form of
production.

Production technology (PT)



(P.T) refers to the quantitative relationship
between inputs and outputs. The
production technology could be a laborintensive technology or a capital intensive
one.
A labor-intensive technology relies heavily on
human labor instead of capital, while
A capital-intensive technology relies heavily
on capital instead of human labor.
Production function (PF)
(P.F) explain that Production quantity is a
function of factors-of-production. In the
short run, it is a function of the variable
FoP while in the long run, it is a function
of the total (FoP).
 Q = F (L, C, M, E, R ….. N)

Technological Change (TC)
Economic history records that total
output in the US has grown more than
tenfold over the last century.
 Part of that gain has come from increased
inputs such as labor and machinery.
 Much of the increase of the output has
come from the technological changes
which improve productivity and raises
living standards.

Technological change
Q Production
TP2
TP1
APL
0
2
3
Production Curve
8
L
MPL
Productive activities



A farm takes fertilizer, seed, land, water &
labor and tern them into wheat or corn.
Factories takes energy, raw materials,
machinery & labor and tern them into
tractors or TVs.
An airline takes airplanes, fuel, labor &
computerized reservation system and
provide passengers with the ability to
travel quickly.
continue
An accounting firms takes pencils, papers,
computers, office space & labor and produce
audits reports or tax returns for clients.
 We assume that all firms try to produce
efficiently, that is, at lowest cost. Or they try to
produce the maximum level of output for a
given does of inputs.
 We assume that firms try to maximize
economic profits.

The Production Process
Production technology refers to
the quantitative relationship
between inputs and outputs.
 A labor-intensive technology
relies heavily on human labor
instead of capital.
 A capital-intensive technology
relies heavily on capital instead of
human labor.

Technological change
Economic history record that total output in
the US has grown more than tenfold over the
last century.
 Part of that gain has come from increased
inputs such as labor and machinery.
 Much of the increase of the output has come
from the technological change which improve
productivity and raises living standards.

Examples
Fiber optics that have lowered cost and
improved reliability in telecommunications.
 Improvement in computer technologies that
have increased computational power by
more than 1000 times in three decades.
 When the firm adjust the production
process to reduce waste and increase
outputs.

Profits and Economic Costs

Profit (economic profit) is the
difference between total revenue
and total economic cost.
economic profit  total revenue  total economic cost
Total revenue

Total revenue is the amount
received from the sale of the
product:
T .revenue  (Q x P)
Profits and Economic Costs

Total cost (total economic cost)
is the total of
1. Out of pocket costs,
2. Normal rate of return on capital,
and
3. Opportunity cost of each factor of
production.
Profits and Economic Costs

The rate of return, often referred
to as the yield of the investment, is
the annual flow of net income
generated by an investment
expressed as a percentage of the
total investment.
Short-Run Versus Long-Run
Decisions

The short run is a period of time for
which two conditions hold:
1. The firm is operating under a fixed scale (or
fixed factor) of production, and
2. Firms can neither enter nor exit the
industry.
Short-Run Versus Long-Run
Decisions

The long run is a period of time for which
there are no fixed factors of production.
Firms can increase or decrease scale of
operation, and new firms can enter and
existing, firms can exit the industry.
The Production Function

The production
function or total
product function is
a numerical or
mathematical
expression of a
relationship between
inputs and outputs.
It shows units of
total product as a
function of units of
inputs.
Marginal Product

Marginal product
is the additional
output that can be
produced by adding
one more unit of a
specific input, ceteris
paribus.
MPL
change in total product
marginal product of labor =
change in units of labor used
The Law of
Diminishing Marginal Returns

The law of diminishing marginal
returns states that:
When additional units of a variable input are
added to fixed inputs, the marginal product of the
variable input declines.
Average Product

Average
product is the
average amount
produced by
each unit of a
variable factor
of production.
APL
total product
average product of labor =
total units of labor
Production Schedule
7
(1)
LABOR UNITS
(EMPLOYEES)
(2) TP
TOTAL PRODUCT
(SANDWICHES PER
HOUR)
(3) MPL
MARGINAL
PRODUCT OF
LABOR
(4) APL
AVERAGE
PRODUCT OF
LABOR
0
0


1
50
50
50
2
120
70
60
3
180
60
60
4
220
40
55
5
250
30
50
6
270
20
45
7
280
10
40
8
280
0
35
9
270
-10
30
10
250
-20
25
Q Production
TP
0
2
3
Production Curve
8
L
The relation between TP, MP & AP
Q Production
TP
APL
0
2
3
8
MPL
Production Curve
L
Total, Average, and Marginal Product

Marginal product is the slope of the total product function.
• At point A, the slope of the total product function is
highest; thus, marginal product is highest.
• At point C, total product is maximum, the slope of the
total product function is zero, and marginal product
intersects the horizontal axis.
Total, Average, and Marginal Product
Total, Average, and Marginal Product

When average product is
maximum, average product
and marginal product are
equal.
• Then, average product
falls to the left and right of
point B.
Total, Average, and Marginal Product
Remember that:

As long as marginal product
rises, average product rises.

When average product is
maximum, marginal product
equals average product.

When average product falls,
marginal product is less than
average product.
Appendix: Isoquants and Isocosts

An isoquant is a graph
that shows all the
combinations of capital
and labor that can be
used to produce a
given amount of
output.
Appendix: Isoquants and Isocosts
Alternative Combinations of Capital (K)
and Labor (L) Required to Produce 50,
100, and 150 Units of Output
qx = 50
K
L
A
1
8
B
2
C
qx = 100
K
qx= 150
L
K
L
2
10
3
10
5
3
6
4
7
3
3
4
4
5
5
D
5
2
6
3
7
4
E
8
1
10
2
10
3
Appendix: Isoquants and Isocosts
• Along an isoquant:
K  MPK  L  MPL

The slope of an
isoquant is called the
marginal rate of
technical substitution.
MPL
K

L
MPK
Appendix: Isoquants and Isocosts

An isocost line is a
graph that shows all the
combinations of capital
and labor that are
available for a given total
cost.
• The equation of the
isocost line is:
PK  K  PL  L
Appendix: Isoquants and Isocosts

Slope of the isocost
line:
TC / PK
PL
K


L
TC / PL
PK
Appendix: Isoquants and Isocosts

By setting the slopes of the
isoquant and isocost curves
equal to each other,
MPL PL

MPK PK
we derive the firm’s costminimizing equilibrium
condition is found
MPL MPK

PL
PK
Appendix: Isoquants and Isocosts

Plotting a series of cost-minimizing
combinations of inputs (at points A, B, and C),
yields a cost curve.