Chapter 4

The Theory of Production

Production

Process of transforming inputs into outputs Inputs are factor of production (such as land,

labor, capital & entrepreneur) whereas output are goods and services produced.

Production function refers to r/ship between inputs & outputs

# as input increases, output also increases

Elements in the Process of Production

Firm Productive unit or business (small unit) which convert inputs

into outputs for sale in market

Industry Group of firms which produce the same type of products

produce more good than firms

Factors of production Fixed factors ( fixed inputs)

Do not change as output increases or decreases (eg: land & capital

Variable factors (variable inputs) Change as output increases or decreases. (eg: labor &

entrepreneur)

Time range Short run

At least one fixed input with one or more variable inputs to increase output, producer needs to change his variable inputs but not fixed inputs)

Eg: producer cannot change land & factory size but can change the quantity of labor or raw materials

Long run No fixed inputs only variable inputs Land, labor, capital & entrepreneur are all variable inputs Firms able to build new factories or purchase new

machineries

Short Run Production Function

Q=f (variable inputs, fixed inputs)Q=f (variable inputs, fixed inputs) The production is subjected to the law of diminishing The production is subjected to the law of diminishing

marginal returnsmarginal returns the additional output from each the additional output from each additional unit of variable input will diminishadditional unit of variable input will diminish

Important Concepts

Total product of labor (TPL) Total number of goods produced with a given

amount of factors of production

TPL = APL x QL (Quantity of labors)

Eg: QL = 4 labor , APL = 4 units

TPL = APL x QL

= 4 units x 4 labors = 16 units

Average Product of Labor (APL) Total product (TPL) per unit of labor

APL = TPL/QL

Eg: QL = 3 labors, TPL = 11.70

APL = TPL/QL

= 11.70 units / 3 labors = 3.90 units

Marginal Product of Labor (MPL) Additional output produced as a result of employing one

additional unit of labor

MPL = ∆TPL/∆QL

= TPn – TPn-1 (where n = period 1,2,3,4,5,…)

QLn – QLn-1

Total Product, Marginal Product and Average Product of Labor

TP labour MP (∆TP/ ∆L) AP(TP/L)

0 0 - 0

8 1 8 8

20 2 12 10

33 3 13 11

44 4 11 11

50 5 6 10

54 6 4 9

56 7 2 8

56 8 0 7

54 9 -2 6

50 10 -4 5

Relationship between TPL, APL and MPL

Land Labor TPL APL MPL Law of Marg. Returns

Stages of Production

1 1 3 3 - Increasing Marg. Returns Stage 11 2 7 3.5 4

1 3 33 11 26

1 4 50 12.5 17

Diminishing Marg. Returns Stage 2

1 5 65 13 15

1 6 75 12.5 10

1 7 80 11.43 5

1 8 80 10 0

1 9 78 8.67 -2 Negative Marg. Returns

Stage 3

1 10 72 7.2 -6

Production

Labor

TPL maximum

TPL

APL

MPL

MPL = 0

APL maximumMPL maximum

0

Stage 1 Stage 2 Stage 3

3 Stages of Production Curve in Short Run

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Stages of ProductionStages of Production

Stage 1Stage 1Begins from point 0 to the intersection point of MP Begins from point 0 to the intersection point of MP and AP curves. At this stage, there is sharp increase and AP curves. At this stage, there is sharp increase of total product (TP) as we increase the units of of total product (TP) as we increase the units of labor employed labor employed

each additional increase in labor units will result each additional increase in labor units will result in a greater increase of the TP. in a greater increase of the TP. A rational producer will continue to produce A rational producer will continue to produce goods at this stage as TP increase by increasing goods at this stage as TP increase by increasing more labormore labor

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Stage 2Stage 2Begins from the intersection point of MP and AP Begins from the intersection point of MP and AP curves ( end of stage 1) until MP curve touches the x-curves ( end of stage 1) until MP curve touches the x-axis. At this stage, the values of AP and MP are axis. At this stage, the values of AP and MP are decreasing. decreasing.

AP curve is always higher than the MP curve, and AP curve is always higher than the MP curve, and when the MP curve touches the x-axis, the TP reaches when the MP curve touches the x-axis, the TP reaches its maximum pointits maximum point most efficient stage of production because the most efficient stage of production because the combinations of variables and fixed inputs are used combinations of variables and fixed inputs are used efficiently. efficiently. rational producer will want to produce at this stage rational producer will want to produce at this stage of production as the TP has already achieved its of production as the TP has already achieved its maximum point (if he continues to produces beyond maximum point (if he continues to produces beyond this stage, TP will start to decline)this stage, TP will start to decline)

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Stage 3Stage 3

Begins when MP equals to zero and Begins when MP equals to zero and continues to decline thereafter. continues to decline thereafter.

rational producer should not be rational producer should not be producing at this stage of production producing at this stage of production because an increase in labor leads to a because an increase in labor leads to a decline in the total product.decline in the total product.

Law of Diminishing Marginal Returns

States that as labor (variable input) is added to land, eventually MP will fall.

Law of diminishing returns starts when MP is at its maximum point (point a) until MP equal to zero (point b)

Production

Labor

TPL maximum

TPL

APL

MPL

MPL = 0

APL maximum (APL = MPL)MPL maximum

0

Stage 1 Stage 2 Stage 3

Law of Diminishing Marginal Returns

(a)

(b)

R/ship between TP & MP• When MP is increasing, TP is increasing at an increasing rate

• When MP is declining, TP is increasing at a decreasing rate

• When MP is zero, TP is maximum

• When MP is negative, TP is falling

Production

Labor

TPL maximum

TPL

APL

MPL

MPL = 0

APL maximum (APL = MPL)MPL maximum

0

Stage 1 Stage 2 Stage 3

Law of Diminishing Marginal Returns

(a)

(b)

R/ship between AP & MP

• When MP is increasing, AP is also increasing

•MP cuts AP when AP is maximum

•When MP above AP, the AP is rising

•When MP below AP, the AP is falling

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Long Run Production FunctionLong Run Production Function

period where all inputs used are variable period where all inputs used are variable inputs (no fixed inputs)inputs (no fixed inputs)

Firms use this period to plan their production Firms use this period to plan their production by changing all their inputsby changing all their inputs

Law of returns to scale applicable in long run Law of returns to scale applicable in long run when all inputs are variablewhen all inputs are variable

Thus, in long runThus, in long run

Q=f(variable inputs: land,labor,capital,entrepreneur)Q=f(variable inputs: land,labor,capital,entrepreneur)

Economies of Scale

Show the r/ship between output & long run cost

Refer to the advantages & benefits of firm enjoys as it becomes larger (expand its production) since the long run average cost (LRAC) falls.

2 types: Internal economies of scale External economies of scale

Internal economies of scale Benefits enjoyed by the firm itself Occurs as a result of a firms internal decision to increase the

scale of its operation

Division of labor specialization Leads to an increase in efficiency brings higher output thus results

in increasing returns to scale

Financial economies Large firms obtain loans more easily (interest charged also lower) Can also sells shares to obtain more capital to expand firms results in lower LRAC as output expand

Managerial economies Administrative economies such as the employment of professionals

like economists or accountants

External economies of scale Benefits enjoyed by the entire industry Caused by the factors external to the firms itself, relating to the

scale of the industry or market as a whole

Economies of concentration Grouping of firms together within 1 industrial zone can reduce

cost since it is cheaper + easier for government to supply necessary facilities

Infrastructure Facilities available to the industry to ensure smooth operation of

the whole industry Eg: road, ports, railways, water supply, telecommunication, etc

enable firms to save cost & production be more efficient

Economies of information Exposed to new information important to improve quality of

the existing product

Diseconomies of Scale

Disadvantages/ problems a firm will face it becomes too large because increases in output causes a firm’s LRAC curve to rise and reduces efficiency

2 types: Internal diseconomies of scale External diseconomies of scale

Internal diseconomies of scale Disadvantages faced by the firm when it become

too big

Bureaucratic organization Lead to slow process of decision making costly to

firms

Low productivity Division of labor may lead to alienated & demoralize

of workers when the organization gets bigger

Higher wages of professionals Increase the cost of production

External diseconomies of scale Disadvantages that result from the expansion of the entire

industry

Social cost Taxes will be imposed by the govt because the problem of

pollution or traffic congestion

Wage differential in the industry Eg: AB company pays RM20 per day while CD company

pay RM25 per day to their labors prevent worker from leaving the firms + attract new labors, AB company has to pay RM26 or more per day production cost for both firms will increase

Increase in cost of production & fall in returns With stiff competition, whole industry will suffer because

their competition in terms of buying & selling increase in cost of production

Producers’ objective and Producers’ objective and responsibilityresponsibility Conventional viewConventional view

Producer’s objective is to attain maximum profit Producer’s objective is to attain maximum profit make economics decisions make economics decisions

• Islamic viewIslamic view Strive hard in order to get the blessings from Strive hard in order to get the blessings from

Allah SWT + harmony societyAllah SWT + harmony society Maximize profit without sacrificing the blessings Maximize profit without sacrificing the blessings

from Allah SWT according to Al Quran & Sunnahfrom Allah SWT according to Al Quran & Sunnah