ECO 240 - 5

Reading:
Text Chapter 5

Production

Production

Production may be
defined as the process
by which inputs are
combined, transformed,
and turned into outputs.

Production Function

• Expresses the physical

relationship between the
quantities of various inputs and
the quantity of real output, as
determined by the state of
technology and by human
application os that technology.
It exhibits variable proportions
of inputs in the production
process

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Production: Short-run & Long-run

• Short-run – a time period during

which at least one factor of
production is fixed. Output can
only be increased by using more
variable factor
• Long-run – a time period long
enough for all inputs to be
varied. By long enough it means
that a firm can build a second
factory and install new

SR Production:
Law of Diminishing Returns
(LDR)

• When one or more factors are

held fixed, there will come a
point beyond which the extra
output from additional units of
the variable factors will
diminish
• Total output will increase at a
decreasing rate until TP
reaches its maximum, after
which TP declines

The Production Process

• Production technology
relates inputs to outputs.
• The optimal method of
production, for a profit-
maximizing firm, is the one
that minimizes costs.

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 Ways to Measure Input
Productivity

• Total product (TP)

• Average product
(AP)
• Marginal product
(MP)

Total Product (TP)

• A mathematical or
numerical expression of a
relationship between inputs
and outputs

• TP shows units of total

product as a function of
units of inputs

Wheat production per year from a

particular farm (tonnes)

N um ber of TPP APP M PP

W o rk e rs (L b ) ( = T P P /L b ) ( = ∆ T P P /∆ L b )

(a ) 0 0 -
3
1 3 3
7
2 10 5
(b ) 14
3 24 8
12
(c ) 4 36 9
4
5 40 8
2
6 42 7
(d ) 0
7 42 6
-2
8 40 5

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SHORT-RUN THEORY OF
PRODUCTION

• The short-run production

function:
• total physical product (TPP)
• average physical product (APP)
• APP = TPP/QV
• marginal physical product (MPP)
• MPP = ∆TPP/∆QV
• graphical relationship between

Average Product (AP)

The average amount of

output produced by each
unit of a variable factor of
production

AP = Output per unit of an

input.

Average Product
(cont’d)
• APP rises at first
• APP continues to rise as long as the
MPP is greater than the APP (the
MPP pulls the APP up)
• APP goes on rising as long as the
MPP is still above the APP
• After MPP intersecting the APP at
APP’s maximum, MPP then falls
below APP

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 APP (cont’d)

• When MPP lies below APP, new

additional workers add less to
output than the APP. This pulls
the the average down: APP falls.

Wheat production per year from a particular farm

d
d
40
Tonnes of wheat produced per year

30
Maximum output
Diminishing returns
set in here
20
b

10

0
0 1 2 3 4 5 6 7 8

Number of farm workers

Wheat production per year from a particular farm

40
Tonnes of wheat per year

TPP
30

20 b
Diminishing returns
10 set in here

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
Tonnes of wheat per year

12

10

4 APP
2

0 Number of
0 1 2 3 4
fig 5 6 7 8 farm workers (L)
-2
MPP

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Wheat production per year from a particular farm
d
40
Tonnes of wheat per year

TPP
30

20
Maximum
b output
10

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
Tonnes of wheat per year

12

10

4 APP
2

0 d Number of
0 1 2 3 4
fig 5 6 7 8 farm workers (L)
-2
MPP

Wheat production per year from a particular farm

d
40
Tonnes of wheat per year

Slope = TPP / L c TPP

30
= APP

20
b
10

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
Tonnes of wheat per year

12

10
c
8

4 APP
2

0 d
Number of
0 1 2 3 4
fig 5 6 7 8 farm workers (L)
-2
MPP

Marginal Product (MP)

Marginal product is the

additional output (that
can be produced by
adding one more unit of a
specific input, ceteris
paribus.

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 Marginal Product
(cont’d)
• MPP between two points is equal to
the slope of the the TPP curve
between those two points
• MPP rises at first: the slope of TPP
curve gets steeper
• MPP reaches a maximum and at this
point the slope of the TPP curve is
the steepest
• After this maximum, diminishing
returns set in, MPP falls, and TPP
becomes less steep

MPP cont’d

• As long as MPP is greater than

zero, TPP will go on rising, New
workers to total output
• At the maximum of TPP, the
slope is zero. An additional
worker will add nothing to
output; MPP is zero
• When TPP falls, MPP is negative

Relationship : APP &

MPP
• MPP rises faster than APP and
is above APP until MPP reaches
its maximum
• MPP falls cutting the maximum
of APP, after this, MPP is
positioned below APP
• MPP falls reaching zero when
TPP reaches its maximum. MPP
then becomes negative as TPP
falls

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 SR Production –
Law of Diminishing Returns
(LDR)
• LDR – When increasing amounts
of a variable factor are used
with a given amount of fixed
factor, there will come a point
beyond which the extra output
from additional units of the
variable factor will diminish

LR Production: The Scale of

Production

• LR – all factors of production

are variable. There is time to
build a new factory, to install
new machines, to use different
techniques of production, and
even to combine its inputs in
whatever proportion and in
whatever quantities it chooses.

LR Production: Three Possible

Situations
• Constant returns to scale – where a
given percentage increase in inputs
will lead to the same percentage
increase in output
• Increasing returns to scale – where a
given percentage in inputs will lead
to a larger percentage increase in
output
• Decreasing returns to scale – where
a given percentage increase in
inputs will lead to a smaller
percentage increase in output

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Short-run and long-run
increases in output

Short run Long run

Inp ut 1 Inp ut 2 Output Inp ut 1 Inp ut 2 Output

3 1 25 1 1 15

3 2 45 2 2 35

3 3 60 3 3 60

3 4 70 4 4 90

3 5 75 5 5 125

LONG-RUN THEORY OF PRODUCTION

• Economies of scale
• specialisation & division of labour
• indivisibilities
• container principle
• greater efficiency of large machines
• by-products
• multi-stage production
• organisational & administrative economies
• financial economies
• economies of scope

External Diseconomies
of Scale
– Refers to where a firm’s
costs per unit of output
increase as the size of the
whole industry increases.
For example, as an industry
grows larger, it may create
a growing shortage of
specific raw materials or
skilled labour. This will
push up their prices, and
hence the firm’s costs.

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Economies of Scale – LR
Concept
• The concept of increasing returns to
scale is linked to that of economies
of scale
• Economies of scale – when
increasing the scale of production
leads to a lower cost per unit of
output
• Increasing returns to scale – a firm
enjoys producing more output
through using smaller and smaller
amount s of factor inputs per unit of
output.

Reasons: firms experiencing

Economies of Scale of Production

Plant economies of scale

• Specialization and division of
labour
• Indivisibilities
• The container principle
• Greater efficiency of larger
machines
• By-products
• Multistage production

Reasons: firms experiencing

Economies of Scale of Production

Economies of scale associated with

firms being large
• Organizational economies
• Spreading overheads
• Financial economies
• Economies of scope where various
overhead costs and financial and
organizational economies can be
shared among the products

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Reasons: firms experiencing
External Economies of Scale of
Production
• Industry’s infrastructure – as
the industry grows in size, this
can lead to external economies
of scale for its member firms.
The network of supply agents,
communications, skills, training
facilities, distribution channels,
specialized financial services,
etc… that supports a particular
industry. All these can be
shared by its members.

Diseconomies of Scale

• Refers to where costs per unit of

output increases as the scale of
production increases. The reasons
being:
1. Management problems of
coordination may increase as the
firm becomes larger and more
complex, and as lines of
communication get longer, there
may be a lack of personal
involvement by management

Diseconomies of Scale

2. Workers may feel ‘alienated’ if their

jobs are boring and repetitive, and if
they feel an insignificantly small part
of a large organization. Poor
motivation may lead to shoddy work
3. Industrial relations may deteriorate
as a result of these factors and also
as a result of the more complex
interrelationships between different
categories of worker

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Diseconomies of Scale

4. Production-line processes and

the complex interdependencies
of mass production can lead to
great disruption if there are
hold-ups in any one part of the
firm,

External Diseconomies
of Scale

• Refers to where a firm’s costs per

unit of output increase as the size of
the whole industry increases. For
example, as an industry grows
larger, it may create a growing
shortage of specific raw materials or
skilled labour. This will push up their
prices, and hence the firm’s costs.

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