The Theory of Production

You may have heard that economics is about scare resources and unlimited wants. Businesses know this, so they don't just put a bunch of resources together and call it a day. Rather, they consider the benefits of combining their resources in different ways and how these combinations affect their output. The theory of production is all about how resources are used to make outputs, and how changes in these resources result in changes in the outputs. Keep reading as we discuss the theory of production, its stages, and some examples, you'll love it!

Production Theory in Economics

Production theory in economics refers to how businesses decide the quantities of outputs to produce in response to demand. The firm produces goods or commodities with limited resources, and this means that even if it somehow knows people are willing to buy whatever quantity of goods it produces, it just can't instantly make an unlimited quantity of goods.

The resources firms use in production are called the factors of production, and they are also known as inputs.

Let's say the firm uses labor and land as its two resources to make the goods. At any point in time, the firm can increase or decrease the number of workers it employs in response to an increase or decrease in demand. Since the number of workers is so easy to change at any point in time, economists refer to it as a variable factor of production or input. On the other hand, since land cannot be changed so easily, it is often called a fixed input.

Firm Hiring, pixabay

Theory of Production Function

Since the production theory is about deciding how much output to make, the production function helps by showing how the output will change when a variable input changes. For example, how many products will the company make if it employs two more employees? The production function answers this question!

The production function is illustrated with a graph that shows the effects of changes in input.

Now, let's show the production function with an example.

Table 1. Production Schedule, StudySmarter Originals

From the production schedule in Table 1 above, we can see that the total product changes with each added worker. This change is what economists call the marginal product. The marginal product is the change in output resulting from the addition of an extra unit of input.

Table 1 shows that the total product continues to rise until the 10th worker is added. If more than 9 workers are added, then the total product starts to fall. This is because production follows the law of diminishing marginal returns, which states that adding extra units of inputs results in smaller increases in output.

This can be confirmed by looking at the column for marginal product. It increases at the beginning, then begins to drop until it reaches negative values!

The production function is presented in Figure 1 below. It shows the total product on the vertical axis and the number of workers or quantity of variable input on the horizontal axis.

Figure 1. The production function, StudySmarter Originals

The Theory of Production Stages

Because of the law of diminishing marginal returns, production has three main stages.

Let's take a look at Figure 2 below, which is based on Table 1.

Figure 2. Production Stages, StudySmarter Originals

Looking at Figure 2 above, we observe a period of heavy rise (Stage I), followed by a period of slower rise (Stage II), which is then followed by a period of decline (Stage III) of the total product. These are the three stages of production. The three stages are characterized by increasing marginal returns, decreasing marginal returns, and negative marginal returns.

The theory of production Stage I

This is the stage of increasing marginal returns, where the marginal product of each additional worker increases. In this stage, the addition of each worker means the workers are able to use the company's equipment more effectively. For instance, the first worker had a marginal product of 5, whereas the next worker had a marginal product of 10. This continues until the sixth worker is added. The firm will continue to hire more workers since it is benefiting greatly by adding a worker each time.

The theory of production Stage II

This is the stage of decreasing marginal returns. Here, the marginal product is still increasing, but the marginal product of the added worker is less than that of the previous worker. This stage comes as the company continues to employ workers in Stage I. In this stage, the total product is still increasing, and the company sees no reason to stop hiring. In Figure 2, this stage ends with the ninth additional employee. Soon, the company enters the third stage.

The theory of production Stage III

This is the stage of negative marginal returns. As the company continues to hire, there will be too many workers in the company. For instance, if one machine can only be operated by 2 people and there are 4 workers, this means there are two extra workers distracting the other workers and slowing things down. Therefore, the company begins to see negative marginal returns. This begins with the addition of the tenth employee as seen in Figure 2.

Short Run Theory of Production

The short run is the period where only the variable inputs can be changed. Usually, this variable input is labor, and the fixed inputs are usually capital and land. In more practical terms, the company can easily hire more workers in this period, but things like machines and the company office cannot be changed. This means that any change in output must be a result of a change in the variable input.

The opposite of the short run is the long run - a period that is long enough, allowing for all inputs to be changed. For instance, if a company increases the number of workers, the company may be doing so well that it will add more machines in the future as it can make more money this way.

Theory of Production Example

Let's take a look at an example of production theory below:

From this example, the period where 5 more workers were added is the short run, whereas the period where the company will be able to add 5 more machines is the long run.