Production theory basics

Production, in microeconomics is simply the conversion of inputs into outputs. It is an economic process that uses resources to create a commodity that is suitable for exchange. This can include manufacturing, storing, shipping, and packaging. Some economists define production broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production.

Production is a process, and as such it occurs through time and through space. Because it is a flow concept, production is measured as a �rate of output per period of time�. There are three aspects to production processes: 1) the quantity of the commodity produced, 2) the form of the good produced, and 3)the temporal and spatial distribution of the commodity produced. A production process can be defined as any activity that increases the similarity between the pattern of demand for goods, and the quantity, form, and distribution of these goods available to the market place.

Table of contents

1 Efficiency and X-efficiency
2 Factors of production
3 Total, average, and marginal product
4 Diminishing marginal returns
5 See also
6 Finding related topics

Efficiency and X-efficiency

A production process is efficient if a given quantity of outputs cannot be produced with any less inputs. It is said to be inefficient when there exists another feasible process that, for any given output, uses less inputs. Some economists (in particular Leibenstein) use the term X-efficiency to indicate that production processes tend to be inherently inefficient due to satisficing behaviour. The �rate of efficiency� is simply the amount of (or value of) outputs divided by the amount of (or value of) inputs. If a production process uses 50 units of input (or $5000 worth of inputs) to produce one unit of output it is more efficient than a process that uses 55 units of input (or $5500 worth of inputs) to produce the same level of output. It is said to be 10% more efficient ({55-50}/50=10).

Factors of production

The inputs or resources used in the production process are called factors by economists. The myriad of possible inputs are usually grouped into four or five categories. These factors are:

Raw materials (natural capital)
Labour services (human capital)
Capital goods
Land

Sometimes a fifth category is added, entrepreneurial and management skills, a subcategory of labour services. Capital goods are those goods that have previously undergone a production process. They are previously produced means of production. Some textbooks use "technology" as a factor of production.

In the �long run� all of these factors of production can be adjusted by management. The �short run� however, is defined as a period in which at least one of the factors of production is fixed. A fixed factor of production is one who�s quantity cannot readily be changed. Examples include major pieces of equipment, suitable factory space, and key managerial personnel. A variable factor of production is one whose usage rate can be changed easily. Examples include electrical power consumption, transportation services, and most raw material inputs. In the short run, a firm�s �scale of operations� determines the maximum number of outputs that can be produced. In the long run, there are no scale limitations.

Total, average, and marginal product

Total Product Curve

The total product (or total physical product) of a variable factor of production identifies what outputs are possible using various levels of the variable input. This can be displayed in either a chart that lists the output level corresponding to various levels of input, or a graph that summarizes the data into a �total product curve�. The diagram shows a typical total product curve. In this example, output increases as more inputs are employed up until point A. The maximum output possible with this production process is Qm. (If there are other inputs used in the process, they are assumed to be fixed.)

The average physical product is the total product divided by the number of units of variable input employed. It is the output of each unit of input. If there are 10 employees working on a production process that manufactures 50 units per day, then the average product of variable labour input is 5 units per day.

Average and Marginal Physical Product Curves

The average product typically varies as more of the input is employed, so this relationship can also be expresses as a chart or as a graph. A typical average physical product curve is shown (APP). It can be obtained by drawing a vector from the origin to various points on the total product curve and plotting the slopes of these vectors.

The marginal physical product of a variable input is the change in total output due to a one unit change in the variable input (called the discrete marginal product) or alternatively the change in total output due to an infinitesimally small change in the variable input (called the continuous marginal product). The discrete marginal product of capitalis the additional output resulting from the use of an additional unit of capital (assuming all other factors are fixed). The continuous marginal product of a variable input can be calculated as the derivative of quantity produced with respect to variable input employed. The marginal physical product curve is shown (MPP). It can be obtained from the slope of the total product curve.

Because the marginal product drives changes in the average product, we know that when the average physical product is falling, the marginal physical product must be less than the average. Likewize, when the average physical product is rising, it must be due to a marginal physical product greater than the average. For this reason, the marginal physical product curve must intersect the maximum point on the average physical product curve.

Diminishing marginal returns

These curves illustrate the principle of diminishing marginal returns to a variable input (not to be confused with dis economies of scale which is a long term phenomenon in which all factors are allowed to change). This states that as you add more and more of a variable input, you will reach a point beyond which the resulting increase in output starts to diminish. This point is illustrated as the maximum point on the marginial physical product curve. It assumes that other factor inputs (if they are used in the process) are held constant. An example is the employment of labour in the use of trucks to transport goods. Assuming the number of available trucks (capital) is fixed, then the amount of the variable input labour could be varied and the resultant efficiency determined. At least one labourer (the driver) is necessary. Addition workers could be productive in loading, unloading, navigation, or 24/7 driving. But at some point returns to labour will start to diminish and efficiency will decrease.