BE505: Part 3 – Production Theory and the Concept of Cost
TOPIC: Lecture 9: The production theory: the law of diminishing marginal returns
Reference: Waud, R.N., et al. Chapter 7, pp.176-186
The Concept of Firm
Firm is a business organization which: owns, rents and operates equipment, hires labour and buys materials and
energy inputs; organizes and coordinates the use of all these factors of production for the purpose of producing and
marketing goods and services. Legal Forms of the Firm: 1. sole proprietorship, whole liabilities, limited funds; 2.
partnership, shared liabilities, shared funds; 3. public and private companies limited liabilities, raised funds. The
sole objective of a business firm is to maximise profit. Profit is the difference between revenue and cost or profit =
revenue – cost. Cost arises from production while revenue arises from sales in the market.
Production Theory states that the output of a commodity or service depends on a number of production inputs used.
Production Function describes the technical relationship between combinations of factors of production and the final
product. Formula: Output = f (Inputs) or Output = f (L, K, ...).
Inputs are economic resources, also called the factors of production, including all the natural, man-made, and human
resources that are used in the production of goods and services. Capital (K) is all the man-made aids used in
production; Land (La) is all natural resources that are used in production; Labour (L)is all the different capabilities
and skills possessed by human beings; Entrepreneurship is risk-taking spirit and management quality. Outputs are
economic goods and services that are desired and scarce.
Chair Production (Table 7.1)
No. of Workers (L) Cap’l (K) Land (La) Total Product (TP) Marginal Product (MP) Average Product (AP)
0 1 1 0
1 1 1 1 1 1
2 1 1 3 2 1.5
3 1 1 6 3 2
4 1 1 10 4 2.5
5 1 1 13 3 2.6
6 1 1 15 2 2.5
7 1 1 16.5 1.5 2.3
8 1 1 17.5 1 2.2
9 1 1 18 0.5 2
10 1 1 18 0 1.8
Total Product (TP): TP = AP * L or K or the output per unit of a production factor multiplied by the total units of
a production factor used. Average Product (AP): AP = TP/L or K or the total output divided by the total units of a
production factor used. Marginal Product(MP): MP = change in TP/change in L or K or the additional or
incremental output if one more unit of production factor is used. It is a slope of TP curve.
MP and AP: The relationship between the marginal product and the average product is: 1. MP curve passes through
the AC at its maximum point. 2. AP curve falls over the range where the MP curve is below AP. 3. AP curve
increases over the range where the MP curve is above AP.
The Law of Diminishing Marginal Returns states that, in the short run, the total output will increase at a slower
pace when more of a production factor is used in producing a good so long as at least one other production factor is
fixed. This is why in the short run all product curves are N-shaped. The law of Diminishing Marginal Returns sets in
from the four unit of labour employed at the output level of 10 (Refer to the above table AND Figure 7.2).