Production Theory & Profitability

• Production


  The economic process of converting inputs into outputs
• Output Y


  A function of inputs x1, x2, x3, ..., xn
• Output for a farm


  • Y = f(cost of fertilizer, cost of land, labour costs, machineries)
• Output for a boarding facility


  • Y = f(cost of foods provided, cost of caging to set up accommodation, electricity costs, water costs)
• Relationships between output and inputs


  • Constant return
  • Increasing return
  • Diminishing return
• Short Run Production Function


  A time period where at least one factor of production is in fixed supply
• Long Run Production Function

  A time period where all factors of production are variable
• Short Run Production


  • Associated with start-ups or initial production stage where demand is still an estimate
  • Capped by law of diminishing return
  • Assumes fixed costs and variable inputs
• Long Run Production


  • Associated with how a business "returns to scale"
  • Assumes variable costs and variable inputs
  • Associated with economies of scale or diseconomies of scale
• Economies of scale


  Long run average cost DECREASES, corresponding to increasing return to scale in production
• Diseconomies of scale


  Long run average cost INCREASES, corresponding to decreasing return to scale in production
• Return to scale refers to production, while economies of scale refers to cost aspects
• Constant return


  Returns are consistent and linear with inputs invested
• Constant return example


  • 1 input = 10 output, 2 inputs = 12 output (difference of 2), 3 inputs = 14 output (difference of 2), etc.
• Increasing return


  Increasing returns with increasing inputs
• Increasing return example


  • 1 input = 12 output, 2 inputs = 16 output (difference of 4), 3 inputs = 22 output (difference of 6), 4 inputs = 30 output (difference of 8), 5 inputs = 40 output (difference of 10)
• Diminishing return


  Decreasing return with increasing inputs, typically occurring after an inflection point due to Laws of Diminishing Returns
• Diminishing return example


  • 1 input = 12 output, 2 inputs = 18 output (difference of 6), 3 inputs = 23 output (difference of 5), 4 inputs = 26 output (difference of 3), 5 inputs = 27 output (difference of 1)
• Average product (AP)


  The quantity of total output produced per unit of a variable input, holding all other inputs fixed
• Marginal product (MP)


  The change in the quantity of total product resulting from a unit change in a variable input, keeping all other inputs unchanged
• When MP < AP

  AP declines
• When MP > AP

  AP increases
• When MP = AP

  AP stays
• MP and AP relationships are important to adjust profitable size of operation and length of time to market
• Region I (MPP > APP)


  • Profitable to keep on increasing input, enterprise has huge potential to grow
• Region II (MPP < APP)

  • Rational region, enterprise still achieves profitable operation but at diminishing output
• Region III (MPP < APP)

  • Increasing inputs are causing issues, e.g. deterioration of egg production and quality
• Optimal input increment is where Value of MPP = Input Cost/Output Cost, for maximum profitability
• Marginal Physical Product (MPP)


  Relates the level of input to output in physical units
• Marginal Revenue Product (MRP)


  Assigns monetary value to the physical level of output (MPP), enabling economic decisions based on productivity level
• MRP is more important than MPP because employers/business owners are more interested in revenues generated per new unit of investment
• PP, or MPP x Output cost


  Input cost
• Maximum profitability


  When MPP = Input Cost/Output Cost
• Marginal Physical Product (MP)


  Relates the level of input to output, measured in physical units
• Marginal Revenue Product (MRP)


  Assigns monetary value to the physical level of output (MPP), enables economic decisions to be made based on the attained productivity level
• MRP is more important because employers or business owners are more interested in revenues generated per every new unit of investment placed
• Comparing productivity based on monetary value

  • RM 100 vs RM 104 vs RM 60
• Profit maximization


  1. Total Output - Total Costs

  2. Total Output = Output quantity x market price

  3. Total Costs = Fixed costs + variable costs
• Profit is maximized when dπ/dx = 0
• Profit maximization


  MPP = Input Cost/Output Cost