Theory of Production Questions and Answers [With PDF]

How does a firm turn land, labour and capital into goods? When does adding one more worker stop helping? How should a firm combine inputs to produce at the lowest cost? The theory of production answers these questions. Here are 50 important questions with clear answers, grouped by topic, with a worked table for the law of variable proportions and a drawn diagram of the producer’s equilibrium.

This is Chapter 7 of our Economics course. It follows Basic Elements of Supply and leads into Theory of Cost.

Production and Factors of Production

Q1. What is production?

In economics, production means creating or adding utility. A carpenter who turns timber into a chair has added utility to what nature provided. Production includes making goods and providing services.

Q2. What is the theory of production?

The theory of production explains how a firm decides how much to produce and which combination of inputs to use, so as to minimize costs and maximize profit, and how output changes when inputs change.

Q3. What are the factors of production?

Q4. What is land?

In everyday speech, land means the earth’s surface. In economics, land means all the free gifts of nature used in production: the soil, minerals, forests, water, rivers, climate and fisheries.

Q5. What are the features of land?

• It is a free gift of nature and not produced by human effort.
• Its total supply is fixed and cannot be increased by people.
• It is immobile. It cannot be moved from one place to another.
• It varies in fertility and location.
• It is a passive factor. It needs labour and capital to be useful.
• It is versatile, because the same land can be used in many ways.
• It is subject to the law of diminishing returns.
• Some natural resources, such as coal and oil, can be used up, so land is not unlimited.

Q6. What is labour?

In economics, labour means any physical or mental effort of human beings, done for payment, to produce goods or services. A doctor, a teacher and a farm worker are all labour.

Q7. What are the features of labour?

• Labour is an active human factor.
• It cannot be separated from the labourer. The worker has to be present.
• It is perishable. A day’s lost work cannot be stored.
• Its mobility is relatively low, because workers are tied to family and place.
• Labour differs in skill, efficiency and training.
• Labour supply responds to wages. At very high wages some workers choose more leisure, giving a backward-bending supply curve.
• Labour may be physical or mental, skilled or unskilled.

Q8. What is capital?

In business language, capital means money invested. In economics, capital means man-made goods used to produce other goods, such as machines, tools, factories, roads and stocks of raw material.

Q9. What are the features of capital?

• It is produced by humans, not a free gift of nature.
• It is a passive factor, like land.
• Its supply can be increased or decreased.
• It is highly mobile and transferable.
• It depreciates with use and time.
• It is formed by saving and investment.

Q10. What is organization (entrepreneurship)?

The fourth factor of production. The entrepreneur plans the business, brings the other factors together, takes decisions and bears the risk of loss. The reward for this is profit.

Q11. How are factors of production classified by use in the short run?

• Fixed factors (inputs)
• Variable factors (inputs)

Q12. What are fixed factors?

Inputs that cannot be changed in the short run, so they are used in a fixed quantity regardless of output. Examples: factory building, large machinery.

Q13. What are variable factors?

Inputs that can be changed in the short run as output changes. Examples: labour, raw materials, fuel.

Production Function

Q14. What is the production function?

A production function shows the relationship between inputs and the maximum output that can be produced from them, with a given technology. With capital and labour as inputs it is written Q = f(K, L), where Q is output, K is capital and L is labour.

Q15. What are the types of production function?

• Short-run production function
• Long-run production function

Q16. What is the short-run production function?

The short run is a period in which at least one factor cannot be changed. Output is changed by varying only the variable factors. This is studied under the law of variable proportions.

Q17. What is the long-run production function?

The long run is a period long enough for a firm to change all inputs, including the scale of production. All factors are variable. This is studied under returns to scale.

Q18. What are the assumptions of the production function?

• Inputs and output are perfectly divisible.
• Capital and labour can be substituted for each other, but only to a limited degree.
• The state of technology does not change.
• The firm uses its inputs efficiently.
• It refers to a specific period of time.

Q19. What is a method of production?

A particular combination of inputs (capital and labour) used to produce one unit of output. A firm may choose a labour-intensive method or a capital-intensive method.

Isoquants

Q20. What is an isoquant?

An isoquant (equal-product curve) shows all the combinations of two inputs, such as labour and capital, that produce the same level of output.

Q21. What are the features of an isoquant?

• It slopes downward from left to right.
• It is convex to the origin.
• A higher isoquant shows a higher level of output.
• Two isoquants never intersect.

Q22. What is a linear isoquant?

A straight-line isoquant. It assumes inputs are perfect substitutes, so output can be made with only labour, only capital, or any mix.

Q23. What is a kinked isoquant?

An isoquant made of straight segments with kinks. It shows that there are only a few technically possible processes, so substitution happens only at the kinks. It is also called an activity analysis or linear programming isoquant.

Q24. What is an input-output (L-shaped) isoquant?

An L-shaped isoquant. It assumes that inputs must be used in fixed proportions, so they are perfect complements and cannot be substituted for each other. There is only one way to make the good, as with a car that needs exactly one driver.

Q25. What is a convex isoquant?

The most common shape. Inputs can be substituted for each other, but not perfectly: as a firm uses more labour in place of capital, each extra worker replaces less and less capital. This is the diminishing marginal rate of technical substitution (MRTS).

Product Concepts and the Law of Variable Proportions

Q26. What is total product (TP)?

The total quantity of output produced by a firm with a given quantity of inputs in a given period.

Q27. What is marginal product (MP)?

The change in total product when one more unit of the variable factor is used: MP = change in TP / change in the variable input.

Q28. What is average product (AP)?

Output per unit of the variable factor: AP = TP / units of the variable input.

Q29. What is the law of variable proportions?

It describes what happens to output when only one input is increased while the others stay fixed. At first output rises faster and faster, then at a slower rate, and at last it may fall. It is the short-run production law, also called the law of diminishing returns.

Q30. What are the assumptions of the law of variable proportions?

• Technology stays the same. If it improves, product may rise rather than fall.
• At least one factor is fixed and one is variable.
• All units of the variable factor are identical.
• The law applies to the short run.

Q31. What are the three stages of the law? Show an example.

A farm has a fixed amount of land and adds workers one at a time:

• Stage I (increasing returns): MP rises, up to the 3rd worker, and AP rises up to its maximum.
• Stage II (diminishing returns): MP falls but stays positive, from the 4th to the 7th worker. TP is highest (66) when MP is zero. A rational firm operates here.
• Stage III (negative returns): MP is negative and TP falls (8th worker).

Notice that MP cuts AP at AP’s maximum: at the 4th worker, MP = AP = 13.

Q32. What are increasing returns to a factor?

When more units of the variable factor are added to a fixed factor, the marginal product of the variable factor rises, so output increases at an increasing rate.

Q33. What are diminishing returns to a factor?

When the marginal product of each additional unit of the variable factor falls but stays positive, so total product still rises, but at a decreasing rate.

Q34. What are negative returns to a factor?

When adding more of the variable factor makes the marginal product negative, so total output falls. For example, too many workers on a small plot get in each other’s way.

Q35. What are the reasons behind the law of returns?

• Indivisibility of the fixed factor: a fixed factor such as a machine needs a certain number of workers to be used fully. With too few workers, it is underused, so adding workers raises productivity at first.
• Specialization: more workers allow the division of labour.
• Over-crowding: once the fixed factor is fully used, extra workers add less and less, and eventually they get in each other’s way.

Q36. What are the limitations of the law of variable proportions?

• Units of the variable input, especially labour, are not truly identical.
• In practice, technology and input prices change over time.
• It does not apply when all factors can be changed, as in the long run.

Returns to Scale

Q37. What are returns to scale?

The change in output when all inputs are increased in the same proportion. It is a long-run concept.

Q38. What are the types of returns to scale?

Q39. What are increasing returns to scale?

When a given percentage increase in all inputs leads to a larger percentage increase in output.

Q40. What are the reasons for increasing returns to scale?

• Indivisibility: some inputs, such as machinery and managers, can only be used in a minimum size. As output grows, the cost per unit falls.
• Specialization: workers with specific skills raise productivity per unit of input.
• Technical economies: large firms can use better technology and bulk buying.

Q41. What are constant returns to scale?

When all inputs are increased in the same proportion and output increases in exactly the same proportion.

Q42. What causes constant returns to scale?

They occur when the factors are perfectly divisible and the advantages of large-scale production are exactly cancelled by its disadvantages. In mathematical terms, the production function is homogeneous of degree one.

Q43. What are diminishing returns to scale?

When all inputs are increased in the same proportion but output increases by a smaller proportion.

Q44. What are the causes of diminishing returns to scale?

• Diseconomies of scale: as a firm grows very large, management becomes harder and less effective, so output grows more slowly.
• Limited natural resources: doubling the size of a coal mine may not double output, because deposits are limited.

Producer’s Equilibrium and the Isocost Line

Q45. What is producer’s equilibrium?

The position in which a producer either produces a given output at the lowest possible cost, or gets the maximum output for a given cost. It is found where the isoquant just touches (is tangent to) the isocost line, so MRTS = w / r (the ratio of input prices).

Q46. What is the isocost line?

The isocost line (outlay line or equal-cost line) shows all the combinations of two inputs that a firm can buy for a given total cost, at given input prices.

Q47. What is the shape of the isocost line?

A straight line that cuts both axes. Its equation is C = wL + rK, where w is the wage rate, r is the price of capital, L is labour and K is capital.

Example: C = 1,000, w = 20 and r = 50. If everything is spent on labour, the firm hires 1,000 / 20 = 50 workers. If everything is spent on capital, it buys 1,000 / 50 = 20 units. The line joins these two points.

Q48. What is the slope of the isocost line?

With labour on the horizontal axis and capital on the vertical axis, the slope is -w / r, the ratio of the input prices. In the example it is -20 / 50 = -0.4.

Q49. What causes the isocost line to shift?

• A change in total spending, with input prices unchanged: the line shifts in parallel.
• A change in input prices, with spending unchanged: the line pivots and its slope changes.

Q50. What is the least cost combination of factors?

The combination of inputs that either produces a given output at the lowest cost, or produces the greatest output for a given cost. It is reached when the isoquant is tangent to the isocost line, where MRTS equals the input price ratio.

Quick Revision Points

• Factors: land (rent), labour (wages), capital (interest), entrepreneur (profit).
• Short run: law of variable proportions. Long run: returns to scale.
• MP cuts AP at AP’s maximum. TP is highest when MP = 0. A firm operates in Stage II.
• Isoquants slope downward, are convex to the origin and never intersect.
• Isocost: C = wL + rK, slope -w / r. Equilibrium: MRTS = w / r.

Test yourself with the chapter quiz below, then read the last Economics chapter, Theory of Cost.