1.5 Theory of the firm – Production

It is very important to distinguish between short run and long run when talking about production:

  • Short run – period of time when at least one factor of production is fixed (by definition meaning, that one or more are variable). Usually, capital is chosen to be fixed and number of employees (labor) – variable.
  • Long run – period of time when all factors of production are variable.

There are a few definitions that you must know and be able to explain:

  • Total product – total quantity of goods or services produced with given inputs. This simply means the total output being produced.
  • Average product (AP) – quantity of goods or services produced per some quantity of input. Normally, we choose to calculate average product of labour: divide total quantity by number of workers.
  • Marginal product (MP) – the additional quantity added to total product as one more unit of a factor is added. For example, a pizzeria adds one more cook and their total quantity of pizzas produced increases by 50, the marginal product of that additional worker is 50.

See the average product, marginal product and total product diagrams below:

Theory of the Firm - Production: Average Product and Marginal Product diagrams

This diagram illustrates a very important concept in IB economics which you have to understand and be able to clearly explain. It is called the law of diminishing marginal returns. The definition of this law: as more of a variable factor (of production) is added to a fixed factor (of production) the additional to total output will eventually begin to decline. This is a good definition to memorise for your exam. In simple words it means that as you add more of a variable factor of production to fixed factor of production (in an attempt to increase total output) the additions (marginal product) to total output will eventually become negative. It is easier to understand this with an example.

Imagine a kebab truck on a university campus. Say it has one person producing kebabs. Total output per hour is 10 kebabs. If we add another worker, they will divide jobs – one will be preparing the fries and veggies, the other one – meat. Their total production will be 25 kebabs per hour, meaning marginal product of the second worker was 15. If we add another person, who is an expert on dealing with the customers, the previous two guys will concentrate on just cooking and they might be able to start producing 50 kebabs per hour. MP of the 3rd guy = 25 kebabs. MP1 = 10, MP2 = 15, MP3 = 25. The additions to total output are increasing. But what happens if you add another person? He might be able to add 20 kebabs, but not more. And another one? Maybe another 10. So the marginal product started to decline. (The law of diminishing marginal returns kicked in! Actually, for the person who had smaller MP than the previous one is the point at which the law started working.)

Looking at the diagram: until L1 – increasing marginal returns (i.e. MP is increasing), at L1 the law of diminishing marginal returns kicks in and MP starts falling.
Also, as long as the addition to total output of the additional unit of labor is above the average product, average product will keep increasing (until L2). Afterwards, each additional worker will add less than the average so AP will start to decline. You can think of this mathematically: if you have 2+8 = 10, 10/2 = 5 the average of two numbers and you add 11 which is above the average, average will increase: 2+8+11 = 21, 21/3 = 7 and 7 > 5. If however, you added 2 which is below the average, the average would have fallen: 2+8+2 = 12; 12/3 = 4 and 4 < 5.

Total product diagram:

Theory of the Firm - Production: Total product diagram

Up to L1, each unit of labor adds MORE than the previous one (MP3 > MP2 > MP1), hence, total product is increasing in an increasing manner. i.e. the speed of TP growth is increasing.
Recall our previous example of the kebab truck. Is it possible that the marginal product of the 6th worker would be negative? Imagine 6 people in a small kebab truck trying to sell kebabs. They will start getting into each other’s way, they will not be able to hear the orders clearly through all the chattering. And so the 6th added worker could actually decrease total output! Meaning, his MP6 < 0. Let us say L3 is that 6th worker with negative marginal product.
Between L1 and L3 marginal product is still positive (MP > 0) but it is falling. Meaning, TP is still increasing but slower.
At L3, total product begins to fall as each added worker has a negative marginal product.


It is important to understand these concepts as they underlie other topics you will learn. Also, they have asked about this in the essay paper for the microeconomics part in part a for 10 marks – to explain the law of diminishing marginal returns or relationships between average, marginal and total products.