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Production Theory -- Introduction

Management has been described as decision making. Among the many decisions that managers make are questions about producing a good or service to achieve the goal of earning a profit. The questions include "what product should I produce," "how should I produce this product," and "how much should I produce" to maximize profit.

Or more practically, the questions might be "Should I change the way I produce my product to increase profit? Should I use a different quantity of the input to increase profit? Should I use a different input? Should I use a different combination of inputs? Should I try to produce more or less of the product? Should I produce a slightly different product? Should I make a major change by producing an entirely different product, and the list of questions goes on. What is consistent among these questions is the objective of earning a profit or increasing profit, and the need to analyze the business operation.

The answer to these questions is unique for each business and the manager needs to make these decisions. No one can make these decisions for the manager. It is his or her responsibility to consider these important issues.

Even though the goal of increasing profit may be the primary criterion for these decisions, it may not be the only criteria. However for the purpose of this discussion, it is assumed that the manager will always strive to make the decision that maximizes profit.

The purpose of this series of web pages is to review economic concepts that can help managers analyze their business situations. The explanation will not answer the managers' questions nor will it provide the detailed data needed to analyze the business' alternatives. Instead, the explanation provides a conceptual framework with which managers can assess their own opportunities.

The economic concepts reviewed in these pages can be referred to as production theory, and addresses the three questions introduced above -- what product should I produce to maximize profit, how should I produce the product to maximize profit, and how much of the product should I produce to maximize profit. The majority of the discussion addresses the third question -- how much should I produce. The other two questions are briefly addressed thereafter.

Note that each of these questions is based on the premise that one of the manager's goal is to maximize profit.

Throughout this discussion, an underlying proposition is that diminishing marginal productivity is real. This bit of reality will be the foundation for all of this discussion. Diminishing marginal productivity is discussed more fully on a subsequent page.

How much output or product should the business produce to maximize profit (factor-product)

The purpose of this series of web pages is to present a general overview of several economic concepts relating to the broad topic of production theory. The topics include

• diminishing marginal productivity
• the production function
• stages of production
• determining the profit maximizing quantity of variable input and profit maximizing level of production
• determining demand for the variable input
• defining and determining the cost of producing the product
• determining supply of the product, and
• minimizing loss if the business is unable to generate a profit

Embedded in these topics are secondary discussions about 1) short-run versus long-run, 2) fixed inputs and variable inputs, and 3) fixed costs and variable costs. The discussion often uses "advancing technology" as an example to illustrate the application of these economic concepts. A relationship between enterprise analysis and production response also is suggested.

Several assumptions form the foundation for this discussion. The first assumption (as already introduced) is that the manager wants to produce the quantity of output that will maximize profit. A second assumption is that the business can increase production or output by using more input, and that increased output means increased profit.

As the second assumption is discussed in subsequent sections, it will become clear that this assumption is NOT always true. There are times when using more input will increase production and increase profit, but there also are times when using more input will increase output but decrease profit. Furthermore, there are times when using more input decreases production and profit.

Increasing input will NOT always lead to increased profit. Accordingly, the manager will not want to maximize production, but instead will want to use the level of input that produces the level of output that achieves the goal of maximizing profit.

The manager's task is to determine the profit maximizing level of quantity or level of input. The manager's decision could be restated as "how much input should I use to maximize profit."

This web page introduces why the answer to the simple question of "how much should I produce" is complex. The page also introduces how a manager can decide how much input to use to maximize profit.

Although the stated goal for managers may be to maximize profit, some of the concepts addressed on these pages also can be illustrated with other examples. For example, there are many recipes for making a chocolate cake but the recipes differ and thus the resulting cakes may differ. Despite these differences, those of us who enjoy chocolate cake would likely find many of these cakes to be acceptable, that is, they are substitutable even though they are not identical.

A third assumption is that there is more than one way or one "recipe" for producing a product. Take the example of a chocolate cake but think about it from a slightly different perspective. Instead of asking "how much input should I use to maximize profit," a baker may ask " how much chocolate should I use in making the cake?" That is, the baker could bake several cakes using the same amount of flour, sugar and milk and the same number of eggs, but vary the amount of chocolate in each cake. The cake made with a small quantity of chocolate may not have much flavor and thus not achieve the goal of baking a good chocolate cake. At the other extreme if the baker uses a large quantity of chocolate in one cake, the flavor may be bitter. Neither of these decisions achieve the goal of baking a good chocolate cake. Some quantity of chocolate between these two extremes will likely result in an acceptable cake.

A similar situation can arise for a wheat farmer who uses a small quantity of fertilizer per acre; the farmer may not reach the yield potential for the acre of land. However, using a large quantity of fertilizer may diminish production; that is, too much fertilizer can stunt the growth of the crop. Somewhere between these two extremes is the quantity of fertilizer that achieves the farmer's goal of maximizing profit from raising wheat on the acre of land.

There is more than one way to produce a product and the "recipe" that one business uses will be different than the recipe used by another business. Each manager must determine the "recipe" the works best for his or her business. What one manager does may not make sense for another manager. Each manager needs the skills to decide which "recipe" is most appropriate for his or her business.

In summary, the purpose of these materials is to introduce principles, including economic principles that help describe a decision making process for the baker, the farmer and many other managers. Restated, this series of web pages demonstrates that these economic concepts are relevant in making numerous production decisions.

• The discussion initially assumes the managers (the decision makers) know what product (good or service) they want to produce.
• The discussion recognizes that there are different ways to produce similar products.
• The discussion also initially assumes that the managers know how to produce the product; that is, the managers have a general understanding of how they want to produce the product. Restated, the manager has determined what technology will be used to produce the product and what inputs will be used in the production process.
• The discussion assumes a goal for the manager is to earn a profit from producing and selling the product. This goal is often stated as maximizing profit, but maximizing profit may not always be the managers' only goal.
• Adding inputs is expected to increase production and profit, but in reality, adding inputs can decrease profit and in some situations, decrease production.
• The purpose for these materials is to help decision makers understand how to analyze their business in order to make decisions that will advance the goal of earning a profit.

The next section introduces the concept of diminishing marginal productivity -- a natural phenomenon that impacts decision making.

Last Updated September 14, 2010

Email: David.Saxowsky@ndsu.edu

This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.

E-Mail:sswandal@ndsuext.nodak.edu
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