The three stages of production are a fundamental economic model used by businesses to analyze how changes in a single variable input affect total output in the short run. This framework applies when at least one factor of production, such as factory size or major equipment, remains fixed. Understanding the order and characteristics of these stages is important for efficient resource allocation, helping managers determine optimal staffing levels and control production costs.
Essential Concepts: Defining the Production Function
The production function is the mathematical relationship between a firm’s inputs and its maximum possible output, analyzed under two time horizons. The short run is defined by the existence of at least one fixed factor of production, meaning a firm cannot instantly change all inputs. Conversely, the long run is the period where all inputs, including capital and space, can be adjusted.
Productivity is measured using three interconnected metrics. Total Product (TP) is the total quantity of output produced by a given amount of input. Marginal Product (MP) measures the change in TP resulting from adding one more unit of the variable input. For example, if hiring a sixth worker increases output from 50 to 58 units, the MP is 8 units.
The third metric is the Average Product (AP), which calculates the total output divided by the total number of variable inputs used. If five workers produce 50 units, the AP is 10 units per worker. The behaviors of these three metrics—TP, MP, and AP—define the three distinct stages of production.
Stage I: Increasing Marginal Returns
Stage I begins when a small amount of variable input is applied to the fixed input, characterized by rapidly increasing productivity. Adding variable inputs, such as hiring additional workers, allows for specialization and better organization of tasks. This division of labor ensures that each new worker contributes more to the total output than the previous one, causing the Marginal Product (MP) to rise quickly.
Throughout Stage I, the Total Product (TP) increases at an increasing rate, reflecting high efficiency gains. The Average Product (AP) also rises because the MP of the new inputs is higher than the existing average output. This stage continues until the AP reaches its highest possible point, signifying the peak efficiency per unit of variable input.
Stage II: Diminishing Positive Returns
Stage II begins the moment the Average Product (AP) is maximized and extends until the Marginal Product (MP) falls to zero. This span is defined by the Law of Diminishing Returns, which states that adding successive units of a variable input to a fixed input causes output to increase at a slower rate. New workers still contribute to production, but not as dramatically as earlier workers.
In this stage, MP remains positive, meaning Total Product (TP) is still rising, but the rate of increase continually slows down. AP begins to fall because each additional worker’s contribution (MP) is less than the average output of the existing workforce. TP continues its upward trajectory throughout Stage II, reaching its absolute maximum only when MP hits zero.
This stage represents the only rational range of production. Operating here allows the firm to maximize its total output by fully utilizing its fixed resources without overcrowding.
Stage III: Negative Marginal Returns
Stage III begins immediately after the Total Product (TP) has reached its peak, coinciding with the point where the Marginal Product (MP) becomes negative. Adding further units of the variable input causes TP to decrease. This negative contribution results from severe overcrowding, where additional workers impede the efficiency of the existing workforce.
For instance, too many workers operating a single piece of machinery may lead to bottlenecks or delays. The Average Product is also declining rapidly throughout Stage III, reflecting a significant drop in overall efficiency. Since total output is actively falling while total costs are increasing, this stage is considered economically irrational.
Practical Application: Why Stage II is the Rational Choice
Firms use the analysis of these three stages to make informed decisions about resource allocation, specifically regarding staffing levels. A business will always avoid operating in Stage I because it is an inefficient use of the fixed resources. By hiring more variable input, the firm could increase the output per worker, thereby lowering the cost per unit of production.
Operating in Stage III is also unsustainable because the firm actively reduces its total output by hiring more workers. This results in higher costs for labor combined with lower total revenue. Therefore, the goal of any profit-maximizing enterprise is to operate somewhere within the boundaries of Stage II.
The exact point within Stage II depends on the relative costs of the variable and fixed inputs. Managers aim to find the optimal balance between labor and capital, maximizing technical efficiency. This strategic use ensures the cost of producing each unit of output is minimized before making significant investments in new fixed inputs.