Theory of Production

 Concept of production and production function(short-run

and long run)
 Total , average and marginal product and derivation
 Law of variable proportion
 Law of returns to scale
 General numerical examples
Production:
Production is the result of co-operation of four factors of
production viz., land, labour, capital and organization.
Production may be defined as any activity whether physical or
mental which is directed to the satisfaction of other people’s
wants through exchange.” J.R Hicks
The aim of the producer is to maximize his/her profit.
The producer secures the best combination by applying the
principles of equi-marginal returns and substitution.
According to the principle of equi-marginal returns, any
producer can have maximum production only when the marginal
returns of all the factors of production are equal to one another.
For instance, when the marginal product of the land is equal to
that of labour, capital and organization, the production becomes
maximum.
Meaning of Production Function:
Production function refers to the functional relationship
between the quantity of a good produced (output) and factors
of production (inputs).
Defined production function as “the relation between a firm’s
physical production (output) and the material factors of
production (inputs).” Prof. Watson. Mathematically,
Q = f( L, K, R, Ld, T, t, M)
where
Q = output R= Raw Material
L= Labour Ld = Land
K= Capital T = Technology
t = time M = Management
For our current analysis, let’s reduce the inputs to two, capital (K)
and labor (L):
Q = f(L, K)
Types of Production function:
 Short – run production function:
Short run is time interval which is too short to change all factors of production.
Short term production function is defined as functional relationship between factor
input and output where some factors are assumed to be constant(say capital K )
and some factors are assumed variables( say labour L). Symbolically,
Q = f ( L, K¯)
The bar over the variable k means fixed for the short run. In short run firm do not
use extra fixed factors. Law of variable proportion(diminishing return) is used in
short run.
 Long - run production function:
Long run refers to a period of time which is long enough to allow the firms to
change the quantities of all resources. Long term production function is defined as
functional relationship between factor input and output where all the factors of
productions are variables.
Q = f ( L, K)
In long run production, firm expands its branch, machinery etc. production theory
viz. return to scale is used.
 Total product (TP):
The total amounts of a output produced by a firm or an industry employing various
units of inputs(ceteris paribus) in a period of time is known as total product.
Total production refers to the sum of marginal product.
TP =
Where,
TP = total production
MP = marginal product
Average production (AP):
Average production of a factor which is obtained by dividing the total production,
by number of input used in production or it is the per unit output produced by
factors used.
      

Where, TP = AP x L
APL = average product of labor TP = AP x C
APC = average product of capital
TP = total product
L = no. of labors
C = capital
Marginal production (MP):
Marginal production of an input is the change in TP due to change in an additional
unit of input in production. Mathematically,
           

Where,
MPL = marginal production of labor
∆TP = change in total product
∆L = change in no. of labor
Alternatively,
MPL = TPn – TPn-1
Law of Variable Proportion (Diminishing Returns)
This law is related to short run production function. In the short run if we want to
change output we can change only variable factor but not the fixed factor.

This law states that, if we increase the amount of variable factor (labour) keeping
the amounts of fixed input( capital) constant, then the total product initially
increases at increasing rate, then it increases at decreasing rate, becomes
maximum and ultimately total product begins to fall.
Mathematically
Q = f ( L, K¯)
Where Q = Output
L = Labour
K¯ = Fixed capital
“An increase in some inputs relative to other fixed inputs will in a given state of
technology cause output to increase, but after a point the extra output resulting
from the same additions of extra inputs will become less and less.” Samuelson

It states that;” keeping some factor constant(capital), if another factors (labour)

are increased in a certain proportion, output increases at a varying proportion.
Marshall: “An increase in the capital and labour applied in the cultivation of land
causes in general a less than proportionate increase in the amount of product
raised unless it happens to coincide with an improvement in the arts of
agriculture.”
Assumptions:
1.Constant state of Technology: It is assumed that the state of technology will
be constant and with improvements in the technology, the production will
improve.
2.Variable Factor Proportions: This assumes that factors of production are
variable. The law is not valid, if factors of production are fixed.
3.Homogeneous factor units: This assumes that all the units produced are
identical in quality, quantity and price.
4.Short Run: This assumes that this law is applicable for those systems that are
operating for a short term, where it is not possible to alter all factor inputs.
 Illustration of TP, MP, AP
Unit of labour L Capital K Total Product Marginal Product Average
(Variable) (Constant TP MP(MPL = TPn – TPn-1) Product AP
) AP = TP/L
0 10 0 0 0
1 10 10 10 – 0 = 10 10
2 10 30 (TP inc) 30 – 10 = 20 15
3 10 60 60 -30 = 30 Max 20
4 10 80 80 -60 = 20 20 First Stage
5 10 90 constant 90 – 80 =10 Dim 18 Second Stage
6 10 90 90 -90 = 0 15
7 10 80 dec 80 – 90 = -10 neg 11.4 Third Stage
 Chart Title
100

80

60 Third
TP Second Stage Stage
First Stage
40
AP

20MP

0
1 2 3 4 5 6 7
Unit of labour
-20
Three Stages of the Law
1.Stage I (Increasing return)– The TP increases at an increasing rate and the MP
increases too. The MP increases with an increase in the units of the variable factor.
Therefore, it is also called the stage of increasing returns.
Causes of increasing returns in the first stage:
 Increase in efficiency of fixed factor.
 Increase in efficiency of variable factor.

2. Stage II (Decreasing returns) – The TP continues to increase but at a diminishing

rate. However, the increase is positive. Further, the MP decreases with an increase
in the number of units of the variable factor. Hence, it is called the stage of
diminishing returns.
Causes of decreasing returns in second stage:
• Scarcity of fixed factor
• Overstaffing reduces productivity
3. Stage III (Negative returns) – Now, the TP starts declining, MP decreases and
becomes negative. Therefore, it is called the stage of negative returns.
• Overload for management(too much cooks spoil broth)
Stages of Operation of the firm:
Stage I
The marginal product increases with an increase in the variable factor.
Therefore, the producer can employ more units of the variable to efficiently utilize
the fixed factors. Hence, the producer would prefer to not stop in Stage I but will try
to expand further.
Stage III
Producers do not like to operate in Stage III either. In this stage, there is a decline in
total product and the marginal product becomes negative.
In order to increase the output, producers reduce the amount of variable factor.
However, in Stage III, s/he suffers higher costs and also gets lesser revenue thereby
getting reduced profits.
Stage II
Any rational producer avoids the first as well as third stages of production.
Therefore, producers prefer Stage II – the stage of diminishing returns. This stage is
the most relevant stage of operation for a producer according to the law of variable
proportions.
Applicability of the Law of Variable Proportions:
The law of variable proportions applies to any field of production where some factors
are fixed and others are variable.
That is why it is called the law of universal application.
1. Application to Agriculture:
With a view of raising agricultural production, labour and capital can be increased to
any extent but not the land, being fixed factor. Thus, when more and more units of
variable factors like labour and capital are applied to a fixed factor then their
marginal product starts to diminish and this law becomes operative.
2. Application to Industries: It is only applicable in mining……
Why Application of the law of variable proportions in agriculture?
1.Predominant role of nature:
2. Land as fixed factor:
In an economy the supply of land is fixed so production can be changed only by
changing the proportion of labor and capital in relation to land. Due to the excess
burden of these factor marginal productivity of land starts to decline.
3.Less scope of division of labor:
There is limited scope of division of labor in agriculture sector than industrial
sector. As additional units of labor capital are applied without any extension of
division of labor invites law of diminishing return to scale.
4. Less supervision:
Cultivated areas are spread far and wide. It is physically very difficult to exercise
adequate supervision. It causes diminishing returns.
5. Less use of machines:
There is less possibility to use machines in agriculture in comparison to industry.
Due to inadequate use of machines in agriculture, output tends to diminish.
6.Differences in fertility of land:
Some lands are more fertile and sore are less fertile. As the demand for agricultural
output increases, less and less fertile land also comes under cultivation.
The Laws of returns to scale

The law of returns scale is the long run concept of production theory. In the long
run all the factors of production are changeable. So, this law explains the rate of
change in output due to the same proportionate change in input i.e. labor and
capital.

According to this theory production process may have three kinds of returns to
scale. They are:
• Increasing return to scale
• Constant return to scale and
• Decreasing return to scale
Assumption of Laws of Return to Scale
 All factors of productions are variables
 No change in production tools and techniques
 Based on long run production function
 Perfect competition in market
 Homogeneous factors input
Increasing returns to scale (IRS):
If all inputs are doubled then all the output will be increased more than double.
Causes:
Division of labour
Specialization in management and machine
Proper utilization of resources
Unit of Unit of Sum of Output Increasing Return to Scale
labour capital L and (TP)
K 35
30
1 1 2 5 25
TP 20
2 2 4 12 15
10
4 4 8 30
5
0
2 4 8

Column2 L+K
Constant Returns to Scale:
 
When all inputs are increased by a certain percentage, the output increases by the
same percentage, the production function is said to exhibit constant returns to
scale.
For example, if a firm doubles inputs, it doubles output.
It occurs due to indivisibility of fixed factors. Chart Title
25
Unit of Unit Sum of L Output
20
Labour Capital and K TP)
1 1 2 5 15

2 2 4 10
10
4 4 8 20
5

0
2 4 8

Column2
Diminishing Returns to Scale:
 
The term 'diminishing' returns to scale refers to scale where output increases in a
smaller proportion than the increase in all inputs.
For example, if a firm increases inputs by double but the output increases by less
than double, the firm is said to exhibit decreasing returns to scale.
Causes: Difficulty in coordination and management
Technical diseconomies
Exhaustibility of resources
Unit of Unit of Sum of L Output
Labour Capital and K (TP)
1 1 2 5
2 2 4 7
4 4 8 12
1. Consider the
following table.
2. Complete the above Labour Capital Total TP MP
schedule. unit of
3. Explain the type of input(L
return to scale. +K)
1 2 3 8 0 Increasing
2 4 6 10 10-8=2 Return
3 6 9 18 8 To scale
4 8 12 28 10 Constant return
5 10 15 38 10 To scale
6 12 18 48 10
7 14 21 56 8 Diminishing
8 16 24 62 6 return
to scale
 Chart Title
12

10
Constant
In return Dimi
8 cr nishi
ea ng
MP si
6
retur
n n
g
4 re
tu
2 rn

0
3 6 9 12 15 18 21 24
L+K
 Isoquant:
(composed of two terms ‘iso’ and ‘quant’).
Iso is a Greek word which means equal
and quant is a Latin word which means quantity.

An isoquant curve is the representation of a set of locus of different combinations of

two inputs (labor and capital) which yield the same level of output.
It is also known as or equal product curve or producer’s indifference curve.
Assumptions of Isoquant Curve
1.Only two inputs (labor and capital) are employed to produce a goods.
2.No change in production tools and techniques
3.Labor and capital are divisible.
4.The producer must be rational, i.e. trying to maximize his profit.
5.Marginal rate of technical substitution diminishes in production process.
6.Two inputs are substitutable to each other at diminishing rate up to a level.
 Isoquant Schedule
Isoquant graph
Combinatio Unit of Unit of Output(TP)
ns labour X capital Y 16

axis axis 14

A 1 15 100 12

B 2 11 100 10

8
C 3 8 100
6
D 4 6 100
4
E 5 5 100
2

0
1 2 3 4 5
Properties of Iso-quant Curves
1. Iso-quant Curves Slope Downward from Left to Right
2. An isoquant is convex to the origin because of the diminishing marginal rate
of technical substitution.
MRTS may be defined as the amount of factor x (labour) which can be
replaced by one unit of factor y (capital), the level of output remaining
unchanged.
MRTS =  ∆K/ ∆L
MRTS = dk/dl
3. Right Isoquant Indicates Higher Output than Left Isoquant:
4. Two or More Isoquants May or May Not Be Parallel.
5. Negative Slope: To increase the number of units for one factor, the
producer has to decrease the units of the other production factor. This
principle leads to negative sloping of the isoquant curve.
6. Two or More Isoquants Never Intersect: We can say that they cannot have
any combination of factors in common. Thus, the two curves can never
intersect one another.
Isoquant Map
An isoquant map is a set of isoquants that shows the maximum attainable
output from any given combination inputs.
 Law of returns to scale (alternative method using isoquant )
The law of returns to scale is a long term phenomenon.
Increasing returns to scale:-
When the increase in the output is in greater proportion than the increase in the
input, then it is the case of increasing returns to scale. For example, if all the inputs
are increased by 10%, then the output increases by more than 10%. The major
causes of increasing returns to scale are better combination and utilization of
resources, managerial efficiency, marketing efficiency, etc.

100 units of output require 3C + 3L=6(input)

200 units of output require 5C + 5L= 10
300 units of output require 6C + 6L=12
In increasing return to scale , less input
Provides equal output.
 Constant returns to scale:-
              When the increments in the outputs are in the same proportion with
the increase in input, then it is the case of constant returns to scale. For
example; if all the inputs are increased by 10%, then the output also increases
by 10%. 

100 units of output require 2C+2L=4(input)

200 units of output require 4C+4L= 8
300 units of output require 6C+6L=12
In constant return to scale , equal input
provides equal output.
Decreasing returns to scale
When the increase in the output is in less proportion than the increase in input,
then it is the case of decreasing returns to scale. For example, if all the inputs are
increased by 10%, then the output increases by less than 10%. The major causes
of decreasing returns to scale are managerial inefficiency, poor combination, and
utilization of resources, labor problem and exhaustibility of natural resources.

100 units of output require 2C+2L=4(input)

200 units of output require 5C+5L= 10
300 units of output require 9C+9L=18
In diminishing return to scale , more input
Provides less output.