THE PRODUCTION PROCESS

Production is a process in which economic resources or inputs (composed of natural

resources, labour and capital equipment) are combined by entrepreneurs in order to create
goods and services (output or products). Thus, the production process can be thought
of; as transforming inputs into outputs. For example, a sugar mill uses such inputs as labour,
raw material like sugarcane and capital invested in machinery, factory building to produce
sugar. In fact, “production is any activity that increases consumer usability of goods and
services”. Thus, production consists of producing, storing, and distributing tangible goods
and services. The intangible goods and services include banking, insurance, education etc.
In this process, both desired and undesired goods and services are resulted. In economics the
basic factors of production and their rewards are as follows:
INPUTS DEFINITION REWARD
1. Land All that is gifted by nature Rent
2. Labour Physical and mental effort spent in producing Wages
goods and services
3. Capital Man-made means of production like Interest
machinery, factory building etc.
4. Entrepreneurship Co-ordination and control of all inputs to Profit
produce output and take risk in business.

Broadly, all these inputs are classified into two categories:

1. Fixed inputs – where the quantity cannot be varied during the period of production under
consideration. Plant and equipment are examples of fixed inputs.
2. Variable inputs- an input whose quantity can be changed during the period of production
under consideration. Example- Raw materials, labour, power, transportation etc.

Production Function
A production function is a mathematical expression of relation between the inputs and
outputs of the production process. In its general form it states that the level of output is
dependent on the level of various inputs. Every firm uses factors of production such as land,
labour, capital etc., in the process of production. The relationship between the input a firm
uses and the physical quantity of output is the production. A generalized one variable
production can be written as Q = f(L) where Q is quantity of output, f is the functional
relation between input and output and L represents the quantity of labour utilized in the
process. It may however be noted that there are many cases where output is dependent on a
combination of more than one factor of production. For example, when we take into account
of capital (K) and labour (L) as factors of production then the production function assumes
the form Q = f ( K, L).
 However the production function implies that output Q is a result of combining a
variable input, say X, with fixed quantities of other inputs.

A factor of production is called ‘fixed resources’ if its quantity cannot be varied

during the production period. However, if its quantity can be varied during production
period is known as ‘Variable resource’. All resources used in production function is a
snapshot of a production process at a particular point of time. Since various technologies are
available in the production of a particular product, managers intend to use most productive
technology.

Conventionally economists treat labour as a variable factor and capital as a fixed

factor of production in case of short-run application. Resources may be fixed due to various
reasons. For example an automobile manufacturer might want to investigate various fuel
mixtures for petrol mileage, but the assumption is that engine will not be changed, for the
automobile is fixed in terms of engine technology.

The distinction between variable and fixed resources is used to clarify the time periods
involved t in the process of production as follows

1. Very short-run (time so short that all resources are fixed)

2. Short-run (at least one resources is fixed and at least one can be varied.)

3. Long-run ( long time period that all resources can be varied.)

The above time period helps clarifying production situation and simplify economic
analysis and decision making. In most production process, there exist a long time,
gestation period between decision and actual implementation. The short and long runs,
however, refer only to input relationship and not to precise chronological periods.

Production function with one variable (short run)

The output of any process is the result of the combination of many factors : one of
which may be variable and one other fixed. Thus Q = f (X1,X2,X3,..........Xn) Where X1,
X2, X3, etc. are all factors and X1 is variable and others are fixed. The time period is short-
run and some of the inputs are fixed.

In short-run, production function is also known as ‘Single Variable Production.’ In the long
run all inputs are variable.
THE LAW OF VARIABLE PROPORTIONS

The law of Variable Proportions plays an important role in economic theory. This
law examines the production function with one factor variable keeping the quantities of other
factors fixed. In other words, it refers to the input - output relation when the output is
increased by varying the quantity of one input. Since under this law we study the effects on
output of variations in factor production. This is known as the law of variable proportions.

The law of variable proportion is the new name of the famous law of diminishing
returns of classical economists. This law has been variously defined by different economists.
“As equal increments of one input are added, the inputs of other productive resources being
held constant beyond a certain point, the resulting increments of product will decrease, that
is marginal product will diminish.” - G.J. Stigler

“In the words of Prof. F. Benham, “ As the proportion of one factor in a combination
of factors is increased, after a point, first the marginal and then the average product of that
factor will diminish.”

Marshall discussed the law of diminishing returns in relation of agriculture. He

defines the law as follows: “ 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.”

It is clear from the above definitions of the law of variable proportions that it refers to
the behavior of output. As the quantity of one factor is increased, keeping the quantity of
other factors fixed and further it states that marginal and the average product will eventually
decline.

Assumptions of the Law

1. The state of technology is assumed to be given and unchanged.

2. There must be some inputs whose quantity is kept fixed.
3. The law is based upon the possibility of varying proportions in which the various factors
can be combined to produce the product.
4. The law does not apply to those cases where factors must be used in fixed proportions to
yield a product.
5. The additional units of the variable factor should be identical units.
Three stages of the Law of Variable Proportions (L V P)

The behavior of the output when the varying quantity of one factor is combined with
a fixed quantity of the other can be divided into three distinct stages. A graphical illustration
of the L V P is given below:

In the diagram the quantity of variable factors are measured in the x-axis the total product
TP, average product AP and marginal product MP in the in the y-axis.

Stage I

In this stage TP increases at an increasing rate up to a point. From the point F onwards the TP
curve increases at a diminishing rate. Corresponding to this point the MP starts declining.
The stage I end where the AP curve reaches its highest point. This stage is known as
increasing returns of scale because AP of variable factor increases through out this stage.

In the beginning the quantity of the fixed factor is abundant related to the quantity of variable
factor. Therefore, when more and more units of variable factor is added to the constant fixed
factor, the fixed factor is intensively and effectively utilized. This leads to increasing returns
in the first stage. The reason for the operation of the increasing returns is the relative
abundance of the fixed factor in the beginning compared to variable factors. This is due to
the indivisibility of the fixed factor.

Stage II

In the second stage, the total product continues to increase at a diminishing rate until it
reaches its maximum point H where the second stage ends. In this stage, MP and AP of the
variable factors are diminishing but positive. At the end of the second stage at M MP is zero,
corresponding to the highest point of H of the TP. This stage is known as the stage of
diminishing returns as both MP and AP of the variable factors continues to fall during this
stage.

Why diminishing returns?

Once the point is reached at which the amount of variable factor is sufficient to ensure the
efficient utilization of the fixed factor, then further increases in the variable factor will cause
MP and AP to decline because the fixed factor then becomes inadequate relative to the
quantity of the variable factor.

The additional units of the variable factors have less and less of the fixed factor to
work with. The phenomenon of diminishing returns depends upon the indivisibility of the
fixed factors.

Stage III

Total Product declines, therefore the T P curve slopes downwards. In this stage, MP
is negative and variable factors are too much relative to the fixed factor. The phenomenon of
negative returns in stage III is because the number of variable factor becomes too excessive
relative to the fixed factor.

Stage of Operation

Now in which stage the rational producer will seek to produce? Stage I and III are
non-economic regions in production. A rational producer will seek to produce in stage II.
According to Joan Robinson, the Law of Variable Proportions operates because of the two
factors.
1) Elasticity of the substitution between factors is not infinite.
2) There is scarcity of various factors of production.
It helps them in two ways. That is 1) how to obtain the optimum output form the given set
of inputs. 2) to determine the least cost factor combination of production planning.
1) How to obtain a given output from a minimum set of inputs. The value of utility of
employing variable input factors in the production can be better judged by the help of
production function. Additional employment of the various inputs is desirable only when
the marginal revenue productivity of variable factor is more than its price. It is rational to
stop the additional employment of the variable factor at a point where the marginal
revenue productivity equals its price. The production function where all factors are
variable is highly useful in making long-run decisions.

PRODUCTION FUNCTION WITH TWO VARIABLES

A method of production (process, activity) is a combination of factor inputs required for the
production of one unit of output.
Usually a commodity may be produced by various methods of production.

Process P1 P2 P3
Labour units 2 3 1
Capital units 3 2 4

A method of production A is technically efficient relative to any other method B, if A uses

less of at least one factor and no more from the other factors as compared with B.
Process A B
Labour units 2 3
Capital units 3 3
Equal Product Combinations

Combinations Factor X Factor Y Total output

A 1 12 100

B 2 8 100

C 3 5 100

D 4 3 100

E 5 2 100
Marginal Rate of Technical Substitution
• It may be defined as the rate at which a factor of production can be substituted for
another at the margin without any change in the quantity of output.
• For example, MRTS of X for Y is the number of units of Y that can be replaced by
one unit of factor X, quantity of output remaining the same.
Combinations Factor X Factor Y M R T S of X for
Y

A 1 12 nil

B 2 8 1:4

C 3 5 1:3

D 4 3 1:2

E 5 2 1:1

Marginal Rate of Technical Substitution

• It may be defined as the rate at which a factor of production can be substituted for
another at the margin without any change in the quantity of output.
• For example, MRTS of X for Y is the number of units of Y that can be replaced by
one unit of factor X, quantity of output remaining the same.

ISO-QUANT

• Iso-quant is the locus of all technically efficient methods (or all the combinations of
factors of production) for producing a given level of output.
• The shape of the iso-quant depends on the substitutability of the factors of production.

Properties of iso-quants are similar to those of indifference curves. The important

properties are the following.
• 1. They slope downwards from left to right.
• 2. Generally they are convex to the origin.
• 3. No two iso-quants intersect each other.
• 4. An iso-quant lying to the right represents higher output and vice-versa.
• 5. They need not be parallel to each other always.
LINEAR ISO-QUANT
• Perfect substitutability of factors of production.
• Only labour and zero capital or only capital and zero capital, or by infinite
combination of K and L

INPUT-OUTPUT ISO-QUANT
• Strict complementarity (that is zero substitutability) of the factors of production
• Right angle iso-quant
• Only one method of production
• Also called as Leontief isoquant

KINKED ISO-QUANT
• Limited substitutability of K and L
• Only few processes of producing the output
• Substitutability only at the kinks
• Also called ‘activity analysis isoquant’ or ‘linear programming isoquant
Iso-cost line or Iso-cost curve
• It is a parallel concept to the budget or price line of the consumer.
• It indicates the different combinations of the two inputs which the firm can purchase
at given prices with a given outlay.
• Let us suppose that a producer wants to spend Rs. 3000 to purchase factor X and Y. If
the price of X per unit is Rs.100, he can purchase 30 units of X. similarly if the price
of factor Y is Rs.50, he can purchase 60 units of Y.

PRODUCER’S EQUILIBRIUM
• The intention of a producer is to maximize the profits. This will become possible
when he produces the highest output at the lowest cost of production.
• Hence, the producer selects the least cost combination of the factors of production.
Cobb-Douglas production function

Paul H. Douglas and C.W. Cobb formulated a statistical production function. Q = K

LC
Where Q = output, L= quantity of labour employed, C = quantity of capital employed. K is
a positive constant, x is a fraction and measures a percentage, response of output to the
percentage change in L and 1-x measures the percentage response of output to a given
change in C.

Profit = the difference between total revenue and total cost

Profit per unit = AR - ATC

A firm adds to profits if marginal revenue from selling an extra unit is greater than the
marginal cost of production

Break-even output occurs when AR=ATC

Revenue maximization is when MR = zero

Profit maximisation occurs at the output where MR = MC