Economics

Economics
Principles &
Applications
Dr. Manoj Mishra
Production
Function
CNLU PATNA
Chapter 5
Firm as a Producer
Managerial
All rights reserved Economics, 2e
©Oxford University
Creation of a firm
• To minimize Transaction costs

• One entity takes the responsibility
to bring all the factors together
required for production
Managerial
©Oxford University
PRODUCTION
• The term “Production” means transformation

of physical “Inputs” into physical “Outputs”.
• Production always results in either creation of
new utilities or addition of values
• It is to be noted that higher levels of production is
an index of progress and growth of an
organization and that of a society.
Managerial
©Oxford University
Production Function
• “A production Function” expresses the technological

or engineering relationship between physical quantity
of inputs employed and physical quantity of outputs
obtained by a firm over a period of time.
• Factor inputs are of two types
• Fixed Inputs: land, buildings, machines … Variable
inputs: raw materials, power…
Managerial
©Oxford University
Production Function
• 1. Short Run Production Function

• 1. Quantities of all inputs constant and only one
variable input will be varied. For example, Law of
Variable Proportions.
• 2. Quantities of all factor inputs are kept constant and
only two variable factor inputs are varied. For
example, Iso-Quants and Iso-Cost curves.
Managerial
©Oxford University
Production Function
2. Long Run Production Function
• The producer will vary the quantities of all factor
inputs, both fixed as well as variable in the same
proportion. For Example, The laws of returns to
scale.
1. The quantity of inputs may be reduced while the quantity of output
may remain same.
• 2. The quantity of output may increase while the quantity of inputs
may remain same.
• 3. The quantity
All rights reserved of output may increase and quantity of2einputs may
Managerial
Economics,
©Oxford University
“Law of Diminishing Returns”
• Assumptions of the Law
1. Only one variable factor unit is to be varied while all other factors should be
kept constant.
❑ Different units of a variable factor are homogeneous.
❑ Techniques of production remain constant.
❑ The law will hold good only for a short and a given period.
❑ There are possibilities for varying the proportion of factor inputs.
Illustration
• A hypothetical production schedule is worked out to explain the operation of
the law.
Managerial
©Oxford University
• Fixed factors = 1 Acre of land + Rs 5000-00 capital.

Variable factor = labor.
• Total Product or Output:
• (TP) It is the output derived from all factors units,
both fixed & variable employed by the producer. It is
also a sum of marginal output.
Managerial
©Oxford University
Managerial
©Oxford University
Managerial
©Oxford University
Motive behind existence of a Firm
• Profits
- economic Profits
- total revenue minus total ‘economic’
costs
• Economic costs are ‘relevant’ costs using

the principle of opportunity costs
Managerial
©Oxford University
Marginal Analysis
• Used to arrive at the profit-maximizing output

level
• Uses the concepts of Marginal revenue and
Marginal Cost
• Marginal revenue is the change in total revenue
due to an additional unit of output
• Marginal cost is the change in total cost due to an
additional unit of output
Managerial
©Oxford University
Production function with Two Variable Inputs
• ISO-Quants and ISO-Costs

• The prime concern of a firm is to workout the
cheapest factor combinations to produce a given
quantity of output.
• Iso-product curve is a technique developed in recent
years to show the equilibrium of a producer with
two variable factor inputs.
• Parallel to …???
• INDIFFERENCE CURVE (FROM CONSUMPTION) Managerial
©Oxford University
Managerial
©Oxford University
Managerial
©Oxford University
• Iso – Quant Map
• Number of Iso Quants representing different amount of out put
are known as Iso-quant map.
• (FROM CONSUMPTION)
Managerial
©Oxford University
• Marginal Rate of Technical Substitution (MRTS)
• It may be defined as the rate at which a factor of production can be substituted for another at the margin without
affecting any change in the quantity of output.
• Law of Diminishing Marginal Rate of Technical Substitution (DMRTS). ROM

CONSUMPTION)
Managerial
©Oxford University
• Properties of Iso- Quants:
1. An Iso-Quant curve slope downwards from left to right.
2. Generally an Iso-Quant curve is convex to the origin.
3. No two Iso-product curves intersect each other.
4. An Iso-product curve lying to the right represents higher
output and vice-versa.
5. Always one Iso-Quant curve need not be parallel to other.
6. It will not touch either X or Y – axis.
Managerial
©Oxford University
• ISO-Cost Line or Curve (FROM CONSUMPTION)
Managerial
©Oxford University
Managerial
©Oxford University
• PRODUCERS EQUILIBRIUM (Optimum factor combination or least cost
combination).
Managerial
©Oxford University
Profit-maximizing Rules
• Rule- The level of output at which MR = MC

• Should this level of output be produced at all?
- Shut Down Rule:
If at the optimal level of output, Average
Revenue is less than Average (economic) Cost,
then, SHUT DOWN.
Managerial
©Oxford University
Long Run Production Function
• Long Run Production Function [Change
In All Factor Inputs In The Same
Proportion]
• Laws of Returns to Scale
• Three Phases of Returns to Scale
• Increasing Returns to Scale:
• Constant Returns to Scale
• Diminishing Returns to Scale
Managerial
©Oxford University
Managerial
©Oxford University
Managerial
©Oxford University
• Increasing Returns to Scale:
• Increasing returns to scale is said to
operate when the producer is increasing
the quantity of all factors [scale] in a
given proportion, output increases more
than proportionately. For example,
when the quantity of all inputs are
increased by 10%, and output increases
by 15%
Managerial
©Oxford University
Increasing Returns to Scale
Managerial
©Oxford University
• Causes for Increasing Returns to Scale
• Increasing returns to scale operate in a firm on account of
several reasons. Some of the most important ones are as
follows:
1. Wider scope for the use of latest tools, equipments, machineries,
techniques etc to increase production and reduce cost per unit.
2. Large-scale production leads to full and complete utilization of
indivisible factor inputs leading to further reduction in production
cost.
3. As the size of the plant increases, more output can be obtained at
lower cost.
Managerial
©Oxford University
• Causes for Increasing Returns to Scale
4. As output increases, it is possible to introduce the principle of division of
labor and specialization, effective supervision and scientific management of the firm etc
would help in reducing cost of operations.
5. As output increases, it becomes possible to enjoy several other kinds of
economies of scale like overhead, financial, marketing and risk-bearing economies etc,
which is responsible for cost reduction.
It is important to note that economies of scale outweigh diseconomies of scale in
case of increasing returns to scale.
Managerial
©Oxford University
• Constant returns to scale is operating
when all factor inputs [scale] are
increased in a given proportion, output
also increases in the same proportion.
When the quantity of all inputs is
increased by 10%, and output also
increases exactly by 10%
Managerial
©Oxford University
Constant Returns to Scale
Managerial
©Oxford University
• Causes for Constant Returns to Scale
• various internal and external economies of scale
are neutralized by internal and external
diseconomies
• Thus, when both internal and external economies
and diseconomies are exactly balanced with each
other, constant returns to scale will operate.
Managerial
©Oxford University
• Diminishing returns to scale is operating
when output increases less than
proportionately when compared the quantity
of inputs used in the production process. For
example, when the quantity of all inputs are
increased by 10%, and output increases by
5%
Managerial
©Oxford University
Diminishing Returns to Scale
Managerial
©Oxford University
• Causes for Diminishing Returns to Scale
1. Emergence of difficulties in co-ordination and control.
2. Difficulty in effective and better supervision.
3. Delays in management decisions.
4. Inefficient and mis-management due to over growth and
expansion of the firm.
5. Productivity and efficiency declines unavoidably after a
point.
Managerial
©Oxford University
Do Firms really maximize Profits?
• Satisficing Theory
• Other Objectives:
- provide good products/services to
customers
- a good work place for employees
- responsibility to society
Managerial
©Oxford University
Control Mechanisms
• Principal – Agency Cost
Therefore CONTROL MECHANISMS
Internal External
-board of Directors - Takeovers
- ESOPs
Managerial
©Oxford University
Non- Profit Firms
• No right to accumulate Profits
• Operate with funds from external sources
• Exempt from Corporate Tax
Managerial
©Oxford University
Public Sector Firms
• Operate in areas where Private sector

will not operate
• Involved in the provision of Public goods
Managerial
©Oxford University
Global firms
• What characterizes MNCs?

- Operations in several countries
- production /trading activities all over the
world
- Substantial direct investment in foreign
countries and actively engaged in the
management
Managerial
©Oxford University
Global firms
• What is attractive about being an MNC?
- Access to multiple sources of supply and markets-

global access
- So rework costs towards higher profits
Managerial
©Oxford University
Global firms
• How to become a MNC?

- Through licensing
- Through exports
- Through Foreign Direct Investments

Managerial
©Oxford University
Global firms
• Complications:
- Coping with country specific features
- Differences in factor costs
- Differing contexts complicate competitive

strategies
Managerial
©Oxford University
Chapter 6
Analysis of Production
Managerial Economics,
All rights reserved 2e
©Oxford University
Production function
• A production function is a functional
specification that provides the most
efficient combination of input with
which a chosen target level of output
can be produced
• It is specific to each industry and
technology
©Oxford University
Short and long run
• Short
run: a period during which a firm has
to work with some fixed factors which
cannot be reduced or increased.
- has no correspondence to the calendar
period
- Long run: a period where no factor is
fixed. Managerial Economics,
©Oxford University
Production function with one variable input
• Total Product: Q = 30L+20L2-L3

• Average Product : Q /L
• Marginal Product : MP = dQ/dL =
30+40L-L2
Also called Short run Production
function
©Oxford University
Short run production function
• Law of diminishing returns
- Marginal Product of the variable input

eventually diminishes.
©Oxford University
Three Stages of Production
• Stage 1: AP is increasing, MP is increasing and
Production Elasticity is > 1.
• Stage 2: AP and MP are decreasing and Production
Elasticity is 0 < Prod.Elas < 1
• Stage 3: MP and AP continue to decrease and
Production Elasticity < 0.
©Oxford University
Production Elasticity
• ∆Q / ∆X * X / Q = MPx * 1 / APx
©Oxford University
Optimal Input Levels
• With one variable input:
Marginal Revenue Product (MRP) = Marginal
Variable Cost.
MRP = MP * MR
• With many variable inputs:
MPL / PL = MPK / PK = ……….
©Oxford University
Production Function with two variable
inputs
• Q = f (K , L) where K is capital and L is labour

Also called Long run Production function
©Oxford University
Isoquants
• Graphical representation of production

function
• A curve drawn through the technically
feasible combinations of inputs to produce a
target level of output
©Oxford University
Map of Isoquants
Output 260
Output 200
Output 160
©Oxford University
Properties of Isoquants
• They are downward sloping – diminishing Marginal Rate
of Technical Substitution
MRTS
• They are convex to the origin
• They do not intersect

©Oxford University
Elasticity of substitution
• ( % change in K/L) / ( % change in MRTS)
• Denoted by ‘σ’- All about the curvature of the isoquant

• The ease with which a production process can shift from
labor intensive to capital intensive
©Oxford University
Optimal combination of inputs
• The case of Long run Production function:
• Slope of the isocost line = MRTS
©Oxford University
Returns to scale
• The rate at which output changes when all

inputs change by the same proportion-
called Scale change
©Oxford University
Returns to Scale
• Increasing Returns to ScaleWhen output

increases by a proportion greater than the
proportionate increase in all inputs.
• Decreasing returns to scale
• Constant returns to scale
©Oxford University
Cobb – Douglas Production Function
• Q = A Lα Kβ
Where, α + β indicates Returns to Scale

If > 1, it exhibits Increasing Returns to Scale
If < 1, it exhibits Decreasing Returns to Scale
If = 1, it exhibits Constant Returns to Scale
©Oxford University
Estimation of Production functions
• Cobb Douglas function can be estimated

using the Linear Regression technique in
Log form.
• The coefficients will be the elasticities
©Oxford University
Euler’s Theorem
• if the production function is linearly

homogeneous, and if each input is acquired at a
price equal to its marginal product, then the total
amount paid to all the inputs put together will
exactly exhaust the value of the total output.
©Oxford University
Isoproduct curves and production frontier
• ‘isoproduct’ curve would give the

combinations of outputs that these two
levels of inputs can produce, assuming that
production is most efficient and the inputs
are completely exhausted.
• Also called Production frontier
©Oxford University
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Economics - 4

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• To minimize Transaction costs

• The term “Production” means transformation

• “A production Function” expresses the technological

• 1. Short Run Production Function

• Fixed factors = 1 Acre of land + Rs 5000-00 capital.

• Economic costs are ‘relevant’ costs using

• Used to arrive at the profit-maximizing output

• ISO-Quants and ISO-Costs

• Law of Diminishing Marginal Rate of Technical Substitution (DMRTS). ROM

• Rule- The level of output at which MR = MC

• No right to accumulate Profits

• Operate with funds from external sources

• Exempt from Corporate Tax

• Operate in areas where Private sector

• Involved in the provision of Public goods

• What characterizes MNCs?

• What is attractive about being an MNC?

- Access to multiple sources of supply and markets-

- So rework costs towards higher profits

• How to become a MNC?

- Through Foreign Direct Investments

- Differences in factor costs

- Differing contexts complicate competitive

• Total Product: Q = 30L+20L2-L3

• Law of diminishing returns

- Marginal Product of the variable input

• Q = f (K , L) where K is capital and L is labour

• Graphical representation of production

• They are convex to the origin

• They do not intersect

• ( % change in K/L) / ( % change in MRTS)

• Denoted by ‘σ’- All about the curvature of the isoquant

• Slope of the isocost line = MRTS

• The rate at which output changes when all

• Increasing Returns to ScaleWhen output

Where, α + β indicates Returns to Scale

• Cobb Douglas function can be estimated

• if the production function is linearly

• ‘isoproduct’ curve would give the

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