PRODUCTION ANALYSIS

Classification of Factors of Production:

A factor of production may be defined as that good or service which is required for
production. A factor of production is indispensable for production because without it no
production is possible. It is customary to attribute the process of production to three factors,
land, labour and capital, to which we add organisation.

1. Land:
In economics, land as a factor of production does not refer only to the surface of land but to
all gifts of nature, such as rivers, oceans, climate, mountains, fisheries, mines, forests, etc. In
the words of Dr. Marshall “By land is meant materials and forces which nature gives freely for
man’s aid, in land, water, in air, light and heat.” Land is, thus, an important factor of
production which helps in the production of goods and services in one way or the other.

Characteristics of land:

• Free gift of nature

• The supply of land is fixed
• Land is permanent
• Land is immobile
• Land is heterogenous
• Land is passive factor of productions

2. Labour:
Labour refers to all mental and physical work undertaken for some monetary reward. It
includes the services of a factory worker, a doctor, a teacher, a lawyer, an engineer, an officer,
etc. But labour does not include any work done for leisure or which does not carry any
monetary reward.

A person painting for leisure, singing a song to entertain his friends, or attending to his garden
would not be considered to have done any labour in the sense of economics. On the other
hand, if a person sells his paintings, a singer sings a song for a film and a gardener looks after
a garden in payment for money, their services are regarded as labour. Thus, labour is essential
for production.

Characteristics of labour:

• Labour is perishable
• Labour is inseparable from the labourer
• Labour has weak bargaining power
• Labour is not as mobile as land
 PRODUCTION ANALYSIS

• Inelastic supply of labour

• Labour differs in efficiency

3. Capital:
Capital means all man-made resources. It comprises all wealth other than land which is used
for further production of wealth. It includes tools, implements, machinery, seeds, raw
materials and means of transport such as roads, railways, canals, etc.

In modern usage, capital not only refers to physical capital but also to human capital which is
the “process of increasing knowledge, the skills and capacities of all people of the country.”
It is this human capital which is regarded more important than physical capital in production
these days.

As pointed out by Prof. Galbraith, “We now get the larger part of our industrial growth not
from more capital investment but from investment in men and improvements brought about
by improved men.”

Characteristics of capital:

• Capital is man made

• Capital grows out of savings
• Capital depreciates
• Capital is variable
• Capital is productive
• Capital yields income

4.Organisation:
Land, labour and capital are respectively natural, human and material means of production
No production is possible without bringing together these three factors of production and
employing them in right proportions.

So, there must be somebody to hire them from their owners by paying rent wages and
interest, and to decide the quantities of each needed for production, this is known as
organisation. Organisation refers to the services of an entrepreneur who controls, organises
and manages the policy of a firm innovates and undertakes all risks.

Significance of production function in business:

Let us study about the theory of production function. After reading this article you will learn
about: 1. Concept of the Theory of Production Function 2. Importance of the Theory of
Production Function.
 PRODUCTION ANALYSIS

Concept of the Theory of Production Function:

The theory of production and cost (Cost function is derived from the production function) is
central to the economic management of the firm. The starting point of the theory of
production is the technology of production of the firm. This technology describes the
relationship between inputs and output.

This relationship or the production function governs the level of production. Output is a
function of inputs. In the short run, output behaviour is governed by the levels of non-
proportional returns. Here we keep some inputs fixed. In the long run, inputs are subject to
change.

Importance of the Theory of Production Function:

The theory of production is at the heart of business economics. That is why, its importance is
great. Firstly, cost theory is a derived theory—it is derived from the production theory. Cost
has great relevance in the determination of price of a commodity.

Secondly, the theory of production may be used in the determination of rewards of an input.
The basis of input demand theory is indeed the theory of production.

The Production Function:

The key concept in the theory of production is the production function. The word ‘function’
in mathematics expresses the relationship between dependent and independent variables.
Or a function shows a cause—and—effect relationship. The production function shows the
technological or engineering relationship between inputs (independent variables or cause)
and output (dependent variable or effect).

A general production function can be written as:

Output = f (input1, input2, input3 …. inputN)

Using one-output and two-input function, the relationship between output and inputs is
summarized in the following form:
 PRODUCTION ANALYSIS

Q = f (L, K)

where Q denotes the quantity of output produced and L and K denote the respective
quantities of labour—the human resource— and capital—the physical resource—used. By
using L and K in a production process, one obtains output (Q). The technician or the engineer
of an establishment describes the production process in terms of variables such as pressure,
density and horse power.

The economist’s production function incorporates the engineering technology. Production

engineers tell us how many units of L and K are used to yield a given output by using a
particular process of production. Which particular production process (out of various
alternatives) will be chosen by the firm depends on the prices of inputs and output that are
bought and sold in the market place.

Thus, a production function, being a technical one, presents physical combinations only. It
does not say anything about least-cost input combination or maximum profitable output. In
brief, a production function is a graph or a table or an equation showing the maximum output
that can be produced with the help of inputs.

To the economists, a production function is something more. A production function shows

costs for using inputs and revenues for output sold. As the production function is given in the
form of a table showing physical combinations of different inputs to obtain certain unit of
output, it is not within the domain of economics.

Economists are concerned not with the physical combinations but with the costs, revenue,
output behaviour in response to changes in inputs used, etc. Whenever there is a change in
input usage in a production process, the output changes. Why does output change in this way
or that way is studied by economists through production function. Consequently, different
laws governing output are obtained.

The form of production function of an establishment is determined by the state of technology

whose size depends on the time span. This means that a short run production function is
different from a long period production function. To understand the difference, let us define
short run and long run.

Homogenous production function:

A function is said to be homogeneous of degree n if the multipli-cation of all the independent
variables by the same constant, say λ, results in the multiplication of the dependent variable
by λn. Thus, the function

Y = X2 + Z2

is homogeneous of degree 2 since

 PRODUCTION ANALYSIS

(λX)2 + (λZ)2 = λ2 (X2 + Y2) = λ2Y

A function which is homogeneous of degree 1 is said to be linearly homogeneous, or to display

linear homogeneity. A production function which is homogeneous of degree 1 displays
constant returns to scale since a doubling all inputs will lead to an exact doubling of output.
So, this type of production function exhibits constant returns to scale over the entire range of
output. In general, if the production function Q = f (K, L) is linearly homogeneous, then

F (λK, λL) = λf (K ,L) = λQ

for any combination of labour and capital and for all values of λ. If λ equals 3, then a tripling
of the inputs will lead to a tripling of output.

There are various examples of linearly homogeneous functions.

Two such examples are the following:

Q = aK + bL

and Q = A Kα L1-α 0 < α < 1

The second example is known as the Cobb-Douglas production function. To see that it is,
indeed, homogeneous of degree one, suppose that the firm initially produces Q0 with inputs
K0 and L0 and then doubles its employ-ment of capital and labour.

The resulting output would equal:

This shows that the Cobb-Douglas production function is linearly homo-geneous.

Properties:

There are various interesting properties of linearly homoge-neous production functions. First,
we can express the function, Q = f (K,L) in either of two alternative forms.

(1) Q = Kg (L/K) or,

(2) Q = Lh (K/L)

This property is often used to show that marginal products of labour and capital are functions
of only the capital-labour ratio.
 PRODUCTION ANALYSIS

In particular, the marginal products are as follows:

MPk = g (L/K) – (L/K) g’ (L/K)

and MPL = g’ (L/K)

where g’ (L, K) denotes the derivative of g (L/K). The significance of this is that the marginal
products of the inputs do not change with proportionate increases in both inputs. Since the
marginal rate of technical substitution equals the ratio of the marginal products, this means
that the MRTS does not change along a ray through the origin, which has a constant capital-
labour ratio. Since the MRTS is the slope of the isoquant, a linearly homo-geneous production
function generates isoquants that are parallel along a ray through the origin.

Expansion Path:

If a firm employs a linearly homogeneous production function, its expan-sion path will be a
straight line. To verify this point, let us start from an initial point of cost minimisation in Fig.12,
with an output of 10 units and an employment (usage) of 10 units of labour and 5 units of
capital. Now, suppose, the firm wants to expand its output to 15 units. Since input prices do
not change, the slope of the new iso-quant must be equal to the slope of the original one.

But, the slope of the isoquant is the MRTS, which is constant along a ray from the origin for
linearly ho-mogeneous production function. Consequently, the cost minimising capital-labour
ratio will remain constant. Since output has increased by 50%, the inputs will also increase by
50% from 10 units of labour to 15 and from 5 units of capital to 7.5. Thus, the expansion path
is a straight line.

Production functions may take many specific forms. Typically economists and researchers
work with homogeneous production function. A function is said to be homogeneous of degree
 PRODUCTION ANALYSIS

n if the multiplication of all of the independent variables by the same constant, say λ, results
in the multiplication of the independent variable by λn. Thus, the function:

Q = K2 + L2

is homogeneous of degree 2 since

(λK)2 + (λ L)2 = λ2 (K2 + L2) = λ2Q

A function which is homogeneous of degree 1 is said to be linearly homogeneous, or to display

linear homogeneity. A production function which is homogeneous of degree 1 displays
constant returns to scale since a doubling all inputs will lead to a doubling of output.

A production function is homogeneous of degree n if when inputs are multiplied by some

constant, say, α, the resulting output is a multiple of a2 times the original output.

That is, for a production function:

Q = f (K, L)

then if and only if

Q = f (αK, αL) = αnf (K, L)

is the function homogeneous. The exponent, n, denotes the degree of homo-geneity. If n=1
the production function is said to be homogeneous of degree one or linearly homogeneous
(this does not mean that the equation is linear). A linearly homogeneous production function
is of interest because it exhib-its CRS.

This is easily seen since the expression αn. f(K, L) when n=1 reduces to α. (K, L) so that
multiplying inputs by a constant simply increases output by the same proportion. Examples
of linearly homogeneous production functions are the Cobb-Douglas production function and
the constant elas-ticity of substitution (CES) production function. If n > 1, the production
function exhibits IRS. If n< 1 DRS prevails.

Cobb-Douglas Production Function:

Economists have at different times examined many actual production func-tions and a famous
production function is the Cobb-Douglas production function. Such a function is an equation
showing the relationship between the input of two factors (K and L) into a production process,
and the level of output (Q), in which the elasticity of substitution between two factors is equal
to one. As applied to the manufacturing production, this production function, roughly
speaking, states that labour contributes about three-quar-ters of the increases in
manufacturing production and capital the remaining one-quarter.
 PRODUCTION ANALYSIS

Suppose, the production function is of the following type:

Q = AKα Lβ

where Q is output, A is constant, K is capital input, L is labour input and a and (3 are the
exponents of the production function. This is known as the Cobb-Douglas production
function. It has an important property.

The sum of the two exponents indicates the returns to scale:

(i) If α + β > 1, the production function exhibits increasing returns to scale,

(ii) If α + β = 1, there are constant returns to scale,

(iii) Finally, if α + β < 1, there are decreasing returns to scale.

Suppose, the production is of the following type:

Q = AK0.+75 L0.25

It exhibits constant return to scale because α = 0.75 and β = 0.25 and α + β = 1.

Importance of C-D production function:

1. It suits to the nature of all industries.

2. It is convenient it international and inter-industry comparisons.
3. It is most commonly used function in the field of economics.
4. It can be fitted to time series analysis cross section analysis.
5. The function can be generalized in the case of “n” factors of production.
6. The unknown parameters alfa and beta in the production function can be easily
computed.
7. It becomes linear functions in logarithm.
8. It is more popular in empirical research.

Limitations of C-D production function

1. The function includes only two factors and neglects other inputs.
2. The function assumes constant returns to scale.
3. There is the problem of measurement of capital which takes only the quantity of
capital available for production.
4. The function assumes perfect competition in the factor market which is unrealistic.
5. It does not fit to all industries.
6. It is based on the substitutability of factors and neglects complementarities of factors.
7. The parameters cannot give proper and correct implications.
 PRODUCTION ANALYSIS

Short run & long run production function

The firm may change only the quantities of the variable inputs in the short run when the
quantities of the fixed inputs remain unchanged.

That is, in the short run, the output quantity can be increased (or decreased) by increasing (or
decreasing) the quantities used of only the variable inputs. This functional relationship (of
dependence) between the variable input quantities and the output quantity is called the short
run production function.

We have to remember here, of course, that in the short-run, the firm uses a particular
combination of fixed inputs, and its short-run production function is obtained in respect of
that combination.

In the long run, however, all the inputs used by the firm, the variable inputs and the so called
fixed inputs, all are variable quantities and the firm’s production is a function of all these
inputs. This functional relation of dependence between all the inputs used by the firm and
the quantity of its output is called the long run production function of the firm.

We may illustrate the difference between the short-run and the long run production functions
in the following way. Let us suppose that the firm uses only two inputs X and Y to produce its
output of one commodity, Q, and of these two inputs X is a variable input and Y is a fixed
input.

Therefore, in this case, the firm’s short-run production function may be written as:

q = f(x, y̅) (8.5)

where y̅ is the fixed quantity of the fixed input y. The firm’s long run production function in
this example would be:

q = f(x, y) (8.6)

where x and y are the variable quantities of the inputs X and Y.

We may write the firm’s short-run production function (8.5) in the following form also:

q = h(x) (8.7)

For, in our example, in the short-run, the change in the firm’s output depends on the change
in the quantity used of the input X only.
 PRODUCTION ANALYSIS

Concept of total product, average product and marginal product

Total product

Total product is the complete output from a production system. total product is a measure of
total output the results from employing a specific quantity of resources in a given production
system. The total product concept is used to describe the relation between the output and
variation in only one input in a production function.

TP = Q

Where,

TP is total product

Q is output.

Given the total product function for an input, both the average product and marginal product
can be easily derived.

Average product

Average product (AP) is the total product (TP) divided by the number of units of input
employed.

The average product is expressed as,

AP = Q / X

Where,

AP is average product,

Q is output,

X is the variable factor.

Marginal product

Marginal product (MP) is change in output associated with a one-unit change in a single input.

The marginal product can be expressed as,

MP = delta Q / delta X

Where,

MP is marginal product,
 PRODUCTION ANALYSIS

Delta Q is change in output resulting from one-unit change in factor input.

Delta X is the variable factor.

Law of variable proportion

Law of Variable Proportions occupies an important place in economic theory. This law is also
known as Law of Proportionality.

Keeping other factors fixed, the law explains the production function with one factor variable.
In the short run when output of a commodity is sought to be increased, the law of variable
proportions comes into operation.

Therefore, when the number of one factor is increased or decreased, while other factors are
constant, the proportion between the factors is altered. For instance, there are two factors
of production viz., land and labour.

Land is a fixed factor whereas labour is a variable factor. Now, suppose we have a land
measuring 5 hectares. We grow wheat on it with the help of variable factor i.e., labour.
Accordingly, the proportion between land and labour will be 1: 5. If the number of labourers
is increased to 2, the new proportion between labour and land will be 2: 5. Due to change in
the proportion of factors there will also emerge a change in total output at different rates.
This tendency in the theory of production called the Law of Variable Proportion.

Definitions:

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

“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

Assumptions:

Law of variable proportions is based on following assumptions:

(i) Constant Technology:

The state of technology is assumed to be given and constant. If there is an improvement in

technology the production function will move upward.

(ii) Factor Proportions are Variable:

The law assumes that factor proportions are variable. If factors of production are to be
combined in a fixed proportion, the law has no validity.
 PRODUCTION ANALYSIS

(iii) Homogeneous Factor Units:

The units of variable factor are homogeneous. Each unit is identical in quality and amount
with every other unit.

(iv) Short-Run:

The law operates in the short-run when it is not possible to vary all factor inputs.

Explanation of the Law:

In order to understand the law of variable proportions we take the example of agriculture.
Suppose land and labour are the only two factors of production.

By keeping land as a fixed factor, the production of variable factor i.e., labour can be shown
with the help of the following table:

From the table 1 it is clear that there are three stages of the law of variable proportion. In the
first stage average production increases as there are more and more doses of labour and
capital employed with fixed factors (land). We see that total product, average product, and
marginal product increases but average product and marginal product increases up to 40
units. Later on, both start decreasing because proportion of workers to land was sufficient
and land is not properly used. This is the end of the first stage.

The second stage starts from where the first stage ends or where AP=MP. In this stage,
average product and marginal product start falling. We should note that marginal product
falls at a faster rate than the average product. Here, total product increases at a diminishing
rate. It is also maximum at 70 units of labour where marginal product becomes zero while
average product is never zero or negative.
 PRODUCTION ANALYSIS

The third stage begins where second stage ends. This starts from 8th unit. Here, marginal
product is negative and total product falls but average product is still positive. At this stage,
any additional dose leads to positive nuisance because additional dose leads to negative
marginal product.

Graphic Presentation:

In fig. 1, on OX axis, we have measured number of labourers while quantity of product is

shown on OY axis. TP is total product curve. Up to point ‘E’, total product is increasing at
increasing rate. Between points E and G it is increasing at the decreasing rate. Here marginal
product has started falling. At point ‘G’ i.e., when 7 units of labourers are employed, total
product is maximum while, marginal product is zero. Thereafter, it begins to diminish
corresponding to negative marginal product. In the lower part of the figure MP is marginal
product curve.

Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3 units of labourers are
employed, it is maximum. After that, marginal product begins to decrease. Before point ‘I’
marginal product becomes zero at point C and it turns negative. AP curve represents average
product. Before point ‘I’, average product is less than marginal product. At point ‘I’ average
 PRODUCTION ANALYSIS

product is maximum. Up to point T, average product increases but after that it starts to
diminish.

Three Stages of the Law:

1. First Stage:

First stage starts from point ‘O’ and ends up to point F. At point F average product is maximum
and is equal to marginal product. In this stage, total product increases initially at increasing
rate up to point E. between ‘E’ and ‘F’ it increases at diminishing rate. Similarly marginal
product also increases initially and reaches its maximum at point ‘H’. Later on, it begins to
diminish and becomes equal to average product at point T. In this stage, marginal product
exceeds average product (MP > AP).

2. Second Stage:

It begins from the point F. In this stage, total product increases at diminishing rate and is at
its maximum at point ‘G’ correspondingly marginal product diminishes rapidly and becomes
‘zero’ at point ‘C’. Average product is maximum at point ‘I’ and thereafter it begins to
decrease. In this stage, marginal product is less than average product (MP < AP).

3. Third Stage:

This stage begins beyond point ‘G’. Here total product starts diminishing. Average product
also declines. Marginal product turns negative. Law of diminishing returns firmly manifests
itself. In this stage, no firm will produce anything. This happens because marginal product of
the labour becomes negative. The employer will suffer losses by employing more units of
labourers. However, of the three stages, a firm will like to produce up to any given point in
the second stage only.
 PRODUCTION ANALYSIS

In Which Stage Rational Decision is Possible:

To make the things simple, let us suppose that, a is variable factor and b is the fixed factor.
And a1, a2 , a3….are units of a and b1 b2b3…… are unit of b.

Stage I is characterized by increasing AP, so that the total product must also be increasing.
This means that the efficiency of the variable factor of production is increasing i.e., output
per unit of a is increasing. The efficiency of b, the fixed factor, is also increasing, since the total
product with b1 is increasing.

The stage II is characterized by decreasing AP and a decreasing MP, but with MP not negative.
Thus, the efficiency of the variable factor is falling, while the efficiency of b, the fixed factor,
is increasing, since the TP with b1 continues to increase.

Finally, stage III is characterized by falling AP and MP, and further by negative MP. Thus, the
efficiency of both the fixed and variable factor is decreasing.

Rational Decision:

Stage II becomes the relevant and important stage of production. Production will not take
place in either of the other two stages. It means production will not take place in stage III and
stage I. Thus, a rational producer will operate in stage II.

Suppose b were a free resource; i.e., it commanded no price. An entrepreneur would want to
achieve the greatest efficiency possible from the factor for which he is paying, i.e., from factor
a. Thus, he would want to produce where AP is maximum or at the boundary between stage
I and II.

If on the other hand, a were the free resource, then he would want to employ b to its most
efficient point; this is the boundary between stage II and III.

Obviously, if both resources commanded a price, he would produce somewhere in stage II. At
what place in this stage production takes place would depend upon the relative prices of a
and b.

Condition or Causes of Applicability:

There are many causes which are responsible for the application of the law of variable
proportions.

1. Under Utilization of Fixed Factor:

In initial stage of production, fixed factors of production like land or machine, is under-
utilized. More units of variable factor, like labour, are needed for its proper utilization. As a
 PRODUCTION ANALYSIS

result of employment of additional units of variable factors there is proper utilization of fixed
factor. In short, increasing returns to a factor begins to manifest itself in the first stage.

2. Fixed Factors of Production.

The foremost cause of the operation of this law is that some of the factors of production are
fixed during the short period. When the fixed factor is used with variable factor, then its ratio
compared to variable factor falls. Production is the result of the co-operation of all factors.
When an additional unit of a variable factor has to produce with the help of relatively fixed
factor, then the marginal return of variable factor begins to decline.

3. Optimum Production:

After making the optimum use of a fixed factor, then the marginal return of such variable
factor begins to diminish. The simple reason is that after the optimum use, the ratio of fixed
and variable factors become defective. Let us suppose a machine is a fixed factor of
production. It is put to optimum use when 4 labourers are employed on it. If 5 labourers are
put on it, then total production increases very little and the marginal product diminishes.

4. Imperfect Substitutes:

Mrs. Joan Robinson has put the argument that imperfect substitution of factors is mainly
responsible for the operation of the law of diminishing returns. One factor cannot be used in
place of the other factor. After optimum use of fixed factors, variable factors are increased
and the amount of fixed factor could be increased by its substitutes.

Such a substitution would increase the production in the same proportion as earlier. But in
real practice factors are imperfect substitutes. However, after the optimum use of a fixed
factor, it cannot be substituted by another factor.

Applicability of the Law of Variable Proportions:

The law of variable proportions is universal as it applies to all fields of production. This law
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.

The main cause of application of this law is the fixity of any one factor. Land, mines, fisheries,
and house building etc. are not the only examples of fixed factors. Machines, raw materials
may also become fixed in the short period. Therefore, this law holds good in all activities of
production etc. agriculture, mining, manufacturing industries.

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
 PRODUCTION ANALYSIS

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:

In order to increase production of manufactured goods, factors of production has to be

increased. It can be increased as desired for a long period, being variable factors. Thus, law of
increasing returns operates in industries for a long period. But, this situation arises when
additional units of labour, capital and enterprise are of inferior quality or are available at
higher cost.

As a result, after a point, marginal product increases less proportionately than increase in the
units of labour and capital. In this way, the law is equally valid in industries.

Economies and diseconomies of scale

Economies of scale are defined as the cost advantages that an organization can achieve by
expanding its production in the long run.

In other words, these are the advantages of large-scale production of the organization. The
cost advantages are achieved in the form of lower average costs per unit.

It is a long-term concept. Economies of scale are achieved when there is an increase in the
sales of an organization. As a result, the savings of the organization increases, which further
enables the organization to obtain raw materials in bulk. This helps the organization to enjoy
discounts. These benefits are called as economies of scale.

The economies of scale are divided in to internal economies and external economies
discussed as follows:

i. Internal Economies:

Refer to real economies which arise from the expansion of the plant size of the organization.
These economies arise from the growth of the organization itself.

a. Technical economies of scale:

Occur when organizations invest in the expensive and advanced technology. This helps in
lowering and controlling the costs of production of organizations. These economies are
enjoyed because of the technical efficiency gained by the organizations. The advanced
technology enables an organization to produce a large number of goods in short time. Thus,
production costs per unit falls leading to economies of scale.
 PRODUCTION ANALYSIS

b. Marketing economies of scale:

Occur when large organizations spread their marketing budget over the large output. The
marketing economies of scale are achieved in case of bulk buying, branding, and advertising.
For instance, large organizations enjoy benefits on advertising costs as they cover larger
audience. On the other hand, small organizations pay equal advertising expenses as large
organizations, but do not enjoy such benefits on advertising costs.

c. Financial economies of scale:

Take place when large organizations borrow money at lower rate of interest. These
organizations have good credibility in the market. Generally, banks prefer to grant loans to
those organizations that have strong foothold in the market and have good repaying capacity.

d. Managerial economies of scale:

Occur when large organizations employ specialized workers for performing different tasks.
These workers are experts in their fields and use their knowledge and experience to maximize
the profits of the organization. For instance, in an organization, accounts and research
department are created and managed by experienced individuals, SO that all costs and profits
of the organization can be estimated properly.

e. Commercial economies:

Refer to economies in which organizations enjoy benefits of buying raw materials and selling
of finished goods at lower cost. Large organizations buy raw materials in bulk; therefore, enjoy
benefits in transportation charges, easy credit from banks, and prompt delivery of products
to customers.

ii. External economies:

Occur outside the organization. These economies occur within the industries which benefit
organizations. When an industry expands, organizations may benefit from better
transportation network, infrastructure, and other facilities. This helps in decreasing the cost
of an organization.

a. Economies of Concentration:

Refer to economies that arise from the availability of skilled labour, better credit, and
transportation facilities.

b. Economies of Information:

Imply advantages that are derived from publication related to trade and business. The central
research institutions are the source of information for organizations.
 PRODUCTION ANALYSIS

c. Economies of Disintegration:

Refer to the economies that arise when organizations split their processes into different
processes.

Diseconomies of scale occur when the long run average costs of the organization increases.
It may happen when an organization grows excessively large. In other words, the
diseconomies of scale cause larger organizations to produce goods and services at increased
costs.

There are two types of diseconomies of scale, namely, internal diseconomies and external
diseconomies, discussed as follows:

i. Internal diseconomies of scale:

Refer to diseconomies that raise the cost of production of an organization. The main factors
that influence the cost of production of an organization include the lack of decision,
supervision, and technical difficulties.

ii. External diseconomies of scale:

Refer to diseconomies that limit the expansion of an organization or industry. The factors that
act as restraint to expansion include increased cost of production, scarcity of raw materials,
and low supply of skilled labourer.

i. Poor Communication:

Act as a major reason for diseconomies of scale. If production goals and objectives of an
organization are not properly communicated to employees within the organization, it may
lead to overproduction or production. This may lead to diseconomies of scale.

Apart from this, if the communication process of the organization is not strong then the
employees would not get adequate feedback. As a result, there would be less face-to-face
interaction among employees- thus the production process would be affected.

ii. Lack of Motivation:

Leads to fall in productivity levels. In case of a large organization, workers may feel isolated
and are less appreciated for their work, thus their motivation diminishes. Due to poor
communication network, it is harder for employers to interact with the employees and build
a sense of belongingness. This leads to fall in the productivity levels of output owing to lack
of motivation. This further leads to increase in costs of the organization.
 PRODUCTION ANALYSIS

iii. Loss of Control:

Acts as the main problem of large organizations. Monitoring and controlling the work of every
employee in a large organization becomes impossible and costly. It is harder to make out that
all the employees of an organization are working towards the same goal. It becomes difficult
for managers to supervise the sub-ordinates in large organizations.

iv. Cannibalization:

Implies a situation when an organization faces competition from its own product. A small
organization faces competition from products of other organizations, whereas sometimes
large organizations find that their own products are competing with each other.

Law of returns to scale

In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale
of production can be changed by changing the quantity of all factors of production.

Definition:

“The term returns to scale refers to the changes in output as all factors change by the same
proportion.” Koutsoyiannis

“Returns to scale relates to the behaviour of total output as all inputs are varied and is a long
run concept”. Leibhafsky

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Explanation:

In the long run, output can be increased by increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an increase in output due to increase in all factors
in the same proportion. Such an increase is called returns to scale.

Suppose, initially production function is as follows:

P = f (L, K)

Now, if both the factors of production i.e., labour and capital are increased in same proportion
i.e., x, product function will be rewritten as.
 PRODUCTION ANALYSIS

The above stated table explains the following three stages of returns to scale:

1. Increasing Returns to Scale:

If the proportional change in the output of an organization is greater than the proportional
change in inputs, the production is said to reflect increasing returns to scale. For example, to
produce a particular product, if the quantity of inputs is doubled and the increase in output
is more than double, it is said to be an increasing return to scale. When there is an increase
in the scale of production, the average cost per unit produced is lower. This is because at this
stage an organization enjoys high economies of scale.
 PRODUCTION ANALYSIS

In Figure-13, a movement from a to b indicates that the amount of input is doubled. Now, the
combination of inputs has reached to 2K+2L from 1K+1L. However, the output has Increased
from 10 to 25 (150% increase), which is more than double. Similarly, when input changes from
2K-H2L to 3K + 3L, then output changes from 25 to 50(100% increase), which is greater than
change in input. This shows increasing returns to scale.

2. Constant Returns to Scale:

The production is said to generate constant returns to scale when the proportionate change
in input is equal to the proportionate change in output. For example, when inputs are
doubled, so output should also be doubled, then it is a case of constant returns to scale.

In Figure-14, when there is a movement from a to b, it indicates that input is doubled. Now,
when the combination of inputs has reached to 2K+2L from IK+IL, then the output has
increased from 10 to 20.

Similarly, when input changes from 2Kt2L to 3K + 3L, then output changes from 20 to 30,
which is equal to the change in input. This shows constant returns to scale. In constant returns
to scale, inputs are divisible and production function is homogeneous.

3. Diminishing Returns to Scale:

Diminishing returns to scale refers to a situation when the proportionate change in output is
less than the proportionate change in input. For example, when capital and labour is doubled
but the output generated is less than doubled, the returns to scale would be termed as
diminishing returns to scale.
 PRODUCTION ANALYSIS

n Figure-15, when the combination of labour and capital moves from point a to point b, it
indicates that input is doubled. At point a, the combination of input is 1k+1L and at point b,
the combination becomes 2K+2L.

However, the output has increased from 10 to 18, which is less than change in the amount of
input. Similarly, when input changes from 2K+2L to 3K + 3L, then output changes from 18 to
24, which is less than change in input. This shows the diminishing returns to scale.

Diminishing returns to scale is due to diseconomies of scale, which arises because of the
managerial inefficiency. Generally, managerial inefficiency takes place in large-scale
organizations. Another cause of diminishing returns to scale is limited natural resources. For
example, a coal mining organization can increase the number of mining plants, but cannot
increase output due to limited coal reserves.

Meaning & properties of isoquants

The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant = quantity or
product = output.

Thus it means equal quantity or equal product. Different factors are needed to produce a
good. These factors may be substituted for one another.

A given quantity of output may be produced with different combinations of factors. Iso-quant
curves are also known as Equal-product or Iso-product or Production Indifference curves.
Since it is an extension of Indifference curve analysis from the theory of consumption to the
theory of production.

Thus, an Iso-product or Iso-quant curve is that curve which shows the different combinations
of two factors yielding the same total product. Like, indifference curves, Iso- quant curves also
 PRODUCTION ANALYSIS

slope downward from left to right. The slope of an Iso-quant curve expresses the marginal
rate of technical substitution (MRTS).

Definitions:

“The Iso-product curves show the different combinations of two resources with which a firm
can produce equal amount of product.” Bilas

“Iso-product curve shows the different input combinations that will produce a given output.”
Samuelson

“An Iso-quant curve may be defined as a curve showing the possible combinations of two
variable factors that can be used to produce the same total product.” Peterson

Iso-Product Schedule:

Let us suppose that there are two factor inputs—labour and capital. An Iso-product schedule
shows the different combination of these two inputs that yield the same level of output as
shown in table 1.

The table 1 shows that the five combinations of labour units and units of capital yield the
same level of output, i.e., 200 metres of cloth. Thus, 200 metre cloth can be produced by
combining.

(a) 1 units of labour and 15 units of capital

(b) 2 units of labour and 11 units of capital

(c) 3 units of labour and 8 units of capital

(d) 4 units of labour and 6 units of capital

(e) 5 units of labour and 5 units of capital

 PRODUCTION ANALYSIS

Iso-Product Curve:

From the above schedule iso-product curve can be drawn with the help of a diagram. An.
equal product curve represents all those combinations of two inputs which are capable of
producing the same level of output. The Fig. 1 shows the various combinations of labour and
capital which give the same amount of output. A, B, C, D and E.

Iso-Product Map or Equal Product Map:

An Iso-product map shows a set of iso-product curves. They are just like contour lines which
show the different levels of output. A higher iso-product curve represents a higher level of
output. In Fig. 2 we have family iso-product curves, each representing a particular level of
output.

The iso-product map looks like the indifference of consumer behaviour analysis. Each
indifference curve represents particular level of satisfaction which cannot be quantified. A
higher indifference curve represents a higher level of satisfaction but we cannot say by how
much the satisfaction is more or less. Satisfaction or utility cannot be measured.
 PRODUCTION ANALYSIS

Marginal rate of technical substitution

The principle of marginal rate of technical substitution (MRTS or MRS) is based on the
production function where two factors can be substituted in variable proportions in such a
way as to produce a constant level of output.

Salvatore defines MRTS thus:

“The marginal rate of technical substitution is the amount of an output that a firm can give
up by increasing the amount of the other input by one unit and still remain on the same
isoquant.”

The marginal rate of technical substitution between two factors С (capital) and L (labour)
MRTS is the rate at which L can be substituted for С in the production of good X without
changing the quantity of output. As we move along an isoquant downward to the right, each
point on it represents the substitution of labour for capital.

MRTS is the loss of certain units of capital which will just be compensated for by additional
units of labour at that point. In other words, the marginal rate of technical substitution of
labour for capital is the slope or gradient of the isoquant at a point. Accordingly, slope = MRTS,
LC = – ∆С/∆ L. This can be understood with the aid of the isoquant schedule, in Table 2

The above table shows that in the second combination to keep to output constant at 100
units, the reduction of 3 units of capital requires the addition of 5 units of labour, MRTSLC =
3:5. In the third combination, the loss of 2 units of capital is compensated for by 5 more units
of labour, and so on.

In Figure 9 at point B, the marginal rate of technical substitution is AS/SB, at point Q it is BT/TG
and at H, it is GR/RH.
 PRODUCTION ANALYSIS

The isoquant AH reveals that as the units of labour are successively increased into the factor-
combination to produce 100 units of good X, the reduction in the units of capital becomes
smaller and smaller. It means that the marginal rate of technical substitution is diminishing.

This concept of the diminishing marginal rate of technical substitution (DMRTS) is parallel to
the principle of diminishing marginal rate of substitution in the indifference curve technique.

This tendency of diminishing marginal substitutability of factors is apparent from Table 2 and
Figure 9. The MRTSLC continues to decline from 3:5 to 1:5 whereas in the Figure 9 the vertical
lines below the triangles on the isoquant become smaller and smaller as we move downward
so that GR < ВТ < AS. Thus, the marginal rate of technical substitution diminishes as labour is
substituted for capital. It means that the isoquant must be convex to the origin at every point.

Concept of isocost line

The extent to which a factor is combined to the other factor depends on the prices of factor
and the willingness of organization to spend money on factors.

Iso-cost line represents the price of factors along with the amount of money an organization
is willing to spend on factors.

In other words, it shows different combinations of factors that can be purchased at a certain
amount of money.

For example, a producer wants to spend Rs. 300 on the factors of production, namely X and
Y. The price of X in the market is Rs. 3 per unit and price of Y is Rs. 5 per unit.

In such a case, the iso-cost line is shown in Figure-10:

 PRODUCTION ANALYSIS

As shown in Figure-10, if the producer spends the whole amount of money to purchase X,
then he/she can purchase 100 units of X, which is represented by OL. On the other hand, if
the producer purchases Y with the whole amount, then he/she would be able to get 60 units,
which is represented by OH.

If points H and L are joined on X and Y axes respectively, a straight line is obtained, which is
called iso-cost line. All the combinations of X and Y that lie on this line, would have the same
amount of cost that is Rs. 300. Similarly, other iso-cost lines can be plotted by taking cost
more than Rs. 300, in case the producer is willing to spend more amount of money on
production factors.

With the help of isoquant and iso-cost lines, a producer can determine the point at which
inputs yield maximum profit by incurring minimum cost. Such a point is termed as producer’s
equilibrium.

Least cost combination of factors

Producer’s equilibrium or optimisation occurs when he earns maximum profit with optimal
combination of factors. A profit maximisation firm faces two choices of optimal combination
of factors (inputs).

1. To minimise its cost for a given output; and

2. To maximise its output for a given cost.

Thus the least cost combination of factors refers to a firm producing the largest volume of
output from a given cost and producing a given level of output with the minimum cost when
the factors are combined in an optimum manner. We study these cases separately.

Cost-Minimisation for a Given Output:

 PRODUCTION ANALYSIS

In the theory of production, the profit maximisation firm is in equilibrium when, given the
cost-price function, it maximises its profits on the basis of the least cost combination of
factors. For this, it will choose that combination which minimizes its cost of production for a
given output. This will be the optimal combination for it.

This analysis is based on the following assumptions:

1. There are two factors, labour and capital.

2. All units of labour and capital are homogeneous.

3. The prices of units of labour (w) and that of capital (r) are given and constant.

4. The cost outlay is given.

5. The firm produces a single product.

6. The price of the product is given and constant.

7. The firm aims at profit maximisation.

8. There is perfect competition in the factor market.

Explanation:

Given these assumptions, the point of least-cost combination of factors for a given level of
output is where the isoquant curve is tangent to an iso-cost line. In Figure 17, the iso-cost line
GH is tangent to the isoquant 200 at point M.

The firm employs the combination of ОС of capital and OL of labour to produce 200 units of
output at point M with the given cost-outlay GH. At this point, the firm is minimising its cost
for producing 200 units.
 PRODUCTION ANALYSIS

Any other combination on the isoquant 200, such as R or T, is on the higher iso-cost line KP
which shows higher cost of production. The iso-cost line EF shows lower cost but output 200
cannot be attained with it. Therefore, the firm will choose the minimum cost point M which
is the least-cost factor combination for producing 200 units of output.

M is thus the optimal combination for the firm. The point of tangency between the iso-cost
line and the isoquant is an important first order condition but not a necessary condition for
the producer’s equilibrium.

There are two essential or second order conditions for the equilibrium of the firm:

1. The first condition is that the slope of the iso-cost line must equal the slope of the isoquant
curve. The slope of the iso-cost line is equal to the ratio of the price of labour (w) to the price
of capital (r) i.e… W/r. The slope of the isoquant curve is equal to the marginal rate of technical
substitution of labour and capital (MRTSLC) which is, in turn, equal to the ratio of the marginal
product of labour to the marginal product of capital (MPL/MPC).

Thus the equilibrium condition for optimality can be written as:

W/r = MPL/MPC = MRTSLC

2. The second condition is that at the point of tangency, the isoquant curve must he convex
to the origin. In other words, the marginal rate of technical substitution of labour for capital
(MRTSLC) must be diminishing at the point of tangency for equilibrium to be stable. In Figure
18, S cannot be the point of equilibrium, for the isoquant IQ1 is concave where it is tangent
to the iso-cost line GH.

At point S, the marginal rate of technical. substitution between the two factors increases if
move to the right or left on the curve lQ1 .Moreover, the same output level can be produced
at a lower cost CD or EF and there will be a corner solution either at С or F. If it decides to
produce at EF cost, it can produce the entire output with only OF labour. If, on the other hand,
it decides to produce at a still lower cost CD, the entire output can be produced with only ОС
capital.

Both the situations are impossibilities because nothing can be produced either with only
labour or only capital. Therefore, the firm can produce the same level of output at point M
where the isoquant curve IQ is convex to the origin and is tangent to the iso-cost line GH. The
analysis assumes that both the isoquants represent equal level of output IQ = IQ1 = 200.

Output-Maximisation for a given Cost:

The firm also maximises its profits by maximising its output, given its cost outlay and the prices
of the two factors. This analysis is based on the same assumptions, as given above.
 PRODUCTION ANALYSIS

The conditions for the equilibrium of the firm are the same, as discussed above.

1. The firm is in equilibrium at point P where the isoquant curve 200 is tangent to the iso-cost
line CL in Figure 19.

At this point, the firm is maximising its output level of 200 units by employing the optimal
combination of OM of capital and ON of labour, given its cost outlay CL. But it cannot be at
points E or F on the iso-cost line CL, since both points give a smaller quantity of output, being
on the isoquant 100, than on the isoquant 200.

The firm can reach the optimal factor combination level of maximum output by moving along
the iso-cost line CL from either point E or F to point P. This movement involves no extra cost
because the firm remains on the same iso-cost line.

The firm cannot attain a higher level of output such as isoquant 300 because of the cost
constraint. Thus the equilibrium point has to be P with optimal factor combination OM + ON.
At point P, the slope of the isoquant curve 200 is equal to the slope of the iso-cost line CL. It
implies that w/r = MPL/MPC = MRTSLC

2. The second condition is that the isoquant curve must be convex to the origin at the point
of tangency with the iso-cost line, as explained above in terms of Figure 18.
 PRODUCTION ANALYSIS

Ridge Lines and the Economic Region of Production

One of the major assumptions underlying the properties of isoquants is that the inputs, X and
Y, are continuously, but not perfectly, substitutable. As the firm goes on substituting X for Y,
or the other way round, the marginal rate of technical substitution (MRTS) diminishes
monotonically.

However, in the case of some production functions, we may see that the MRTSX,Y while
diminishing, may become equal to zero at some point, because no more of Y can be given up
for having more of X. Thereafter, as x rises, y also would have to rise to correct the
mismanagement caused by the presence of excessive quantities of input X, and perhaps at an
increasing rate.

All this implies that the slope of an IQ would be zero at some point (where MRTSX,Y = 0) and
then the IQ would be positively sloped and convex downwards.

Similarly, MRTSX,Y, while diminishing as y increases, may become equal to zero, i.e., MRTSX,Y
may become equal to infinity, at some point. Thereafter, as y rises, x also would have to rise,
and perhaps at an increasing rate.

All this implies that the slope of an IQ would become infinity as some point (where MRTSX,Y
= 0 or MRTSX,Y = ∞), and then the IQ would be positively sloped and it would be concave
downwards.

We have shown the IQ map for such a production function in Fig. 8.17, where we have
constructed only four IQs. For any of these IQs, say for IQ1, we may observe the following:

(i) At some point like A, the slope of IQ1 is zero, i.e., MRTSX,Y = 0 and the IQ is horizontal.
 PRODUCTION ANALYSIS

(ii) At some point like E, the slope of IQ, = i.e., MRTSX,Y = ∞ or MRTSY,X = 0, and the IQ is
vertical.

(iii) In between the points A and E, IQ1 is negatively sloped and convex to the origin.

(iv) To the right of the point A, IQ1 is convex downwards, and to the right of the point E, IQ1
is concave downwards.

If we join the point of origin O and the points like A, B, C, D, etc. where MRTSX,Y = 0, by a line
like OS in Fig. 8.17, we obtain what is known as a ridge line. Similarly, if we join the point O
and the points like E, F, G, H, etc., where MRTSX, Y = by a line like OT, we obtain another ridge
line.

Let us note that OS is called the lower ridge line and OT is called the upper ridge line. Let us
also note that at each point on the lower ridge line, MRTSX, Y = 0 and at each point on the
upper ridge line, MRTSX Y = ∞. Lastly, let us note that the ridge lines separate the negatively
sloped portion of an IQ from its positively sloped portions.

We have discussed above about the positively sloped portions of IQs that some production
functions may give rise to. But the firm would prima facie reject these positively sloped
portions as uneconomic.

This is because along these portions the firm uses more of both the inputs, but the output
does not increase, it remains constant. Therefore, a profit-maximising firm purchasing the
inputs at positive prices, would summarily reject the positively sloped portions as irrelevant.

Now, what can we say about this irrelevance in terms of marginal productivity (MP) of the
inputs. Along the positively sloped portions below the lower ridge line, as x increases, y
remaining constant, the firm would move from a higher IQ to a lower IQ, i.e., here MPX would
be obtained to be negative.

On the other hand, if the firm increases y, x remaining constant, it would move from a lower
IQ to a higher IQ, i.e., here MPY would be positive. Similarly, we would find that along the
positively sloped portions above the upper ridge line, MPX would be positive and MPY would
be negative. Since the MP of one of the inputs is negative along the positively sloped portions,
the firm would consider the region as uneconomic.

But, the negative slope of an IQ has been obtained on the basis of the assumption that both
the inputs have positive MPs. This is apparent in Fig. 8.17 also. Along the negatively sloped
portions, as the firm increases x, y remaining constant, it moves from a lower to a higher IQ,
i.e., here MPX would be positive.

Similarly, here MPY would also be positive. So the negatively sloped portions of IQs form the
economic region of the production function. The firm would select some point (input
 PRODUCTION ANALYSIS

combination) in this region where it can produce a given quantity of output at the lowest
possible cost.

Meaning of Expansion Path:

We know that the production function of the firm

q = f(x,y) (8.21)

gives us the isoquant map of the firm, one isoquant (IQ) for each particular level of output,
and the cost equation of the firm

C = rXx + rYy (8.54)

gives us the family of parallel iso-cost lines (ICLs), given the prices of the inputs rX and rY, one
ICL for one particular level of cost. The IQ-map and the family of ICLs have been given in Fig.
8.14. If we now join the point of origin 0 and the points of tangency, E1, E2, E3, etc., between
the IQs and the ICLs by a curve, then this curve (OK in Fig. 8.14) would give us what is known
as the expansion path of the firm.

The expansion path is so called because if the firm decides to expand its operations, it would
have to move along this path. Let us note that the firm may expand in two ways.

First, it may want to expand by successively increasing its level of cost or its expenditure on
the inputs X and Y, i.e., by using more and more of inputs, and, consequently, by producing
more of its output.

Second, the firm may decide to expand by increasing its level of output per period. This the
firm may do by increasing the expenditure on the inputs, i.e., by using more and more of
them.
 PRODUCTION ANALYSIS

The two approaches to expansion apparently appear to be the same, for both involve an
increase in expenditure. However, there is a fundamental difference. In the first case, decision
is taken initially at the point of cost. Cost levels are made higher and higher and then efforts
are made to maximise the level of output subject to the cost constraint.

On the other hand, in the second case, decision-making occurs initially and directly at the
point of output. Here the firm first decides to produce more of output and then efforts are
made to produce the output at the minimum possible cost.