Chapter – 5

Production Function
Production - It refers to transformation of raw materials and semi-finished goods into finished
goods.

Production Function - It refers to functional or technical relationship between physical inputs

& output in a given period of time.
Qx = (L1, L2, C, E)

FIXED FACTORS
→ Fixed factor are those factors that does not change with change in output.
→ These factors remain constant in short run.
→ E.g. – Land, Capital, etc.

VARIABLE FACTORS
→ Variable factor are those factor that changes with change in output.
→ These factors changes in short run.
→ E.g. – Labour, Raw material, etc.

SHORT RUN AND LONG RUN

Basis Short Run Long Run
It refers to the period in which the It refers to the period in which the
Meaning output can be changed by changing output can be changed by changing
only the variable factors. all the factors of production.
It has both variable factors as well as All the factors are variable in long
Factors
fixed factors. run.

Phase of Long run beings when short run

It is the initial phase of production.
Production ends.
Only demand plays a key role in Both demand and supply plays a key
Price
determining the prices of the role in determining the prices of the
Determination
commodity. commodity.
Operation of Law of Variable Proportion operates Law of Returns to Scale operates in
Law in short run. long run.

Types of Production Function

1. Short Run Production Function
→ It refers to a situation in which there are two factors i.e. fixed factor & variable factor.
→ Production can be increased only by changing the variable factor, keeping other factors
constant.
→ The law that operates here is known as the Law of Variable Proportion or Returns to
Factor.

2. Long run production function

→ It refers to a situation in which all factor are variable, that there is no fixed factor.
→ Production can be increased by changing all the factors in the same proportion.
→ The law that operates here is known as Return to Scale.
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Production Function Micro Economics

PRODUCT (OUTPUT)
It refers to the total volume of goods produced by a firm in a given period of time.

TYPES OF PRODUCT

1. Total Product (TP) 50

Total Product (TP)

→ It refers to the total output produced by the firm with a 40
combination of fixed & variable factor in a given period of
30
time.
20
→ TP = ΣMP
10
→ Behaviour of TP
o Increases at increasing rate 0
0 5 10
o Increases at decreasing rate & reaches maximum
o Decreases Units of Variable factors

12
2. Average Product (AP)
10

Average Product
→ It refers to output per unit of variable factor.
8
→ AP = TP/Units of Variable Factors
6
→ Behaviour of AP
4
o Increases
2
o Reaches maximum
o Decreases but remains positive. 0
0 5 10 15
Units of Variable Factor

15
3. Marginal Product
Marginal Product

10
→ It refers to the additional output produced by the firm
by employing one additional unit of variable factor. 5
→ MP = TPn - TPn-1
→ MP = ∆TP/∆Units of Variable Factors (when more than 0
1 unit is asked). 0 5 10
-5
→ Behaviour of MP Units of Variable Factor
o Increases & reaches maximum
o Decreases & reaches zero
o Goes negative.

Units of Variable
TP MP AP
Factor
1 5 5 5
2 15 10 7.5
3 30 15 10
4 40 10 10
5 45 5 9
6 45 0 7.5
7 40 -5 5.7

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Micro Economics Production Function

RELATIONSHIP BETWEEN TP and MP

1. When TP increases at increasing rate, MP increases & reaches maximum.

2. When TP increases at decreasing rate, MP decreases
3. When TP is maximum, MP reaches zero.
4. When TP decreases, MP goes negative.

Note: The point where TP reaches maximum is known as point of saturation and the point
where MP reaches zero, it is known as point of satiety.

RELATIONSHIP BETWEEN MP and AP

15
10
MP and AP

5
MP
0
AP
0 2 4 6 8
-5
-10
Units of Variable Factors

1. When MP is more than AP, AP is rising but MP rises faster than AP.
2. When MP is equal to AP, AP is maximum.
3. When MP is less than AP, AP is falling but MP falls faster than AP.

Note: MP is additional and AP is average and marginal pulls average towards itself.

A Handbook by CA Sahil Jain Study Circle

Production Function Micro Economics

LAW OF VARIABLE PROPORTION (RETURNS TO FACTOR)

STATEMENT - The law states that as we keep on applying more & more units of variable factor
on a given fixed factor, the total product initially increases at increasing rate, then increase at a
decreasing rate & reaches maximum and finally it decreases.

ASSUMPTION
→ The law applies only in the field of production.
→ It operates in short run where some factors are fixed while some are variable.
→ Technology remains constant.
→ All the units of variable factor are homogenous.
→ All factors of production are imperfect substitutes of each other.

TABLE
Units of Variable
TP MP AP
Factor
1 5 5 5
2 15 10 7.5
3 30 15 10
4 40 10 10
5 45 5 9
6 45 0 7.5
7 40 -5 5.7

DIAGRAM

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Micro Economics Production Function

EXPLANATION
From the above table & diagram, we can see three phases of production.
→ Phase I – Increasing Returns
In this phase, the total product increases at an increasing rate and the marginal product
increases & reaches maximum due to better utilization of fixed factor, increased efficiency of
variable factor and indivisibility of fixed factor.

→ Phase II - Diminishing Returns

In this phase, the total product increases at decreasing rate & reaches maximum and the
marginal product decreases and reaches zero due to optimum combination of factors and the
factors are imperfect substitutes of each other.

→ Phase III - Negative Returns

In this phase, the total product decreases and the marginal product goes negative due to poor
coordination between fixed factor & variable factor and, limitation of fixed factors and decrease
in efficiency of variable factors. .

CONCLUSION
From the above explanation, it can be concluded that the total product initially increases at
increasing rate then at decreasing rate and finally it decreases.

Note - A rational producer will to operate till Phase II because at the end of this stage the total
product is maximum and marginal product is zero. So, he will get maximum profits in the
second phase.

REASON FOR THE PHASES OF LAW OF VAIABLE PROPORTION

1. Increasing returns
→ Better utilization of fixed factor - In the initial phase of production the fixed factor is idle &
can be utilized by applying more of variable factor on it. This leads to better utilization of
fixed factor due to which the firm will get increasing returns.

→ Increased efficiency of variable factor - As more & more of variable factor are applied on a
fixed factor, it leads to greater coordination and specialization among variable factor. As a
result of which, the firm will get increasing return.

→ Indivisibility of fixed factor - Fixed factors are indivisible in nature. They cannot be divided
into smaller units. So, in order to increase the production, they can be used better by
applying more of variable factor on them and by which, the firm will get increasing returns.

2. Diminishing Returns
→ Optimum combination of factors - Optimum combination refers to the best combination of
factors on which a firm operates. If a firm crosses this combination by applying more of
variable factor, he will get diminishing returns. It is also known as ‘ideal factor ratio’.

→ Imperfect Substitutes - There is a limit up to which the fixed factor and variable factor can
be substituted for another. If a firm crosses these limit, the firm with start getting
diminishing returns. Hence, production can be increased by applying more variable factor.

A Handbook by CA Sahil Jain Study Circle

Production Function Micro Economics

3. Negative returns
→ Limitation of fixed factor - Every fixed factor has certain limits of its usage. If these limits
are crossed the firm will get negative returns.

→ Decreased efficiency of variable factors - If more and more of variable factors are applied
on fixed factors, the advantages of coordination & specialization disappears due to which the
firm will get negative returns.

→ Poor Coordination between fixed & variable factor - As more of variable factors are applied
on fixed factors (after a limit) it leads to poor coordination between these factors due to which
the firm will get negative returns.

A Handbook by CA Sahil Jain Study Circle