Production

Function

Namrata K
 Meaning of Production
Production may be defined as a process through which a firm transforms inputs
into output. It is the process of creating goods and services with the help of factors
of production or inputs for satisfaction of human wants. In other words,
‘transformation of inputs into output’ whereby value is added, is broadly called
production.

Production is the conversion of input into output or creation of value. The factors
of production and all other things which the producer buys to carry out production
are called inputs. The final goods and services produced are known as output. It is
the result of co-operation of four factors of production viz., land, labour, capital
and entrepreneurship / organization.
 Factors of Production-Land
Land: Land is not created by mankind but it is a gift of nature available to us free of cost
and called as original or primary factor of production.
The salient features of land are highlighted below.
– Land is a free gift of nature to mankind. It is primary factor of production.
– Supply of land is perfectly inelastic i.e. fixed in quantity. Neither it can be increased
nor decreased.
– Land is a passive factor in the sense that it can not produce anything of its own. It
needs help of Labour, Capital, Entrepreneur, etc.
– There is no social cost of land since; it is a gift of nature to society. It is not created by
society by putting any efforts and paying any price. So its supply price for society is zero.
At the same time, the supply price for individual is not zero.
– Land is a perfectly immobile factor.
– Economic reward for the use of land is rent.
 Factors of Production
Labour: refers to only human effort which can be physical, mental or both for carrying out
production. The salient features of labour are highlighted below.

– Labour can not be separated from laborers. Worker sells their service not themselves.

– Labour can not be stored. Once lost, it can not be made up. Unemployed workers can not
store their labour for future employment.

– Labour is an active factor of production unlike land.

– Labour is heterogeneous. Quality, Skills and efficiency of labour differs.

– Labour is an imperfectly mobile factor.

– Labour supply is inelastic in general. Supply of labour depends upon many factors like size
of population, age and sex composition, desire to work, quality of education, attitude towards
work, etc. Thus, supply cannot be changed easily according to changes in demand.
 Factors of Production-Labour
– The amount of labour is the product of (i) duration of time over which it is
performed and (ii) the intensity

with which it is performed.

Supply of labour in a country refers to

– the total number of workers available for labour

– the intensity with which they can work

– the duration for which they work

– their efficiency ( or productivity )

 Factors of Production
Capital: Capital is another important factor which includes things like tools, machines,
technology etc that is part of wealth business uses for production. It means– assets, wealth /
money,or income. The salient features of capital are highlighted below.

– Capital is not a gift of nature. It is man made, secondary or artificial factor of production.

– Capital helps in increasing level of productivity and speed of production.

– Supply of capital is relatively elastic.

– Capital is not perishable like labour. It has a long life subject to periodical depreciation.

– Capital is a perfectly mobile factor.

– Capital has a social cost. Capital as a resource has alternative uses. It can be put to either of
the uses. The society in order to have one of them sacrifices another; accounting it as social
cost
 Factors of Production
Entrepreneurship: Factors of production viz. land, labour and capital are scattered at different
places. These are brought together in a coordinated way, managing and supervising to create
output. Thus it involves ideation to assembling various factors to carry out production smoothly. It
is an independent factor of production. The salient features of an entrepreneur as a factor of
production are highlighted below.

– Entrepreneur should be able to plan, organize, manage and allocate other primary factors of
production efficiently.

– Entrepreneur should be able to define objective precisely.

– Entrepreneur should be able to deal with numerous risks involved in entrepreneurship.

– Entrepreneur should be able to incorporate innovation and adopt modern techniques of

production.

– Entrepreneur should be able to take decisions promptly. Quick decisions are expected but hasty
decisions may be avoided.
“The production function is a technical or engineering relation between input and
output. As long as the natural laws of technology remain unchanged, the production
function remains unchanged.” Prof. L.R. Klein

“Production function is the relationship between inputs of productive services per unit
of time and outputs of product per unit of time.” Prof. George J. Stigler

Mathematically, such a basic relationship between inputs and outputs may be

expressed as:

Q = f( L, C, N )

Where Q = Quantity of output, L = Labour C = Capital, N = Land.

Hence, the level of output (Q), depends on the quantities of different inputs (L, C, N)
available to the firm. In the simplest case, where there are only two inputs, labour (L)
and capital (C) and one output (Q), the production function becomes Q =f (L, C).
The production function is based on the following set of assumptions:

– The level of technology remains constant.

– The firm uses its inputs at maximum level of efficiency.

– A change in any of the variable factors produces a corresponding change in the level
of output.

–It relates to a particular unit of time.

– The inputs are divisible into most viable units.

Following are the main features of production function:

1. Substitutability:

2. Complementarity:

3. Specificity:
 Long Run Short Run

Long run function

Production in short run

Concepts of
Fixed Factors Production Variable Factors
Function
Factors cannot be Those factors that can be
changed in short run varied to vary production

Level of Production Scale of Production

The quantity of production All factors can be increased

can be increased with in long run that increases the
increasing one factor scale of production
 Objectives of Production Function

• How to obtain Maximum output

• Helps the producers to determine whether employing variable inputs /costs
are profitable
• Highly useful in long run decisions
• Least cost combination of inputs and to produce an output
 Important facts about production function

A Production function is expressed with reference to a particular period of time.

It expresses a physical relation because both inputs and outputs are expressed in
physical terms.
Production function describes a purely technological relation because what can be
produced from a given amount of inputs depends upon the state of technology.
The nature of production function, ie.how output varies with change in the quantity of
inputs,depends upon the time period allowed for the adjustment of inputs.
On this basis Production function is classified into two types:
Short run production function- Time when one input (say, capital) remains constant
and an addition to output can be obtained only by using more labour.
Long run production function= Both inputs become variable
 Concept of Time in Production Function
Alfred Marshal introduced the element of time in production decision. Time can
categorize as under:
• Market Period or Very Short Period: is a period during which all factors of' production
and hence cost remains fixed. As such, outputs as well as supply also remain fixed.
• Short Run: a period so brief that the amount of at least one input is fixed. Thus we
have both fixed as well as variable factors. A period in which the firm can change
production and supply but cannot change plant size. Higher prices cause larger quantities
to be supplied.
• Long Run: is a period of time sufficient enough for all inputs (or factors of production),
to be variable as far as an individual firm is concerned. The length of time necessary for
all inputs to be variable may differ according to the nature of the industry and the
structure of a firm.Plant size can vary and all costs become variable Secular period -
(Very long Permits run) technology and population to vary
 Types of Production Function
Before analyzing the types of production-function it will be useful to understand
the meaning of following important terms :
A. Fixed Factors and Variable Factors Factors of production are broadly
classified into two categories i.e. fixed and variable factors:
(i) Fixed Factors- The factor inputs which cannot be varied in the short-period,
as and when required are called fixed factors. Examples of Fixed Factors are :
Plant, machinery, heavy equipments, factory building, land etc.
(ii) Variable Factors - The factor inputs which can easily be varied, in the
short-period as and when required, are called variable factors. Examples of
variable factors are : labour, raw material, power, fuel etc. The distinction
between fixed factors and variable factors appears only in the short-period. In
the long-run, all the factors of production become variable factors.
 Terms Production Function
(a) Total Product (TP) is the total amount of a commodity that is produced with
a given level of factor inputs and technology during a given period of time.
(b) Average Product (AP) is the output produced per unit of input employed. It
can be obtained by dividing TP by the number of units of variable input.
So AP = TP/L where L is the units of labour.
(c) Marginal Product (MP) of an input is the additional output that can be
produced by employing one more unit of that input while keeping other inputs
constant.
TPP = ΣMPP (Sum of MPP of all the units of a variable factor) or
TPP = MPP1 + MPP2 + MPP3 + ............ MPP(n) or
TPP = APP × L where L indicates units of labour
APP = TPP/ L where L indicates units of labour
MPP = 𝚫TPP/ 𝚫L ' ' where '𝚫TPP is change in TPP and '𝚫L is change in units of labour or
MPP(n) = TPP(n) – TPP(n – 1) for eg: MPP of 2 units = TPP of 2 units – TPP of 1 units of
labour
 RELATIONSHIP BETWEEN TPP & MPP AND APP & MPP

The relationship between TPP and MPP can be explained as given below:
(i) As long as MPP increases, TPP increases at an increasing rate.
(ii) When MPP falls but remains positive, TPP increases but at a diminishing rate.
(iii) When MPP becomes zero, TPP is maximum.
(iv) If MPP becomes negative, TPP starts decreasing.

The relationship between APP and MPP

(i) As long as MPP is greater than APP, APP increases.
(ii) When MPP is equal to APP, APP is maximum and constant.
(iii) When MPP is less then APP, APP decreases.
(iv) MPP can be zero and negative but APP is never zero or negative.
TPP increases from point O to point B. There are two phases
of this increase in TPP. First, from O to A in which TPP
increases at on increasing rate. In this phase in the lower
portion of the diagram MPP increases upto point. C. So we can
conclude that when MPP increases TPP increases at an
increasing rate. Second phase of increase in TPP is from A to B
in which TPP increases at a diminishing rate. In the lower
portion of the diagram, MPP decreases from point C to point D
but it remain positive. So we can conclude that when MPP falls
but remains positive, TPP increases at a diminishing rate. At
point B on TPP curve, TPP is maximum. In the lower portion of
the diagram MPP is zero at point D. So we conclude that
where MPP is zero, TPP is maximum. After point B, TPP falls.
After point D MPP becomes negative and TPP falls. In the
lower portion of the above, APP and MPP curves have been
drawn. Before point R on APP curve, MPP is greater than APP,
so APP increases. At point R MPP is equal to APP. At this point.
APP is constant and maximum. After point R on APP curve,
MPP curve is below APP curve, so we can say that when MPP is
less than APP, APP falls.
 Law of Variable Proportions
The law of variable proportions is a short period production law. It is also called
returns to a factor. Let us first understand the meaning of variable proportions. In a
production process when only one factor is varied and all other factors remain
constant, as more and more units of variable factor are employed, the proportion
between fixed and variable factors goes on changing. So it is termed as the law of
variable proportions. This law states that if you go on using more and more units of
variable factor (labour) with fixed factor (capital), the total output initially increases
at an increasing rate but beyond a certain point, it increases at a diminishing rate
and finally it falls. This law was initially called the law of diminshing returns Marshall
who applied the law only in agriculture sector but modern economist called it the
law of variable proportion and proposed its applicability to all the sectors of the
economy.
 Assumptions of Law of Variable Proportions
(i) The firm operates in the short run.
(ii) There is no change in technology of production.
(iii) The production process allows the different factor ratios to produce different levels out
output.
(iv) All the units of variable factor are equally efficient.
(v) Full substitutability of factors of production is not possible.
According to the law when we employ more and more units of a variable factor with the
fixed quantity of other factors and technology, the marginal product of the variable factor
first increases and then decreases. In other words, with employment of more and more
units of a variable factor with fixed quantity of other factors, the total product first
increases and then starts decreasing. It means that in short run labour is the only variable
factor, Return to labour or marginal product of labour initially increases but as more units
of labour are employed its MPP declines and may also become negative. There are three
phases of returns to a variable factor which are discussed below.
 Law of Variable Proportions
(a) Phase I: Increasing Returns to a factor In this phase TPP increases at an
increasing rate and marginal product of variable factor, labour increases. In the end
of this phase MPP is maximum. So, this is the phase of increasing returns to a
factor.
(b) Phase II: Diminishing Returns to a factor In this phase TPP increases but at a
diminishing rate MPP declines but remains positive. At the end of this phase MPP is
zero. At this point TPP is maximums. So, this is the phase of diminishing returns to
a factor.
(c) Phase III: Negative Returns to a factor In this phase, MPP declines and it
becomes negative. Here the TPP also starts falling. It operates from the level of
output where MPP of labour is zero but subsequently becomes negative. The table
17.2 given below illustrates the three phases of the law of variable proportions
 REASONS BEHIND DIFFERENT PHASES OF THE LAW OF VARIABLE
PROPORTIONS
In phase I, we get increasing returns to a variable input because greater use of variable inputs makes it
possible to utilize fixed indivisible factor more efficiently and also to introduce a greater division of
labour and specialization. It leads to optimum combination of fixed and variable inputs.

In phase II, we get diminishing returns to a variable input because in this stage the proportion between
variable and fixed inputs has crossed the optimum proportion between them and a variable input such as
labour has less and less fixed input to work with. In phase III, the variable input becomes too much
relative to fixed inputs which obstructs the production process and therefore results in fall of TPP.
because MPP becomes negative. So, phase III is called the stage of negative returns to variable factor.
So phase III is called the stage of negative returns to variable factor.

The law of variable proportions is an extension of the law of diminishing returns to a factor. The law
of diminishing returns to a factor states that as more and more units of a variable factor are employed
with fixed factors and technology, its marginal product eventually declines.If technical advancements do
not take place there is no increase in the efficiency of the factor inputs, then diminishing returns shall
be applicable even in industry
 Law of Returns to Scale
The law of returns to scale explains the proportional change in output with respect to
proportional change in inputs. In other words, the law of returns to scale states when there are
a proportionate change in the amounts of inputs, the behavior of output also changes. The
degree of change in output varies with change in the amount of inputs.

“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

 Law of Returns to Scale
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.
Unit of K Unit of INCREASING CONSTANT DIMINISHING
Labour

1K 1L 10 10 10

2K 2L 25 20 18

3K 3L 50 30 25
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 eg, 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 returns to scale. When there is an increase in the
scale of production, the average cost per unit produced is lower
as the organization enjoys high economies of scale.

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+2L 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.
Constant Returns to Scale & Diminishing 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. 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 2K+2L 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.

Diminishing returns to scale refers to a situation when the proportionate

change in output is less than the proportionate change in input. For eg, when
capital and labor is doubled but the output generated is less than doubled, the
returns to scale would be termed as diminishing returns to scale.When the
combination of labor and capital moves from point a to b, it indicates that input
is doubled. At point a, the combination of input is 1k+1L and at 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.
 Economies of scale
Economies of scale refer to the cost advantage experienced by a firm when it increases its level of
output. The advantage arises due to the inverse relationship between per-unit fixed cost and the
quantity produced. The greater the quantity of output produced, the lower the per-unit fixed cost. It
also result in a fall in average variable costs (average non-fixed costs) with an increase in output.
This is brought about by operational efficiencies and synergies as a result of an increase in the scale
of production.

Effects of Economies of Scale on Production Costs

1. It reduces the per-unit fixed cost. As a result of increased
production, the fixed cost gets spread over more output than
before.
2. It reduces per-unit variable costs. This occurs as the
expanded scale of production increases the efficiency of the
production process. In economics, a key result that emerges from
the analysis of the production process is that a profit-maximizing
firm always produces that level of output which results in the least
average cost per unit of output.
Types of Economies of Scale

1. Internal Economies of Scale

This refers to economies that are unique to a firm. For instance, a firm may hold a patent
over a mass production machine, which allows it to lower its average cost of production
more than other firms in the industry.

2. External Economies of Scale

These refer to economies of scale enjoyed by an
entire industry. For instance, suppose the
government wants to increase steel production. In
order to do so, the government announces that all
steel producers who employ more than 10,000
workers will be given a 20% tax break. Thus, firms
employing less than 10,000 workers can potentially
lower their average cost of production by employing
more workers. This is an example of an external
economy of scale – one that affects an entire industry
or sector of the economy.
 Sources of Economies of Scale

1. Purchasing- Firms might be able to lower average costs by buying the inputs required for the
production process in bulk or from special wholesalers.
2. Managerial - Firms might be able to lower average costs by improving the management structure
within the firm. The firm might hire better skilled or more experienced managers.

3. Technological- A technological advancement might drastically change the production process. For
instance, fracking completely changed the oil industry a few years ago. However, only large oil firms that
could afford to invest in expensive fracking equipment could take advantage of the new technology.

4. Marketing economies of scale - it arise from the ability to spread advertising and marketing budget
over an increasing output. That means, as production increases, firms can spread (fixed) marketing
expenses over a larger output, which reduces per-unit costs. In addition to that, large firms often profit
from a strong brand, which means they can get a higher reach and better advertising deals than smaller
companies.

5. Financial economies of scale- are achieved through cheap access to capital and financial markets. That
means as organizations grow, they are usually considered to be more creditworthy (i.e., they get a higher
credit rating). This allows them to get more favorable interest rates when borrowing money from banks. In
addition to that, really large firms can raise money on the stock market or by issuing bonds.
 Sources of Economies of Scale

6. Commercial economies of scale - arise from price reductions due to discounts or bargaining power.
That means large firms can buy most of the goods and services they need (i.e., their inputs) in large
quantities. This, in turn, allows them to profit from bulk discounts and a strong bargaining position to
negotiate lower prices. These discounts allow them to reduce the per-unit costs of the products they sell
significantly.

7.Network economies of scale - can be achieved when the marginal costs of adding additional customers
are extremely low or decreasing. That means firms who can support large numbers of new customers with
their existing infrastructure can substantially increase profitability as they grow. This type of EoS occurs
mostly in online businesses, such as e-commerce shops. The reason for this is that adding additional
customers to an online shop costs next to nothing. Therefore the profit margin usually increases
significantly when large numbers of new customers are added to the network.

8. Division of Labor
As a company gets larger, it can benefit from the division of labor. By allocating workers to specific tasks,
they can do more effectively and efficiently. For example, Apple splits its operations down into design,
hardware, software, manufacturing, marketing, production, and assembly. Each employee has a different
role that they specialize in. That allows them to master a specific skill, benefiting the company through
greater efficiency. A software designer is not going to be much use producing the units, nor would a
production worker be able to do the work of a software designer.
 External Economies of Scale

External economies are slightly different from internal economies in the fact that they occur
outside, independent of the firm, but within the industry. For example, the local council may
build a new railway line, with local businesses benefiting from cheaper transport, and
potentially a greater influx of new customers. Both of which may help reduce unit costs.
Examples of external economies of scale include:
● Infrastructure
● Government influence
● Suppliers
 Advantages of Economies of Scale
1. Reduced unit costs- The bigger a company becomes, the more customers it can serve –
thereby allowing it to reduce costs per head. For example, companies with high fixed costs
tend to benefit the most as these costs can be spread out per customer.

2. Higher profits- Economies of scale reduce the unit price and by extension, produce
greater profit margins. As a firm gets bigger, it starts to sell to more customers. When
combining lower costs and higher customer volumes – higher profits result.

3. Competitive Advantage- As a company grows larger, its presence in the market also
increases. Customers start to become aware of its brand and develop trust in it – which
allows the firm to establish its position in the market. It may also be afforded lower interest
rates as well as greater availability of credit.

4. Influence over-regulation- As a business grows and increases its presence in the market,
it hires more workers and becomes a more integral part of the economy. In turn, it is able to
use this fact to lobby the government for regulatory change. For instance, it might be to
leave the country because the regulatory costs are too high.
 Advantages of Economies of Scale
5. Lower prices- As the firm is able to reduce its average cost per unit – it can feed into
lower prices for the consumer. Whilst some companies will take all the profits from
increased efficiency – firms in a competitive market will pass on some of the cost savings
to the customer.

6. New Products and Services- As a company grows larger, it often seeks to grow further.
Now the best way of doing that is by extending its existing offering and attracting new
customers – which leads to greater consumer choice.

7. Higher wages- In a competitive market, economies of scale can lead to growing wages
as firms have lower costs. This is why big firms are able to afford higher salaries than local
competitors. As the firm grows, production starts to become more efficient. In turn, they are
able to offer higher wages than competitors to attract the top talent.
 Disadvantages of Economies of Scale
1. Poor communication- When a firm grows, it sets up numerous departments for specific
tasks. Now that may benefit the firm through the division of labour, but it makes
communicating between teams difficult. For instance, who do you speak to if you have a
problem with X. Often in such big companies, you are passed on and on and on again –
taking, what should be an easy issue to resolve, significantly longer.

2. Loss of control- As the firm grows, management may go from having one or two
delegates, to having 10 or 15 people working under them. It is far easier to monitor and
assist a smaller team rather than keeping tabs on a large workforce. In turn, this can lead to
some employees underperforming – either because they don’t receive adequate training, or,
because their performance is not being monitored.

3. Poor morale- In small companies, there may be a nice community feel whereby everyone
knows each other and are all friendly. When a company starts to grow, it is easy for
employees to feel like they are ‘another cog in the wheel’. They are something small and
insignificant in this large company – which can contribute to poor employee engagement
and performance.
 Disadvantages of Economies of Scale
4. Tasks being repeated- When there are thousands of employees in one firm – it is very
easy for two or more people to end up doing the same tasks. This is particularly prevalent
when considering poor communication as a factor. When the left arm doesn’t know what
the right is doing, it is easy enough for them to be doing the same thing.

5. Public opinion- A big company such as Nike or McDonald’s faces a bigger backlash from
paying staff low wages or using cheap labor from abroad. On occasion, this has led to
boycotts. Yet a small local store doing the same may not face such criticisms. Quite simply,
bigger stores are held to a higher standard.
There a number of factors responsible for increasing returns to scale. Some of the
factors are as follows:

1. Technical and managerial indivisibility:

Implies that there are certain inputs, such as machines and human resource, used for
the production process are available in a fixed amount. These inputs cannot be divided
to suit different level of production.Therefore, when there is increase in inputs, there is
exponential increase in the level of output.

2. Specialization

Implies that high degree of specialization of man and machinery helps in increasing the
scale of production. The use of specialized labor and machinery helps in increasing the
productivity of labor and capital per unit. This results in increasing returns to scale.
 Producer’s equilibrium- TC & TR approach
Producer's equilibrium refers to a situation where
profits are maximised, i.e., the difference between
total revenue and total cost is maximised, or in cases
losses, the difference is minimised, so as to minimise
losses.
A producer is said to be in equilibrium when it is
producing a level of output at which his profit is
maximum. Profits are defined as the difference
between total revenue (TR) and total cost (TC). Thus,
Profit = TR - TC. Profits will be maximum when the
difference between total revenue and total cost is
maximum. The difference between total revenue and
total cost is maximum at the level of output where the
slope of TR curve = slope of TC curve. Thus refers to
the situation of ‘Profit Maximization’.
 Producer’s equilibrium- MR & MC approach
MR-MC approach to determine Producer’s Equilibrium:
The producer’s equilibrium can be explained in terms of Marginal Revenue and Marginal
Cost of production.

Conditions of MR-MC approach:

The profit is maximised when two conditions are satisfied:

a) MR = MC.

b) MC is rising ( or MC is greater than MR beyond the level of equilibrium output).

 The table shows the marginal revenue and
marginal cost at different levels of output
in perfect competition. Therefore, the
price or AR is constant i.e. Rs.10 and so as
MR is also constant at Rs.10.
Determination of Equilibrium point:
In this, the first condition i.e. MR=MC is
satisfied in two situations:
1) When 2 units of output are produced.
2) When 8 units of output are produced.
However, while in situation 1 (when
output is 2 units), the MC is falling. On the
other hand, in situation 2 (when output is
8 units), the MC is rising.
As noted earlier, the second condition for the determination of the producer’s equilibrium is – MC is
rising. Therefore, from these two situations, only the 2nd situation satisfies this condition. Hence,
here the producer’s equilibrium will strike when 8 units of output are produced, not when 2 units of
output are produced. Falling MC only increases distance between TR-TC, that is profit tends to rise in
situation of falling MC. So for a producer it will be irrational to strike equilibrium in falling MC , it will
only at 8th unit thereafter MC increases.
The reason for this is that with the given price and
falling MC results to the increase in the difference
between TR and TVC (because of ∑MC = TVC and
∑MR = TR) or increase in total profit. Consequently,
as the MC continues to fall, the difference between
TR and TVC tends to rise. As a result, the profit
tends to rise while falling MC. Accordingly, this
situation would be irrational for the producer to
strike the situation of equilibrium. This is because
he has the ability to earn more profits. Thus, the
equilibrium can only be struck when MC=MR = Rs. 10
and MC is rising. Therefore, here the producer will
maximise his profits only when 8 units of the
output can be produced.
 Producer’s equilibrium- Isocost curve approach
The value of all assets used for production is limited. Hence, the producer has to use such a
combination of inputs as would provide him with maximum output and profits. This optimum
level of production, also called producer’s equilibrium, is achieved when maximum output is
derived from minimum costs. In order to achieve this, producers first have to classify their
resources into different combinations. Each combination would provide production in
different quantities. The combination that provides the highest amount of produce at the
least amount of costs is the optimum level of production. In order to find out producer’s
equilibrium, we first need to understand isoquant curves and iso-cost lines.

Isoquant Curves

These lines represent various input combinations which produce the same levels of output.
The producer can choose any of these combinations available to him because their outputs
are always the same. Thus, we can also call them equal–product curves or production
indifference curves. Just like indifference curves, isoquants are also negatively-sloping and
convex in shape. They never intersect with each other. When there are more curves than one,
the curve on the right represents greater output and curves on the left show less output.
 Producer’s equilibrium- Isoquant curve approach
Isoquant curve shows combinations of inputs employable to produce a certain output. Isocost lines
portray cost combinations of two inputs like capital and labour which produce the same amount of
output. A combination of both these graphs helps us determine how inputs must be employed to produce
maximum output with the least expensive costs underlying them. Consider the table below. It shows four
combinations, i.e. A, B, C and D, which produce varying levels of output. The X-axis shows units of
labour, while the Y-axis represents units of capital. Points A, B, C and D are combinations of factors on
which IQ is the level of output, i.e. 100 units. IQ1 and IQ2 represent greater potential output.

Factor combinations Units of Labour Units of Capital

A 5 9

B 10 6

C 15 4

D 20 3
 Producer’s equilibrium- Isocost curve approach
Isocost lines represent combinations of two factors that can be bought with different outlays.
In other words, it shows how we can spend money on two different factors to produce
maximum output. These lines are also called budget lines or budget constraint lines. Let’s
assume that a farmer has Rs. 1,000 to spend on labour costs and ploughs for farming. The cost
of one such plough and wage per labourer is Rs. 100. Considering his total outlay of Rs. 1,000,
he can spend that money in the following combinations:

The farmer, in this case, can either spend the entire sum of Rs. 1,000 on just ploughs by buying
10 of them. Similarly, he can also spend it all on labour by employing 10 labourers. He can
even purchase both, labour and ploughs using different combinations as shown above. The
total outlay of Rs. 1,000 will remain the same.
Plough 0 100 200 300 400 500 600 700 800 900 1000

Labour 1000 900 800 700 600 500 400 300 200 100 0
Hence, the isocost line will remain straight as shown. The x-axis
represents units of ploughs, and Y-axis would show units of labour.
Output levels are shown by a straight line because they remain constant.

Production Equilibrium
Isoquant curves, as we learned above, show us input combinations that
we can employ to produce certain levels of output. Furthermore, isocost
lines help us determine combinations of two factors in which we can
invest our outlays to produce output. A combination of these two graphs
is what gives us the optimum production level, i.e. the producer’s
equilibrium.

Using this equilibrium, the producer can determine different

combinations to increase output. He can also use this information to
find ways to cut costs using the same inputs and consequently generate
more profit. We can find out the least expensive combinations of factors
by superimposing isoquant curves on isoquant lines.
The graph below shows how we can use isoquant curve and isocost lines
to determine optimum producer’s equilibrium. In the figure shown above, Plotting Producer’s
the isoquant curve represents targeted output, i.e. 200 units. Isocost lines Equilibrium
EF, GH and KP show three different combinations in which we can utilize
the total outlay of inputs, i.e. capital and labour.

The isoquant curve crosses all three isocost lines on points R, M and T.
These points show how much costs we will incur in producing 200 units.
All three combinations produce the same output of 200 units, but the least
costly for the producer will be point M, where isocost line GH is tangent
to the isoquant curve.Points R and T also cross the isoquant curve and
equally produce 200 units, but they will be more expensive because they
are on the higher isocost line of KP. At point R the producer will spend
more on capital, and labour will be more expensive on point T.

Thus, point M is the producer’s equilibrium. It will produce the same

output of 200 units, but will a more profitable combination as it will cost
less. The producer must, therefore, spend OC amount on capital and OL
amount on labour.
What is the Isocost Line?
Plotting Producer’s
Also termed as budget lines or budget constraint lines, isocost lines Equilibrium
represent a combination of 2 money spending factors that will
maximize the output. These various combinations of 2 factors are
labour and capital. A firm can decide to purchase on any combination
given the total outlay or the money at disposal. A combination of
isoquant curves and isocost lines gives us the producer’s equilibrium.
We can represent the isocost line mathematically as follows.

C = (w * L) + (r * K)
Here C - the cost of production
w - the cost of labour wages
L - units of labour
r - the price of capital or interest rate
K - units of capital

Any combination of these can be selected which satisfies the above

equation, for example, “30 units of labour + 20 units of capital”.
What is an Isoquant Curve? Explain Producer Equilibrium
with Isoquant Curve. Plotting Producer’s
Equilibrium

Isoquant curves demonstrate the different input

combinations that produce the same level of output. The
producer can select any of these combinations since the
output is the same in all the cases. Isoquant curves are
also called equal-product curves. Their key features are:

● They have negative slopes.

● Convex in shape.
● They never intersect.
● The curves on the right denote more output and
curves on the left denote lesser outputs.