Theory of production

Back to the basics

 Production refers to the creation of economic utilities by transforming inputs to outputs.

Production = inputs outputs

 There are four kinds of inputs [ factor of productions]

 Total summation of all  Net addition to total  Production per unit

outputs. o/p due to additional of variable input
labor (variable factor) (e.g. labor)
 or
 It includes all o/p from  Change in T.P due to 
variable as well as fixed change in the variable
factors. factor.

Understanding MP AP curves :

Let us understand the movement of MP and AP with the help of schedule.

Labor Total Product (TP)

MP AP
0 0 - -
1 10 10 10
2 24 14 12
 3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5

Observation: From the table, we can see that MP initially increases up to 3 rd unit of labour and then
starts to fall.

For AP: We can see that AP also increases up to 3rd unit of labour and then starts to fall.
Conclusion: Both MP & AP curves will be of ‘inverted-u’ shape.
Graphical Representation of MP & AP curves

Relationship b/w AP MP Curves:

 MP cuts AP from above at its maximum point, here MP = AP

 The rate of increase of MP > the rate of ↑ in AP [when MP > AP, AP↑]

 The rate of fall of MP > the rate of fall in AP [when MP < AP, AP ↓]

[In short MP rises steeply / rapidly as compared to AP and also falls rapidly in contrast to AP]

Production Function:
 It is the functional relationship between inputs and outputs.
 Q = f (L, l, K, E)

 O/P is a function of land, labour, capital, and entrepreneur.

  Production function can be bifurcated into short run and long run [on the basis of time period]

 Short Run Production Function: When some factors are fixed and some are variable.
 Factors Proportions may vary as only the variable factors are changed and other factors
undergo zero change.
 E.g.: Law of variable proportions.

 Long-Run Production Function: When all factors are variable.

 Factor proportions are Constant as per the requirement.
 E.g.: Law of returns to scale.

Law of Variable Productions: It is a short-run production function

 Production can be increased only by increasing the variable unit/factor.
 Factor proportions may vary hence the name variable proportions.
 It is also known as returns to factor.
 Assumption:
1. There is no change in technology.
2. Applicable in short term
3. The factor productions are variable.
4. The production is homogenous (identical) in nature.
 Law :- In the short run, when one factor is variable and others are fixed (land) the production
can be increased only by increasing the variable (labour) factors. Initially the TP increases at
increasing rate, then it increases at decreasing rate and ultimately it starts to fall.

Tabular Presentation Of Law

(L) (TP/L)
Land TP Remarks
Labour AP

1 1 2 2 - STAGE-I
Increasing Returns
1 2 5 2.5 3
MP>AP
1 3 9 3 4
Graphical Representation:

1 4 12 3 3
 There are total 3 stages of production as follows: Operates up to MP = AP
1 5 14 2.8 2

1 Stage 1: 6 15 2.5 1
 It is known as the stage of increasing returns.
1 7 15 2.14 0
 Here TP increases at an increasing rate as MP is constantly rising.
 Point of inflexion is reached when MP is maximum. STAGE-III -ve MP
1 8 14 1.75 -1
Negative
[Point of inflexion refers to a specific point after which returns
the curve changes its
trajectory (Shape)]
 MP is increasing.
 TP curve is concave in shape.
 The stage ends where MP = AP (or at the maximum point of AP)
 Reasons of increasing returns:
i. Indivisibility of fixed factor (Land)
ii. Efficient utilization of resources
Stage 2:
 It is called the stage of Diminishing returns.
 Here TP increases at decreasing rate as MP is constantly falling.
 MP is falling.
  TP becomes maximum when MP = 0.

 TP curve is convex in shape.

 The stage operates upto the point where MP = 0.
 Reason for decreasing returns:
i. Scarcity of fixed factor.
ii. Imperfect substitutability b/w land and labour.
Stage 3:

 It is known as the stage of negative return .

 Here TP curve begins to fall.
 MP is negative.
 Reason for negative return:
i. Over utilisation of resources.
ii. Fall in efficiency of variable factors. (also depicts the problem of
disguised unemployment in the agriculture sector where the additional
labour is not adding anything to the production I.e., when MP = 0 or -
ve)
iii. Lack of coordination b/w fixed and variable factor.

Optimum Stage Production:

2nd stage is known as the rational stage of production. This is so because we are getting the
maximum O/P in this stage (TP is max in 2nd stage) and hence we are able to reach optimum
combination/ratio b/w (fixed factor) and labour (variable factor).

Returns to Scale:

 It is a long-run production function.

 All factors are variable.
 There is no segregation between fixed and variable factors.
 Under this law, we study the proportion change in output with respect to proportionate change
in inputs.
 In the long run, the factor proportion are assumed to be constant.
 Aim of study:
% △ in Total O/P % △ in Total factor inputs.

 Assumptions:
i. The firm has only 2 factors of production that are capital and labour.
ii. Both labour and capital are combined in fixed proportions for different combinations.
iii. No change in price of factors.
iv. Fixed state of technology.

 Law:
 In the long run, when all factors are variable, the production can be increased by changing the
proportions of all factors. Initially, the firm experience increasing returns to scale, then it shifts to
constants returns to scale and finally the stage of diminishing returns to scale.

 When proportion △ in output  When proportion change in  When proportion in △

is greater than proportionate
△ in input.
 E.g.: we ↑ the inputs by
100% but O/P is ↑ed by
200%.
 Graphical Depiction
output = proportionate △ O/P <proportionate △ in
in inputs. inputs.
 E.g.: we ↑ the inputs by  E.g.: we ↑ the inputs by
25% and as a result O/P 200% but the subsequent
↑es by 25%.
D in O/P is only 100%.
 Graphical Depiction  Graphical Depiction

 Observation:
 Observation:  Observation:
Distance between isoquants
Distance between isoquants Distance between
is equal i.e., equidistant.
is decreasing. isoquants is increasing.
 Reason: Economies to
 Reason: Economic to scale.  Reason: Dis-economies
scale = Dis-economies to to scale
scale.

Note: Economics to scale refers to a fall in per-unit cost due to expansions of production (Output).
Dis-economies to scale refers to an increase in per unit of cost due to expansion of output.
 Return To Scale at Glance

Explanation:

Increasing Returns:
 Up to I3
 Distance b/w IQ decreasing.
 Prop △ in O/P > prop △ in input.
 Reason: Economics to scale.

Constant Returns:
 Up to I6
 Equidistant IQs
 Prop △ in O/P = prop △ in input.
 Reason: Economics to scale offset the dis-economies.

Decreasing Returns:
 I6 onwards
 Distance b/w IQs increases.
 Proportionate △ in O/P < proportionate △ in input.
 Reason: Dis-economies to scale.