Theory Of Firm Behaviour

Unit 3

Managerial Economics
Production Function
The production function expresses a functional relationship between physical inputs and
physical outputs of a firm at any particular time period. The output is thus a function of
inputs. Mathematically production function can be written as Q= f (A, B, C, D). Where
“Q” stands for the quantity of output and A, B, C, D are various input factors such as
land, labour, capital and organization. Here output is the function of inputs. Hence output
becomes the dependent variable and inputs are the independent variables. The above
function does not state by how much the output of “Q” changes as a consequence of
change of variable inputs. In order to express the quantitative relationship between
inputs and output, Production function has been expressed in a precise mathematical
equation i.e. Y= a+b(x) Which shows that there is a constant relationship between
applications of input (the only factor input ‘X’ in this case) and the amount of output (y)
produced.
Production Function

Production is the result of co-operation of four factors of production viz., land, labour, capital and organization. This
is evident from the fact that no single commodity can be produced without the help of any one of these four factors
of production. Therefore, the producer combines all the four factors of production in a technical proportion. The aim
of the producer is to maximize his profit. For this sake, he decides to maximize the production at minimum cost by
means of the best combination of factors of production.The producer secures the best combination by applying the
principles of equi-marginal returns and substitution. According to the principle of equi-marginal returns, any producer
can have maximum production only when the marginal returns of all the factors of production are equal to one
another. For instance, when the marginal product of the land is equal to that of labour, capital and organisation, the
production becomes maximum. “The production function is purely a technical relation which connects factor inputs
and output.” Prof. Koutsoyiannis
Features of Production Function:
1. Substitutability:
The factors of production or inputs are substitutes of one another which make it possible
to vary the total output by changing the quantity of one or a few inputs, while the
quantities of all other inputs are held constant. It is the substitutability of the factors of
production that gives rise to the laws of variable proportions.

2. Complementarity:
The factors of production are also complementary to one another, that is, the two or more
inputs are to be used together as nothing will be produced if the quantity of either of the
inputs used in the production process is zero.The principles of returns to scale is another
manifestation of complementarity of inputs as it reveals that the quantity of all inputs are
to be increased simultaneously in order to attain a higher scale of total output.
Features of Production Function:

3. Specificity: It reveals that the inputs are specific to the production of a particular
product. Machines and equipment’s, specialized workers and raw materials are a few
examples of the specificity of factors of production. The specificity may not be complete
as factors may be used for production of other commodities too. This reveals that in the
production process none of the factors can be ignored and in some cases ignorance to
even slightest extent is not possible if the factors are perfectly specific.Production
involves time; hence, the way the inputs are combined is determined to a large extent by
the time period under consideration. The greater the time period, the greater the freedom
the producer has to vary the quantities of various inputs used in the production process.
In the production function, variation in total output by varying the quantities of all inputs is
possible only in the long run whereas the variation in total output by varying the quantity
of single input may be possible even in the short run.
Importance:
1. When inputs are specified in physical units, production function helps to estimate the level of production.

2. It becomes is equates when different combinations of inputs yield the same level of output.

3. It indicates the manner in which the firm can substitute on input for another without altering the total output.

4. When price is taken into consideration, the production function helps to select the least combination of
inputs for the desired output.

5. It considers two types’ input-output relationships namely ‘law of variable proportions’ and ‘law of returns to
scale’. Law of variable propositions explains the pattern of output in the short-run as the units of variable
inputs are increased to increase the output. On the other hand law of returns to scale explains the pattern of
output in the long run as all the units of inputs are increased.

6. The production function explains the maximum quantity of output, which can be produced, from any chosen
quantities of various inputs or the minimum quantities of various inputs that are required to produce a given
quantity of output.
Assumptions:

1. The production function is related to a particular period of time.

2. There is no change in technology.

3. The producer is using the best techniques available.

4. The factors of production are divisible.

5. Production function can be fitted to a short run or to long run.

ISOQUANTS:

The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and
‘quent’ implies quantity. Isoquant therefore, means equal quantity. A family of
iso-product curves or isoquants or production difference curves can represent a
production function with two variable inputs, which are substitutable for one another
within limits. Isoquants are the curves, which represent the different combinations of
inputs producing a particular quantity of output. Any combination on the isoquant
represents the some level of output. For a given output level firm’s production become,
Q= f (L, K) Where ‘Q’, the units of output is a function of the quantity of two inputs ‘L’
and ‘K’. Thus an isoquant shows all possible combinations of two inputs, which are
capable of producing equal or a given level of output. Since each combination yields
same output, the producer becomes indifferent towards these combinations.
ISOQUANTS

An isoquant in economics is a curve that, when plotted on a graph, shows all the
combinations of two factors that produce a given output. Often used in
manufacturing, with capital and labor as the two factors, isoquants can show the
optimal combination of inputs that will produce the maximum output at minimum
cost.An isoquant is a concave-shaped curve on a graph that measures output, and
the trade-off between two factors needed to keep that output constant.
The Properties of an Isoquant Curve

1: An isoquant curve slopes downward, or is negatively sloped.

This means that the same level of production only occurs when increasing units of input are offset with
lesser units of another input factor. This property falls in line with the principle of the Marginal Rate of
Technical Substitution (MRTS). As an example, the same level of output could be achieved by a
company when capital inputs increase, but labor inputs decrease.

2: An isoquant curve, because of the MRTS effect, is convex to its origin.

This indicates that factors of production may be substituted with one another. The increase in one
factor, however, must still be used in conjunction with the decrease of another input factor.

3: Isoquant curves cannot be tangent or intersect one another.

Curves that intersect are incorrect and produce results that are invalid, as a common factor
combination on each of the curves will reveal the same level of output, which is not possible.
The Properties of an Isoquant Curve

4: Isoquant curves in the upper portions of the chart yield higher outputs.
This is because, at a higher curve, factors of production are more heavily employed. Either more
capital or more labor input factors result in a greater level of production.

5: An isoquant curve should not touch the X or Y axis on the graph.

If it does, the rate of technical substitution is void, as it will indicate that one factor is responsible
for producing the given level of output without the involvement of any other input factors.

6: Isoquant curves do not have to be parallel to one another.

The rate of technical substitution between factors may have variations.

7: Isoquant curves are oval-shaped.

This allows firms to determine the most efficient factors of production.
Assumptions:

1. There are only two factors of production, viz. labour and capital.

2. The two factors can substitute each other up to certain limit

3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.

4. The technology is given over a period.

We consider the production of a good,
X, and suppose that only two factors of
production— labour and capital—are
employed.

Suppose also that it is always possible

to substitute capital for labour and
labour for capital continuously in the
production process.
ISOQUANTS
On the basis of these assumptions, it is possible that a given quantity of good X can be produced
using different combinations of labour and capital. This is shown in Fig. 6.3, where the vertical
axis measures units of capital (K) and the horizontal axis measures units of labour (L). Point A
represents just one possible combination of K and L which can be used to produce Q1 units of
output. There are, in fact, an infinite number of other points on the isoquant Q1 all of which
represent different combinations of K and L which can be used to produce Q1 units.Output Q2
and Q3 can be produced using any of the combinations of K and L represented by points along
the isoquants.An isoquant — or isoproduct — curve is a contour line which joins together the
different combinations of two factors of production that are just physically able to produce a given
quantity of a particular good.For example, at A, 1 unit of labour and 3 units of capital yield Q1 =
10 units of output, whereas, at D, the same output can be produced by 3 units of labour and 1 unit
of capital. Similarly, Q2 = 20 measures all combinations of inputs that yield 20 units of output. Q2
produces more output than Q1, and Q3 > Q2.n isoquant map is a family of isoquants which
shows the production function for a good.
Elasticity of Substitution

Elasticity of substitution measures the ease with which one can switch between factors of
production. The concept has a broad range of applications, from comparisons of labor
and capital in firms, immigrant versus native workers in the labor market, to assessing
‘clean’ versus ‘dirty’ methods of production for environmental economics. In order to
calculate an elasticity of substitution it is first necessary to determine an isoquant and
work out input ratios and marginal rates of technical substitution along the isoquant.
Elasticity of substitution changes at different points along an isoquant. For example, it
may be harder to swap machines for people when only a few people are involved in
production, whereas it is easier to introduce machines while there are enough people to
run the machines. The best-known example of a ES production function is the
Cobb-Douglas production function.
Cobb-Douglas production function:

Production function of the linear homogenous type is invested by Junt wicksell and first tested
by C. W. Cobb and P. H. Dougles in 1928. This famous statistical production function is known
as Cobb-Douglas production function. Originally the function is applied on the empirical study of
the American manufacturing industry. Cabb – Douglas production function takes the following
mathematical form.

Y= (AKX L 1-x )

Where Y=output K=Capital L=Labour A, ∞=positive constant

Assumptions:

1. The function assumes that output is the function of two factors viz. capital and labour.

2. It is a linear homogenous production function of the first degree

3. The function assumes that the logarithm of the total output of the economy is a linear
function of the logarithms of the labour force and capital stock.

4. There are constant returns to scale

5. All inputs are homogenous

6. There is perfect competition

7. There is no change in technology

Returns to Scale

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

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. Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

 1. Increasing Returns to Scale:
Increasing returns to scale or diminishing cost
refers to a situation when all factors of production
are increased, output increases at a higher rate. It
means if all inputs are doubled, output will also
increase at the faster rate than double. Hence, it
is said to be increasing returns to scale. This
increase is due to many reasons like division
external economies of scale. Increasing returns to
scale can be illustrated with the help of a diagram
8.In figure 8, OX axis represents increase in
labour and capital while OY axis shows increase
in output. When labour and capital increases from
Q to Q1, output also increases from P to P1 which
is higher than the factors of production i.e. labour
and capital.
 2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production

situation, where if all the factors of production are increased in a
given proportion, output increases in a smaller proportion. It
means, if inputs are doubled, output will be less than doubled. If
20 percent increase in labour and capital is followed by 10 percent
increase in output, then it is an instance of diminishing returns to
scale.The main cause of the operation of diminishing returns to
scale is that internal and external economies are less than internal
and external diseconomies. It is clear from diagram 9.On OX axis,
labour and capital are given while on OY axis, output. When
factors of production increase from Q to Q1 (more quantity) but as
a result increase in output, i.e. P to P1 is less. We see that
increase in factors of production is more and increase in
production is comparatively less, thus diminishing returns to scale
apply.
 3. Constant Returns to Scale:

Constant returns to scale or constant cost refers to the

production situation in which output increases exactly in the
same proportion in which factors of production are increased.
In simple terms, if factors of production are doubled output will
also be doubled.In this case internal and external economies
are exactly equal to internal and external diseconomies. This
situation arises when after reaching a certain level of
production, economies of scale are balanced by diseconomies
of scale. This is known as homogeneous production function.
Cobb-Douglas linear homogenous production function is a
good example of this kind. This is shown in diagram 10. In
figure 10, we see that increase in factors of production i.e.
labour and capital are equal to the proportion of output
increase. Therefore, the result is constant returns to scale.
Profit Maximization

Profit maximization is the act of achieving the highest revenue or profit. The sales level
where profits are highest is at the strategic level. It is typically used as a benchmark for
the best situation and for planning purposes. Profit maximization is simply, using a
product in order to generate a desired profit or return on investment.
Profit maximization can be achieved in a variety of ways, but usually requires a high level
of specialization and knowledge because minimizing costs and maximizing revenues are
two key concepts that must be addressed for this to occur.
The most common benchmark for profit maximization is called breakeven point, which
means that if a company can increase sales above this point, then they will not just
maximize profits but also create an opportunity to grow in the future.
Assumptions
1. The objective of the firm is to maximise its profits where profits are the difference between the
firm’s revenue and costs.

2. The entrepreneur is the sole owner of the firm. 3

. Tastes and habits of consumers are given and constant.

4. Techniques of production are given.

5. The firm produces a single, perfectly divisible and standardised commodity.

6. The firm has complete knowledge about the amount of output which can be sold at each price.

7. The firm’s own demand and costs are known with certainty.

8. New firms can enter the industry only in the long run. Entry of firms in the short run is not possible.

9. The firm maximises its profits over some time-horizon.

Profit Maximization Theory

The profit maximization theory is the principle that every firm should operate in order to
make a profit.Profitable companies can achieve this by selling more by charging higher
prices for their goods or services and reducing production costs. They have the
opportunity to do so because they have better access to more resources that other
companies may not have.There are many cases where the profit maximization theory
has been put into practice successfully in the workforce and has resulted in people's
wages being increased.In economics, the profit maximization theory asserts that a firm
will select the course of action that results in the maximum profits.
Profit Maximization Theory

Profit maximization is also an economic principle which states that firms will select the
course of action with the lowest costs for production, even if other alternatives may result
in lower total costs or higher total benefits.This theory helped economists understand
how firms decide on what to produce, how much they produce, and what prices they
charge for their products.This theory is a cornerstone of microeconomics, and it has
been extensively analyzed by various economists in terms of its assumptions and
implications.The profit maximization theory assumes that a company's goal is to
maximize profits. It assumes that the decision-making process in a company is rational
and efficient, and in order to maximize profits, the firm will take advantage of market
opportunities and use its resources efficiently
Profit Maximization
The term profit maximisation' is usually taken to mean the generation of amount largest absolute of profits
over the time period being analysed. This then leads us to defining the term "time Economists have
suggested two broad time period'. periods: the short run and the long run ; short-run consequently, there is
profit maximisation and long-run profit maximisation. The short run is defined as a adjustments to period
where changed conditions are only partial, e.g. if demand for the product for a fim short run it can meet
increases, in the the increased demand through changes in manhours and intensive use of existing
machinery, but it cannot increase its production capacity. On the other hand, long run in 8 a period where
adjustment changed circumstances to is complete. For example, the above-mentioned firm can meet the in
the long run by making increased demand changes in its production capacity changes in man-hours and
intensive use of its constraints existing machinery. Thus, in the short run there are certain (physical or
financial or both) on expansion. As time passes, these constraints can overcome. And, when all gradually be
the constraints are overcome, the long specified for short or run is reached. No calendar time can be long
runs -these depend upon the nature of production. For example, a furniture workshop can increase its
automobiles may capacity take years and make to do so. complete The long adjustments run will, within a
matter of months, while a fim manufacturing therefore, be a matter workshop and a matter of of months in
casè of a furniture years for an automobile firm.
Profit Maximization Formula
Marginal cost is the increase in the total cost of production as a result of one more unit of output.
Marginal revenue is the change in total revenue per one more unit produced. Marginal revenue
equals marginal cost when profit maximization occurs. In order to determine which factor causes
firms to enter or exit markets, it is important to understand profit maximization. In order for firms to
maximize profits, the marginal cost must equal marginal revenue for all goods or services offered in
a marketplace. Most businesses have a profit maximization formula. They use this formula to
determine the level of output and input, as well as the profits that can be generated by a certain
company.A business can use this equation in order to achieve its desired level of output and profit.
This formula is also used in order to determine what type of products or services are needed in a
given time frame, or if the business is thriving with its current offerings.
Marginal Cost = Marginal Revenue
The formula to determine the marginal revenue would be:
Marginal Revenue = Change in revenue / Change in quantity
The formula to determine the marginal cost would be:
Marginal Cost = Change in cost / Change in quantity