Theory of Production-II

Production Function with Two Variable Inputs:

 Isoquant:
An Isoquant is a curve representing the different combination of two
inputs that produce the same amount of output. An isoquant curve is
also known as iso-product curve or equal product curve or production
indifference curve.
 Assumptions:
 Two factors of production
 Divisible factors of production
 Constant Technique
 Possibility of Technical Substitution
 Efficient Combinations
Cont.
Isoquant Schedule
Combination Units of Labour Units of Capital Output
A 1 15 200
B 2 11 200
C 3 8 200
D 4 6 200
E 5 5 200
Cont.
Isoquant Curve
Properties of Isoquant Curves:
 Isoquant Curves Slope Downward from Left to Right:
 Isoquants are Convex to the Origin:
 Two Isoquant Curves Never Cut Each Other:
 Higher Isoquant Curves Represent Higher Level of Output:
 Isoquants Need Not be Parallel to Each Other:
 No Isoquant can Touch Either Axis:
Cont.
 Isoquants are convex to the origin.
 The marginal rate of technical substitution between L and K (MRTSLK )
is defined as the quantity of K which can be given up in exchange for
an additional unit of L. It can also be defined as the slope of an
isoquant.
• MRTSLK = – ∆K/∆L = - dK/ dL, where ∆K is the change in capital and
∆L is the change in labour.
• An increase in the use of labour, fewer units of capital will be used. A
declining MRTS refers to the falling marginal product of labour in
relation to capital. To put it differently, as more units of labour are
used, and as certain units of capital are given up, the marginal
productivity of labour in relation to capital will decline.
Cont.
 The slope of the isoquant curve is the rate of substitution that shows how
one input can be substituted for another while holding the output
constant. This is called marginal rate of technical substitution (MRTS).
 MRTS is also equal to the ratio of marginal product of one input to the
marginal product of another input. If the change in labour is substituted
for the change in capital, then the increase in output due to increase in
labour should match with the decrease in output due to decrease in
capital. Mathematically,
∆L x MPL= ∆K x MPk
∆Q= ∆L x MPL + ∆K x MPk
 Since the output remains unchanged at a given isoquant,
∆L x MPL + ∆K x MPk = 0
(MPL / MPK )= (- ∆K / ∆L)
MRTSKL = (MPL / MPK )
Types of isoquant Curve
 There is a continuous substitution of one input variable by the other input
variable at a diminishing rate. Perfect complements and perfect
substitutes give different forms of isoquants.
 The different types of isoquant curve are as follows:
 Linear Isoquant
 L-shaped Isoquant (Input-output)
Linear Isoquant
 This type of isoquant are depicted by
a straight line sloping downward from
left to right. It indicated a perfect and
unlimited substitutability between two
factors implying that the product may
be produced even by using only
capital or labour or by infinite
combinations of the two factors.
L-shaped Isoquant
 Input-output isoquants are L-
shaped curve and also known as
Leontief isoquants. They assume a
perfect complementary nature
between factors implying zero
substitutability. Factors are jointly
used in a fixed proportion. It means
that there is only one method of
production to produce a commodity.
Hence, to increase output, both
factors are to be increased holding
the proportion constant.
Isoquant Map
 An isoquant map, is a cluster of
isoquants, each one of which
represents production of a
specific quantity of output. As we
move away from the point of
origin or on a higher isoquant, it
will show a higher level of output.
In other words, an isoquant closer
to the point of origin will indicate a
lower level of output. Isoquant Q1
represents a lower level of output
as compared to isoquant Q2 and
Q3 .
Ridge Line:
 The ridge lines are the locus of
points of isoquants where the
marginal products (MP) of factors
are zero. The upper ridge line
implies zero MP of capital and the
lower ridge line implies zero MP of
labour. Production techniques are
only efficient inside the ridge lines.
The marginal products of factors
are negative and the methods of
production are inefficient outside
the ridge lines.
Cont.
 If a producer uses more of capital or more of labour then the total
product will eventually decline. The firm will produce only in those
segments of the isoquants which are convex to the origin and lie
between the ridge lines. This is the economic region of production.
 Curves OA and OB are the ridge lines and in between them only
feasible units of capital and labour can be employed to produce 100,
200, 300 and 400 units of the product.
 For example, OT units of labour and ST units of the capital can produce
100 units of the product, but the same output can be obtained by using
the same quantity of labour OT and less quantity of capital VT.
Cont.
 To attain the highest possible level of output for a given level of cost or
the lowest possible cost for producing any given level of output the firm
needs to know the prices of inputs and the amount of resources available
with the firm.
 Inputs have specific market prices. In determining the optimal
combination of inputs, producer must take into account the relative prices
of inputs so as to minimize the cost of producing a given output. That is,
if a firm use more of the relatively cheaper input and less of the relatively
costlier input, the cost of production can be minimized.
 Prices of inputs for an individual firm are usually given. The different
possible combinations of inputs which the firm can buy with the help of
its resources (given input prices) is represented by an Isocost line.
Isocost Line:
 An isocost line shows various
combinations of the factor inputs
that the firm can buy with a given
outlay and factor prices. Every
point on an isocost line will result
in the same level of total cost.
 Just as there are various isoquant
curves, so there are various
isocost lines, corresponding to
different levels of total output.
Cont.
 Algebraically, the isocost or the budget line can be expressed as
E = PL . L + PK . K
Where, E = Total budget allocation for inputs L & K
PL & PK = Prices of labour & capital respectively
L & K = Quantity of Labour & Capital respectively
K = E/PK – PL/PK . L
Thus, slope of the budget line is PL/PK = w/r
Optimal Combination of Inputs
 Whatever the firm choose to
produce, it wishes to produce it at
the least possible cost or maximum
output with a given level of cost.
 Production of given output at
minimum cost:
Equilibrium of the producer is
reached at point L where the
isoquant representing the chosen
output is just tangent to the isocost
line. The tangency point means the
slope of the isoquant (MRTS) equals
the slope of the isocost line (ratio of
price of labour to price of capital).
Cont.
 The price ratio of inputs tells the producer about the rate at which one
input can be substituted for another in purchasing, while MRTS tells
about the rate at which these inputs can be substituted in production.
To minimize cost subject to a given level of output (given input prices)
the firm must purchase those amount of the two inputs which
equalize the MRTSLK of the inputs to their relative prices (w/r).
 The optimal combination of inputs which minimizes the cost for a
given level of output is L* of labour and K* of capital is given by the
equilibrium Point L.
Cont.
 Production of Maximum output with a given level of cost:
The firm wants to maximize output, subject to given resources as
represented by the isocost line AB. This can be achieved where the
isoquant is tangent to the isocost line.
In order to maximize output subject to a given cost, the firm must employ
inputs in such amounts as to equate the MRTSLK and the input price ratio.
 Change in Firm’s Resources and output: The Expansion Path
When a firm’s expenditure on inputs increases (input prices remaining the
same), it would lead to a parallel shift in the budget line. Each budget line
will give a new tangency point and therefore, a new equilibrium point. If we
join these equilibrium points, we get a curve known as expansion path.
 An expansion path is the locus of different points of equilibrium when the
firm’s production expenditure changes, input prices remaining constant. The
expansion path shows how factor proportions changes when output and
expenditure change, input prices remaining constant throughout.
Long run Production Function: A Case of Return to
Scale
 In the long-run all the inputs can change. These can change in two
ways, (I) both L and K can change in the same proportion, implying
that (K/L) ratio or technique of production remains the same, (II) L
and K change in different proportion implying the (K/L) ratio or
technique of production varies with change in output.
 The percentage increase in output when all inputs vary in the same
proportion is known as Returns to Scale. Return to scale relate to
greater use of inputs maintaining the same technique of production.
Return to scale occurs in three alternative situations. They are;
Constant Returns to Scale:
 Output increases in the same
proportion as the increase in
inputs.
Increasing Return to Scale:
 Output increases by a greater
proportion than the increase in
inputs.
 Causes:
 Indivisibility of the factors.
 Specialization of labour and
machinery.
 Dimensional economies - Increasing
the size of operation gives some
dimensional advantages eg. Cold
storage.
Decreasing Return to Scale:
 Output increases by lesser proportion
than the increase in inputs.
 Causes:
 “Inefficiency of managing large
operations” as one factor that tends to
produce decreasing returns to scale
after a limit. This is because:
 Difficulty in coordination and control
 Loss or distortion of information when
transmitted from top to bottom or
bottom to top.