Production Theory II

ODWAR VINCENT-LIRA UNIVERSI
TOPIC
Production Economics
Economic Resources:
"Economic resources are those scarce resources which help in the production of
goods and services".
The economic resources are classified under two main heads:
(1) Property Resources and (2) Human Resources.
(1) Property Resources: In property resources, we include land and capital. The term
land is used to describe all natural resources which are used in the process of
production and yield income. These resources which are free gifts of nature include
agricultural land, forests, mineral deposits, fisheries, rivers, lakes, oil deposits, etc.
The term capital refers to all man made resources which aids production. Thus
machinery, equipment, tools, factories, storage, transportation, etc., which are used in
the production of new goods and supplying them to the ultimate consumers are capital
resources.
(2) Human Resources: Human resources include labor and entrepreneurial ability.
Labor in economics refers to human effort, physical and mental which is directed to the
production of goods and services. Thus factory worker, clerk, typist, teacher, doctor.
Judge, physicist, etc., fall under the category of labor.
It may here be noted that it is the services of labor which are bought and sold for money
and not the labor itself. As regards the supply of labor, it depends upon the (i) size of
total population (ii) age composition of the population (iii) the availability working
population (iv) the working hours devoted to production (v) the remuneration paid to the
workers, etc., etc.
Entrepreneur or Enterprise, The entrepreneur or enterprise is the person who takes

initiative and combines resources for the production of goods and services (i) makes
basic business policy decisions (ii) attempts: to introduce new products, new
techniques, new forms of business organization, etc., and (iii) bears risk.
(a). Land as a Factor of Production:
The term land in economics is used in a special sense. It does not mean soil or earth
surface alone. Land in economics means natural resources. It includes all those things
which are found under and over the surface of earth. Land means the material and the
forces which nature gives freely to man's aid in land and water, in air and light and
heat".
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Characteristics/Features:
The main characteristics/Features of land as a factor of production are as follows:
(i) Supply of land. The supply of land from the point of view of the economy is perfectly
inelastic. However, from the point of view of a firm, it is relatively elastic.
(ii) No geographical mobility. Land has no geographical mobility. It cannot be shifted

from one region to another region.
(iii) Land differs in fertility. All the plots of land are not homogeneous. They differ in
fertility.
(iv) Land is permanent. The power of the soil is original and indestructible.
(b). Labor as a Factor of Production:
"Labor is an important factor of production. It is described as any human work which is

performed with the help of mind or physique with a view to earn income".
Characteristics/Features:
(i) Labor as a source. Labor is the source of his own labor power, It is inseparable from
labor himself.
(ii) Labor is perishable. A worker cannot store his labor. It is perishable.
(iii) Difference is labor power. The labor power differs from worker to worker
(iv). Labour is mobile. Labour is able to change places or jobs
(c). Entrepreneur as a Factor of Production:
The entrepreneur is an organizer. He is the person who organizes production by

bringing together the other three factor of production land, labor and capital.
"An entrepreneur as a person who controls the policy of the firm".
Functions of an Entrepreneur:
An entrepreneur performs the following functions:
(i) He conceives the idea of launching the project.
(ii) He mobilizes the resources for smooth running of the project.
(iii) The decision of what, where and how to produce goods are taken by the
entrepreneur.
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(iv) He undertakes the risks involved in production.
(v) He is an innovator. He innovates new techniques of production, new products and

brings improvements in the quality of existing products. He is in fact the captain of the
industry.
(vi) In a Joint stock Organization, the entrepreneurial functions are shared between the
shareholders, the directors and the top executives
Division of labour
"By division of labor is meant the specialization, of work. It refers to splitting up of a

task into a number of processes and sub-processes and carrying it out by a person or a
group of persons who are best fitted for it".
Two types are given below:
(1) Complex Division of Labor:
When a particular work is split up into different processes and sub-processes and each
process is carried out by a single person or a group of persons, the division of labor is
said to be complex. For example, in a needle manufacturing industry, no one
specializes in the making of a whole pin. The work is split up into different processes
and each worker is assigned a definite part in the whole work.
(2) Territorial Division of Labor:
When a certain locality specializes in the production of a particular commodity, the

division of labor is said to be territorial. For instance, Pakistan has specialized in the'
manufacturing of sports goods, Bangladesh in the production of Jute goods etc.
Advantages/Merits:
The system of division of labor has proved very beneficial to society. The main benefits
arising out of division of labor are briefly discussed as below:
(i) Increase in Productivity. Division of labor helps in bringing about a vast increase in
productivity.
(ii) Increase in Dexterity and Skill. Division of labor increases dexterity and skill of the
workers. When a person continuously works at one task for a longer time, he becomes
expert of that task.
(iii) Division of Labor stimulates Inventions. When a man is doing the same job over
and over again, he always keeps in mind as to how the work can be made easier. He
sometimes succeeds in inventing easier methods of production.
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(iv) Diversity of Employment. Division of labor splits up one work into many parts.
With the division of work, the range of occupation increases. This gives opportunity to
all types of workers such as young man, women, aged people, children, crippled
persons, etc., to get employment.
(v) Economy in the use of Machinery and Tools. When division of labor is introduced
in a certain work, there is a continuous use of machinery and tools and they do not
remain ideal. For instance if a worker is assigned the job of sewing shirts, he will be all
the time in need of sewing machine and not complete set of implements needed for
sewing the clothes.
(vi) Saving in Time and Efforts. If a worker has to learn all the processes of producing
a commodity, then the period of apprenticeship will be fairly long. In case, the work is
split up into small processes, the task can be specialized in a short period and there can
be much economy in time and efforts.
(vii) Large Scale Production at Cheaper Cost. Another advantage claimed by division
of labor is that it makes possible larger production at lesser cost.
(viii) Right man for the Right Job. Division of labor helps in bringing about the right
man in the right place. When there are too many jobs, every man tries to get himself
absorbed in a work, where he thinks himself to be best fitted. Thus, the chances of
putting, square pegs in round holes are minimized.
(ix) Increased in the use of Machinery. As the work is split up into a number of
processes, each process of production becomes so simple and easy that it can be
easily taken over by machines invented for that particular process. It is in this way, we
say, that division of labor leads to extensive use of machinery.
Disadvantages/Demerits:
Division of labor is not an unmixed blessing. It gives rise to certain disadvantages also.
They are briefly discussed below:
(i) Repetition Increases Monotony. When a worker has to perform the same work
over and over again, it creates sense of boredom in him. His individual incentive is
curbed. It is in fact, a poor record of a man's whole life never to have made more than
18th part of a pin.
(ii) Loss of Responsibility. Where a particular commodity is the Joint product of a

number of workers who are generally unknown to each other, they do not feel
responsibility of their work. Moreover, the workers do not feel pleasure and pride in it.
The creative instinct of the workers thus slackens.
(iii) Risk of Unemployment. If a person specializes in a part of the job and totally
depends upon it, then he can always be in danger of unemployment.
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(iv) Evils of Factory System. There is no doubt that division of labor involves
production on a large scale but the other side of the picture is that it brings over
crowdedness, slums, immorality, loss of individual freedom, strained relations of the
employer and the employees, etc., along with it. These we all name as the evils of
factory system.
(v) Disruption of Family Life. Another evil which is associated with division of labor is
that it bring disruption, in family life. As division of labor provides opportunities for
employment to women and children, so, it results in the break up of the family life.
Mobility of Labor:
"Mobility of labor refers to movement of labor from one place to another or changing of
profession or status or grade".
Types:
Mobility of labor is of five types.
(i) Geographical mobility. It means the movement of labor from one peace to another.
(ii) Horizontal mobility. Horizontal mobility of labor is from one Job to another having
similar status or salary in the same or some other profession.
(iii) Vertical mobility. It is the movement of worker from a junior position to a senior
position.
(iv) Occupational mobility. If refers to the change of profession by a worker for higher
status or income.
(v) Social mobility. It is the movement of worker from one social class to another e.g.,
the daughter of a labor becomes a doctor.
Factors Promoting Mobility of Labor:
The main factors which promote mobility of labor are:
(i) Increase in wages.
(ii) Better conditions of work.
(iii) Strong urge to make progress in life.
(iv) Peace and security.
(v) Better means of communication and transport.
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(vi) Quality of education.
(vii) Development projects.
Obstacles to Mobility of Labor:
The main hindrances or obstacles to mobility of labor are as under:
(i) Home sickness.
(ii) Unfavorable climatic conditions.
(iii) Difference in customs.
(iv) Language barrier.
(v) Restrictions imposed by the government.
(vi) Political disturbances.
(vii) Ethnic disturbances.
(d). Capital as Factor of Production:
Capital is as factor of production consists of those goods which are produced by the
economic system and are used as inputs in the production of further goods and
services. Capital may be physical or tangible or intangible. Capital goods yield valuable
production services over time.
Physical or Tangible Capital:
The material things which are used as inputs in the production of future goods are
called tangible capital. The major categories of tangible capital are office buildings,
power plants, factories, ware-houses, machines, inventories of inputs, roads, highways,
etc.
Intangible Capital:
Intangible capital consists of non-material things that contribute to the output of future
goods and services. For example, investment by a firm in advertising to establish a
brand name, or establishing a training programme for employees to increase their still
(human capital) is an input and so included in capital.
Functions of Capital:
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Capital occupies an important position in determining the rate of economic development
in the country. The main functions of capital, in brief, are as under:
(i) Capital provides equipments which help in the process of economic development.
(ii) An increase in the stock of capital goods like machinery factories, equipments,
buildings, economic overhead capital (transport, railroad, communication, etc) and
equipment for education, health, shelter etc., enhances the growth of output per capita
and consequently the income per capital raised.
(iii) The accumulation of capital makes the labor better equipped and delays the
operation of law of diminishing returns in agriculture and industry to a great extent.
(iv) Capital determines the quantity and also the composition of output in the
economy.
(v) Capital puts the economy on the path to development. It results, in technological
discoveries.
(vi)
The availability of capital helps in the creation of employment opportunities in the
country.
(vii) Capital adds value to the products.
(viii) An increase in the stock of capital once initiated feeds on itself. The process of
capital formation thus becomes interacting and cumulative.
Capital Formation
Capital is one of the important factors which governs the quantity and the composition
of output in a country. If there are increasing resources of capital in a country, it results
in technological discoveries, raises productivity of labor, increases the rate of economic
development and provides higher standard of living for the masses.
In case, there is deficiency of capital assets such as machinery equipment tools, dams.
roads, railways, bridges, etc., etc., the country then remains trapped in the vicious circle
of poverty. Capital accumulation/formation, thus is a core of economic development.
"Economic development has much to do with human endowments, social attitudes,

political conditions, and historical accidents. Capital is necessary but not a sufficient
condition of economic progress".
Capital formation is the process of building up the capital stock of a country through
investing in productive plants and equipment. Capital formation, it involves the
increasing of capital assets by efficient utilization of the available and human resources
of the country.
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Sources of Capital Formation and Importance:
The stock of capital goods can be built up and increased through two main sources:
(1) Domestic Resources and (2) External Resources.
(1) Domestic Resources:
Domestic resources play an important part in promoting development activities in the

country. These sources in brief are:
(i) Voluntary Savings. There are two main sources of voluntary savings (a) households
(b) business sector. As regards the volume of personal savings of the households. It
depends upon various factors such as the income per capita, distribution of wealth,
availability of banking facilities, value system of the society, etc.
The business sector is an important source of voluntary savings in the less developed
countries. But statistics of many underdeveloped countries indicate that both these
sources hardly manage to save 15% of their GDP. This is not even sufficient to maintain
the present standard of living of the masses.
(ii) Involuntary Savings.

The traditional methods used for increasing the volumes of savings are (a) taxation (b)
compulsory schemes for lending to the government. The two fiscal measures stated
above are very sensitive and delicate: They should be devised and handled very
carefully.
(iii) Government Borrowing. The volume of domestic savings can also be increased
through government borrowing. The government issues long and short term bonds of
various denominations and mobilizes saving from the genera! public as well as from the
financial institutions.
(iv) Use of Idle Resources. In the developing countries of the world there are many
resources which remain unutilized and underutilized. If they are properly tapped and
diverted to productive purposes, the rate of capital formation can increase rapidly.
(v) Deficit Financing. Deficit financing is regarded an important source of capita!

formation. In the developed countries this method is used for increasing effective
demand and ensuring continued high levels of economic activity. In the less developed
countries, it is used to meet the development and non development expenditure of the
government.
(2) External Resources:
External resources has the following types:
(i) Foreign Economic Assistance. In case, the developing nations needing foreign
capital and technical assistance and have the will to absorb capital and technical
knowledge and the social and political barriers are overcome, capital then becomes the
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touchstone of economic development. The main benefits of the foreign economic
assistance, however, in brief are as under:
(a) Foreign loans to bridge saving gap. Foreign loans supplement domestic savings
and help in bridging the resource gap between the desired investment and the domestic
savings.
(c) Provides greater employment opportunities. The financing of various projects

with the help of foreign assistance provides greater employment opportunities in a
country.
(d) Increase in productivity of various economic sectors. The inflow of capital and
technical know-how increases the productive capital of various sectors of the economy.
(e) Increase in real wages. The foreign resources help in increasing marginal
productivity of labor in the recipient country. The real wages of the workers are thus
increased with the help of foreign assistance.
(f) Provision of higher products. The foreign capital helps in the establishment of
industries in the country. The inflow of technical knowledge improves the quantity and
quality of manufactured goods and makes them available at lower prices to the
domestic consumers.
(g) Increase in tax revenue. The profits earned on foreign investment are taxes by the
government, The revenue of the state is thus increased.
(h) External economies. The inflow of foreign capital and advanced technology
stimulates domestic enterprises. The firm avails of the benefits of external economies
like that of training of labor, introduction of new technology, new machinery, etc., etc.
(ii) Donor Country and the Economic Assistance: Here a question can be asked .as
to why the developed nations are kind in giving aid to the developing countries?
According to the rich nations, the foreign aid is given for a combination of humanitarian
and self-interest reasons:
(a) Humanitarian ground. If a country is faced with famine, drought, epidemic,

diseases, earthquake etc., it is obligatory for the developed nations to help that country
financially purely on humanitarian grounds. The rich countries are extending economic
assistance in the form of grants to the poor nations of the world.
(b) Self-interest reasons. Foreign economic assistance is also provided on the

following self-interest reasons by the donor countries.
(a) The foreign aid may be given to protect the developing country from the influence of-
other camp countries.
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(b) The donor country may have surplus products. In order to check the fall in the prices
of products in the domestic market and to maintain level of production, the surplus
goods are exported to the needy countries on loan.
(c) Economic assistance is also provided by the donor countries to remove the
economic disparities among the nations of the world.
(d) Some advanced nations particularly the socialist countries provide financial and
technical help for the propagation of political ideology in the capitalist developing
countries.
(e) Foreign aid is also given for increasing the camp followers of the donor countries.
Capital Market:
The means by which large amounts of money (capital) are raised by companies,
governments and other organizations for long term use and the subsequent trade of the
instruments issued in recognition of such capital.
Types:
There are two types of financing/capital markets:
(1) Money Market.
(2) Capital Market.
(1) Money Market:
Money market is the market for very short term loans. It mainly centers round its
activities on the discount houses, the commercial banks. The money market, deals in
various credit instruments such as, the bill of exchange, short dated bonds, certificate of
deposits, the treasury bills, etc.
(2) Capital Market:
Capital market refers to a market where the financial institutions mobilize the savings
of the people and lend them for long term, period for raising new capital in country.
Capital Market, in other words, refers to the long term borrowing and lending of capital
funds.
Capital Market Instruments:
The principal capital market instruments used for long term funds are:
(i) Mortgages.
(ii) Corporation bonds.
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(iii) State and local government bonds.
(iv) Federally sponsored credit agency securities.
(v) Finance company bonds.
(vi) Commercial banks bonds and commercial paper.
(viii) Corporate stock.
Institutional sources of Capital Market:
There are a number of financial institutions which are directly involved with real
investment in the economy. These institutions mobilize the saving from the people and
channel funds for financing the development expenditure of the industry and
government of a country.
The financial institutions take maximum care in investing funds in those projects where
there is high degree of security and the income is certain. The main institutional sources
of capital market are as follows:
(i) Insurance Companies. Insurance companies are financial intermediaries. They call
money by providing protection from certain risks to individuals and firms. The insurance
companies invest the funds in long term investments primarily mortgage loans and
corporate bonds.
(ii) Pension Funds. The pension funds are provided by both employees and
employers. These funds are now increasing utilized in the provision of long term loans
for the industry and government.
(iii) Building Societies. The building societies are now activity engaged in providing
funds for the construction, purchase of buildings for the industry and houses for the
people.
(iv) Investment Trusts. The investment trust mobilize saving and meet the growing,
need of corporate sector, The income of the investment trust depends upon the
dividend it receives from shares invested in various companies.
(v) Unit Trust. The Unit Trust collects the small savings of the people by selling units of
the trust. The holders of units can resell the units at the prevailing market value to the
trust itself.
(vi) Saving Banks. The saving banks collect the savings of the people. The
accumulated saving is invested in mortgage loans, corporate bonds.
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(vii) Specialized Finance Corporation. The specialized finance corporations are being
established to help and provide finance to the private industrial sector in the form of
medium and long term loans or foreign currencies.
(viii) Commercial banks. The commercial banks are also now activity engaged in the
provision of medium and long terms loans to the industrialists, agriculturists, specialist
finance institutions, etc., etc.
(ix) Stock Exchange. The stock exchange is a market in existing securities (shares,
debentures and securities issued by the public authorities). The stock exchange
provides a place for those persons who wish to sell the shares and also wish to buy
them. Stock exchange thus helps in raising equity capital for the industry
What is Scale of Production?
"Scale of production is set by the size of plant, the number of plants installed and the
technique of production adopted by the producer".
Classifications/Types:
The scale of production is classified as under:
(i) Small Scale Production.
(ii) Large Scale Production.
(iii) Optimum Scale of Production.
(i) Small Scale Production: If a firm produces goods with small sized plants, the scale
of production is said to be small scale production. Small scale of production is
associated with low capital output and capital labor ratios. In small scale of production,
the economies of scale do not occur to the firm.
(ii) Large Scale of Production: If a firm uses more capital and larger quantities of other
factors, it is said to be operating on large scale production. Large scale production
enjoys both internal and external economies of scale.
(iii) Optimum Scale of Production. The optimum scale of production refers to that size
of production which is accompanied by maximum net economics of scale, it is a scale at
which the cost of production per unit is the lowest.
Economics of Large Scale Production:
Classifications/Types and Explanation:
The economies of large scale production are classified by Marshall into:
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(1) Internal Economies and (2) External Economies.
(1) Internal Economies of Scale:
Definition and Types:
Internal economies of scale are those economies which are internal to the firm. These
arise within the firm as a result of increasing the scale of output of the firm. A firm
secures these economies from the growth of the firm independently. The main internal
economies are grouped under the following heads:
(i) Technical Economies: When production is carried on a large scale, a firm can
afford to install up to date and costly machinery and can have its own repairing
arrangements. As the cost of machinery will be spread over a very large volume of
output, the cost of production per unit will therefore, be low.
A large establishment can utilize its by products. This will further enable the firm to
lower the price per unit of the main product. A large firm can also secure the services of
experienced entrepreneurs and workers which a small firm cannot afford. In a large
establishment there is much scope for specialization of work, so the division of labor
can be easily secured.
(ii) Managerial Economies: When production is carried on a large scale, the task of
manager can be split up into different departments and each department can be placed
under the supervision of a specialist of that branch. The difficult task can be taken up by
the entrepreneur himself. Due to these functional specialization, the total return can be
increased at a lower cost.
(iii) Marketing Economies: Marketing economies refer to those economies which a

firm can secure from the purchase or sale of the commodities. A large establishment is
in a better position to buy the raw material at a cheaper rate because it can buy that
commodity on a large scale. At the time of selling the produced goods, the firm can
secure better rates by effectively advertising in the newspapers, journals and radio, etc.
(iv) Financial Economies: Financial economies arise from the fact that a big
establishment can raise loans at a lower rate of interest than a small establishment
which enjoys little reputation in the capital market.
(v) Risk Bearing Economies: A big firm can undertake risk bearing economies by
spreading the risk. In certain cases the risk is eliminated altogether. A big establishment
produces a variety of goods in order to cater the needs of different tastes of people. If
the demand for a certain type of commodities slackens, it is counter balanced by the
increase in demand of the other type of commodities produced by the firm.
(vi) Economies of Scale: As a firm grows in size, it is-possible for it to reduce its cost.
The reduction in costs, as a result of increasing production is called economies of scale.
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The economies of scale are obtained by the firm up to the lowest point on the firms long
run average cost curve. The main sources of economies of scale are in brief as under.:
Diseconomies of Scale:
The extensive use of machinery, division of labor, increased specialization and larger
plant size etc., no doubt entail lower cost per unit of output but the fall in cost per unit is
up to a certain limit. As the firm goes beyond the optimum size, the efficiency of the firm
begins to decline. The average cost of production begins to rise.
Factors of Diseconomies:
The main factors causing diseconomies of scale and eventually leading to higher per
units cost are as follows:
(i) Lack of co-ordination. As a firm becomes large scale producer, it faces difficulty in
coordinating the various departments of production. The lack of co-ordination in the
production, planning, marketing personnel, account, etc., lowers efficiency of the factors
of production. The average cost of production begins to rise.
(ii) Loose control. As the size of plant increases, the management loses control over
the productive activities. The misuse of delegation of authority, the redtapisim bring
diseconomies and lead to higher average cost of production.
(iii) Lack of proper communication. The lack of proper communication between top
management and the supervisory staff and little feedback from subordinate staff causes
diseconomies of scale and results in the average cost to go up.
(iv) Lack of identification. In a large organizational structure, there is no close liaison

between the top management and the thousands of workers employed in the firm. The
lack of identification of interest with the firm results in the per unit cost to go up.
(2) External Economies of Scale:
External economies of scale are those economies which are not specially availed of
by .any firm. Rather these accrue to all the firms in an industry as the industry expands.
The main external economies are as under:
(i) Economies of localization. When an industry is concentrated in a particular area,

all the firms situated in that locality avail of some common economies such as (a) skilled
labor, (b) transportation facilities, (c) post and telegraph facilities, (d) banking and
insurance facilities etc.
(ii) Economies of vertical disintegration. The vertical disintegration implies the

splitting up the production process in such a manner that some Job are assigned to
specialized firms. For example, when an industry expands, the repair work of the
various parts of the machinery is taken up by the various firms specialists in repairs.
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(iii) Economies of information. As the industry expands it can set up research
institutes. The research institutes provide market information, technical information etc
for the benefit of alt the firms in the industry.
(iv) Economies of byproducts. All the firms can lower the costs of production by
making use of waste materials.
External Diseconomies:
A firm or an industry cannot avail of economies for an indefinite period of time. With the
expansion and growth of an industry, certain disadvantage also begin to arise. The
diseconomies of large scale production are:
(i) Diseconomies of pollution, (ii) Excessive pressure on transport facilities, (iii) Rise in
the prices of the factors of production, (iv) Scarcity of funds, (v) Marketing problems of
the products, (iv) Increase in risks.
Optimum Firm:
Optimum firm is that firm which fully utilizes its scale of operation and produces
optimum output with the minimum cost per unit production.
In the short-run, a firm would build the scale of plant and operate it at a point where
the average cost is at its minimum. This is regarded as the optimum level of
production for the firm concerned, if the demand for the product increases from this
least cost output; it cannot change the amount of land, buildings, machinery and other
input in short period of time. It has to move along the same scale or type of plant. The
average total cost, therefore, begins to rise due to the diseconomies of the scale.
In the long run, all inputs are variable. The firm can build larger plant sizes or revert to
smaller plants to deal with the changed demand for the product. If the size of plant
increases to cope with the increased demand, the average cost per unit begins to fall
due to the economies of scale such as increased specialization of labor, better and
greater specialization of management, efficient utilization of productive equipment, etc.,
etc. So long as the resources are successfully utilized, the average cost of production
continues declining.
Eventually a stage comes when the firm is not able to use the least cost combination of
inputs. The building of a still larger plant cause the average cost of production to go up.
The point at which the per unit cost is the lowest is the optimum level of production for
the firm. The firm of the most efficient size.
The concept of the optimum firm can be explained with the help of the following
figure:
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In the diagram (10.1) units of output are measured along OX axis and units of cost
along OY axis. In this figure, there are four alternative scales of plant. SAC 1, SAC2,
SAC3 and SCA4.
If the anticipated output rate is OK, the firm should choose the smallest plant, SAC1.
This is due to the fact that the cost per unit for OK output is lowest at point A on plant
SAC1. If the anticipated output rate is OL plant SAC2 yields lowest cost per unit at point
B. This is the optimum plant of the firm and is of the most efficient size. If a larger plant
of the SAC3 size is constructed to meet the rising demand for the product, then the
economies of the scale mainly of managerial nature arise. The per unit cost of
production begins to arise. Thus the scale SAC 2 represent the optimum plant and BL is
the least cost output of this plant.
Production Function:
A given output can be produced with many different combinations of factors of
production (land, labor, capita! and organization) or inputs. The output, thus, is a
function of inputs. The functional relationship that exists between physical inputs and
physical output of a firm is called production function.
Formula:
In abstract term, it is written in the form of formula:
Q = f (x1, x2, ......., xn)
Q is the maximum quantity of output and x 1, x2, xn are quantities of various inputs. The
functional relationship between inputs and output is governed by the laws of returns.
The laws of returns are categorized into two types.
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(i) The law of variable proportion seeking to analyze production in the short period.
(ii) The law of returns to scale seeking to analyze production in the long period.
Law of Variable Proportions/Law of Non Proportional Returns/Law of Diminishing

Returns:
(Short Run Analysis of Production):
There were three laws of returns mentioned in the history of economic thought up till
Alfred Marshall's time. These laws were the laws of increasing returns, diminishing
returns and constant returns. Dr. Marshall was of the view that the law of diminishing
returns applies to agriculture and the law of increasing returns to industry. Much time
was wasted in discussion of this issue. However, it was later on recognized that there
are not three laws of production. It is only one law of production which has three
phases, increasing, diminishing and negative production. This general law of production
was named as the Law of Variable Proportions or the Law of Non-Proportional
Returns.
The Law of Variable Proportions which is the new name of the famous law of
Diminishing Returns has been defined by Stigler in the following words:
"As equal increments of one input are added, the inputs of other productive services
being held constant, beyond a certain point, the resulting increments of produce will
decrease i.e., the marginal product will diminish".
"An increase in some inputs relative to other fixed inputs will in a given state of
technology cause output to increase, but after a point, the extra output resulting from
the same addition of extra inputs will become less".
Assumptions:
The law of variable proportions also called the law of diminishing returns holds good
under the following assumptions:
(i) Short run. The law assumes short run situation. The time is too short for a firm to
change the quantity of fixed factors. All the, resources apart from this one variable, are
held unchanged in quantity and quality.
(ii) Constant technology. The law assumes that the technique of production remains
unchanged during production.
(iii) Homogeneous factors. Each factor unit in assumed to be identical in amount and
quality.
The law of variable proportions is, now explained with the help of table and graph.
17
Schedule:
Fixed Variable Total Marginal Product (MP Average

Inputs Resource Produce Quintals) Product (AP
(Land (labor) (TP Quintals)
Capital) Quintals)
30 1 10 10 Increasing marginal 10
30 2 25 15 return 12.5
30 3 37 12 Diminishing marginal 12.3

30 4 47 10 returns 11.8
30 5 55 8 11.0
30 6 60 5 10.0
30 7 63 3 9.0
30 8 63 0 Negative marginal 7.9

returns
30 9 62 -1 6.8
In the table above, it is assumed that a farmer has only 30 acres of land for cultivation.
The investment on it in the form of tubewells, machinery etc., (capital) is also fixed.
Thus land and capital with the farmer is fixed and labor is the variable resource.
As the farmer increases units of labor from one to two to the amount of other fixed
resources (land and capital), the marginal as well as average product increases. The
total product also increase at an increasing rate from 10 to 25 quintals. It is the stage of
increasing returns.
The stage of increasing returns with the employment of more labor does not last long. It
is shown in the table that with the employment of 3rd labor at the farm, the marginal
product and the average product (AP) both falls but marginal product (MP) falls more
speedily than the average product AP). The fall in MP and AP continues as more men
are put on the farm.
The decrease, however, remains positive up to the 7th labor employed. On the
employment of 7th worker, the total production remains constant at 63 quintals. The
marginal product is zero. if more men are employed the marginal product becomes
negative. It is the stage of negative returns. We here find the behavior of marginal
product (MP). it shows three stages. In the first stage, it increases, in the 2nd it
continues to fall and in the 3rd stage it becomes negative.
Three Stages of the Law:
18
There are three phases or stages of production, as determined by the law of variable
proportions:
(i) Increasing returns.
(ii) Diminishing returns.
(iii) Negative returns.
Diagram/Graph:
These stages can be explained with the help of graph below:
(i) Stage of Increasing Returns. The first stage of the law of variable proportions is
generally called the stage of increasing returns. In this stage as a variable resource
(labor) is added to fixed inputs of other resources, the total product increases up to a
point at an increasing rate as is shown in figure 11.1.
The total product from the origin to the point K on the slope of the total product curve
increases at an increasing rate. From point K onward, during the stage II, the total
product no doubt goes on rising but its slope is declining. This means that from point K
onward, the total product increases at a diminishing rate. In the first stage, marginal
product curve of a variable factor rises in a part and then falls. The average product
curve rises throughout .and remains below the MP curve.
Causes of Initial Increasing Returns:

The phase of increasing returns starts when the quantity of a fixed factor is abundant
relative to the quantity of the variable factor. As more and more units of the variable
factor are added to the constant quantity of the fixed factor, it is more intensively and
effectively used. This causes the production to increase at a rapid rate. Another reason
of increasing returns is that the fixed factor initially taken is indivisible. As more units of
the variable factor are employed to work on it, output increases greatly due to fuller and
effective utilization of the variable factor.
19
(ii) Stage of Diminishing Returns. This is the most important stage in the production
function. In stage 2, the total production continues to increase at a diminishing rate until
it reaches its maximum point (H) where the 2nd stage ends. In this stage both the
marginal product (MP) and average product of the variable factor are diminishing but
are positive.
Causes of Diminishing Returns:

The 2nd phase of the law occurs when the fixed factor becomes inadequate relative to
the quantity of the variable factor. As more and more units of a variable factor are
employed, the marginal and average product decline. Another reason of diminishing
returns in the production function is that the fixed indivisible factor is being worked too
hard. It is being used in non-optima! proportion with the variable factor, Mrs. J.
Robinson still goes deeper and says that the diminishing returns occur because the
factors of production are imperfect substitutes of one another.
(iii) Stage of Negative Returns. In the 3rd stage, the total production declines. The TP,
curve slopes downward (From point H onward). The MP curve falls to zero at point L 2
and then is negative. It goes below the X axis with the increase in the use of variable
factor (labor).
Causes of Negative Returns:
The 3rd phases of the law starts when the number of a variable, factor becomes, too
excessive relative, to the fixed factors, A producer cannot operate in this stage because
total production declines with the employment of additional labor.
A rational producer will always seek to produce in stage 2 where MP and AP of the
variable factor are diminishing. At which particular point, the producer will decide to
produce depends upon the price of the factor he has to pay. The producer will employ
the variable factor (say labor) up to the point where the marginal product of the labor
equals the given wage rate in the labor market.
Importance:
The law of variable proportions has vast general applicability. Briefly:
(i) It is helpful in understanding clearly the process of production. It explains the input
output relations. We can find out by-how much the total product will increase as a result
of an increase in the inputs.
(ii) The law tells us that the tendency of diminishing returns is found in all sectors of the
economy which may be agriculture or industry.
(iii) The law tells us that any increase in the units of variable factor will lead to increase
in the total product at a diminishing rate. The elasticity of the substitution of the variable
factor for the fixed factor is not infinite.
20
From the law of variable proportions, it may not be understood that there is no hope for
raising the standard of living of mankind. The fact, however, is that we can suspend the
operation of diminishing returns by continually improving the technique of production
through the progress in science and technology.
Law of Diminishing Returns/Law of Increasing Cost:
(Version of Classical and Neo Classical Economists):
The law of diminishing returns (also called the Law of Increasing Costs) is an
important law of micro economics. The law of diminishing returns states that:
"If an increasing amounts of a variable factor are applied to a fixed quantity of other
factors per unit of time, the increments in total output will first increase but beyond some
point, it begins to decline".
The law of diminishing return can be studied from two points of view, (i) as it applies to
agriculture and (ii) as it applies in the field of industry.
(1) Operation of Law of Diminishing Returns in Agriculture:
Traditional Point of View. The classical economists were of the opinion that the law of
diminishing returns applies only to agriculture and to some extractive industries, such as
mining, fisheries urban land, etc. The law was first stated by a Scottish farmer as such.
It is the practical experience of every farmer that if he wishes to raise a large quantity of
food or other raw material requirements of the world from a particular piece of land, he
cannot do so. He knows it fully that the producing capacity of the soil is limited and is
subject to exhaustion.
As he applies more and more units of labor to a given piece of land, the total produce
no doubt increases but it increases at a diminishing rate.
"As Increase in capital and labor applied to the cultivation of land causes in general a
less than proportionate increase in the amount of the produce raised, unless it happens
to coincide with the improvement in the act of agriculture".
Explanation and Example:
This law can be made clearer if we explain it with the help, of a schedule and a curve.
Fixed Input Inputs of Variable Total Produce TP (in Marginal product MP (in
Resources tons) tons)
12 Acres 1 Labor 50 50
12 Acers 3 Labor 180 60
21
12 Acers 5 Labor 200 0
12 Acres 6 Labor 195 -5
In the schedule given above, a firm first cultivates 12 acres of land (Fixed input) by
applying one unit of labor and produces 50 tons of wheat.. When it applies 2 units of
labor, the total produce increases to 120 tons of wheat, here, the total output increased
to more than double by doubling the units of labor. It is because the piece of land is
under-cultivated. Had he applied two units of labor in the very beginning, the marginal
return would have diminished by the application of second unit of labor.
In our schedules the rate of return is at its maximum when two units of labor are
applied. When a third unit of labor is employed, the marginal return comes down to 60
tons of wheat With the application of 4 th unit. the marginal return goes down to 20 tons
of wheat and when 5th unit is applied it makes no addition to the total output. The sixth
unit decreased it. This tendency of marginal returns to diminish as successive units of a
variable resource (labor) are added to a fixed resource (land), is called the law of
diminishing returns. The above schedule can be represented graphically as follows:
In Fig. (11.2) along OX are measured doses of labor applied to a piece of land and
along OY, the marginal return. In the beginning the land was not adequately cultivated,
so the additional product of the second unit increased more than of first. When 2 units of
labor were applied, the total yield was the highest and so was the marginal return.
When the number of workers is increased from 2 to 3 and more. the MP begins to
decrease. As fifth unit of labor was applied, the marginal return fell down to zero and
then it decreased to 5 tons.
Assumptions:
The table and the diagram is based on the following assumptions:
(i) The time is too short for a firm to change the quantity of fixed factors.
22
(ii) It is assumed that labor is the only variable factor. As output increases, there occurs
no change in the factor prices.
(iii) All the units of the variable factor are equally efficient.
(iv) There are no changes in the techniques of production.
(2) Operation of the Law in the Field of Industry:
The modern economists are of the opinion that the law of diminishing returns is not
exclusively confined to agricultural sector, but it has a much wider application. They are
of the view that whenever the supply of any essential factor of production cannot be
increased or substituted proportionately with the other sectors, the return per unit of
variable factor begins to decline. The law of diminishing returns is therefore, also called
the Law of Variable Proportions.
In agriculture, the law of diminishing returns sets in at an early stage because one very
important factor, i.e., land is a constant factor there and it cannot be increased in right
proportion with other variable factors, i.e., labor and capital. In industries, the various
factors of production can be co-operated, up to a certain point. So the additional return
per unit of labor and capital applied goes on increasing till there takes place a dearth of
necessary agents of production. From this, we conclude that the law of diminishing
return arises from disproportionate or defective combination of the various agents of
production. Or we can any that when increasing amounts of a variable factor are applied
to fixed quantities of other factors, the output per unit of the variable factor eventually
decreases.
.
The law of diminishing returns, therefore, in due to Imperfect substitutability of factors of
production.
The law of diminishing returns is also called as the Law of Increasing Cost. This is
because of the fact that as one applies successive units of a variable factor to fixed
factor; the marginal returns begin to diminish. With the cost of each variable factor
remaining unchanged by assumptions and the marginal returns registering .decline, the
cost per unit in general goes on increasing. This tendency of the cost per unit to rise as
successive units of a variable factor are added to a given quantity of a fixed factor is
called the law of Increasing Cost.
Importance:
The law of diminishing returns occupies an important place in economic theory. The
British classical economists particularly Malthus, and Ricardo propounded various
economic theories, on its basis. Malthus, the pessimist economist, has based his
famous theory of Population on this law.
23
The Ricardian theory of rent is also based on the law of diminishing return. The classical
economists considered the law as the inexorable law of nature.
Law of Increasing Returns/Law of Diminishing Cost:
The law of increasing returns is also called the law of diminishing costs. The law
of increasing return states that:
"When more and more units of a variable factor is employed, while other factor remain
fixed, there is an increase of production at a higher rate. The tendency of the marginal
return to rise per unit of variable factors employed in fixed amounts of other factors by a
firm is called the law of increasing return".
An increase of variable factor, holding constant the quantity of other factors, leads
generally to improved organization. The output increases at a rate higher than the rate
of increase in the employment of variable factor.
The increase in output faster than inputs continues so long as there is not deficiency of
an essential factor in the process of production. As soon as there occurs shortage or a
wrong or defective combination in productive process, the marginal product begins to
decline. The law of diminishing return begins to operate. We can, therefore, say that
there are no separate laws applicable to agriculture and to industries. It is only the law
of variable proportions which applies to a!! the different industries. However, the
duration of stages in each productive undertaking will vary. They will depend upon the
availability of resources, their combination in right proportions, etc., etc.
Application of the Law of Increasing Returns in Industries:
There are certain manufacturing industries where the factors of production can be
combined and substituted up to a certain limit, it is the law of increasing returns which
operates.
The increasing returns mainly arises from the fact that large scale production is able to
secure certain economies of production, both internal and external. When an industry is
expanded, it reaps advantages of division of labor, specialized machinery, commercial
advantages, buying and selling wholesale, economies in overhead expenses, utilization
of by products, use of extensive publicity and advertisement, availability of cheap credit,
etc.
The law of increasing returns also operates so long as a factor consists of large
indivisible units and the plant is producing below its capacity. In that case, every
additional investment will result in the increase of marginal productivity and so in
lowering the cost of production of the commodity produced. The increase in the
marginal productivity continues till the plant begins to produce to its full capacity.
Assumptions:
24
The law rests upon the following assumptions:
(i) There is a scope in the improvement of technique of production.
(ii) At least one factor of production is assumed to be indivisible.
(iii) Some factors are supposed to be divisible.
The law of increasing returns can also be explained with the help of a schedule and a
curve.
Inputs Total Returns (meters of Marginal Returns

cloth) (meters of cloth)
1 100 100
2 250 150
3 450 200
4 750 300
5 1200 450
6 1850 650
7 2455 605
8 3045 600
In the above table it is dear that as the manufacturer goes on expanding his business by
investing successive units of inputs, the marginal return goes on increasing up to the
6th unit and then it beings to decline steadily, Here, a question ca be asked as to why
the law of diminishing returns has operated in an industry?
The answer is very simple. The marginal returns has diminished after the sixth unit
because of the non-availability of a factor or factors of production or. the size of the
business has become so large that it has become unwieldy to manage it, or the plant is
producing to its full capacity and it is not possible further to reap the economies of large
scale production, etc., etc.
25
In figure 11.3, along OX axis are measured the units of inputs applied and along OY
axis the marginal return is represented. PF is the curve representing the law of
increasing returns.
Compatibility of Diminishing and Increasing Returns:
It is often pointed out by the classical economists that the law of diminishing returns is
exclusively confined to agriculture and other extractive industries, such as mining
fisheries, etc. while manufacturing industries obey the law of increasing returns.
The modern economists differ with this view and are of the opinion that the law of
diminishing returns applies both to agriculture and the industry. The only difference is
that in agriculture the law of diminishing returns begins to operate at an early stage and
in an industry somewhere at a later stage.
The law of increasing returns is also named as the Law of Diminishing Cost. When the
addition to output becomes larger, as the firm adds successive units of a variable input
to some fixed inputs, the per unit cost begins to decline. The tendency of the cost per
unit to decline with increased application of a variable factor to fixed factors is called the
Law of Diminishing Cost.
Law of Constant Returns/Law of Constant Cost:
The law of constant returns also called law of constant cost. It is said to operate
when with the addition of successive units of one factor to fixed amount of other factors,
there arises a proportionate increase in total output. The yield of equal return on the
successive doses of inputs may occur for a very short period in the process of
production. The law of constant return may prevail in those industries which represent a
combination of manufacturing as well as extractive industries.
26
On the side of manufacturing industries, every increased investment of labor and capital
may result in a more than proportionate increase in the total output. While on the other
extractive side, an increase in investment may cause, in general, a less than
proportionate increase in the amount of produce raised. If the tendency of the marginal
return to increase is just balanced by the tendency of the marginal return to diminish
yielding an equal return, we have the operation of the law of constant returns.
"If the actions of the law of increasing and diminishing returns are balanced, we have
the law of constant return".
In actual life, the law of constant returns can operate only if the following conditions are
fulfilled:
(i) There should not be any increase in the prices of raw materials in the industry. This
can only be possible if commodities are available in large supply.
(ii) The prices of various factors of production should remain the same. The .supply of
various factors of production needed for a particular industry should be perfectly
elastic.
(iii) The productive services should not be fixed and indivisible.
If we study the above mentioned conditions carefully, we will easily conclude that in the
actual world, it is not possible to find an industry which obeys the law of constant
returns. The law of constant returns can operate for a very short period when the
marginal return moves towards the optimum point and begins to decline. The law is
represented now in the form of a table and a curve.
Schedule:
Productive doses Total Return (meters of Marginal

cloth) Return (meters of
cloth)
1 60 60
2 120 60
3 180 60
4 240 60
5 300 60
In the table given above, the marginal return remains the same, i.e. 60 meters of cloth
with the increased investment of inputs.
Diagram/Graph:
27
In figure (11.4) along OX are measured the productive resources and along OY is
represented the marginal return. CR is the fine representing the law of constant returns.
It is parallel to the base axis.
Law of Costs:
Law of Costs is also known as laws of returns. As an industry is expanded with the
increased investment of resources, the marginal cost (i.e., the amount which is added to
the total cost when the output is increased by one unit) decreases in some cases,
increases in others and in some, it remains the same. This tendency on the part of the
marginal cost to fall, rise or to remain the same as output is expanded, is described in
economics as the law of diminishing costs, the law of increasing costs, and the
law of constant costs.
If we know the money cost of a unit of a factor invested in a particular industry, then the
marginal cost can be derived easily dividing the money cost of a unit of factor by its
marginal return.
The following table will make clear as to how the marginal cost decreases with the
increases in marginal returns, rises with the fall in marginal returns and remains
constant with the marginal return remaining the same. Let us suppose that the cost of
each unit of factor applied is worth $100 only.
Units Total Return Marginal Return Marginal Cost (in

of Factor (meters of Cloth) (meters) Dollars) (per meter)
1 10 10 10
2 30 20 5
3 55 25 4
4 88 33 3
5 138 50 2
6 238 100 1
7 338 100 1
28
8 400 62 1
9 450 50 2
10 475 25 4
11 490 15 6
In the schedule given above, the taw of diminishing costs operates up to the 6th unit,
between the 6th and 7th units, it is the law of constant costs which prevails and from 7th
unit onward, it is the law of increasing costs which sets in.
In the Fig. (11.5) units of factors are measured along OX axis and marginal cost along
OY axis. The failing curve MN represents the operation of law of diminishing costs. NP
shows constant costs, and PC indicates the increasing cost. MC is the marginal cost
curve.
Law of Returns to Scale:
The law of returns are often confused with the law of returns to scale. The law of
returns operates in the short period. It explains the production behavior of the firm with
one factor variable while other factors are kept constant. Whereas the law of returns to
scale operates in the long period. It explains the production behavior of the firm with all
variable factors.
There is no fixed factor of production in the long run. The law of returns to scale
describes the relationship between variable inputs and output when all the inputs, or
factors are increased in the same proportion. The law of returns to scale analysis the
effects of scale on the level of output. Here we find out in what proportions the output
changes when there is proportionate change in the quantities of all inputs. The answer
to this question helps a firm to determine its scale or size in the long run.
It has been observed that when there is a proportionate change in the amounts of
inputs, the behavior of output varies. The output may increase by a great proportion, by
in the same proportion or in a smaller proportion to its inputs. This behavior of output
with the increase in scale of operation is termed as increasing returns to scale, constant
returns to scale and diminishing returns to scale. These three laws of returns to scale
are now explained, in brief, under separate heads.
29
(1) Increasing Returns to Scale:
If the output of a firm increases more than in proportion to an equal percentage increase
in all inputs, the production is said to exhibit increasing returns to scale.
For example, if the amount of inputs are doubled and the output increases by more
than double, it is said to be an increasing returns to scale. When there is an increase in
the scale of production, it leads to lower average cost per unit produced as the firm
enjoys economies of scale.
(2) Constant Returns to Scale:
When all inputs are increased by a certain percentage, the output increases by the
same percentage, the production function is said to exhibit constant returns to scale.
For example, if a firm doubles inputs, it doubles output. In case, it triples output. The
constant scale of production has no effect on average cost per unit produced.
(3) Diminishing Returns to Scale:
The term 'diminishing' returns to scale refers to scale where output increases in a
smaller proportion than the increase in all inputs.
For example, if a firm increases inputs by 100% but the output decreases by less than
100%, the firm is said to exhibit decreasing returns to scale. In case of decreasing
returns to scale, the firm faces diseconomies of scale. The firm's scale of production
leads to higher average cost per unit produced.
Graph/Diagram:
The three laws of returns to scale are now explained with the help of a graph below:
30
The figure 11.6 shows that when a firm uses one unit of labor and one unit of capital,
point a, it produces 1 unit of quantity as is shown on the q = 1 isoquant. When the firm
doubles its outputs by using 2 units of labor and 2 units of capital, it produces more than
double from q = 1 to q = 3.
So the production function has increasing returns to scale in this range. Another output
from quantity 3 to quantity 6. At the last doubling point c to point d, the production
function has decreasing returns to scale. The doubling of output from 4 units of input,
causes output to increase from 6 to 8 units increases of two units only.
Technical Efficient Combination:
Production function establishes a physical relationship between output and inputs. It

describes what is technical feasible when the firm uses each combination of input. The
firm can obtain a given level of output by using more labor and less capital or more
capital and less labor. Production function describes the maximum output feasible for a
given set of inputs in technical efficient manner.
Production Function takes Quantities of Inputs:
It is imperative to note that production function does not take unto account the prices of
input or of the output. It simply takes into account the quantities of inputs which are
employed to produce certain quantities of output
Long Run Production with Variable Inputs:
The long run is the lengthy period of time during with all inputs can be varied. There
are no fixed outputs in the long run. All factors of production are variable inputs.
We now analyze production function by allowing two factors say labor and capital to
very while all others are held constant. With both factors are variable, a firm can
produce a given level of output by using more labor and less capital or a greater amount
of capital and less labor or moderate amounts of both. A firm continues to substitute one
input for another while continuing to produce the same level of output.
If two inputs say labor and capital are allowed to vary, the resulting production function
can be illustrated in the figure 12(a).
31
In this figure each curve (called an isoquant) represents a different level of output. The
curves which lie higher and to the right represent greater output levels than curves
which are lower and to the left.
For example, point D represents a higher output level of 250 units than point A or B
which shows output level of 150 units.
The curve isoquant which represents 150 units of output illustrate that the same level of
output (150 units) can be produced with different combinations of labor and capital.
Combination of labor and capital represented by A, can employ OL 1 quantity of labor
and OC1 units of capital to produce 150 units of output.
The combination of labor and capital represented by point B will use only OL 2 units of
labor and OC1 of capital to produce the same level of output. Thus, if a country has
surplus labor and less capital, it may use the combination of labor and capital
represented by point A. In case the country has abundant capital and less labor, it might
produce at point B. The isoquants through points A and B shows all the different
combinations of labor and capita that can be used to produce 150 units of output.
Isoquants:
The word 'iso' is of Greek origin and means equal or same and 'quant' means quantity.
An isoquant may be defined as:
"A curve showing all the various combinations of two factors that can produce a given
level of output. The isoquant shows the whole range of alternative ways of producing
the same level of output".
The modern economists are using isoquant, or "ISO" product curves for determining the
optimum factor combination to produce certain units of a commodity at the least cost.
Schedule:
The concept of isoquant or equal product curve can be better explained with the help of
schedule given below:
32
Combinations Factor X Factor Y Total Output
A 1 14 100 METERS
B 2 10 100 METERS
C 3 7 100 METERS
D 4 5 100 METERS
E 5 4 100 METERS
In the table given above, it is shown that a producer employs two factors of production X
and Y for producing an output of 100 meters of cloth. There are five combinations which
produce the same level of output (100 meters of cloth).
The factor combination A using 1 unit of factor X and 14 units of factor Y produces 100
meters of cloth. The combination B using 2 units of factor X and 10 units of factor Y
produces 100 meters of cloth. Similarly combinations C, U and E, employing 3 units of X
and 7 units of Y, 4 units of X and 5 units of Y, 5 units of X and 4 units of Y produce 100
units of output, each. The producer, here., is indifferent as to which combination of
inputs he uses for producing the same amount of output.
Diagram/Graph:
The alternative techniques for producing a given level of output can be plotted on a
graph.
The figure 12.1 shows y the 100 units isoquant plotted to ISO product schedule. The
five factor combinations of X and Y are plotted and are shown by points a, b, c, d and e.
if we join these points, it forms an 'isoquant'.
33
An isoquant therefore, is the graphic representation of an iso-product schedule. It may
here be noted that all the factor combinations of X and Y on an iso-product curve are
technically efficient combinations. The producer is indifferent as to which combination
he uses for producing the same level of output. It is in this way that an iso product curve
is also called 'production indifference curve'. In the figure 12.1, ISO product IP curve
represents the various combinations of the two inputs which produce the same level of
output (100 meters of cloth).
Isoquant Map:
An isoquant map shows a set of iso-product curves. Each isoquant represents a

different level of output. A higher isoquant shows a higher level of output and a lower
isoquant represents a lower level of output.
Diagram/Graph:
In the figure 12.2, a family of three iso-product curves which produce various level of
output is shown. The iso product IQ1 yields 100 units of output by using quantities of
inputs X and Y. So is also the case with isoquant IQ3 yielding 300 units of output.
We conclude that an isoquant map includes a series, of iso-product curves. Each

isoquant represents a different level of output. The higher the isoquant output, the
further right will be the isoquant.
Properties of Isoquants:
The main properties of the isoquants are similar to those of indifference curves.
These properties are now discussed in brief:
(i) An Isoquant Slopes Downward from Left to Right:
This implies that the Isoquant is a negatively sloped curve. This is because when the
quantify of factor K (capital) is increased, the quantity of L (labor) must be reduced so
as to keep the same level of output.
34
The figure (12.3) depicts that an isoquant IP is negatively sloped curve. This curve
shows that as the amount of factor K is increased from one unit to 2 units, the units of
factor L are decreased from 20 to 15 only so that output of 100 units remains constant.
(ii) An Isoquant that Lies Above and to the Right of Another Represents a Higher
Output Level:
The figure 12.4 represents this property. It shows that greater output can be secured by
increasing the quantity combinations of both the factors X and Y. The producer
increases the output from 100 units to 200 units by increasing the quantity combination
of both the X and Y. The combination of OC of capital and OL of labor yield 100 units of
production. The production can be increased to 200 units by increasing the capital from
OC to OC1 and labor from OL to OL1.
(iii) Isoquants Cannot Cut Each Other:
The two isoquants cannot intersect each other.
35
If two isoquant are drawn to intersect each other as is shown in this figure 12.5, then it
is a negation of the property that higher Isoquant represents higher level of output to a
lower Isoquant. The intersection at point E shows that the same factor combination can
produce 100 units as well as 200 units. But this is quite absurd. How can the same level
of factor combination produce two different levels of output, when the technique of
production remains unchanged. Hence two isoquants cannot intersect each other.
(iv) Isoquants are Convex to the Origin:
This property implies that the marginal significance of one factor in terms of another
factor diminishes along an ISO product curve. In other words, the isoquants are convex
to the origin due to diminishing marginal rate of substitution.
In this figure 12.6 MRSKL diminishes from 5:1 to 4:1 and further to 3:1. This shows that
as more and more units of capital (K) are employed to produce 100 units of the product,
lesser and lesser units of labor (L) are used. Hence diminishing marginal rate of
technical substitution is the reason for the convexity of an isoquant.
(v) Each Isoquant is Oval Shaped:
36
The iso product curve, is elliptical. This means that the firm produces only those
segments of the iso-product curves which are convex to the origin and lie between the
ridge lines. This is the economic region of production.
Isocost Lines/Outlay Line/Price Line/Factor Cost Line:
A firm can produce a given level of output using efficiently different combinations of two
inputs. For choosing efficient combination of the inputs, the producer selects that
combination of factors which has the lower cost of production. The information about the
cost can be obtained from the isocost lines.
Explanation:
An isocost line is also called outlay line or price line or factor cost line. An isocost
line shows all the combinations of labor and capital that are available for a given total
cost to-the producer. Just as there are infinite number of isoquants, there are infinite
number of isocost lines, one for every possible level of a given total cost. The greater
the total cost, the further from origin is the isocost line.
Example:
The isocost line can be explained easily by taking a simple example.
Diagram/Figure:
Let us examine a firm which wishes to spend $100 on a combination of two factors labor
and capital for producing a given level of output. We suppose further that the price of
one unit of labor is $5 per day. This means that the firm can hire 20 units of labor. On
the other hand if the price of capital is $10 per unit, the firm will purchase 10 units of
capital. In the fig. 12.7, the point A shows 10 units of capital used whereas point T
shows 20 units of labor are hired at the given price. If we join points A and T, we get a
37
line AT. This AT line is called isocost line or outlay line. The isocost line is obtained with
an outlay of $100.
Let us assume now that there is no change in the market prices of the two factors labor
and capita! but the firm increases the total outlay to $150. The new price line BK shows
that with an outlay of $150, the producer can purchase 15 units of capital or 30 units of
labor. The new price line BK Shifts upward to the right. In case the firm reduces the
outlay to $50 only, the isocost line CD shifts downward to the left of original isocost line
and remains parallel to the original price line.
The isocost line plays a similar role in the firm's decision making as the budget line does
in consumer's decision making. The only difference between the two is that the
consumer has a single budget line which is determined by the income of the consumer.
Whereas the firm faces many isocost lines depending upon the different level of
expenditure the firm might make. A firm may incur low cost by producing relatively
lesser output or it may incur relatively high cost by producing a relatively large quantity.
Isocost Lines/Outlay Line/Price Line/Factor Cost Line:
A firm can produce a given level of output using efficiently different combinations of two
inputs. For choosing efficient combination of the inputs, the producer selects that
combination of factors which has the lower cost of production. The information about the
cost can be obtained from the isocost lines.
Explanation:
An isocost line is also called outlay line or price line or factor cost line. An isocost
line shows all the combinations of labor and capital that are available for a given total
cost to-the producer. Just as there are infinite number of isoquants, there are infSinite
number of isocost lines, one for every possible level of a given total cost. The greater
the total cost, the further from origin is the isocost line.
Example:
The isocost line can be explained easily by taking a simple example.
Diagram/Figure:
38
Let us examine a firm which wishes to spend $100 on a combination of two factors labor
and capital for producing a given level of output. We suppose further that the price of
one unit of labor is $5 per day. This means that the firm can hire 20 units of labor. On
the other hand if the price of capital is $10 per unit, the firm will purchase 10 units of
capital. In the fig. 12.7, the point A shows 10 units of capital used whereas point T
shows 20 units of labor are hired at the given price. If we join points A and T, we get a
line AT. This AT line is called isocost line or outlay line. The isocost line is obtained with
an outlay of $100.
Let us assume now that there is no change in the market prices of the two factors labor
and capita! but the firm increases the total outlay to $150. The new price line BK shows
that with an outlay of $150, the producer can purchase 15 units of capital or 30 units of
labor. The new price line BK Shifts upward to the right. In case the firm reduces the
outlay to $50 only, the isocost line CD shifts downward to the left of original isocost line
and remains parallel to the original price line.
The isocost line plays a similar role in the firm's decision making as the budget line does
in consumer's decision making. The only difference between the two is that the
consumer has a single budget line which is determined by the income of the consumer.
Whereas the firm faces many isocost lines depending upon the different level of
expenditure the firm might make. A firm may incur low cost by producing relatively
lesser output or it may incur relatively high cost by producing a relatively large quantity.
Marginal Rate of Technical Substitution (MRTS)
Prof. R.G.D. Alien and J.R. Hicks introduced the concept of MRS (marginal rate of
substitution) in the theory of demand. The similar concept is used in the explanation of
producers equilibrium and is named as marginal rate of technical
substitution (MRTS).
Marginal rate of technical substitution (MRTS) is:
39
"The rate at which one factor can be substituted for another while holding the level of
output constant".
The slope of an isoquant shows the ability of a firm to replace one factor with another
while holding the output constant. For example, if 2 units of factor capital (K) can be
replaced by 1 unit of labor (L), marginal rate of technical substitution will be thus:
MRS = ΔK = 2 = 2
ΔL 1
Explanation:
The concept of MRTS can be explained easily with the help of the table and the graph,
below:
Schedule:
Factor Units of Units of Units of Output of MRTS of Labor for

Combinations Labor Capital Commodity X Capital
A 1 15 150 -
B 2 11 150 4:1
C 3 8 150 3:1
D 4 6 150 2:1
E 5 5 150 1:1
It is clear from the above table that all the five different combinations of labor and capital
that is A, B, C, D and E yield the same level of output of 150 units of commodity X, As
we move down from factor A to factor B, then 4 units of capital are required for obtaining
1 unit of labor without affecting the total level of output (150 units of commodity X).
The MRTS is 4:1. As we step down from factor combination B to factor combination C,
then 3 units of capital are needed to get 1 unit of labor. The MRTS of labor for capital
3:1. If we further switch down from factor combination C to D, the MRTS of labor for
capital is 2:1. From factor D to E combination, the MRTS of labor for capital falls down
to 1:1.
Formula:
MRTSLK = ΔK
ΔL
It means that the marginal rate of technical substitution of factor labor for factor capital
(K) (MRTSLK) is the number of units of factor capital (K) which can be substituted by one
unit of factor labor (L) keeping the same level of output. In the figure 12.8, all the five
combinations of labor and capital which are A, B, C, D and E are plotted on a graph.
40
Diagram/Graph:
The points A, B, C, D and E are joined to form an isoquant. The iso-product curve
shows the whole range of factor combinations producing 150 units of commodity X. It is
important to point out that ail the five factor combination of labor and capital on an iso-
product curve are technically efficient combinations. The producer is indifferent towards
these, combinations as these produce the same level of output.
Diminishing Marginal Rate of Technical Substitution:
The decline in MRTS along an isoquant for producing the same level of output is named
as diminishing marginal rates of technical education. As we have seen in Fig. 12.8, that
when a firm moves down from point (a) to point (b) and it hires one more labor, the firm
gives up 4 units of capital (K) and yet remains on the same isoquant at point (b). So the
MRTS is 4. If the firm hires another labor and moves from point (b) to (c), the firm can
reduce its capital (K) to 3 units and yet remain on the same isoquant. So the MRTS is 3.
If the firm moves from point (C) to (D), the MRTS is 2 and from point D to e, the MRTS
is 1. The decline in MRTS along an isoquant as the firm increases labor for capital is
called Diminishing Marginal Rate of Technical Substitution.
Optimum Factor Combination:
In the long run, all factors of production can be varied. The profit maximization firm will
choose the least cost combination of factors to produce at any given level of output. The
least cost combination or the optimum factor combination refers to the combination
of factors with which a firm can produce a specific quantity of output at the lowest
possible cost.
Explanation:
There are two methods of explaining the optimum combination of factor:
(i) The marginal product approach.
(ii) The isoquant / isocost approach.
41
These two approaches are now explained in brief:
(i) The Marginal Product Approach:
In the long run, a firm can vary the amounts of factors which it uses for the production of
goods. It can choose what technique of production to use, what design of factory to
build, what type of machinery to buy. The profit maximization will obviously want to use
that mix of factors of combination which is least costly to it. In search of higher profits, a
firm substitutes the factor whose gain is higher than the other. When the last rupee
spent on each factor brings equal revenue, the profit of the firm is maximized. When a
firm uses different factors of production or least cost combination or the optimum
combination of factors is achieved when:
Formula:
Mppa = Mppb = Mppc = Mppn

Pa Pb Pc Pn
In the above equation a, b, c, n are different factors of production. Mpp is the marginal
physical product. A firm compares the Mpp / P ratios with that of another. A firm will
reduce its cost by using more of those factors with a high Mpp / P ratios and less of
those with a low Mpp / P ratio until they all become equal.
(ii) The Isoquant / Isocost Approach:
The least cost combination of-factors or producer's equilibrium is now explained with the
help of iso-product curves and isocosts. The optimum factors combination or the least
cost combination refers to the combination of factors with which a firm can produce a
specific quantity of output at the lowest possible cost.
As we know, there are a number of combinations of factors which can yield a given level
of output. The producer has to choose, one combination out of these which yields a
given level of output with least possible outlay. The least cost combination of factors for
any level of output is that where the iso-product curve is tangent to an isocost curve.
The analysis of producers equilibrium is based on the following assumptions.
Assumptions of Optimum Factor Combination:
The main assumptions on which this analysis is based areas under:
(a) There are two factors X and Y in the combinations.
(b) All the units of factor X are homogeneous and so is the case with units of factor Y.
(c) The prices of factors X and Y are given and constants.
(d) The total money outlay is also given.
42
(e) In the factor market, it is the perfect completion which prevails. Under the conditions
assumed above, the producer is in equilibrium, when the following two conditions are
fulfilled.
(1) The isoquant must be convert to the origin.
(2) The slope of the Isoquant must be equal to the slope of isocost line.
Diagram/Figure:
The least cost combination of factors is now explained with the help of figure 12.9.
Here the isocost line CD is tangent to the iso-product curve 400 units at point Q. The
firm employs OC units of factor Y and OD units of factor X to produce 400 units of
output. This is the optimum output which the firm can get from the cost outlay of Q. In
this figure any point below Q on the price line AB is desirable as it shows lower cost, but
it is not attainable for producing 400 units of output. As regards points RS above Q on
isocost lines GH, EF, they show higher cost.
These are beyond the reach of the producer with CD outlay. Hence point Q is the least
cost point. It is the point which is the least cost factor combination for producing 400
units of output with OC units of factor Y and OD units of factor X. Point Q is the
equilibrium of the producer.
At this point, the slope of the isoquants equal to the slope of the isocost line. The MRT
of the two inputs equals their price ratio.
Thus we find that at point Q, the two conditions of producer's, equilibrium in the choice
of factor combinations, are satisfied.
(1) The isoquant (IP) is convex the origin.
43
(2) At point Q, the slope of the isoquant ΔY / ΔX (MTYSxy) is equal to the slope of the
isocost in Px / Py. The producer gets the optimum output at least cost factor
combination.
44

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ODWAR VINCENT-LIRA UNIVERSI

The economic resources are classified under two main heads:

(1) Property Resources and (2) Human Resources.

Entrepreneur or Enterprise, The entrepreneur or enterprise is the person who takes

(a). Land as a Factor of Production:

The main characteristics/Features of land as a factor of production are as follows:

(ii) No geographical mobility. Land has no geographical mobility. It cannot be shifted

(b). Labor as a Factor of Production:

"Labor is an important factor of production. It is described as any human work which is

(ii) Labor is perishable. A worker cannot store his labor. It is perishable.

(c). Entrepreneur as a Factor of Production:

The entrepreneur is an organizer. He is the person who organizes production by

An entrepreneur performs the following functions:

(i) He conceives the idea of launching the project.

(ii) He mobilizes the resources for smooth running of the project.

(iv) He undertakes the risks involved in production.

(v) He is an innovator. He innovates new techniques of production, new products and

"By division of labor is meant the specialization, of work. It refers to splitting up of a

Two types are given below:

(1) Complex Division of Labor:

(2) Territorial Division of Labor:

When a certain locality specializes in the production of a particular commodity, the

(ii) Loss of Responsibility. Where a particular commodity is the Joint product of a

Mobility of labor is of five types.

Factors Promoting Mobility of Labor:

The main factors which promote mobility of labor are:

(i) Increase in wages.

(ii) Better conditions of work.

(iii) Strong urge to make progress in life.

(iv) Peace and security.

(v) Better means of communication and transport.

(vii) Development projects.

Obstacles to Mobility of Labor:

The main hindrances or obstacles to mobility of labor are as under:

(i) Home sickness.

(ii) Unfavorable climatic conditions.

(iii) Difference in customs.

(iv) Language barrier.

(v) Restrictions imposed by the government.

(vi) Political disturbances.

(vii) Ethnic disturbances.

(d). Capital as Factor of Production:

Physical or Tangible Capital:

(vii) Capital adds value to the products.

"Economic development has much to do with human endowments, social attitudes,

(1) Domestic Resources and (2) External Resources.

(1) Domestic Resources:

Domestic resources play an important part in promoting development activities in the

(ii) Involuntary Savings.

(v) Deficit Financing. Deficit financing is regarded an important source of capita!

(2) External Resources:

External resources has the following types:

(c) Provides greater employment opportunities. The financing of various projects

(a) Humanitarian ground. If a country is faced with famine, drought, epidemic,

(b) Self-interest reasons. Foreign economic assistance is also provided on the

There are two types of financing/capital markets:

(1) Money Market.

(2) Capital Market.

(1) Money Market: