UNIT – III

Production Function
The production function refers to the relationship between the
inputs and the outputs produced by a firm at any particular time
period. The relationship is purely physical or technological in
character that is it ignores the price of inputs and outputs. The
output is thus a function of inputs. Mathematically production
function can be written as.

Q = f (X1, X2 …….etc.)
Q = Quantity of outputs
Where Q stands for the quantity of output and X1, X2 ….. are
the various input factors such as land labour capital etc.

(The production function expresses a functional relationship

between physical inputs & physical outputs of a firm at any
particular time period. The output is thus a function of inputs.)

We are concerned with three types of production function in

economic theory.
1. Production function with one variable input
2. Production function with two variable inputs
3. Production function with all variable inputs

1. Production Function with one variable input

Law of variable proportions - Law of variable proportions

shows the input outputs relationship or production function with
one factor4 variable while other factors of production are kept
constant. It is also called the law of diminishing marginal returns
or law of diminishing marginal productivity.
Eg. For a farmer land has fixed investment such as capital, tube
well, farmhouse and farm machinery while labour (men) may
vary. Thus labour is the variable factors. The change in the
number of men will change the output.
Relationship among Total, Average and Marginal Product
Curves
Diagram

Law of diminishing return does not state that each and every
increase in the amount of the variable factors employed in the
production process will yield diminishing marginal returns. It is
possible that initial increase in the amount of variable factor,
employed in the production process may yield increasing
marginal returns. However in increasing amount of the variable
factor employed a point will be reached where the marginal
increases in total output will begin declining or marginal return
will begin declining.

Stage I –
- Stage I is the segment form origin to point X2
- AT this point X2 the marginal product of X equals its average
product.
- X2 is of course, also the point at which the average product is
maximised.
- The production function is characterised first by increasing
marginal returns to the variable factors from the origin to point X 1
and then by diminishing marginal returns, from X1 to X2.

Stage II –
- It lies in the range from X2 to X3
- II stage begins where the average product of the variable
factor is maximised and continues to the point at which total
product is maximised and marginal product is zero. This
stage is characterised by diminishing returns to the variable
inputs over its entire range. That is although total product is
increasing in this range it does so at a continuously
decreasing rate.
Stage III – The area beyond X3 where the total product curve
starts decreasing. In this range the marginal product of the
variable factor is negative.

Assumptions
a. Constant Technology – If technology changes marginal
and average product may rise instead of diminishing.

b. Short Run – The law operates in the short run because it is

here that some factors are fixed and others are variable. In
the long run all factors are variable.

c. Homogeneous Input – The variable input as applied unit

by unit is homogeneous or identical in amount and quality.

d. It is possible to use various amounts of a variable factor on

the fixed factors of production.
Production Function with Two variable Inputs

Isoquant - An isoquant is also called an Iso-product curve,

equal product curve or a production indifference curve.
These curves shows the various combinations of two variable inputs resulting in the
same level of output.
Labour Capital Output
(input in Units) (input in Units) (in Units)
1 5 15
2 3 15
3 2 15
4 1 15
5 0 15

It is clear that out put is the same either by employing 4L +1C or

by 5L +0C etc.
If we represent this relationship graphically that is called an
isoquant.
- For each land of output there will be a different isoquant.

Substitutability – inputs can be substituted for each other

Different types of isoquants – Isoquants assume different
shapes depending upon the degree of substitutability of inputs
under consideration.
1. Linear Isoquants – perfect substitutability of inputs.
2. Right-angle Isoquants – There is complete non-
substitutability between the inputs or (strict complimentarity)

e.g. exactly four wheels and 1 chassis is required to produce a

car, two wheels & one chassis is required to produce a scooter.
(Also known as Leontief isoquant or Input output isoquant).

3. Convex Isoquant – If the substitutability of inputs is there but

the substitutability is not perfect e.g. a shirt can be made with
relatively small amount of labour (L1) and a large amount of cloth
(C1).
 Properties of Isoquants

1. Isoquant is downward slopping to the right i.e. negatively

inclined. This implies that the quantity of one variable will
have to be reduced in order to increase the quantity of
other variable.
2. A higher isoquant represents a higher output.
3. No two isoquants interest or touch each other. If two
isoquants intersect on touch each other this means that
there will be a common point on the two curves, and this
would imply that the same amount of two inputs can
produce two different levels of output which is absurd.

Production Function with All Variable Inputs

We are interested to know how a proportionate increase in all
the input factors will affect total production. This is the question
of returns to scale and we can think of three possible situations.

1. Constant Return to Scale – If the proportional increase in all

inputs in equal to the proportional increase in output, returns
to scale are constant e.g. if a simultaneous doubling of all
inputs results in a doubling of production, then return to
scale are constant.

O X,Y

2. Increasing Return to scale – If the proportional increase in

output is larger than that of the inputs then we have
increasing return to scale.
3. Decreasing Return to Scale – If output increases less than
proportionally with input increases, we have decreasing
return to scale.

Variable Return to Scale - The most typical situation is for a

production function to have first increasing then decreasing
returns to scale.
Measurement of Production Function - We have the several
types of mathematical functions but in applied research we use
four types of measurement of production functions.

(a) Linear Function -

Total product y = a + bx
From the above function equation for average product will
be Y/X = a/X + b
(b) Power Function – This function expresses output Y as a
function of input x in the form Y = aXb
where Y = Output
X = Input
b = The exponent represents the elasticity of production
The equation is linear is logarithms that is it can be written as
log Y = log a + b log X

(c) Quadratic Production Function -

Y = a+ bX – CX2
a,b,c are the parameters, their probable values of course are
determined by a statistical analysis of the data.
(i) The minus sign in the last term denotes diminishing marginal
returns.
(ii) It has one bend as compared with a linear equation which
has no bend.
(iii) The equation allows for decreasing marginal product but not
for both increasing and decreasing marginal products.

(d) Cubic Production Function

Y = a+bx+cx2 –dx3
(i) It allows for both increasing and decreasing marginal
production.
(ii) The elasticity of production varies at each point along the
curve.
(iii) Marginal productivity decreases at an increasing rate with
later stage.
 Cobb-Douglas Production Function

A very popular production function which deserves special

mention in the Cobb-Douglas function. It relates output in
American manufacturing industries from 1899-1922 to labour
and capital inputs, taking the form.
P= bLaC1-a
Where P = Total Output
L = Index of employment of labour in manufacturing
C = Index of fixed capital in manufacturing

The exponents a and 1-a are the elasticities of production that is,
a and 1-a measure the percentage response of output to
percentage changes in labour and capital respectively.
The function estimated for the U.S.A. by Cobb and Douglas is
P = 1.01 L.75 C.25 R2 = 0.9409
The production function shows that 1% change in labour input,
capital remaining constant is associated with a 0.75% change in
output. Similarly, a 1% change in capital, labour remaining
constant is associated with a 0.25% change in output. The
coefficient of determination (R2) means that 94% of the variation
on the depended variable (P) were accounted for by the
variation in the independent variables (L and C).

Managerial Use of Production Function

– How to obtain the maximum output from a given set of inputs.
- How to obtain a given output from the minimum aggregation
of inputs.
 Cost Analysis
Cost – The actual expenditure incurred for acquiring or
producing a good or service is called cost.

Various types of costs:-

i Opportunity cost Vs Outlay Cost
ii Past Vs Future Cost
iii Traceable Vs Common Cost
iv Incremental Cost Vs Sunk Cost
v. Escapable Vs Unavoidable Cost
vi. Shut Down Vs Abandonment Cost
vii. Urgent and Postponable Cost
viii. Controllable and Non-?Controllable Cost
ix. Historical Cost Vs Replacement Cost
etc.

Short-run and Long-run costs

Short-run Costs that vary with output when fixed plant and
capital equipment remain the same.
Long-run Costs are those which vary with output when all input
factors including plant and equipment vary.

Fixed and Variable Costs

TC = FC +VC
FC = which remain the same at a given capacity and do not vary
with output.
(also exist even if no output is produced)
Examples: - (rent, interest, depreciation, Salary, insurance
premium etc.)
VC = Vary directly as output changes.
Total Cost, Average Cost & Marginal Cost
TC = TFC + TVC

Average fixed cost – AFC = TFC/Q

AVC = TVC/Q
 Cost –Output Relationship

In the study of cost output relationship we have two aspects

(a) Cost-output relationship in the short run.
(b) Cost-output relationship in the long run.

- Alterations in the fixed equipment (machinery, buildings etc)

and in the size of the organisation are not permitted for any
desired increase in output in the short-run.
- But the alteration in the equipment & in the size of
organisation is possible in long-run period.

Cost-output relationship in the short run – we can study the

cost output relationship in the short run in terms of
1. Average fixed cost & output – Greater the output, the
lower the fixed cost per unit or the average fixed cost.
Because the total fixed costs remain the same and do not
change with a change in output. Average fixed cost falls
continuously as output rises (indivisibility of factors).
2. Average Variable Costs & Output – The average variable
costs will first fall and then rise as more and more units are
 produced in a given plant. This is so because as we add
more units of variable factors in a fixed plant, the efficiency
of the inputs first increases and than decreases. Because
once the optimum capacity is reached any further increase
in output will undoubtedly increase average variable cost
quite sharply. Greater output can be obtained but at much
average variable cost. eg. More & More Workers.
3. Average Total Cost and Output – The average total cost
(average cost) would decline first and than rise upwards.
Average Cost = average fixed cost + average variable cost
AC = AFC +AVC
Least Cost output level – Where the average total cost in the
minimum.
A firm may decide to produce more than the least cost output
level.
Short-run output cost curves –
- AFC falls as out put rises from lower levels to higher levels.
- The AVC curve first falls and than rises as also the ATC
curve.
- The AVC curve stats rising earlier than the ATC curve L T is
the least cost output level.
- Marginal cost curve (MC) intersects both the AVC curve and
the ATC curve at their minimum points.

The inter-relationship between AVC, ATC and AFC is

1. If both ARC & AVC fall ATC will fall.
2. It AFC falls but AVC rises.
a. ATC will fall where the drop in AFC is more than the rise
in AVC.
b. ATC will not fall where the drop in AFC is equal to the
rise in AVC.
c. ATC will rise where the drop in AFC is less than the rise
in AVC.
Cost-output Relationship in the long-Run – In the long-run
the entrepreneur has before him a number of alternatives which
include the construction of various kinds and sizes of plants.
Thus there are no fixed costs since the firm has sufficient time to
fully adapt its plant. And all costs become variable.
Long-run Costs Curve

To draw a long run cost curve, we have to start with a number of

short run average cost curves each curve representing a
particular scale or size of the plant including the optimum scale.
One can now draw the cost curve for long run (LAC) which
would be tangential to the entire family of SAC curves, that is, it
would touch each SAC curve at one point.
- The LAC Curve is Tangential to various SAC curves
- The LAC curve is U-shaped and indicates that in the long run
such economics are possible as can not be had in the short-
run. Likewise some of the diseconomies which are faced in
short run may not be faced in the long run.
- The long run cost curve can never cut a short-run average
cost curve. This implies that for any given output average cost
can not be higher in the long-run than in the short run.
- LAC curve will touch the optimum scale curve at the least cost
point i.e. at N1.
- LAC curve will touch SAC curves lying to the left of the
optimum scale curve at the left of their least cost points.
- LAC curve will touch SAC curves lying to the right of the
optimum scale curve at the right of their least cost point.
 Supply Analysis
Meaning of Supply – The supply of a commodity means the
amount of that commodity which producers are able and willing
to offer for sale at a given price.
Supply is related to Scarcity – This means that it is only the
scarce goods which have a supply price; goods which are freely
available have no supply price.

Supply Schedule of Firms A, B & C

Price Output Output Output Aggregate

A B C Output A+B+C
2 Zero Zero Zero Zero
4 300 100 Zero 400
6 400 150 75 625
8 500 200 100 800
10 700 250 200 1,150
12 900 400 250 1,550
14 1,200 700 400 2,300
This means that as the price increases, each firm supplies
greater quantity of output and vice-versa.

Supply Curve

(a) Supply curve has a positive slope

(b) Supply curve slopes downward from right to left
Reserve Price: - If the price falls too much, supply may dry up
altogether. The price below which, the seller will refuse to sell is
called Reserve Price. At this price, the seller is said to buy his
own stock.

Supply Function
∫x = f (PX, FE, FP, PR, W, E, N)
Where PX = Product price
FE = Factor productivity or state of technology
FP = Factor prices
PR = Price of Other products related to production
W = Weather, strikes and other short-run forces
E = Firm’s expectations about future prospects for
price cost, sales and state of economy in general
N = Number
Law of Supply – “other things remaining the same, as the price
of commodity rises, its supply increases and as the price falls its
supply declines”.
Thus the quantity offered for sale varies directly with price,
i.e. higher the price the larger is the supply and vice-versa.

- An increase in price generally implies higher profits leading

producers to offer increased quantity.
- In the long-run due to higher profitability new producers may
enter the field of production leading to an increase in output.

Limitation of law of supply –

(1) Future Prices – When the price rises and the seller
expects that future price to rise further, supply will
decline as the seller will induced to withhold supplies so
as to sell later and earn larger profits then. Likewise,
when the price falls and the seller fears that the price is
going to fall further the supply will rise as he will be ready
to sell more of the commodity in anticipation of future
price fall.
 (2) Agricultural output – Law of supply may not apply in
case of agricultural commodities as their production can
not be increased at once following price increases.
(3) Subsistence Farmers – In underdeveloped countries
where agriculture is characterised with subsistence
farmers, law of supply may not apply. Here, as
foodgrains prices rise, marketable surplus of foodgrains
falls rather than rise this is because with rise in price of
foodgrains farmers can get the required amount of
income by selling less and keep the remaining output for
their own consumption.
(4) Factors other than price not remaining constant –
The law of supply are stated on the assumption that
factors other than the price of commodity remain
constant. Hence the law of supply will not apply in the
following cases.
(a) If prices of other commodities show a rising trend, the
quantity supplies of a commodity may fall at a given price.
(b) The change in the state of technology can bring about a
change in the quantity supplied even if the price of that
commodity does not undergo a change.

Elasticity of Supply

It is the degree of responsiveness of supply to a given change in

price
es = ∆Q/Q
----------
∆P/P
Or
Proportionate change in quantity supplied
Proportionate change in price
e.g. Firm a Supplies 300 units of its output at a price of Rs. 4
when price increases to Re 8 the quantity supplied increases to
500 units. Find the elasticity of supply?
Types of Elasticity of Supply
(i) A supply curve of Zero elasticity perfectly in elasticity
es = 0
(ii) A supply Curve of infinite elasticity
es = ∞

(iii) Unit Elasticity – es = 1

(iv) Relatively elastic supply curve – es > 1

(v) Relatively inelastic supply curve – es < 1

Cross elasticity of Supply – This concept was given by three
economists F Gruen, L Ward & A .Powell while estimating
elasticities of supply for Australian agricultural products.
The cross (price) elasticity of supply however measures
change in quantity supplied of one commodity (say wheat) when
the price of another commodity (say paddy) changes.

Esc = Proportionate (%) change in quantity supplied of wheat

Proportionate (%) change in price of paddy
It is always negative

Change in Supply
Increase or decrease means change in supply without any
change in price.
Increase in supply – Increase in supply is there when (a) at the
same price more is offered for sale, and (b) the same quantity is
offered at lower price.

Figure (a)
(a) This increase in supply form OR to OT at the same price is
not due to a rise in price but due to change in other variables
e.g. reduction in the cost of production, adoption of better
technology etc.
 Figure (b)
(b) Producer supplies the same amount at lower price, supply
curve shifts from SS to S1S1.
In both these figures supply curve shifts to the right showing that
more is supplied at the same price or same is supplied at the
reduced price.
Decrease in Supply – In the decrease in supply either less is
supplied at the same price or same amount is supplied at a
higher price. In both these cases, supply curve shifts to the left
as is shown the following figure.

Extension of Supply – means more is being offered for sale at

a high price.
Contraction of Supply – Means that less is supplied at reduced
price.
 These are shown on the same supply curve whereas
increase or decrease in supply is shown by shifts in the supply
curve either downwards or upwards.

Factors (determinants of supply)

1. Change in the cost of production
2. Technological progress
3. Discovery of new sources of Raw materials
4. Complementary relationship – production of one commodity
may result in the production of another commodity
5. Natural Factors – e.g. agricultural commodities
6. Intensity desire for self- consumption – e.g. milk.
7. Change in the price of substitutes
8. Means of transport
9. Political and social Factors.

Backward sloping supply curve – e.g. in the case of

supply of labour rising wages induce more work, but after a
point, leisure is preferred to labour and hence higher wages
induce workers to work less work and even have holiday.

A Special supply curve – e.g. suppose government supplies

electricity at a constant rate & no more. The supply curve will
look like SS| curve in the graph. This shows that at price OP the
quantity supplied are OQ and no more. The supply curve under
the quota system also looks like SS| curve.
Isocost Curves (Isocost Lines)

An isocast line gives all possible combinations of two inputs (L & C) which
the firm can employ, given the price of these inputs.
If the price of labour is wage (W) and the price of capital is interest
®, the total cost incurred by the firm is summation of labour cost (WL) and
capital cost (rk) and can be represented as
C = WL + rd --- 1

The isocost curve represents the lows of points of al the different

combinations of two inputs that a firm can procedure, given the total funds
(cost) and price of the inputs. Therefore if the total cost of the firm is fixed
and the input prices are given, the isocost lines gives various
combinations of labour and capital.

These curves are also known as outlay lines, price lines input lines, factor
cost-lines, constant outlay line etc.
Each iscost curve represents the different combinations of two
inputs that a firm can buy for a given sum of money at a given price of
each inputs.
If the total outlay is raised the isocost curve will shift upward to the
right of initial iscost curve and if the total outlay is reduced it will shift
downward to the left as initial iscost curve. The iscosts are straight lines.

Least Cost Combination: - The point where the iscost line is tangent to an
isquant represents the least cost combination of two factors for producing
a given output if al points of tangwncy like LMN are joined by a line, it is
known as an output-factor curve or lest outlay curve or expansion bath of
a firm.