Objectives

After completing this unit, students will be able to:

• Explain the concept of the production function

• Understand of law of variable proportion

• Learn production function with two variable

inputs

• Understand optimal factor combination

• Know expansion paths

• Comprehend importance of production function

in managerial decision-making
Overview

Production is the creation of utility as studied under economics. Various decisions need to be taken by a firm including how much production
should be done, what proportion of inputs are required and how much resources need to be hired.

The least cost combination is followed as far as the costs of production are concerned.
Production Function The Concept of Fixed and Variable Factor

There can be two categories of inputs:

Production function refers to the maximum output that can be
obtained from the given input.
The input that The inputs that can
The relationship between labour (L), capital (K) and output (Q) is
cannot be varied be changed as and
as follows:
in one quantity is when required are

Q = f (L, K) known as a fixed known as variable

input. This input inputs. For example,
Here, Q is the level of output or the total product includes the plant of labour is a variable
L is labour the firm. input.
K is capital

01 Fixed Inputs 02 Variable Inputs

The Concept of Total Product (TP), Marginal Product TPn -1 is the extra unit produced of the total product
(MP) and Average Product (AP)
The following table and figure show the examples of calculating
Maximum TP can be obtained from different combinations of TP, AP and MP.
inputs in different quantities, which is shown in the production
Figure 12.1: Effects of Output on Adding More inputs
function.
Labor Input, Total Output, Marginal Average Product,
There are two concepts that are important:
L Q Product, MP AP
0 0 –
AP MP
13
1 13 13
The AP is TP (Q) divided by input.
14
(TP) 2 27 13.5
AP = 13
(Amount of input to produce output)
3 39 13
MP is the extra units produced by increasing one extra input. The 11
equation is as follows: 4 50 12.5
9
MP = TPn – TPn – 1
5 59 11.8
Here, MP is the marginal product 5
6 64 10.7
TPn is total product
Labor Input, Total Output, Marginal Average Product, The graphical representation of the relationship between AP, TP

L Q Product, MP AP and MP is as follows:

2
7 66 9.4
–2
8 64 8

Figure 12.2: Total, Marginal and Average Product Figure 12.3: Relationship between TP, AP and MP
Law of Variable Proportion

If the inputs are more, the TP increases at an increased rate up to the point of inflexion. Then, the TP tends to increase at a decreasing rate,
as it reaches the maximum and declines eventually. Figure 12.4 shows the various stages of the law of variable production.

Stages of Production

Following are the three primary stages of production:

Stage 1 Stage 2 Stage 3

Increasing Returns Diminishing Returns Negative Returns

This is the stage where the The total product increases In stage I and III, no firm will like to operate. In stage I, the
total product increases at at a decreasing rate and fixed factors need to be fully utilized and in stage III, the
an increasing rate, marginal reaches its maximum point. negative returns exist. A profit maximizing producer will
product reaches its maximum, marginal product falls and like to operate in stage II because the efficiency of workers
and the average product becomes zero. Average is maximum at this stage, along with the total product.
becomes maximum. product falls.
 Figure 12.4: Graph of the Law of Figure 12.4(a): Amount of a Variable Factor Figure 12.4(b): Amount of a Variable Factor
Variable Proportions

Production Function with Two Variable Inputs Features of Isoquants:

An isoquant has the following properties:

Isoquants
• The slope of all isoquants are downward towards the right.
An isoquant uses various combinations of two inputs to show all
the possibilities of producing a level of an output. • It is convex to the origin and is continuous and smooth.
• These never intersect each other.
Iso-Cost Line: It shows the total expenditure or cost of the firm
when only labour and capital is used by the firm.
C = wL + rK
where C = total cost
w = wage rate of labour
Optimal Factor Combination: A firm may maximize its output and
try to work out the combination of total inputs at minimum cost.
Figure 12.5: Equilibrium in Long Run
At point E, the isoquant is tangent to the budget line, depicting the
firm being at equilibrium.
Expansion Paths: Another application of this analysis is to consider
the scenarios when the firm’s target output increases. The analysis
also serves to express the situation in terms of its twofold, when
the firm’s capital increases. As the firm attains higher output levels,
the optimal combinations of inputs involved will trace an expansion
path.
Figure 12.6: Expansion Path
Importance of Production Function in
Managerial Decision-Making
Following are two important principles of management:
A manager can use its resources
rationally.
The cost of each decision involving
the allocation of scarce resources
and the marginal benefits can be
finalized by the manager.
Summary
Production is the creation of utility. Short run is the time period for which only
one factor is a variable. Long run is the time period in which no variable is
constant, and all the inputs vary. According to the law of variable proportion,
when the quantity of one factor is increased, keeping the others constant,
the marginal product increases at first and then eventually decreases. Then,
it increases at a decreasing rate until it reaches the maximum and declines
eventually. A firm is in equilibrium, where the isocost line and isoquants are
tangent to each other.
Assessment Questions
1. What is the significance of the law of variable proportions?
2. What do you understand by isoquants?
3. Explain the importance of isocost line.
4. When does a firm attain equilibrium?