Production Function

Single Factor
Two Factors
Returns to Scale

Managerial Economics
Microeconomics
Production Function

• All inputs for production are referred as ‘Factors of Production’ and classified
as –
– Land – Rent
– Labour – Wages
– Kapital – Interest
– Entrepreneur skill – Profits
• Production function – functional relationship between quantities of factors of
production and the resultant quantity of output.
• Thus the quantity of Output (Q) from the process of Production can thus be
expressed as a functional relationship –
Q = f (L, Lb, K, E)
Implying that –
– A change in the proportion of factors may vary the level of output
– Same level of output can be achieved using different proportions of factors
• For the sake of simplicity we further assume that there are only 2 factors of
production – i.e. Kapital and Labour
• The Production Function can thus be written as –
Q = f (K, L)
Single Factor Model
Single Factor Model

• Production can further be thought of as a function of a single factor – eg. Labour –

by keeping the other factors constant.
• Eg. – Say a certain amount of investment is done in Plant & machinery – which
remains fixed over a period – i.e. Does not change with additions to Labour.
• Then –
– Total Product can be defined as the total quantity of output produced on employing
certain units of Labour
– Marginal Product of Labour (MPL) can be defined as addition to total product due to an
addition of one unit of labour
– Thus – MPL = dTP/dL
• In such situation – Marginal Product will Total Product will

Increase initially Increase at increasing rate

Then decrease after certain level Increase at decreasing rate

Will reach Zero Reach a maximum

Then becomes negative Start declining

 Total and Marginal Product

Output
Marginal Product will Total Product will

Increase initially (OA) Increase at increasing rate (OD) Marginal Product

A
30
Then decrease after certain level (AB) Increase at decreasing rate (DE)

Will reach Zero (B) Reach a maximum (E)

Then becomes negative (BC) Start declining (EF)

Kapital Labour MP TP AP
B
O
100 1 10 10 10 3 Labour Units 7

100 2 20 30 15 C
102
100 3 30 60 20 E

Output
F
100 4 20 80 20

100 5 15 95 19 D Total Product

100 6 7 102 17

100 7 0 102 15
O Labour Units
100 8 -10 92 12 3 7
Average and Marginal Product

• When Marginal Product (MP) increases – Average Product (AP) also increases – MP
curve is above AP – (OA – OF)
• When MP starts to decline – AP keeps increasing – MP curve is above AP – (AD – FD)
• Till such point where AP is equal to MP – MP and AP intersect – (D)
• Thereafter, AP also starts declining – AP curve is above MP – (DB – DC)
Kapital Labour MP TP AP

100 1 10 10 10

Output
100 2 20 30 15
A
30 D
100 3 30 60 20 20
100 4 20 80 20

100 5 15 95 19
F E
100 6 7 102 17
B
100 7 0 102 15 O
3 4 7
100 8 -10 92 12 Labour Units C
Total Product, Marginal Product and Average Product

Output
• MP = dTP/dL = Slope of TP curve
• AP = TP/L = Slope of line joining point on TP A D
30
curve and Origin
• At point H on the TP curve –
– AP is the slope of line OH
– MP is the slope of line PQ
– PQ is steeper than OH – thus MP is higher B
O
than AP 3 Labour Units 7
• At point G on the TP curve – C
– Slope of OG = AP = MP 102
E
– Point G corresponds to Point D – where MP

Output
F
intersects AP G

• Beyond point G on the TP curve – Q

– Slope of TP Curve < Slope of Line from Origin H

to point on Curve
P
– MP < AP O Labour Units
3 7
Law of Diminishing Marginal Returns

• This phenomenon is usually referred to as the ‘Law of Diminishing

Marginal Returns’
• Statement –
– For a given level of fixed inputs
– and a given level of technology
– Marginal returns from variable input will start diminishing
– beyond a certain point
• Diminishing Marginal Returns of factors is assumed as a standard
condition while analysing Production functions.
• However, capital accumulation and technological change off-sets the
effects of diminishing returns
• If technology is considered as an input – will it also be subject to
Diminishing Returns ?
Two Factor Model
Two Factor Model

• Given Production Function – Q = f(K,L) – let us now

assume that both factors are variable.
• Thus –
– Increasing quantity of K or L or both K and L will increase

Kapital
Output
– Decreasing quantity of K or L or both K and L will decrease
Output
– ALSO, Increasing K and decreasing L in some proportion will IQ3
keep the Output constant IQ2
IQ1
• The last proposition above gives us iso-output curve – i.e.
A curve joining different combinations of K and L such Labour
that Output remains constant – referred to as ISOQUANT
curves.
• Properties similar to indifference curves –
– Negative sloping
– Convex to origin
– Higher Isoquant represent higher levels of Output
– Slope of the curve – here referred to as Marginal Rate of
Technical Substitution (MRTS) gives the MRS between
Kapital and Labour = dK/dL for a given level of Output.
Properties of Isoquants

• Substitution –
– The 2 inputs – K and L – are substitutable
– A rate of substitution exists between K and L such that 4 A

Kapital
the resultant Output remains constant
3
• Diminishing MRTS –
– The convexity of the curve implies a diminishing MRTS 2
B
– Thus every additional units of K can be substituted by
1 C D
lesser and lesser units of L
– Implying Law of Diminishing Marginal Returns
1 2 3 4 5
Marginal Rate of Technical Substitution Labour
Q = f (K, L)
dQ = dL . (δQ/δL) + dK . (δQ/δK) . . . Total differentiation L K ∆K/∆Y
[Marginal addition to total Output] = [additional units if L] x
A 1 4 -
[MPL] + [additional units of K] + [MPK]
dQ = dL . (MPL) + dK . (MPK) B 2 1.75 2.25/1
But along an Isoquant Curve marginal addition to Output is 0. C 3 1.25 0.5/1
So, dQ = dL . (MPL) + dK . (MPK) = 0 D 4 1 0.25/1
- dK/dL = MPL/MPK = MRTSKL
Special Cases

• Perfect Substitutes –
– In fig 1 the Isoquant is linear

Kapital
 Constant MRTS
 Constant MP of factors (not diminishing)
 Factors perfectly substitutable at all stages
of production IQ3
IQ2
 Entire production possible only by K
IQ1
 Entire Production possible only by L O
Labour
• Fixed Factor Proportions –
P
– In fig 2 Isoquants are rt. angled –
 A certain level of Output possible only

Kapital
with a unique combination of K and L
 Quantity of K and L along line OP
IQ3
 For any IQ increase in K or L more than the
combination given by OP results in Zero IQ2
MP of factors IQ1
– Typically modular expansion of production O
Labour
Choice of Inputs

• The Choice of optimum combination of Factors is

determined by the Relative Prices of Factors A
• The logic is similar to that used in the Indifference
Curve analysis
P

Kapital
• In fig, -
– IQ1, IQ2 and IQ3 are various Output levels possible by
combinations of K and L R S
– AB is the ‘Iso-cost Line’ (similar to the Budget line) Q IQ3
• If all resources are used in buying K – OA is the IQ2
maximum K that can be employed T IQ1
• OA – i.e. Total units of K affordable is determined by
cost of K – i.e interest rate (r) O
B
Labour
• If all resources are used in buying L – OB is the
maximum L that can be employed
• OB – i.e. Total units of L affordable is determined by
cost of L – i.e. Wages (w)
• Slope of AB = w/r
– Optimum Choice of Inputs would be point where
Isocost line is tangential to the Isoquant
– At equilibrium –
• Slope of Isoquant = Slope of Isocost
• MRTS = w/r
• MPL/MPK = w/r
Returns To Scale
Returns to Scale

• A unit increase in inputs – how much change in output will it result in ?

Double the Inputs  More than double change in Output  Increasing Returns
Double the Inputs  Less than double change in Output  Decreasing Returns
Double the Inputs  Double the Output  Constant returns
• In the fig. –
– From OA to AB – Inputs have doubled – but
output has more than doubled – Increasing
returns 4 D

Kapital
– From AB to BC – Inputs have grown by 50% - 3 C
Output has grown by more than 50% - 55
Increasing returns 2 B
50
– From BC to CD – Inputs have grown by 33% - 1 A 30
Output has increased by 10% - Decreasing 10
returns O
1 2 3 4 5
Labour
Returns to Scale

Internal Factors – Resulting from Expansion of the Firm

Economies Dis-economies

• Managerial Efficiency • Business too big to manage

• Benefits of specialization
• Benefits of R&D
• Technology
External Factors – Resulting from Expansion of the Industry

Economies Dis-economies

• Specialised Units • Over utilisation of infrastructure

• Common Infrastructure • Competition takes business
• Emergence of Market Place share
Returns to Scale

• Increasing returns normally seen in manufacturing

• In sectors with increasing returns – optimum size of units is large – likely
to be govt. regulated sectors
• Service sector normally displays constant returns