Theory of

Production
(Long-run)
Production Function with Two
Variable Inputs
 Producers being rational would use that
combination of two inputs that is
economically efficient.

 The objective is to minimize cost

producing a given level of output, of
maximize output at a given cost or
ISO- QUANT

ISO-QUANT show the combinations of

two inputs that an individual would be
willing to use, and which would give
him/her equal quantity of production.
ISO-QUANT

INPUT -A

INPUT -B
INPUT -A

INPUT -B
Properties of ISO-QUANT

ISO-QUANT slope downward from left

to right.
ISO-QUANTs are convex to the origin.
ISO-QUANTs place above another
represents higher output.
ISO-QUANTs do not intersect each other.
Plot ISO-QUANT

Output Labour (X1) Capital(X2)

10 1.1 9
10 1.2 8
10 1.4 7
10 1.7 6
10 2.1 5
10 2.6 4
10 3.2 3
10 4 2
10 5.5 1
Marginal Rate of Technical Substitution (MRTS)

It is the rate of exchange between two

productive resources which are equally
preferred.
The quantity of one input to be sacrificed or
given up in order to gain another input by
one unit in process of substitution MRTS of
x1 for x2 is written as -
Calculate MRTS
Output Labour (X1) Capital(X2)
10 1.1 9
10 1.2 8
10 1.4 7
10 1.7 6
10 2.1 5
10 2.6 4
10 3.2 3
10 4 2
10 5.5 1
 Plot & Calculate MRTS
Output Labour (X1) Capital(X2) ∆X1 ∆X2 MRS of X1
on X2
10 1.1 9
10 1.2 8
10 1.4 7
10 1.7 6
10 2.1 5
10 2.6 4
10 3.2 3
10 4 2
10 5.5 1
Output Labour Capital(X ∆X1 ∆X2 MRS of
(X1) 2) X1 on X2
10 1.1 9 -- -- --
10 1.2 8 0.1 1 10
10 1.4 7 0.2 1 5
10 1.7 6 0.3 1 3.33
10 2.1 5 0.4 1 2.5
10 2.6 4 0.5 1 2
10 3.2 3 0.6 1 1.66
10 4 2 0.8 1 1.25
10 5.5 1 1.5 1 0.66
Draw ISO-QUANT & Calculate MRTS
Iso-cost Line

The Iso-cost Line is the locus of

combinations of two goods an individual
can afford to buy with his/her income.
The slope of the line is the price ratio of
the two goods or relative price of each
good.
Suppose a consumer has a fund of
Rs.400/- and he has to spend on two
products that is X1 and X2 . The price per
unit of X1 is Rs.10/- and X2 is Rs.8/-.
A farmer has total sum of Rs.
2,00,000/-. He has to use two inputs
Capital and Labour. The cost of
Labour is 12,500/- per unit and the
cost of Capital is 25,000/- per unit.
Construct an Isocost line for the
farmer given his limited budget.
Isocost Line

C
A
P
I
T
A
L

LABOUR
POINT OF TANGENCY.

The equilibrium point which will give maximum production to

the producer, and which the producer can afford, is where the
Iso-cost Line is tangent to the highest ISO-QUANT.
Continued
 Returns of Scale
 These questions refer to the returns to
scale, or the effects of scale increases of
inputs on the quantity produced

 Three important cases

Constant returns to scale
Increasing returns to scale
Decreasing returns to scale
 Long Run Production - Returns to Scale

In the long run, all factors of production are variable.

How the output of a business responds to a change in
factor inputs is called returns to scale.

21
 Long Run Production - Returns to Scale

In the long run, all factors of production are variable. How the
output of a business responds to a change in factor inputs is called
returns to scale.

22
 Continued
 Constant returns to scale-where a
change in all inputs leads to a proportional
change in output

 Increasing returns to scale- when an

increase in all inputs leads to a more-than-
proportional increase in the level of output

 Decreasing returns to scale occur when a

balanced increase of all inputs leads to a
less-than proportional increase in total
output.
 Technological Change

Process Innovation and Product Innovation

 Process innovation, which occurs when
new engineering knowledge improves
production techniques for existing products

 Product innovation, whereby new or

improved products are introduced in the
marketplace
 Productivity
 When output is growing faster than inputs,
this represents productivity growth

 Productivity grows because

technological of advances such as
process and product
the innovations

 Additionally, productivity grows

because of economies of scale and scope
 Continued

 Economies of scale and mass production

have been important elements of
productivity growth since the Industrial
Revolution

 Economies of scope occur when a number

of different products can be produced more
efficiently together than apart
Happy Learning