Unit: 5

Theory of Production
 Meaning of Production

 It is the process in which inputs are converted into output.

 Production is the result of combine combination of all inputs
 It is the process that creates/adds value or utility. For example, juice
(furniture) gives more utility than sugarcane (timber) and sugar more
utility than juice. Juice (furniture) has more value than sugarcane
(timber) and sugar has more value than juice.
 Creation of utility – Raw material (timber ) to finished goods
(furniture).

Output:
Inputs: Processing finished
means of goods
production
 Factors of Production/Inputs: those
goods and services which are required to produce other goods and services.
1. Labor: it refers to the mental and physical efforts of human being
in the process of production with the aim of earning wage/income
Features of Labor
 labor (effort) is not separated from the laborer (teacher).
 Perishable: capital and land can be saved to use them in the future.
If a worker does not work on a particular day, his labor for that
day is wasted.
 An active factor: it gives life to other inputs
 A mobile factor (from one place to another, from one occupation
to another)
 A laborer sells his labor, not himself
 Weak bargaining power
 Inelastic supply
 CONT..
2. Capital: It refers to manmade factors such as machines, tools,
buildings, money, roads, bridges, raw materials which are used for
further production of good and services and reward for the use of
capital is called interest.
Features of Capital
 Man made factor
 A passive factor: it alone can not produce goods and services (It
requires the help of labor)
 A mobile factor (most mobile factor of production)
 Elastic supply
 Highly affected by technology
 A temporary factor.
 Cont..
 Land (free gift of nature such as surface of the
earth, rivers, forests, mountains, sunlight) and
the reward for the use of land is called rent and
 Organization (it organizes land, labor and
capital to produce goods and services required
for the market) and reward for the organization
is called profit.
 Production Process: It involves the use of
various inputs to produce output.
Inputs are the means of producing goods and services demanded by society.

A commercial bank uses

computer, furniture,
banking staffs and
manager to provide
banking service to its
customers

Organization

A vegetable farmer
A noodle factory uses land, uses land, labor, seed,
flour, labor, machine, fertilizer,
building and so on to spades,Tractors to
produce noodle produce vegetables.
 Types of Inputs
Capital is a fixed input Labor is a variable input
1. Fixed Inputs:
Fixed inputs are those 2.Variable Inputs:
inputs which cannot Variable inputs are
be changed as those inputs which
required. Land, can be changed as
machine, building, required. Raw
permanent staff are material, daily wage
the examples of fixed workers.
inputs.
 Production Function: The production of a
commodity depends on certain specific inputs.
 Production function shows a functional and physical
relationship between inputs and output.
 symbolically,
 Qx(building)= f(Labor, Capital, land, Organization), where Q is
output.
 For simplicity, we consider only two inputs- labor (L) and
capital (K) and one output (Q).
 Q =f (L, K), Other things remaining the same
 Where,
 Q= Output (Furniture, noodle, vegetables, cloth),
 L= Units of labor and
 K = units of capital
 Types of Production Function
1. Short Run Production Function:
 Short-run is the time period that a firm cannot change all of its inputs.
 A production function in which at least one input (capital) is fixed.
(some inputs (capital) are fixed and some inputs (labor) are variables) is
called short run production function.
 Q=f (L, K)
 Where,
 Q= Output,
 L= Units of labor (variable) and
 K = Constant units of capital (Bar over K represents that capital is fixed)
 The law related to the short run production function is the law of
variable proportions.
2. Long Run Production Function:
 Long-run is the time period that a firm can change
all of its inputs.(No factor of production is fixed)
 A production function in which all inputs are
variable is called long run production function.
 Q=f(L,K)
 Where, both inputs are variable
 The law related to it is called the law of returns to
scale
 Concept of TP, AP,MP
1. Total Product (TP):
 The total amount of a output (130 pages) produced by a
firm (producer) employing various units of inputs (13
laborers) in a period of time (1 day) is known as total
product.
2. AVERAGE PRODUCT (AP):
 It a per unit product of an input. It can be calculated by
dividing the total product of an input by the corresponding
unit of employment of that input.
 Average product of labor(APL) ==130/10= 10 pages
 Average product of capital (APk) ==130/13=10 pages
 Cont..
3. Marginal Product (MP):
 The additional output produced by a firm by
using one additional unit of an input is called
marginal product. (extra output produced by
employing one more unit of an input)
 MPL= =
 MPK =
 Law of Variable Proportions
a. Statement:
 It explains short-run production and states that when more and more units
of variable factor/input (say, labor) are combined with fixed input (say,
capital), then the total product (TP) initially increases at increasing
rate, then it increases at decreasing rate, becomes maximum and
ultimately TP begins to fall.
 Likewise, AP and MP also increase in the beginning, become maximum
and start to decrease.
 When the quantity of one factor changed, keeping the quantity of
other factor constant, the proportion between the variable factor and
the fixed factor is changed. Therefore, it is known as the law of
variable proportions.
Symbolically,
Q=f(L,K), where, L= unit of labor and K= unit of capital which remains
constant.
 Cont..
b. Assumptions:
 At least one factors of production/inputs should be fixed
(Short run production function).
 Inputs are used in varying proportions (K/L Ratio varies
(decreases) as units of labor has increased).
 The state of technology is assumed to be given or
unchanged.
 Variable inputs are homogenous (identical skill of all
units of labor).
.
L K TP AP= MP= Stages

0 3 0 - - Stage I: Stage Of Increasing Returns

 Initially, AP=MP
1 3 10 10 10=10-0  TP increases at increasing rate up to 3rd unit of labor.
 MP becomes maximum at 3rd unit of labor
2 3 30 15 20
 AP becomes at 4th unit of labor
3 3 60 20 30  MP>AP
 AP=MP at the end of first stage (when 4 th unit of labor is
4 3 80 20 20 employed)

5 3 90 18 10 Stage II: Stage Of Diminishing Returns

 TP increases at diminishing rate up to the 5th unit of labor
6 3 90 15 0  TP is maximum at the 5h unit of labor
 It becomes stable at 6th unit of labor.
 AP>MP
 MP becomes zero at the end of this stage

7 3 80 11.4 -10 Stage III: Stage Of Negative Returns

 TP starts to decline (beyond 6th unit of labor )
 MP becomes negative,
 AP declines but never becomes zero
Stage I (stage of increasing returns)
 TP is increasing at the increasing rate up to
the point A and then has started to increase
at the diminishing rate
 MP is increasing up to point G and then it
is decreasing.
 AP is increasing up to point H and at point
E, it is stable.
 This stage ends at the point E where
AP=MP.
Stage II(stage of decreasing returns)
 This stage begins from point B of TP
 TP continues to increase at the diminishing
rate until it reaches at the point C and it
remains stable at point D.
 AP is continuously decreasing
 MP is also continuously decreasing and it is
zero at point F.
 This stage ends at the point F where MP=0.
Stage III (stage of negative returns)
 This stage begins from point D.
 TP is declining.
 AP is also declining but never becomes
zero and negative
 MP is negative because it lies below X-axis
 Cont………….
Causes of stage I: Stage of Increasing Returns
1. Increase In Efficiency Of Fixed Factor:
 In the initial stage of production, the quantity of fixed
factor is abundant relative to the quantity of the variable
factor.
 Therefore, when more and more units of the variable
factors are used to the constant quantity of fixed factor, the
fixed factor is more intensively and efficiently utilized.
 (AP of variable factor increases when better and full use of
the fixed indivisible factor)
 As a result, the increasing returns are obtained
 Cont..
2. Increase In Efficiency Of Variable Factor:
 in the beginning, we get increasing returns because as
more and more units of variable factor are employed,
the efficiency or productive capacity of variable
factor itself increases.
 This is because there is sufficient quantity of the
variable factor, it becomes possible to introduce
division of labor (dividing the whole work into
sub-units according to skill of labor) which result
in higher productivity.
 Cont………..
Causes of Stage II: Stage of Diminishing (decreasing)
Returns:
1. Scarcity of Fixed Factor:
 In the short run, the amount of fixed factor cannot be
changed.
 Therefore, once the amount of variable factor is sufficient to
ensure the efficient utilization of the fixed factor, further
increase in variable factor will cause marginal and average
products to decline because the fixed factor becomes
inadequate relative to the quantity of the variable factor.
 This results stage of diminishing returns.
 Cont..
2. Indivisibility Of Fixed Factor:
Once the optimum proportion between fixed and variable
factors is disturbed by the further increase in the variable
factor, AP will diminish because the indivisible factor is
being used in wrong proportion with the variable factor.
3. Imperfect substitutability of the factor:
 When there is scarcity of fixed factor, the quantity of
that factor cannot be increased in accordance with the
varying quantities of the other factors.
 This results in diminishing returns.
 Cont………..
Causes of stage III: Stage of Negative Returns
(MP<0)
 Inefficient utilization of variable inputs (Over
staffing):
 Over utilization of fixed inputs
 Complexity of management (too many cooks
spoil the food)
 Where does rational firm produce?
Stage of operation
 A rational producer will never choose to produce in the
state III where the MP of variable factor is negative.
Even if the variable factor is free, a rational producer
will not produce in the stage III because the TP
declines in this stage.
 A rational producer also does not choose to produce in
the stage I although TP increases and MP of variable
factor is positive. There is an opportunity of increasing
production by increasing quantity of the variable factor
where AP continues to rise throughout the stage I.
 Cont………
 Thus, it is clear that a rational producer will
produce in the stage II where both MP and AP
of variable factors are diminishing.
 The answer of at which particular point in this
stage the producer will decide to produce
depends upon the price of factors.
 Isoquant (IQ)
• The term isoquant is composed of two words,
iso = equal, quant = quantity
• An isoquant is a locus representing
different combinations of two inputs
which yields (gives) same level of
output to the producer.
 Isoquant Schedule: The tabular
representation of IQ.
Combi Units Units Output MRTSLK
nations of of (kg) The table shows that the five
Labor Capit combinations of units of labor
al and units of capital yield the
same level of output, i.e., 200 kg
A 1 12 200 -
of output. Thus, 200 kg can be
produced from the following
B 2 8 200 4/1 combinations.
(a) 1 units of labor and 12 units of
capital
C 3 5 200 3/1 (b) 2 units of labor and 8 units of
capital
(c) 3 units of labor and 5 units of
D 4 3 200 2/1
capital
(d) 4 units of labor and 3 units of
E 5 2 200 1/1 capital
(e) 5 units of labor and 2 units of
capital
Isoquant Curve: The graphical representation of IQ schedule

K In the figure, IQ is an isoquant

A(1,12) curve which is obtained by
plotting isoquant schedule in
B(2,8)
graph. It slopes downward
C(3,5)
D(4,3) from left to the right indicating
E(5,3) that units of capital have to be
IQ=200
decreased in order to increase
L the units of labor without
change in the level of output
ISOQUANT MAP: A set of isoquant curves

K In the figure,

an isoquant
map consists
of four
isoquants
namely IQ1,
L IQ2, IQ3 &
IQ4
 Assumptions of Isoquant
 Only two inputs- labor and capital- are
assumed to be variable.
 Production technology is fixed and given
 Producer must be rational
 Operation of diminishing marginal rate of
technical substitution
 Consistency
 Transitivity.
 Marginal Rate of Technical
Substitution(MRTSLK)
• It a rate at which units of two inputs are
substituted to each other to maintain the
same level of output to the producer.
• Slope of isoquant=MRTSL,K=
Where
MPL =marginal product of labor
MPK =marginal product of capital
Law of Diminishing MRTSL,K
PROPERTIES OF ISO-QUANT
1. Isoquant always slopes downward to the
right .  The Fig. shows that when the
amount of labor is increased
from OL to OL1, the amount of
capital has to be decreased from
OK to OK1 that the total output
remains unaffected.
200  Two inputs are substituted of each
other (if one of the input
increased, the other input has to be
so decreased that the output
remains unaffected. ).
The possibilities of horizontal, vertical,
upward sloping curves can be ruled out
 2. Isoquant is convex to the origin:

 As we move from point A to B,

from B to C and from C to D
along an Iso-quant, the marginal
rate of technical substitution
4 (MRTS) of Labor for capital
diminishes.
 Every time labor units are
3
increasing by an equal amount
2
(AK) but the corresponding units
of capital decreases.
 It is due the operation of the law
of diminishing marginal rate of
technical substitution (MRTS)
 3. Higher IQ yields higher level of output than lower ones.

 IQ1 represents an output
level of 100 units
whereas IQ2 represents
200 units of output.
 It is because higher IQ
contains more units of
both inputs than lower
L
IQ or more units of at
least one input than
lower one.
4. IQs never intersect each other:
 Figure show that TP (A)
=TP(C) at IQ1, TP(A)=TP(B)
at IQ2 TP(IQ1)=TP(IQ2) at
the point of intersection
point A.
 TP(IQ1)>TP(IQ2) at the left
side of the intersection
point.
A  TP(IQ1)<TP(IQ2) at the right
side of the intersection
point.
 Which violates the
assumption of consistency
and transitivity principle in
producer’s preferences.
5.IQs never touches either axis.
K
• this is because a single input
alone can not produce goods and
services.
•Both inputs i.e. labor and capital Q= f(L,0)
are indispensible (essential) for
production. Q=f(0,k)
•Q= f(L,K)
•Q=f(0,K) AND Q=f(L,0) are not
possible. L
 Iso-cost line
• An iso-cost line is a graphical representation of various
combinations of two factors (labor and capital) which the firm
can afford or purchase with a given amount of money or total
outlay.
• Q=f(L,K)
• C= wL +iK
Where,
w= wage
L= unit of labor
i= interest
K= unit of capital
 Cont………
• Now suppose that a producer has a total
budget of Rs 120 and for producing a certain
level of output, he has to spend this amount on
2 factors L and K. Price of factors L and K are
Rs 10 and Rs. 15 respectively. 
 Cont……….

15 10

15x8=120 10x0=0

15x6=90 10x3=30

15x4=60 10x6=60

15x2=30 10x9=90

15x0=0 10x12=120
 Cont………

k ISO-COST LINE
C=120

B L
Shift in iso-cost line:
Px=Rs. 10 and Py=Rs. 5
Producer’s Equilibrium/Least Cost
Combination Of Two Inputs/Optimal
Combination Of Two Inputs
• A producer is said to be in equilibrium when
he is hiring such a combination of two inputs
that leaves him with no tendency to rearranges
the inputs.
• There is two criteria in regard to define
producer’s equilibrium.
 Cont……….
a. Output-Maximization for a given Cost:
Maximize Q=f(L,K) (production function-IQ)
Subject to C= wL + iK (isocost line)
b. Cost-Minimization for a Given Output:
Minimize C=wL +iK (isocost line)
Subject to Q=f(L,K) (IQ)
 b. Cost-Minimization for a Given
Output:
Conditions of producer’s equilibrium:
1. Necessary condition/first order condition:
• Iso- cost line should be tangent with IQ(Slope
of IQ=slope of iso-cost line)
i.e. MRTSLK = w/r
2. Sufficient condition/ second order condition:
• IQ should be convex to the origin at tangency
point.
 Cont…………..
Assumptions:
1. There are two factors, labor and capital.
2. All units of labor and capital are homogeneous.
3. The prices of units of labor (w) and that of
capital (i) are given and constant.
4. The cost outlay is given.
5. The firm produces a single product.
6. The price of the product is given and constant.
7. The firm aims at profit maximization.
 ost-minimization for a given of output

 K1L1 Iso-cost line has become

tangent to Iso-quant
K3 (representing 500 units of
output) at point E.
K2  The firm employs OL0 units of
labor and OK0 units of capital.
 The producing firm is in
K1
equilibrium. It obtains least cost
combination of the two factors
K
to produce 500 units of the
k0 commodity.
 The points such as H, K, R and
S lie on higher iso-cost lines.
They require a larger outlay,
L0
which is beyond the financial
resources of the firm.
a. Output-Maximization for a Given Cost:

 The firm is in equilibrium at

point E where the Iso-quant
curve 200 is tangent to the Iso-
cost line CL in.
 At this point, the firm is
maximizing its output level of
e
K0 200 units by employing the
=IQ3 optimal combination of OK0 of
capital and OL0 of labor, given
=IQ2 its cost outlay CL.
 But it cannot be at points E or F
=IQ1
L0 on the Iso-cost line CL, since
both points give a smaller
quantity of output, being on the
Iso-quant 100, than on the Iso-
quant
 Law of Returns to Scale
a. Statement
 This law is related to the long-run production function and
states that how output changes if we change all factors of
production at the same rate/percentage/proportion.
 Mathematically,
Q=f(L,K) , where, L= unit of labor, K= unit of capital
 There are three types of law of returns to scale.
a. Increasing returns to scale (IRS)
b. Constant returns to scale (CRS)
c. Decreasing returns to scale (DRS)
1. Increasing Returns to Scale(IRS):

 If the percentage or proportionate increase in

output is greater than the percentage increase in
inputs, it exhibits increasing returns to scale.
 For example, if inputs are increased by 100%,
output increases by more than 100%.
L K Q
1 1 10
2 2 30
4 4 70

When we double the inputs from 1L+1K to 2L+2K to 4L + 4k, the output will be more
than double i.e. 10 to 30 to 70
 Causes of increasing returns to scale:

1. Indivisibility (can not de divided into small parts as

requirement) of factors/inputs: There are certain
inputs such as machinery, management, marketing skills
which can not divided into small size to suit the small
scale of production. For example, half of a machine
cannot be used , there can not be half a typewriter or
half of a manager. Such inputs will have to be a
minimum size in order to do job and they have to be
employed even if the scale of production is small.
Therefore, as scale of production increases, these
indivisible inputs are utilized better and more
efficiently. This leads to increasing returns to scale.
 Cont..
2.Greater Specialization:
 When the scale of production increases, production process can be
divided into specific process and each process is carried out by separate
workers. Division of labor (dividing a whole work into different units
and sub-units according to the skills of laborers ) increases the
efficiency of labor with greater skills acquired through specialization of
employment of workers.
 Similarly, when scale of production increases, it becomes possible to
use specialized machines doing various specific operation.
 When the scale of production increases, the firm can employ different
experts handling different jobs- the personnel manager, sales manager
and so on.
 The combined effect of use of specialized labor, management and
machinery with increase in scale results increase productivity of inputs
leading to IRS.
 Cont..
3. Dimensional relationship:
 If the dimensions of a room are 10m and 20m, the size
of the room is 200 sq.m. If the dimension of the room
is doubled to 20m and 40m, the size of the room
increases by more than double (i.e 800 sq m is 4 times
greater than 200 sq m. ).
 When the diameter of a pipe is doubled, the flow of
water is more than doubled.
 Following this dimensional relationship, we can
generalize that when labor and capital are doubled, the
output is more than doubled over same level of output.
Graphically: IRS can be explained with the help
of isoquants and product ray.
 Along the product ray OR, the gap
k between OA, AB & BC is decreasing , that
is OA> AB> BC.
 A movement from A to B, percentage
6K
increase in output (100%) is greater than
5K percentage increase in inputs (66.66%) i.e.
IQ3=300
as inputs are increased by 66.66%, then
output increases by 100%.
3K IQ2=200
 A movement from B to C, percentage
IQ1=100 increase in output (50%) is greater than
percentage increase in inputs (20%) i.e. as
L
inputs are increased by 20%, then output
increases by 50%.
 The distance between successive isoquant
declines because less than double inputs
are required to double output and so on.
 2. Constant Returns to Scale(CRS):

 If the percentage increase in output is exactly

equal to the percentage increase in inputs, it is
the law of constant returns to scale in
operation.
 For example, 100% increase in inputs
increases the output exactly by 100%.
L K Q
1 1 10 When we double the inputs from
2 2 20 1L+1K to 2L+2K to 4L + 4k, the
4 4 40 output will be double i.e. 10 to 20
to 40
 Causes of CRS

• Dis- economies of Scale: Beyond a certain

point, internal and external economies of scale
are exhausted and diseconomies of scale are
to start. When inputs of same efficiency are
duplicated output would increase by equal
proportion.
 Graphically
 Along the ray OR, the gap between
OA, AB & BC is same , that is OA=
AB= BC.
 A movement from A to B,
percentage increase in output
C (100%) is exactly equal to the
6K percentage increase in inputs (100%)
IQ2=300 i.e. as inputs are increased by 100%,
B then output also increases by 100%.
4K  A movement from B to C,
percentage increase in output (50%)
A IQ2=200 is greater than percentage increase in
2K inputs (50%) i.e. as inputs are
increased by 50%, then output also
IQ1-100 increases by 50%.
 The distance between successive
isoquant remains same. It means that
if units are doubled, the output is
also doubled. To treble the output,
units of both factors are trebled
Figure 2
 3. Decreasing Returns to Scale(DRS)

 If the percentage increase in output is less

than the percentage increase in inputs, it is
the law of constant returns to scale in operation.
 For example, if inputs are increased by 100%,
output increases by less than 100%.
L K Q
When we double the inputs from
1 1 10
1L+1K to 2L+2K to 4L + 4k, the output
2 2 15 will be less than double i.e. 10 to 15
4 4 25 to 25
 Causes of DRS
Causes :
1. Complexity of Management: beyond a certain range,
management becomes more and more difficult.
 For instance, when the scale/Volume of production
increases, more people such as assistants and
supervisors are involved in administration and
management. This creates the problems of lack of
communication and command between the top
management and the men of the production line. As a
result, the overall efficiency of management decreases.
 Cont..
2. Exhaustibility of natural resources: If more
and more fisherman use to fishing in certain area
of fusre khole, the catch of fish will not increase
in the same proportion.
3. Entrepreneur/organization is a fixed factor:
According to economists, the entrepreneur and
his functions of decision making and ultimate
control are indivisible and can not be increased
i.e. abilities and skills of the entrepreneur may be
fully utilized.
 Graphically
 Along the ray OR, the gap between OG,
GH & HK is increasing , that is OA< AB<
BC.
C  A movement from A to B, percentage
9K increase in output (150%) is exactly equal
to the percentage increase in inputs
IQ3=300 (100%) i.e. as inputs are increased by
B 150%, then output also increases by 100%.
5K  A movement from C to D, percentage
increase in output (50%) is greater than
A percentage increase in inputs (80%) i.e. as
2K IQ2=200
inputs are increased by 80%, then output
also increases by 50%.
IQ1=100  The distance between successive isoquant
remains is increasing. It means that more
than double inputs are required to double
output and so on.
 Expansion path
• An expansion path is a line connecting optimal
input combinations(equilibrium points) as
scale of production changes.
• In figure, PP is an expansion path that
connects three different equilibrium points
E,E1 and E2. C
A
D
E3

E B D
 Thank you
• Any questions