Production Function: Returns

to Scale

Dr. Aruna Kumar Dash

IBS Hyderabad
 Production function in the long run(LR)
Assumptions:
 only two factors are involved  capital & labour

Capital Variable
Variablefactor
factor

VariableFactor
VariableFactor

 In LR production can be increased by employing more

In long run production function, both inputs are variable i.e. labour
and capital are variable. In long run, there is no fixed inputs. In
long run, all inputs are variable. Hence,firm can increase the output
by different combination of labour and capital.
 ISO Quant
What is an Iso Quant?
An Iso quant is a curve which shows all the
possible combination of two inputs that produce
same level of output. Here two inputs are labour
and capital.

Also called as production-indifference curve.

 Isoquant Schedule
Factor Labour Capital
Combinations
A 1 12
B 2 8
C 3 5
D 4 3
E 5 2

Each of the factor combinations A, B, C, D, and

E produces the same level of output say, 20
units
 Y
Isoquant Curve
Capital 12
A
10
8 B
6 C
4 D E
ISO Quant
2
0 1 2 3 4 5 X
Labour

Thus, along an Isoquant curve, there is an inverse

relationship between the quantity of one factor
employed and the quantity of another
employed isoquant curve slope down
Factor combination A consisting of 1 unit of labour and 12
units of capital produces 20 units of output. Similarly,
factor combination of B consists of 2 units of labour and 8
units of capital produces 20 units of output. Likewise factor
combination E, consists of 5 units of labour and 2 units of
capital produces 20 units of output. We can say producer is
indifferent in point A, B,C,D and E. Hence, the producer is
indifferent on a same ISO quant. ISO quants are similar to
the indifference curve in the theory of consumer behaviour.
 ISO quant Vs. indifference curve
Though ISO quants are similar to indifference curve in the theory of
consumer behaviour, there are some differences.
ISO Quant
Indifference curve
It shows various
It shows various combinations
combinations of two inputs
of two goods which gives same
which gives same output to a
satisfaction/utility to a consumer.
producer.
In IC, we deal with consumer
In ISO quant, we deal with
behaviour
producer behaviour
IC do not specify the level of
 ISO quant specify the
utility/satisfaction in quantitative
level of output in
term
quantitative term
 Properties of ISO Quant
Y
Capital 12
A
10
8 B
6 C
4 D E
ISO Quant
2
0 1 2 3 4 5 X
Labour
First property: An iso quant is downward slopping to the right - At
combination A, Producer uses12 units of capital and 1 labour to produce 20
units of output. At combination B, Producer uses 8 units of capital and 2 units
of labour to produce 20 units of output. It implies that if one factor of
production is used more , the other factor of production is used less
for the same level of output. This happens due to scarce resources.
 ISO Quant Curves Slope Downward to the
Right
Y
Capital Capital
Capital
A Accepted Ruled Out Ruled Out Ruled Out

B A B
B
B

IC A
A
0 X

Labour Labour Labour Labour

10
 Second Property: ISO quants is convex to
the origin
ISO quants is convex to the origin that is because
of Marginal Rate of Technical Substitution (MRTS
What is MRTS?
 MRTS is similar to the Concept MRS
MRTS Indicates the rate at which factors can be substituted
without altering the level of output.
MRTSLK is the amount of Factor, capital which can be
replaced by one unit of Factor labour so that the level of
output remains unchanged.
 MRTS of labour for capital is defined as the number of units
capital that can be substituted/ replaced when one extra
units of labour is used while the level of output remains unchanged.
Marginal Rate of Technical Substitution
(MRTS)
Convex to the origin
 Declining MRTS
Y
Capital 12
A
10 4
8 B
6 3
C
4 2 D E
ISO Quant
2 1
0 1 2 3 4 5 X
Labour

An ISO quant is convex to the origin because of declining Marginal

Rate of Technical Substitution. As producer is moving from A to B , B
to C and C to D and D to E MRTS falls from 4 to 3, 3 to 2 then 2 to 1.
 Marginal Rate of Technical Substitution (MRTS)

(2) Marginal Rate of Technical Substitution is

Diminishing
The Rate of Sacrificing Factor Capital will Gradually
Diminish if More and More of Factor Labour is
Substituted for Factor Capital.
Reason:
As more and more labour is added to the production
process in place of capital, the productivity of labour
falls. Similarly, whwn more capital is added in place of
labour, the productivity of capital falls.
 ISO Quant Curves are Convex to the
Origin
pital Ruled Out Due to
Accepted Due to Ruled Out Due to Constant MRTS
Decreasing MRTS Increasing MRTS
A Capital
Capital

Labour Labour Labour

Problem of Monomania 16
 Slope of ISO Quant is Marginal Rate of
Technical Substitution (MRTS)

The marginal rate of technical substitution

is the slope of the isoquant curve
Capital (K)
T

B
S
ISO Quant
0 T’ X
Labour (L)
 Third Property: Higher the Isoquant higher i
the output

Higher Isoqant curve

Y
Represents Higher
Capital
12
Levels of Output than
Lower Isoquant
10
B
Curves
C
8
6 A
4 ISO Quant 2=40

2 ISO Quant 1=20

0 X
1 2 3 4 5 6 7
Labour
 Fourth Property: TWO ISO Quant Curve cannot
Intersect with Each Other

ISO Quant Curve assumes

the law of Transitivity
Y
In this case there is
ital Violation of Transitivity
Law
A
C
ISO Quant 2
B ISO Quant 1
0 X
Labour
19
 Let’s assume ISO quant 1 and ISO quant 2 intersect with
each other at point A. Points A and B lie in ISO Quant 1.
Point A and Point B provide the same output to a producer.
Hence, the producer is indifferent at point A and point B.
Likewise, point A and C lie in ISO Quant 2. As both points
lie in the same ISO quant, they provide the same output to
a producer. Hence, the producer is indifferent between
points A and C. In ISO Quant 1, A=B and ISO Quant 2,
A=C. It is clearly visible A is common. Hence B=C. But
point B lie in ISO quant 1 and point C lie in ISO quant 2.
Hence B and C are not equal. If you will put one line point
C produces more output by using more capital. You also
know higher ISO Quant is preferable to the lower ISO
Quant. Hence, we can say that two ISO quant can not
interact with each other.
 Isoquant Map
Higher Isoqant curve
Y
Represents Higher
Capital
12
Levels of Output than
Lower Isoquant
D
10
B
Curves
C
8 Isoquant 3=60
6 A
4 ISO Quant 2=40

2 ISO Quant 1=20

0 X
1 2 3 4 5 6 7
Labour
 Different Isoquants
Right Angle: Inputs are used in Fixed Proportions and
therefore are not substitutable. Example: Yeast and Flour
for a specific type of bread.Tires and a Battery for an
automobile
 Straight Line: Inputs are perfectly substitutes. MRTS is
constant. Example: Honey and Brown sugar are nearly
perfect substitutes in the area of baking. Natural Gas and
Fuel Oil in Energy production.
 Downward sloping and Convex to Origin: Common
situation in which inputs are imperfect substitutes. Labor
and Capital are imperfect substitutes in general.
 Iso-cost Line
What is an Iso-cost Line?
It shows various combinations of two inputs (such as
labour and capital) which yields same cost to a
producer.

Example: Suppose the company has Rs 200 to spend and

the price of capital is Rs 5 per unit and the price of
labor is Rs 4 per unit. The Iso cost line is shown in the
next slide.
Least Cost Combination of Factors

In order to maximize the profit, the

manager:

(a) Desires to minimize cost for a

given level of output

(b) Or Desires to maximize the output

level for a given cost or outlay
Capital
Firm wants maximum level of output with minimum cost. The least
cost combination is achieved at the point where the ISO quant curve
tangent to the ISO cost line. We can say producer will be in
equilibrium and least cost combination is achieved when
Necessary condition
1.ISO quant curve is tangent to the ISO cost line.
2.The slope of the ISO Quant is equal to the slope of the ISO cost line.
Sufficient condition
1. At equilibrium the ISO quant should convex to the origin
The X axis represents labour and Y axis represents capital.It is
assumed that producer wants to produce 500 units of output. This
level of output can be produced by various combinations
( R,S,Q,L,K)of labour and capital on the ISO quant curve. It is
evident that the producer is equilibrium and cost is minimum at
point Q where ISO quant curve tangent to the ISO cost line. At
Point Q, the slope of the ISO quant = Slope of the ISO cost and at
equilibrium ISO quant is convex to the origin. Any other points
such as R,S, L,K lie on the higher ISO cost line for the same level
of output. Hence, producer prefers only point Q where output is
maximum and cost is minimum.
Expansion Path
Expansion path is known as scale line. In expansion path prices two factor
inputs remains constant.
AB represents ISO cost line. IQ1 is the ISO quant curve of 100 units of
output. Expansion path connects all the cost minimizing input combinations.
Expansion path connects all the points where cost is minimum. Cost will be
minimum where ISO quant is tangent to ISO cost line with given level of
output. In order to produce 100 units of output, the least cost combination is
P. If the firm wants to expand its scale (Output to 200 units) the firm require
more labour and capital. Here, the least cost combination is Q. If you will
join all the least cost combination points such as P, Q and R, then you will
get an expansion path.
 Returns to Scale
Return to scale is the rate at which
output increases as inputs are
increased proportionately.
Returns to scale is the quantitative change in output of a
firm or industry resulting from a proportionate increase in
all inputs.

Change in output due to change in

scale
Change in Scale means Increase in the
Scale i.e. all inputs or factors are
increased together in the same
proportion
 Different Returns to Scale

There are 3 different types of

returns to scale
Increasing Returns to Scale
Constant Returns to Scale
Decreasing Returns to Scale
 Machine Labour Output
1 + 1 =100 units
2 + 2 =What will be the output?

If the output is equal to 200, then it is known as

Constant returns to scale
If the output is more than 200, then it is known
as increasing returns to scale
If the output is less than 200, then it is known as
decreasing returns to scale
Increasing Returns to Scale
(IRS)
What is IRS?
The output Increases in a greater
proportion than the increase in input
Q  f ( L, K )
 f (L, K )
  f ( K , L)


When   1, then We have IRS

 If inputs are doubled and
Y
output is more than
Capital doubled then it is known
IRS as IRS. Here, labour and
capital are doubled (from
1 to 2) but output is more
than doubled (from 100 to
2
300 units)

1 Isoquant 2=300

Isoquant 1=100
0 X
1 2
Labour
In the long run, the industry may experience certain advantages in terms of cost
reduction and output expansion. These advantages while producing a single product is
known as economies of scale. Increasing returns to scale is closely associated with
economies of scale. When there is an increase in the scale of production, it leads to
lower average cost per unit produced as the firm enjoys economies of scale. When
input prices remain constant, increasing returns to scale results in decreasing long-run
average costs.

Benefits / advantages of producing in large quantities

Increased Specialization of labor
more efficient use of large pieces of machinery
Technology improvement will enhance the output and reduce the per unit cost
of production
Training is given to the employee to enhance their skill for which they can
produce more output.
Transportation benefits
Barganning power benefits
volume discounts
 Constant Returns to Scale
What is Constant Returns to Scale?
Constant returns to scale occurs when the firm’s output rises
proportionate to the increase in inputs
Can be Stated as:
Proportionate Increase in Output = Proportionate
Increase in all inputs
Constant Returns to Scale (CRS)

Q  f ( L, K )
 f (L, K )

  f ( K , L)

When   1, then We have CRS

 If inputs are doubled and
output is exactly doubled
then it is known as CRS.
Y Here, labour and capital
Capital are doubled (from 1 to 2)
and output is exactly
CRS doubled (from 100 to 200
units) . Here output
increases at the same
2 proportion to the inputs.

1 Isoquant 2=200

Isoquant 1=100
0 X
1 2
Labour
 Decreasing Returns to
Scale:
What is DRS?
Output Increases in Smaller
Proportion than the increase in
all Inputs.
Q  f ( L, K )
 f (L, K )
  f ( K , L)


When   1, then We have DRS

 If inputs are doubled and
output is less than
doubled then it is known
Y as DRS. Here, labour and
Capital capital are doubled (from
1 to 2) and output is less
DRS than doubled (from 100 to
150 units) . Here output
increases less than
2 proportionately compared
to the inputs.

1 Isoquant 2=150

Isoquant 1=100
0 X
1 2
Labour
Decreasing returns to scale is closely associated with
diseconomies of scale. It means the disadvantages
occurring to a firm while expanding its output in the long
run. When input prices remain constant, decreasing
returns to scale results in increasing long-run average
costs (diseconomies of scale). An organization may
become too big, thus creating too many layers of
management, too many departments. This leads to a lack
of communications, inefficiency, delays in decision-
making, and inefficient production.
 Reasons:
Increasing Difficulties of
Management/mis management

Increasing Difficulties of Co-ordination

Increasing Difficulties of Control

Less incentives
No proper recognition of talent and
skills
 Application of Returns to Scale
Returns to Scale Affects Company’s cost
With Given Input Prices:
 Company having IRS, will have declining cost per unit of output as output increases.
 Company having DRS, will have increasing cost per unit of output as output
increases.
 Company having CRS, will have constant cost per unit of output as output increases.
It affects the company’s ability to compete with other companies in the same industry
IRS is a important phenomenon in the automobile industry. (The Global Six,
Business Week, Jan 25, 1999)
Companies most aware of the Returns to scale: General Motors, Ford, Daimler-
Chrysler
Thank you