Production Functions

Production Functions

• Production is the result of co-operation of four

factors of production viz., land, labour, capital
and organization.
• The producer combines all the four factors of
production in a technical proportion to
maximize the production at minimum cost by
means of the best combination of factors of
production
 Production Functions

• Meaning of Production Function:

• In simple words, production function refers to
the functional relationship between the
quantity of a good produced (output) and
factors of production (inputs).
• “The production function is purely a technical
relation which connects factor inputs and
output.” Prof. Koutsoyiannis
 Production Functions
• Production function is an indicator of the physical
relationship between the inputs and output of a
firm.
• The reason behind physical relationship is that
money prices do not appear in it.
• production function is for a definite period
• It shows the flow of inputs resulting into a flow of
output during some time. The production function
of a firm depends on the state of technology. With
every development in technology the production
function of the firm undergoes a change.
 Production Functions
Mathematically, such a basic relationship between inputs
and outputs may be expressed as:
• Q = f( L, C, N )
• Where Q = Quantity of output
• L = Labour
• C = Capital
• N = Land.
• level of output (Q), depends on the quantities of different
inputs (L, C, N) available to the firm. In the simplest case,
where there are only two inputs, labour (L) and capital
(C) and one output (Q), the production function
becomes.
• Q =f (L, C)
 Production Functions

• Features of Production Function:

1. Substitutability:
The factors of production or inputs are substitutes of one another
which make it possible to vary the total output by changing the
quantity of one or a few inputs, while the quantities of all other
inputs are held constant. It is the substitutability of the factors of
production that gives rise to the laws of variable proportions.
2. Complementarity:
The factors of production are also complementary to one another,
that is, the two or more inputs are to be used together as nothing
will be produced if the quantity of either of the inputs used in the
production process is zero.
The principles of returns to scale is another manifestation of
complementarity of inputs as it reveals that the quantity of all
inputs are to be increased simultaneously in order to attain a higher
scale of total output.
 Production Functions

3. Specificity:
It reveals that the inputs are specific to the
production of a particular product. Machines and
equipment’s, specialized workers and raw materials
are a few examples of the specificity of factors of
production. The specificity may not be complete as
factors may be used for production of other
commodities too. This reveals that in the production
process none of the factors can be ignored and in
some cases ignorance to even slightest extent is not
possible if the factors are perfectly specific.
 Production Functions
• Production involves time; hence, the way the inputs
are combined is determined to a large extent by the
time period under consideration. The greater the
time period, the greater the freedom the producer
has to vary the quantities of various inputs used in
the production process.
• In the production function, variation in total output
by varying the quantities of all inputs is possible only
in the long run whereas the variation in total output
by varying the quantity of single input may be
possible even in the short run.
 Production Functions

• A production function is a mathematical and

sometimes graphical way to measure the
efficiency of production by considering the
relationships between two or more variables,
meaning two or more factors that are relevant
when producing a good or service, such as raw
materials and labor. Once a business has
determined the factors for production, it can
begin building the production function
 Production Functions
• The Cobb-Douglas production function is a particular
form of the production function. It is widely used
because it has many attractive characteristics, as we will
see below.
• The basic form of the Cobb-Douglas production
function is as follows:
Q(L,K) = A *L^β* K^α
Where:
- Q is the quantity of products.
- L is the quantity of labor.
- K is the quantity of capital.
- A is a positive constant.
 Production Functions
Cost-Output Relationship
• A proper understanding of the nature and behavior of costs is a must
for regulation and control of cost of production. The cost of
production depends on money forces and an understanding of the
functional relationship of cost to various forces will help us to take
various decisions. Output is an important factor, which influences the
cost.
• The cost-output relationship plays an important role in determining
the optimum level of production. Knowledge of the cost-output
relation helps the manager in cost control, profit prediction, pricing,
promotion etc. The relation between cost and its determinants is
technically described as the cost function.
• C= f (S, O, P, T ….)
Where;
C= Cost (Unit or total cost), S= Size of plant/scale of production
 Production Functions

• Considering the period the cost function can

be classified as
• (1) short-run cost function and
• (2) long-run cost function.
• In economics theory, the short-run is defined
as that period during which the physical
capacity of the firm is fixed and the output can
be increased only by using the existing
capacity
 Production Functions
Cost-Output Relation during Short Run or Short
Run Cost Curves:
Time element plays an important role in price
determination of a firm. During short period two
types of factors are employed. One is fixed factor
while others are variable factors of production.
Fixed factor of production remains constant while
with the increase in production, we can change
variable inputs only because time is short in which
all the factors cannot be varied
 Production Functions
A. Short Run Total Costs:
• Short run total costs of a firm are of following
types:
(1) Total Costs:
(2) Total Variable Costs
(3) Total Fixed Costs
 Production Functions
• Total fixed cost remain constant when the
production is zero or its is increasing while
total variable cost is zero when production is
zero and it changes with the change in output
and total cost is the aggregate of total fixed
cost and total variable cost
• [Total cost (TC) = Total fixed cost (TFC) + Total
variable cost (TVC) ]
• Total costs change due to change in the total
variable costs only during short period because
total fixed costs (TFC) remain constant.
 Production Functions

• During short period average costs or per unit

costs can be divided into following categories:
(1) Average fixed costs (AFC)
(2) Average variable costs (AVC)
(3) Average Costs (AC)
(4) Marginal Cost (MC).
 Production Functions
• Short run costs are accumulated in real time
throughout the production process. Fixed costs have
no impact of short run costs, only variable costs and
revenues affect the short run production. Variable
costs change with the output. Examples of variable
costs include employee wages and costs of raw
materials. The short run costs increase or decrease
based on variable cost as well as the rate of
production. If a firm manages its short run costs well
over time, it will be more likely to succeed in reaching
the desired long run costs and goals
 Production Functions
• Cost-Output Relation during Long Run or
Long Run Cost Curves:
• Long period gives sufficient time to business
managers to change even the scale of
production. All the factors of production are
variable. All the costs are variable costs and
there is no fixed cost. The supply of goods can
be adjusted to their demands because scale of
production and factors of production can be
changed.
 Production Functions
• Long run costs are accumulated when firms change
production levels over time in response to expected
economic profits or losses. In the long run there are no fixed
factors of production. The land, labor, capital goods, and
entrepreneurship all vary to reach the long run cost of
producing a good or service. The long run is a planning and
implementation stage for producers. They analyze the current
and projected state of the market in order to make
production decisions. Efficient long run costs are sustained
when the combination of outputs that a firm produces results
in the desired quantity of the goods at the lowest possible
cost. Examples of long run decisions that impact a firm’s costs
include changing the quantity of production, decreasing or
expanding a company, and entering or leaving a market.
 Production Functions
• The main difference between long run and short run
costs is that there are no fixed factors in the long run;
there are both fixed and variable factors in the short
run. In the long run the general price level, contractual
wages, and expectations adjust fully to the state of the
economy. In the short run these variables do not always
adjust due to the condensed time period. In order to be
successful a firm must set realistic long run cost
expectations. How the short run costs are handled
determines whether the firm will meet its future
production and financial goals.
 Production Functions

• 1. Long Run Total Cost:

• Long run Total Cost (LTC) refers to the
minimum cost at which given level of output
can be produced. “The long run total cost of
production is the least possible cost of
producing any given level of output when all
inputs are variable.” LTC represents the least
cost of different quantities of output. LTC is
always less than or equal to short run total
cost, but it is never more than short run cost.
Production Functions
 Production Functions

• As shown in Figure, short run total costs

curves; STC1, STC2, and STC3 are shown
depicting different plant sizes. The LTC curve is
made by joining the minimum points of short
run total cost curves. Therefore, LTC envelopes
the STC curves.
 Production Functions

2. Long Run Average Cost:

• Long run Average Cost (LAC) is equal to long run
total costs divided by the level of output. The
derivation of long run average costs is done from
the short run average cost curves. In the short run,
plant is fixed and each short run curve
corresponds to a particular plant. The long run
average costs curve is also called planning curve or
envelope curve as it helps in making organizational
plans for expanding production and achieving
minimum cost
Production Functions
 Production Functions
• 3. Long Run Marginal Cost:
• Long run Marginal Cost (LMC) is defined as added cost
of producing an additional unit of a commodity when
all inputs are variable. This cost is derived from short
run marginal cost. On the graph, the LMC is derived
from the points of tangency between LAC and SAC.
• We can also draw the relation between LMC and LAC as
follows:
• When LMC < LAC, LAC falls
• When LMC = LAC, LAC is constant
• When LMC > LAC, LAC rises
 Production Functions

• Law of Diminishing Returns

• When more and more units of a variable input
are employed on a given quantity of fixed
inputs, the total output may initially increase at
increasing rate and then at a constant rate, but
it will eventually increase at diminishing rates.
• The total output initially increases with an
increase in variable input at given quantity of
fixed inputs, but it starts decreasing after a
point of time.
 Production Functions
• "Scale of production is set by the size of plant, the number of plants
installed and the technique of production adopted by the producer".

• Classifications/Types:
(i) Small Scale Production. - If a firm produces goods with small sized plants,
the scale of production is said to be small scale production. Small scale of
production is associated with low capital output and capital labor ratios. In
small scale of production, the economies of scale do not occur to the firm.

(ii) Large Scale Production. - If a firm uses more capital and larger quantities
of other factors, it is said to be operating on large scale production. Large
scale production enjoys both internal and external economies of scale.

(iii) Optimum Scale of Production.- -The optimum scale of production refers

to that size of production which is accompanied by maximum net
economics of scale, it is a scale at which the cost of production per unit is
the lowest.
 Production Functions
• In any discussion of production theory and
production process, we draw a distinction
between the short run and long run. It is assumed
that in the short run some of the resources used in
the production process remain constant (i.e., fixed
in supply).
• This is why when there is an increase in the supply
(usage) of one factor, say labour, output increases
no doubt but not proportionately and the
phenomenon of diminishing returns is encoun­
tered
 Production Functions
• In the long run, however, it is possible for a firm to vary the
quantities of all factors of production. More land can be
acquired, new factory and office buildings can be constructed
and more machinery acquired and installed. It is even
possible to change the size of the plant or factory in the long
run

• in the long run it is possible for a firm (or a producing unit) to

change the scale of its operation or its size and the level of
activity. In the true sense a change in the scale (of
production) takes place when the quantities of all the factors
are changed by the same percentage so that the proportions
in which they are combined remain unchanged.
 Production Functions

• It may apparently seem that when all inputs

are changed proportion­ately there is a
proportionate change in output. But, in reality,
this does not happen. A feature of any
production system (process) is that, when
there is a change in the scale of production
there is not necessarily (usually) propor­tionate
change in output. When the size of a firm gets
doubled, output may get more than doubled,
exactly doubled or less than doubled
 Production Functions

• the term returns to scale is used to refer to

the relationship between change in scale of
production (or size of the firm, measured in
terms of the quantities of factors used) and
the resultant changes in output.
• “The term returns to scale refers to the
changes in output as all factors change by the
same proportion.”
 Production Functions
• Returns to scale are of the following three types:
• 1. Increasing Returns to scale.
• 2. Constant Returns to Scale
• 3. Diminishing Returns to Scale
• In the long run, output can be increased by
increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an
increase in output due to increase in all factors in
the same proportion. Such an increase is called
returns to scale.
 Production Functions
Unit Scale of Production Total Returns Marginal Returns

1 1 Labor + 2 Acres of Land 4 4 (Stage I - Increasing Returns)

2 2 Labor + 4 Acres of Land 10 6

3 3 Labor + 6 Acres of Land 18 8

4 4 Labor + 8 Acres of Land 28 10 (Stage II - Constant Returns)

5 5 Labor + 10 Acres of Land 38 10

6 6 Labor + 12 Acres of Land 48 10

7 7 Labor + 14 Acres of Land 56 8 (Stage III - Decreasing Returns)

8 8 Labor + 16 Acres of Land 62 6

Production Functions
 Production Functions

• 1. Increasing Returns to Scale:

Increasing returns to scale or diminishing cost
refers to a situation when all factors of
production are increased, output increases at a
higher rate. It means if all inputs are doubled,
output will also increase at the faster rate than
double. Hence, it is said to be increasing returns
to scale. This increase is due to many reasons
like division external economies of scale
 Production Functions
• 2. Diminishing Returns to Scale:
Diminishing returns or increasing costs refer to that
production situation, where if all the factors of
production are increased in a given proportion, output
increases in a smaller proportion. It means, if inputs
are doubled, output will be less than doubled. If 20
percent increase in labour and capital is followed by 10
percent increase in output, then it is an instance of
diminishing returns to scale.
The main cause of the operation of diminishing returns
to scale is that internal and external economies are
less than internal and external diseconomies.
 Production Functions
3. Constant Returns to Scale:
• Constant returns to scale or constant cost refers to the
production situation in which output increases exactly in
the same proportion in which factors of production are
increased. In simple terms, if factors of production are
doubled output will also be doubled.
• In this case internal and external economies are exactly
equal to internal and external diseconomies. This
situation arises when after reaching a certain level of
production, economies of scale are balanced by
diseconomies of scale. This is known as homogeneous
production function. Cobb-Douglas linear homogenous
production function is a good example of this kind.
 Production Functions

• Economics of Large Scale Production:

The economies of large scale production are
classified by Marshall into:
• (1) Internal Economies and
• (2) External Economies.
 Production Functions

(1) Internal Economies of Scale:

• Internal economies of scale are those
economies which are internal to the firm.
These arise within the firm as a result of
increasing the scale of output of the firm. A
firm secures these economies from the
growth of the firm independently. The main
internal economies are grouped under the
following heads
 Production Functions
i) Technical Economies:
When production is carried on a large scale, a firm can afford to install up
to date and costly machinery and can have its own repairing
arrangements. As the cost of machinery will be spread over a very large
volume of output, the cost of production per unit will therefore, be low.
A large establishment can utilize its by products. This will further enable
the firm to lower the price per unit of the main product. A large firm can
also secure the services of experienced entrepreneurs and workers which
a small firm cannot afford. In a large establishment there is much scope
for specialization of work, so the division of labor can be easily secured.

(ii) Managerial Economies:

When production is carried on a large scale, the task of manager can be
split up into different departments and each department can be placed
under the supervision of a specialist of that branch. The difficult task can
be taken up by the entrepreneur himself. Due to these functional
specialization, the total return can be increased at a lower cost
 Production Functions
(iii) Marketing Economies:
Marketing economies refer to those economies which a firm
can secure from the purchase or sale of the commodities. A
large establishment is in a better position to buy the raw
material at a cheaper rate because it can buy that
commodities on a large scale. At the time of selling the
produced goods, the firm can secure better rates by
effectively advertising in the newspapers, journals and radio,
etc.
(iv) Financial Economies:
Financial economies arise from the fact that a big
establishment can raise loans at a lower rate of interest than
a small establishment which enjoys little reputation in the
capital market.
 Production Functions
v) Risk Bearing Economies:
A big firm can undertake risk bearing economies by spreading the
risk. In certain cases the risk is eliminated altogether. A big
establishment produces a variety of goods in order to cater the
needs of different tastes of people. If the demand for a certain type
of commodities slackens, it is counter balanced by the increase in
demand of the other type of commodities produced by the firm.

(vi) Economies of Scale:

As a firm grows in size, it is-possible for it to reduce its cost. The
reduction in costs, as a result of increasing production is called
economies of scale. The economies of scale are obtained by the firm
up to the lowest point on the firms long run average cost curve. The
main sources of economies of scale are in brief as under.:
 Production Functions
Diseconomies of Scale:
• The extensive use of machinery, division of
labor, increased specialization and larger plant
size etc., no doubt entail lower cost per unit of
output but the fall in cost per unit is up to a
certain limit. As the firm goes beyond the
optimum size, the efficiency of the firm begins
to decline. The average cost of production
begins to rise.
 Production Functions
• Factors of Diseconomies:
(i) Lack of co-ordination. As a firm becomes large scale producer, it faces difficulty in
coordinating the various departments of production. The lack of co-ordination in the
production, planning, marketing personnel, account, etc., lowers efficiency of the
factors of production. The average cost of production begins to rise.

(ii) Loose control. As the size of plant increases, the management loses control over
the productive activities. The misuse of delegation of authority, the red tapisim bring
diseconomies and lead to higher average cost of production.

(iii) Lack of proper communication. The lack of proper communication between top
management and the supervisory staff and little feed back from subordinate staff
causes diseconomies of scale and results in the average cost to go up.

(iv) Lack of identification. In a large organizational structure, there is no close liaison

between the top management and the thousands of workers employed in the firm.
The lack of identification of interest with the firm results in the per unit cost to go up.
 Production Functions
2) External Economies of Scale:
External economies of scale are those economies which are not specially availed
of by .any firm. Rather these accrue to all the firms in an industry as the
industry expands. The main external economies are as under:
(i) Economies of localization. When an industry is concentrated in a particular
area, all the firms situated in that locality avail of some common economies
such as (a) skilled labor, (b) transportation facilities, (c) post and telegraph
facilities, (d) banking and insurance facilities etc.
(ii) Economies of vertical disintegration. The vertical disintegration implies the
splitting up the production process in such a manner that some Job are assigned
to specialized firms. For example, when an industry expands, the repair work of
the various parts of the machinery is taken up by the various firms specialists in
repairs.
(iii) Economies of information. As the industry expands it can set up research
institutes. The research institutes provide market information, technical
information etc for the benefit of alt the firms in the industry.
(iv) Economies of by products. All the firms can lower the costs of production
by making use of waste materials.
 Production Functions
External Diseconomies:
• A firm or an industry cannot avail of
economies for an indefinite period of time.
With the expansion and growth of an industry,
certain disadvantage also begin to arise. The
diseconomies of large scale production are:
• (i) Diseconomies of pollution, (ii) Excessive
pressure on transport facilities, (iii) Rise in the
prices of the factors of production, (iv) Scarcity
of funds, (v) Marketing problems of the
products, (iv) Increase in risks.
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Production Functions
Production Functions