What is Production?

Production is basically an activity of transformation , which connects factor inputs and outputs.
The process of transforming inputs into outputs can be any of the following kinds:
Change in the Form(Raw material transformed to finished goods )
Change in Place( Supply chain, Factory to Retailer)
With these three kinds of transformations, usability of the good or materials increases.
Production is an activity that increases consumer usability of goods and services.
Classification of Inputs
i) Labour (ii) capital (iii) land (iv) raw materials (v) time.

These variables are measured per unit of time and hence referred to as flow variables.
Entrepreneurship has been added as part of the production inputs, though this can be measured
by the managerial expertise and the ability to make things happen.

Basic Concepts of Production Theory

An input is a good or service that goes into the production process. As economists refer to it, an
input is simply anything which a firm buys for use in its production process. An output, on the
other hand, is any good or service that comes out of a production process.

Inputs are considered variable or fixed depending on how readily their usage can be changed

Fixed input

An input for which the level of usage cannot readily be changed - In economic sense, a fixed input
is one whose supply is inelastic in the short run. - In technical sense, a fixed input is one that
remains fixed (or constant) for certain level of output.

Variable input

A variable input is one whose supply in the short run is elastic, example, labour, raw materials,
and the like. Users of such inputs can employ a larger quantity in the short run.

Technically, a variable input is one that changes with changes in output. In the long run, all inputs
are variable.
* Short run At least one input is fixed All changes in output achieved by changing usage of
variable inputs

Long run All inputs are variable Output changed by varying usage of all inputs

What is Production Function?

Prodcution function is a tool of analysis used in explaining the input-output relationship. It

describes the technical relationship between inputs and output in physical terms. In its general
form, it holds that production of a given commodity depends on certain specific inputs. In its
specific form, it presents the quantitative relationships between inputs and outputs. The
production function represents the technology of a firm.

Symbolically,

Q = f(Ld, L, K, M, T, t...)

where,

Q= Output ; Ld = land and building; L = labour; K = capital; M = materials; T = technology; and,

t = time

For sake of convenience, economists have reduced the number of variables used in a production
function to only two: capital (K) and labour (L). Therefore, in the analysis of input-output
relations, the production function is expressed as:

Q = f(K, L)

Types of Production Functions

A. Short Run Production Function: The short run is defined in economics as a period of time
where at least one factor of production is assumed to be in fixed supply i.e. cannot be changed.
We normally assume that the quantity of capital inputs is fixed and that production can be altered
by suppliers through changing the demand for variable inputs such as labour, components, raw
materials and energy inputs. The input and output relationship is studied under the law of
 variable proportion. It is also known as production function with one variable input. Hence, In
the short run, capital is fixed Only changes in the variable labor input can change the level of
output .

) = f ( L )
Short run production function Q =(,

= Constant Capital
where, L= Variable Labour ;

B. Long Run Production Function: The long run is defined in economics as a period of time
where all factors of production are assumed to be in variable supply i.e. can be changed. Hence,
the long run production function is the techneical relationship between inputs and outputs where
all inputs are variable. The input and output relationship is studied under the law of return to
scale. It is also known as production function with two variable inputs. It can be written as:

Q = f(K, L)

where, L= Variable Labour ; = Variable Capital

Concep of Total, Average and Marginal Product

Total Product (TP) :

It refers to the total amount of commodity produced by the combination of all inputs in a given

period of time. It is calculated in two ways:

Multiplying the average product with the total units of the inputs employed,

i.e. TP = APN

where, TP= Total Product, AP= Average Product, N= Total units of inputs employed

Summation of marginal products,

i.e. TP=MP

where, TP= Total Product, MP= Marginal Product

Total Product Curve

The total product (TP) curve represents the total amount of output that a firm can produce with a
given amount of labor. As the amount of labor changes, total output changes.

Units of
Labour TP
0 0
1 4
2 10
3 18
4 24
5 28
6 30
7 30
8 28

Average Product (AP) : AP is defined as the amount of output produced per unit of the factor
employed. It can be obtained by :

= =

Average Product Curve: AP curve starts from the origin, increases at decreasing rate, reaches a
maximum and then starts falling as the factor is increased. AP curve is inverted U-shaped . As
long as TP is positive, AP is positive.

Units of
Labour TP AP
0 0
1 4 4
2 10 5
3 18 6
4 24 6
5 28 5.6
6 30 5
7 30 4.285714286
8 28 3.5

Marginal Product (MP): It is the addition made to the total product by employing one more unit

of the input. In other words, it is the ratio of the change in the total product with the change in

the units of the input. It is expressed as

MP = TP/L

where,
MP= Marginal Product TP= Change in total product

L= Change in units of input

It is also expressed as

MP = TPn TPn-1

where,

MP= Marginal Product

TPn= Total product after employing one more unit (nth unit)

TPn-1= Total product before employing one more unit

Marginal Product Curve: MP curve rises initially, reaches a maximum and then starts falling.

When TP is maximum , MP is zero. When TP falls, MP becomes negative.

Units of
Labour TP MP
0 0
1 4 4
2 10 6
3 18 8
4 24 6
5 28 4
6 30 2
7 30 0
8 28 -2

Relationship between TP, AP and MP

Units of
Labour TP AP MP
0 0
1 4 4 4
2 10 5 6
 3 18 6 8
4 24 6 6
5 28 5.6 4
6 30 5 2
7 30 4.285714286 0
8 28 3.5 -2

The relationship between TP, AP and MP is as follows:

1. Initially all three product curves (TP, AP and MP) are rising but increase in MP is greater than
increase in AP.

2. When AP is maximum, MP= AP

3. When TP is maximum, MP=0.

4. When TP is falling , MP is Negative.

5. As long as TP is positive, AP is positive.

6. Both MP and AP are inverted U-shaped.

Relationship between AP and MP curves

The relationship between AP and MP is as follows:

1. When both AP and MP curves are rising, MP curve rises at faster rate. The reason for rise in
both AP and MP values is under utilisation of fixed factor.

2. When both AP and MP curves are falling, MP curve falls at faster rate. The reason for fall in
both AP and MP values is full utilisation of fixed factor.

3. When MP > AP, AP is rising.

4. When AP is at its maximum, MP=AP.

5. When MP< AP, AP is falling.

6. When MP is rising, AP must rise but when MP is falling, AP may rise or fall.

Law of Variable Proportion

The law of variable proportion is a widely observed law of production which takes place in the short -
run .In the short-run, production can be increased by using more units of the variable factor(s). The
law w a s formulated by Joa n Robi nson and other modern economists.The l a w is applicable
to all sectors of an economy.

The law of variable proportions states that when total output or prod uction of a commodity
is increased by adding units of a variable input w h i l e the quantities of other inputs are held
constant, increase in total production becomes ,after some point, smaller and s m a l l e r .

Assumptions of the Law

The assumptions of the law of variable proportions are:

State of technology remains the same.
All u nits of the variable factor, labour, are homogenous.
There must always be some fixed input and diminishing returns resu lts
due to fixed suppl y of the fixed factor.

Fixed ( Units of Variable (Units of TP AP MP Stage

Land) Labour)
1 Acre 0 0 0 - Stage I
1 Acre 1 4 4 4
1 Acre 2 10 5 6
1 Acre 3 18 6 8
1 Acre 4 24 6 6
1 Acre 5 28 5.6 4 Stage II
1 Acre 6 30 5 2
1 Acre 7 30 4.3 0
1 Acre 8 28 3.5 -2 Stage III
 Three Stages of the Law
The law of variable proportion can be divided into three distinct stages.These three stages of
short-run law of production are graphically illustrated by the relationship between the AP and MP
curves.

Stage I: Stage of Increasing Returns

It goes from the origin to the point where AP curve is maximum (i.e.,from origin to point B) .In
this stage, TP curve is initially increasing at an increasing rate and then starts increasing at a
decreasing rate. AP curve rises throughout in th is stage. MP curve rises initially, reaches a
maximum and then starts falling. The reason behind this stage lies in undenrutilisation of fixed
factor (land).
A rational producer will not operate in this stage because the producer can always expand
through Stage I. It is a non-economic range.

Sta ge II: Stage of Diminishing Returns

It is the most important stage out of the three stages. Stage II of production ranges from the point
where AP curve is maximum to the point where MP curver is zero (i.e., from point B to d). In this
stage, both AP and MP curves are positive but declining. TP curve continues to increase at a
decreasing rate. A rational producer will always operate in. this stage.The law of diminishing
returns operates in Stage II. The reason behind this stage lies in optimal use of fixed factor.

Stage III: Stage of Negative Returns

I t covers the entire range over which MP curve is negative. A rational producer will not operate
in this stage even with free labour because he could increase his output by em1ploying less
labour. It is non-economic and inefficient range.The reason behind this stage lies in overuti
lisation of fixed factor.
 Table summarises the three stages of the law of returns to a factor or the law of variable
proportions which takes place in the short-run.

Short Run Stages of the Law of Variable Proportion

STAGES TERMS USED TP AP MP REFERNCE

POINT (FIGURE)
Increasing Sta rtsfrom Starts from the Increases,
Stage I from origin to
Returns to origin, origin and then reaches a
increases at increases max imum and point b
the Factor
an increasing till its then starts
rate and then falling
maximum
increases at
point
a decreasing
rate
nuously
Stage II Diminishing Increases at a Falls continuously from point b to
Returns to the decreas ing till it is
point d
Factor rate till it equal to
reaches the ze ro
maximum
point
It is negative
Stage III Negative Falls continuously Point d onwards
Returns to the Falls
Factor

LAW OF RETURN TO SCALE

The law of return to scale is applicable in the long run, where all factors of production are in
variable supply. In the long run , output can be increased by increasing all the factors of production
or the scale of production.
Statement of the law: The law of return to scale states that when all factors of production are
increased in the same proportion, output will increase but the increase may be at increasing rate or
constant rate or diminishing rate.
Assumptions

This law is based on the following assumptions:

1. All the factors of production (such as land, labor and capital) but organization are variable
2. The law assumes constant technological state. It means that there is no change in technology
during the time considered.
 3. The market is perfectly competitive.
4. Outputs or returns are measured in physical terms.

Three stages of Law of Return to Scale

The three stages of law of return to scale are:
i. Increasing Return to Scale
ii. Constant Return to Scale
iii. Decreasing Return to Scale

Sta ge I: Increasing Returns to Scale

It occurs when increase in output is more than proportional to an increase in inputs. If labour
and capital are the only two inputs and they are increased by 10% then output increases by more
than 10%. If labour and capital are doubled, output more than doubles.
Increasing returns to scale implies decreasing costs and decreasing costs are due to
econoniies of large scale production,which takes place by increasing the scale of operation.
Increasing Return to Scale can be highlighted with the help of schedule and diagram.
Units of Units of
Labour Capital % increase in Labour & Capital TP % increase in TP Return to Scale
1 3 10 Stage I
2 6 100% 30 200% Increasing
3 9 50% 60 100% Increasing

In the above table it is clearly seen that % increase in TP is higher than % increase in labour
and capital. It shows the stage I i.e. increasing return to scale.
 In figure , OX axis represents increase in labour and capital while OY axis shows increase
in output. When labour and capital increases from Q to Q1, output also increases from P to
P1 which is higher than the factors of production i.e. labour and capital.

Sta ge II :Constant Returns to Scale

It occurs when increase in output is proportional to an increase in inputs. If labour and capital
are increased by 10/o, then output also increases by 10%. If labour and capital are doubled,
output also doubles. Constant returns implies constant costs and constant costs are due to constant
econornies of scale. That is, an increase in the capacity of the firm has no effect on the long-run
average cost of production.
Units of Units of
Labour Capital % increase in Labour & Capital TP % increase in TP Return to Scale
3 9 60 Stage II
4 12 33.33% 80 33.33% Constant
5 15 25% 100 25% Constant

In the above table it is clearly seen that % increase in TP is just equal to % increase in
labour and capital. It shows the stage II i.e. constant return to scale.
In this diagram, constant returns to scale has been shown. On OX axis, labour and capital are
given while on OY axis, output. When factors of production increase from Q to Q1 (say x%) , as
a result of increase in output, i.e. P to P1 is also increased by the same percentage . We see that
increase in factors of production increase in production are same, thus constant returns to scale
apply.

Sta ge 111: Decreasing Returns to Scale

It occurs when increase in output is less than proportional to an increase in inputs. If labour
and capital increase by 10%, output will increase by less than l0%. If labour and capital are
doubled, output less than doubles. Decreasing returns to scale implies increasing costs and
increasing costs are due to diseconornies of large scale production. There is managerial
inefficiency caused by scarce supply of factors of production and imperfect substitution. The
manager is over burdened and faces the problems of control and coordination.
Units of Units of
Labour Capital % increase in Labour & Capital TP % increase in TP Return to Scale
5 15 100 Stage III
6 18 20% 120 10% Decreasing
7 21 16.67 130 8.3% Decreasing

In the above table it is clearly seen that % increase in TP is lower than % increase in labour
and capital. It shows the stage III i.e. decreasing return to scale.
 In this diagram , diminishing returns to scale has been shown. On OX axis, labour and capital are
given while on OY axis, output. When factors of production increase from Q to Q1 (more
quantity) but as a result increase in output, i.e. P to P1 is less. We see that increase in factors of
production is more and increase in production is comparatively less, thus diminishing returns to
scale apply.

Iso-Quant

An isoquant is a curve that shows all the combinations of inputs that yield the same level of
output. Iso means equal and quant means quantity. Therefore, an isoquant represents a
constant quantity of output. The isoquant curve is also known as an Equal Product Curve or
Production Indifference Curve or Iso-Product Curve.

The concept of isoquants can be easily explained with the help of the table given below:
 Combinations of Units of Labor Units of Capital Output of Cloth
Labor and Capital (L) (K) (meters)

A 5 9 100

B 10 6 100

C 15 4 100

D 20 3 100

The above table is based on the assumption that only two factors of production, namely, Labor
and Capital are used for producing 100 meters of cloth.

Combination A = 5L + 9K = 100 meters of cloth

Combination B = 10L + 6K = 100 meters of cloth

Combination C = 15L + 4K = 100 meters of cloth

Combination D = 20L + 3K = 100 meters of cloth

The combinations A, B, C and D show the possibility of producing 100 meters of cloth by
applying various combinations of labor and capital. Thus, an isoquant schedule is a schedule of
different combinations of factors of production yielding the same quantity of output.

An iso-product curve is the graphic representation of an iso-product schedule.

Thus, an isoquant is a curve showing all combinations of labor and capital that can be used to
produce a given quantity of output.
The three laws of returns to scale are now explained with the help of a graph below:

The figure 11.6 shows that when a firm uses one unit of labor and one unit of capital, point a, it
produces 1 unit of quantity as is shown on the q = 1 isoquant. When the firm doubles its outputs
by using 2 units of labor and 2 units of capital, it produces more than double from q = 1 to q =
3.

So the production function has increasing returns to scale in this range. Another output from
quantity 3 to quantity 6. At the last doubling point c to point d, the production function has
decreasing returns to scale. The doubling of output from 4 units of input, causes output to increase
from 6 to 8 units increases of two units only.