THEORY OF PRODUCTION

Inputs in economics are known as factors of production these can be

classified under 2 heads:

1. Fixed factors :- fixed factors of production are those whose factor

inputs cannot be changed at different levels of output in the short
period. Eg: land, machinery etc.

2. Variable Factor :- Variable factor inputs are those whose quantity

will differ at different levels output. Eg : Labour, Raw material etc.

There are 2 time periods under which production takes place.

1) Short Run : Some factor inputs are fixed while others are
variable. The production in short run can be increased only by
increasing. Quantity of variable factors.

2) Long Run : All factors of production become variable the

distinction between fixed & variable factor become irrelevant. the
production in long run. can be increased by increasing all the
factors of production.

Production in economics is defined as transformation of

input into output. Production includes physical goods & services
both.

Production function means relation ship between inputs used &

resulting output.
There are 2 types of production function

1) Short Run Production function: It refers to production in the

short run where some factors remain fix & other is variable. In
short run. product increases when more units of variable factors
are used with the fixed factors. This is known as returns to a
variable factors or law of variable proportions

2) Long Run Production function: It refers to production in a

time period when all factors are variable. The effects of the
changes in all the inputs on total output is called returns to scale
or Long Run Production function.

CONEPTS OF PRODUCT

1) Total product / Total physical product :- It is defined

as the total quantity & services produced by a firm with
the given inputs during a specified period of time or total
product is sum total of output of each unit of variable
factor used in the process of production. Thus
 TP = Sum of MPs
TP = AP X n
2) Marginal Product :- is a net addition to total product
when one more unit of variable factors employed
MP = TPn- TPn-1
MP = ∆TP
∆L
3) Average. product :- is the per unit production of the
variable factors i.e.
AP = TP
Fixed Variabl TP AP MP
Factor e TP TPn – TPn-1
(Land) Factor L

10 0 0 0 0

10 1 4 4 4

10 2 10 5 6 (10 - 4)

10 3 18 6 8 (18 -10)

10 4 24 6 6 (24 -18)

10 5 28 5.6 4 (28 - 24)

10 6 28 4.6 0 (28 – 28)

10 7 20 2.8 - 8 (20 – 28)

10 8 20 – 4 = 16 2 - 4(16 – 20)

Relationship between TP & MP

1. When TP increases at increasing rate, MP also increases.

2. When TP starts increasing at decreasing rate, MP decreases but
remains positive
3. When TP is maximum & constant MP is O (zero)
4. When TP begins to fall, MP is negative
 Relationship between AP & MP

1. Both AP & MP cures are derived from TP since, AP = TP & MP = ∆TP

L
∆L
2. When MP is greater than AP, AP rises but MP rises at faster pace.
3. When MP equals to AP, AP is constant
4. When MP is less than AP, AP falls but MP falls at higher rate.

Y
T
A

Total product

TP

Point of inflexion

O L1 L2 L3 Unit of labour
X

Stage I Stage II Stage III

Average and M.P. M A

AP

O L1 L2 L3 Units of labour X

MP

Law of variable proportions or Returns to factor

It states that as more & more units of a variable factor are applied
to a given quantity of a fixed factor the total product may increase
at an increasing rate initially but eventually it will increase at a
diminishing rate.

Assumptions
1. The law applies only in the short run.
2. One factor of production is variable & others are fixed.
3. All units of variable factor are homogeneous.
4. State of technology is given & remains the same.
5. Factor proportions can he changed.

There are 3 stages of law of Variable proportions

1. Increasing returns :- In this stage, TP increase at increasing rate &

later at the diminishing rate.
AP increases & reaches at its maximum
MP initially increases then starts decreasing but continues to remain
above AP

2. Diminishing Return :- TP increases at a diminishing rate till it

reaches at maximum point & then becomes constant
 AP continues to fall
MP decreases & finally becomes zero (o).

3. Negative Returns :- TP begins to fall AP continues to fall but

remains positive
MP becomes negative

Causes of 3 stages of Law of variable proportion .

1. Increasing return to a factor:-

(i) Fuller utilization of fixed factor : In the initial stages

Fixed factor remain under utilized its fuller utilization starts with
the more application of variable factor, hence, initially additional
unit of variable factors add more to the total output

(ii) Specialization of Labour :- Additional application of

Variable factor causes process based division of Labour that
raises the efficiency of factors. Accordingly marginal productivity
tends to rise.

3. Diminishing return to a factor:-

(i) Imperfect factor substitutability :- Factors of

production are imperfect substitutes of each other. More & more
of Labour, for eg. Cannot be continuously used in place of
additional capital. Accordingly diminishing returns to variable
factor becomes inevitable.

(ii) Disturbing the optimum proportion :- Continuous

increase in application of variable factor along with fixed factors
beyond a point crosses the limit of ideal factor ratio. This results
in poor co-ordination between the fixed & variable factors which
causes diminishing return to a factor.

4. Negative returns to a factor :-

(i) Overcrowding :- When more & more variable factors are added
to a given quantity of fixed factor it will lead to over crowding &
due to this MP of the Labours decreases & it goes into negative

(ii) Management Problems :- When there are too many

workers they may shift the responsibility to others & it becomes
difficult for the management to coordinate with them. The
Labours avoid doing work. All these things lead to decrease in
efficiency of Laboures. Thus the output also decreases.

Q. In which stage should a producer operate?

 A rational producer would always prefer to operate in the 2nnd stage. He will
not stay in Ist stage because it is the stage of increasing returns under no
circumstances he will also not operate under 3rd stage where the total
product starts decreasing. The 1st & 3rd stages are called stages of economic
absurdity hence a rational producer would like to operate in 2 nd stage
because it is the stage where AP & MP of variable factor are declining but
remain positive Thus this is the best stage to work.

Returns to Scale

It refers to a situation in which we study the behavior of output

when all the factor inputs are varied in the same proportion. It is
applicable in the long run.
In long period production of a commodity can be increased by increasing all
the factors in the same proportions. If all the factors increase in same
proportion the scale of production increases & the corresponding behavior of
output is studied as returns to scale.

There are 3 aspects of returns to scale

(i) Increasing returns to scale – occurs when a given percentage

increase in all factor inputs in the same ratio causes proportionately
greater increase in output
: Scale of production Output
1 Machine + 2 Laboures 100 Kgs
2 machine + 4 Laboures 250 Kgs

(ii) Constant returns to scale :- Under this percentage increase

in all factor inputs in the same proportion causes equal percentage
increase an output
Scale of production Output
1 Machine + 2 Laboures 100 Kgs
2 machine + 4 Laboures 200 Kgs

(iii) Diminishing returns to scale :- When a percentage increase

in all factor inputs in the same ratio causes proportionately lesser
increase in output is known as diminishing returns to scale
Scale of production Output
1 Machine + 2 Laboures 100 Kgs
2 machine + 4 Laboures 150 Kgs

Causes for the operation of Law :- the main reasons for the operation of the
different forms of returns to scale are found in economies & diseconomies of scale

Economies of Scale
It refers to the situation in which increasing the scale of production. Reduces the
per unit of cost of production or raises output per unit of factor inputs.

Economies are of 2 types

(i) Internal economies :- Which are firm specific These are available to that
particular firm in the industry which seeks to increase its level of output by way of
increasing the scale of production. These are internal became they are not shared
by other firms in the industry
Eg : Technical economies, Labour economies of purchase & sale, financial
economies & economies of risk.

(ii) External Economies :- These are the economies which are industries
specific the are available to all the firms in the industry when the scale of
operation of the industry as a whole expands.
Eg :- economies of concentration, economies of info, economies of disintegration.
Economies to scale are responsible for increasing returns to scale.

Constant returns to scale :- In this situation economies are neutralized by

diseconomies. It is clear that the constant returns to scale operates when the total
output increases in the same proportion as an increase in the quantity of factor
inputs.
Diminishing returns to scale occurs due to the diseconomies of scale which means
the disadvantages experienced by the production units after increasing the scale
of production beyond the maximum limit. Diseconomies are also of 2 types.

(i) Internal diseconomies :- These disadvantages are firm specific & are not
shared by other firms in industry technical economies Eg : managerial
diseconomies, & Labour inefficiency.

(ii) External diseconomies :- these are the disadvantages which are industry
specific which are experienced by all the firms in the industry due to increase in
scale of production.
Eg :- Rise in input prices, higher wager, costlier transport.

Some specific factors responsible for returns to scale

1. Causes of increasing return to scale

(i) Indivisibility :- Some factor of production cannot be divided hence they

cannot be purchased in parts. When scale increases these indivisible factors of
production become more efficient & they are more efficiently utilized by the
Labours which increases the volume of output.

(ii) Specialization :- As a result of increase in the scale of production division of

Labour becomes possible. It increases the efficiency of factor inputs & the volume
of output also increase.

2. Causes of constant return to scale

(i) Limits to economies of scale :– economies of scale are not indefinitely
available as the scale of production expands a point is reached when economies of
scale are counter balanced by the diseconomies of scale. Thus the output
increases in the same ratio as the input

(ii) Divisibility of inputs :- It may occur in certain productive activities where

factor of production are perfectly divisible.
Eg : Double the output by setting up of two plants
3. Causes of diminishing returns to scale

(i) Entrepreneur is a fixed factor :- with the increase in scale of production.

There may be a point when the abilities & skills of the entrepreneur may be fully
utilized. It decrease. its efficiency thus cost of production increases.

(ii) Exhaustibility of natural resources :- With the increase in scale of

production over utilization of natural resources takes place. Which decrease the
efficiency of it & output also decreases.

Difference between retune to a variable factor & returns to scale

(write on your own)

1. Meaning

2. Time period

3. Factor proportions

4. Scale of production

5. Stages