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Objectives Introduction 6.1.1 What is an Input Production Function: The Concept 6.2.1 Product Cilrves 6.2.2 Law of Diminishing Marginal Product 6.2.3 Fixed and Variable Proportion in Production 6.2.4 Three Stages of Production Operates? 6.2.5 Why Law of Diminishing Retur~is 6.2.6 Iso-Product Curve 6.2.7 Econornic Region of Production 6.2.8 Specific Forms of Productio~i Fu~ictions Input Prices and Iso-Cost Line 6.3.1 Iso-Cost Line 6.3.2 Returns to Scale: A Diagralnrnatic Presentatiocl Let Us Sum Up Key Words Some Usefill Book Answers or 1-lintsto Check Your Progress Exercises
6.0 OBJECTIVES
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After going through 111isunit you should be able to: understand the concept of production function as the relation between output and inputs; deduce the Scale Line when production is subject to different returns to scale; identify the basis of the choice oftechnique; and analyse the operation of the law of variable proportion under variable rehums to scale.
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6.1 INTRODUCTION
Traditionally production is defined as "the creation ofutility." llzis means we produce goods and services collsuming which our wants are satisfied. Seen in such a context, therefore,production includes a wide variety of activities such as making of fabricated material goods, writing of a book for B.A. (Economics) students,inaking of amovie, or providing services as a beautician.
While "production" is referred to creation of any good or service, its concept is understood better when we speak only of goods. For example, you can say that
you have produced 100 bicycles in the month of January 1997. To produce this number of bicycles, you have spent some money to buy machinery, steel and labour. All these activities can now be grouped in two categories to define clearly what is involved in production. One category is put under output (bicycle in the above example). Production of output requires putting together the necessary materials. These constitute the other category and are called 'inputs'. Thus, you put together the inputs in a certain way to produce a specified quantity of output. A theory of production analyses how aproducer combines various inputs to produce a specified quantity of output when the technology of producing the commodity is given. The relationship between quantitiesof inputs and output produced is termed production function.
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variable inputs (x, and x,) and one or more fixed inp~ts the production of a single for output (Q). The function would state the quantity of output (Q) as a function of quantities of variable inputs (x, and x,). This relation gives the idea of maximum output that can be produced from different combination of inputs (x, and x,). Thus production function depicts the technical relation between inputs and output once the technology is given. This concept is used by economists to analyse laws of productioil relating inputs and-output.
: k
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Tract of land
1
Labour employed 1 2
Output (Paddy) 10
24
2
3
4 5 6 7
8
3
4 5 6 7
8
39
52 61 66 66 64
The data in Table 6.1 can be represented in the form of a graph. This is done in Figure 6.1. In order to draw the graph, it may be useful to remember that output produced depends on inputs used. It is customary to the independent variable (labour in our example) on x-axis. The dependent variable (production of paddy) is
r h e o r y of Producti0n
cOsis
plotted on y-axis. Joining successivepoints of labour-output combinations from Table 6.1, total product curve is obtained. It is necessary to take note of an important feature of this curve. It first rises slowly. Then it increases dn increasing rate and slows down again reaching a maximum. After wards there appears a decreasing phase.
Fig. 6.1
Fig.6.1:
Depicts the relation between variable input, labour, and output. Output tends to rise as the use of labour increases. After a while, however, it starts declining.
Average and marginal products of labour can be defined on the basis of above formulation. The average product (AP) of labour is the total product divided by the number of workers employed (X). That is,
Similarly,the marginal product (MP),of X is the rate of change of the total goduct with respect to variations in quantity of X. To see the calculation of AP and MP from total output see Table 6.2 in the following. Features of AP and MP can be seen from their curves. These are presented in Figure 6.2. See that AP for apoint on a total product curve equals the slope of a line segment connectingthat point with the origin. It increases for movements along the total product curve from the origin upto a point and decreases thereafter. Similarly, MP increases initially and declines after a point. MP and AP are equal at the maximum AP.
Fig. 6.2
AP
0
Fig. 6.2 shows the shapes of AP and d c u r v e s . Notes that MP rises faster than A P ~ initially, attains the peak earlier and starts declining faster as well. MP c ts AP at p, which is the maximum height attained by AP. As it falls below AP, go to the negative level of output. In contrast, AP remains at a positive output level. -
Theory of Production
-MP
AP
where
Stage 1
The first stage coi~esponds the use of variable inputs upto point 5 (see Figure to 6.3). In this stage the total product increases at an increasing rate initially. MP rises in this range. However, the slope of TP declines after a point (after point 1 in Figure 6.3). As a result, TP increases at a diminishing rate. Coilsequently the marginal product falls but remains posit've. At point 5, average product reaches its maximum. Stage 1 ends there. In stage 1 P rises first and falls after some level. It reniains
b
\
above average product. On the other hand, AP continues to rise throughout the stage. This part of production, therefore, is known as stage of increasing returns.
Fig. 6.3
Stage 2
,
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I 1 I
I I
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' ' 1 I
I
I I
I I
S
'
AP& MP
I I
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' #
*
1 I
I I I I
I I
I I I
t '
' 1 '
l
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8
t
I I
MP
Fig. 6.3
shows the shapes of total, average and marginal product curves. To appreciate the underlying relation between these, thinkof the figure as consisting of two parts. I n theupper part see the total product curve (TP). Its relation with average and marginal product curves (AP and MP) can be seen by coming down to lower part. The three stages of production are evaluated with the help of TP, AP and
MP
Stage 2
The secorld stage corresponds to use of the variable input between points 5 and 6. In this part, TP continues to rise at a diminishiilg rate. -The gecond stage ends at point 3 when TP reaches the maximum. In this stage both AP and MP are diminishing but are positive. Point 6 givesthe condition where MP is equal to zero and indicates the end of stage 2. This is known as the stage of diminishing returns as both AP and MP are diminishing.
Stage 3
Stage 3 is indicated by the use of variable input to the right of point 6. TP declines and MP becomes negative at this stage. See that MP curve goes down the X - axis. This stage is called the stage of negative returns. An evaluation of three stages of prod~iction discussed above will indicate that a rational producer will never produce at the last sitage. S i n e MP is negative there, the producer will increase the output by reducing the quantity of variable input.
Theory of Production
Total Output 10 24 39 52
61
AP
10 12 13 13 12.2 11.0 9.4 8
MP
14 15 13 9 5 0 (-12
66 66 64
AK
AL MRTS
fi
AL
Here it is shown that the replacement of capital with labour can keep the level of output constant only if each additionalunit of labour replaces lesser and lesser amount of capital. This is due to the operation of the law of diminishing retums in both the inputs. As capital is reduced and labour is increased two forces operate. First, a reduction of capital increases its returns. Second, since capital is replaced by labour, the increased amount of labour has to work with less capital. Hence, labour'smarginal productivity decreases. This is because no two inputs would be perfect substitutes of each other, unless they were absolutely identical. In that case, by definition, they would be the same inputs. Since the marginal productivity of labour decreases and that of capital increases, with the decrease in capital and correspoildingincrease in labour, the substitution of labour for capital to produce a constant level of mtput is possible only if every extra unit of labour displaces less and less of capital per unit. The rate, at which labour cah replace capital keeping the level of output constant, is the marginal rate of technical substitution (MRTS) of labour for capital. MRTS declines as capital decreases and labour increases or labour-capital ratio increases. The diagrammatic presentation of the iso-product line takes the shape oka falling curve, convex to the origin as shown in Figure 6.4. Its properties are the same as that ofthe usual Indifference curves. This is also called Iso-quant. It is a continuous curve, which assumes that two inputs are continuously divisible and substitutable. The slope of the curve
=
'
g ,which is negative.
Since output is constant throughout the curve, the marginal reduction in output with respect to decrease in capital is just equal to the marginal increase in output as a result of increase in labour. The marginal reduction in output due to decrease in capital is MP, x AK where MP, islhe marginal productivity of capital.
AL
Theory of Production
where MP, is the marginal productivity of labour. Hence, the change in total output due to substitutionof labour for capital is zero. That is,
This means the marginal rate oftechnical substitution of labour for capital
Fig. 6.4
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40
3 0
Capital
Labour
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Fig. 6.4 shows that at points A, B, C and Dsame levels of output are being produced. However, to such a level ofoutput, defferent combinationsofcapital and labour as given in Table 6.3 are employed
AK MRTS LK = (-) AL
equals the inverse of the ratio oftheir marginal productivities. The relation between MRTS and the ratio of labour to capital is also dzducible LK from Table 6.3. From this relatlon the elasticity of substitutioncan be defined as
Percentage change in MRTS
ESLK=
LK
--A(L/K)
- AMRTS,
L/K MRTS
This elasticity is greater than, equal to, or less than one according as a givenpercentage change of L K ratio induces greater, equal, or less percentage change in MRTS in the opposite direction.
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Capital
Fig. 6.5
Labour Fig. 6.5 shows that the economic production region is enclosed by RidgeLines OC and OL. The IineOC is the locus of points where Iso-quants arevertical. Similarly, OL is the locus of points on which Iso-quants are horizontal.
',
Fig. 6.6
Fig. 6.6 is drawn by assuming that capital and labour are not subititutableand have to be used in fixed proportions. Thus, when the technique of production is fixed, the shape of the Iso-product curvais like PQR.The Iso-product curve is flat running parallel along the capital and labour.
When the technique of production is fixed, the shape of labour and capital axes would show non-substitutability between these two inputs. If capital or labour is used in excess of OM or ON amount respectively, their marginal productivity will be zero.
Theory of Production
!!
b) Homogeneous Production Function: Degree One When continuous substitutabilityis allowed between these inputs, the production function can be homogeneous or non-homogeneous. In case of the homogeneous production function, the level of production can be increased by using the same technique of production, i.e., by increasing both the inputs in the same proportions. This way of expanding production gives the returns to scale. The scale here refers to change in inputs in the same proportion. Thus, production hlction, hoillogenous of degree one is described by tenns such as linear homogenousor constant returns to scale. All these drive home the essential concept: if all inputs are expanded in the same proportion,output is expanded in that idea proportion. To understand the ~mderlying take an example. Consider a production functian:
q = f(x,y) = A x y
a I-a
where x,y
and o < a < l Now let x and y be increasd by proportion h. Then we write f(x,y) as
=hf (x, y)
=h
Therefore, the expansion of inputs by h has resulted in output expansion by h. This is what is meant by a constant returns to scale. Such an idea is also presented with the help of adiagramme in the following.
Fig. 6.7
Labour
Fig. 6.7: In figure 6.7, parallel Iso-product curves are drawn. A higher Iso-product curve using more o f two inputs represents a higher level ofoutput (say, 200 units). A ray th ough theorigin (OA), crossing the Iso-product curves at B,B1 and B" is known as the scale line or expansion path of output.
The parallel Iso-product curves in the figure indicate that a higher level of output is produced when greater amounts of the inputs. capital and labour are employed. It also shows that a higher point on the scale line corresponds to a higher Iso-product curve and indicates a hlgher level of output. If Iso-product curves are parallel, and the same marginal rates of substitutionbetween inputs prevails on all the points of intersection of the Iso-productcurves and the rays through the origin, the production function related to these Iso-Product curves are homogenous. In the figure slopes at B, B' and B", i.e., points of intersection between OA line and Iso-product curves, are the same. These Iso-product curves are a set of parallel convex curves, like the Indiffe~ence Curves. Then, production can be increased by increasingthe inputs by the same proportion and the scale line is a straight line having a constant slope. When the production function is linear and homogeneous, as in Figure 6.7, proportionate increase in output isjust equal to the proportionate increase in inputs i.e., OB = BB' = B'B". While the scale line is a straight line the proportional increase in output can be higher than that in inputs and can also be less than that in the inputs. I11that case, production h c t i o n is not linear, though homogeneous. c) Non-Homogeneous Production Function and Scale Line When production function is non-homogeneous,the increase in production is not proportional to the increase in the inputs, at the given technique of production. In Figure 6.8, OA is an upward sloping curve through the origin showing that its slope increases as output increases. This implies that capital intensity of the technique of production, i.e., the ratio of capital to labour rises as production increases. It is possible to have a reverse situation where the slope of the expansion curve will decrease and capital intensity will fall with increase in.output.
Fig. 6.8
Capital
N N'N"
Labour
Fig. 6.8 shows that the slopes of the Iso-product curves are the same on the expansion , curve OA. ,
The law of diminishingmarginal production states that increased application of one input keeping others fixed will yield smaller output. ( 1
ii) In production under variable proportions the ratio of all variable inputs ( 1 varies.
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Marginal rate of technical substitution of labour for capital increases as ( 1 capital decreases and labour increases.
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iv) One unit increase in output due to an extra unit of increment in input is known as marginal product. ( 1 v) In case of harnogenous production function production can be increased by increasing the inputs in the same proportion. ( 1 2) Discussthe three stages of production. Explain why the law of diminishing returns operates?
Theory or P r o d u c t i o ~ ~
i.e., the ratio ofprices ofthe two inputs is the slope ofthe line, which is negative and constant. The slope will remain the same as long as the relative price ratio of thk inputs is constant. Intercepts change as total outlay is changed. In Figure 6.9, 'WT' line is drawn on basis of the above qquation to show that the total outlay remains constant over different combinations of two inputs. This is the Iso-cost line, very similar to thebudget line ofthe consumer buying two goods. This, in fact, is the producer's budget, i.e., outlay line for the inputs.
NOW, choice of technique is determined where the Iso-cost line is tangent to the the Iso-product curve at point R. This is the maximum output the outlay can produce. If the technique represented by the ray OA is used, capital-labour ratio is OMION. At point R, the slope of the Iso-cost curve (w/r) is equal to the slope of the Isoproduct curve. Hence, at this point the input-price ratio, the marginal rate of technical substitution and the ratio of marginal productivities of labour and capital inputs are equal. This is similar to consumer equilibrium.
Fig. 6.9
Capital
Labour
Fig. 6.9 shows that OW amount of capital is hired tospend the entire outlay. Similarly, by spending that outlay, O T units of labour can be hired. The straight line WT indicates various combinations of capital and labour, which a producer can employ for the given outlay. It is the Iso-cost line. The Iso-quant (200 units of output) is tangent to WT at R
Fig. 6.10
Labour
Fig.6.10 shows that change in {nputs, capital and labour, does not lead to proportionate change in output.
However, I, and I, have drifted farther and farther. That means, larger and larger amounts ofboth &e factors h e being used but the rise in output remains 'fixed' at the old level of 100 units. Here the returns to scale are diminishing - the output rises at a rate, which is slower than the rate ofrise of the use of inputs. Finally, we find that I, has come closer to I5yet increase in the output remains 100 units - in' other words, smaller increase in the inputs is able to increasethe output by 100units now. This is the case of increasing return to scale.
1) Define an Iso-product curve in one sentence. What are shown along the axes of the figure to draw an Iso-product curve?
2) If, for a particular combination of labour and capital, themarginal productivity of capital is 6 units of output and the marginal rate of technical substitution is 2 units of capital per unit of labour, calculate the marginal productivity of labour.
3) Let the price of capital be Rs. 60 and that of labour Rs.50. Write the Iso-cost equation for the outlay of Rs.2000 and calculate the slope of the Iso-cost curve.
6.5 KEYWORDS
Constant Returns to Scale
If all factorsof production are increased in a given proportion, the output increases in exactly the same proportion under constant returns to scale. If a set of Iso-product curves generated by aproduction h c tion has the same slope along a ray through the origin, then the production function is called homogeneous. Under this law of production, output increases proportionately less than inputs. This is a locus of cost minimising proportions of two inputs to produce maximum output resulting fiom changes in the scale of outlays, keeping the input prices constant. . Under this law of return, output increases proportionately more than inputs.
Expansion Path
Iso-Cost Line
This shows all the different comim binations oftwo inputs that a fr can purchase or hire with given input prices and outlay.
Iso-Product Curve
Theory of Production
erates a set of Iso-product curves having different slopes along a ray through the origin, it is termed as non-homogeneous production function.
ProductionFunction
: This is a technical relation showing the maximum quantityof output that can be produced from a set of input combinations on the basis of existing technology.
: The time period when at least one
Short Run
0;ii)
(F); iii)
0;iv)
(F); v) (T)
1) The curve shows a constant level ofoutput produced by different combinations of two inputs such as capital cgnd labour. Capital(K) is measured on the Y-axis and Labour (L) on the X-axis.
P ~
MPK
3) Iso-cost equations:
Total outlay = Price of capital x quantity capital +Price of labour x quantity of labour