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Production Function
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Production Function
Production: Any activity leading to value
addition
Transformation of inputs into output

Q= f (L,K)


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Production Function
Short term : Time when one input (say,
capital) remains constant and an addition
to output can be obtained only by using
more labour.
Long run: Both inputs become variable.
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Production Function

Production process is subject to various
phases-
Laws of production state the relationship
between output and input.

.

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Laws of production
Short run :

Relationship between input and output are
studied by varying one input , others being
held constant.
Law of Variable Proportions brings out
relationship between varying proportions
of factor inputs and output
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Laws of production
Long run:
Production function is subject to different
phases described under the Law of
Returns to Scale
Studied assuming that all factor inputs are
variable.

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Law of Variable Proportions
Law of Variable Proportions (Short run Law
of Production)
Assumptions:
One factor (say, L) is variable and the
other factor (say, K) is constant
Labour is homogeneous
Technology remains constant
Input prices are given
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Law of Variable Proportions
No of Workers
L
Total Product
(TP
l
)
Marginal
Product (MP
l
)
Average
Product (AP
l
)
Stages of
Returns
1 24 24 24 I)
Increasing
Returns
2 72 48 36
3 138 66 46
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66 II)
Diminishing
Returns

8 528 66 66
9 576 48 64
10 600 24 60
11 594 -6 54 III) Negative
Returns

12 552 -42 46
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Law of Variable Proportions
Panel B
labour
APL
M
P
L
MPL
Panel B represents
Marginal and average
productivity curves of
labour
A
P
/
M
P

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Law of Variable Proportions

Increasing Returns- Stage I:
TP
l
increases at an increasing rate.
Fixed factor (K) is abundant and variable
factor is inadequate. Hence K gets utilised
better with every additional unit of labour
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Stage II- TP
l
continues to increase but at a
diminishing rate.
stage III- TP
l
begins to decline Capital becomes
scarce as compared to variable factor. Hence
over utilisation of capital and setting in of
diminishing returns
Causes of 3 stages: Indivisibility and inelasticity
of fixed factor and imperfect substitutability
between K and L


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Law of Variable Proportions
Significance of Law of Diminishing Marginal
Returns:
- Empirical law, frequently observed in
various production activities
- Particularly in agriculture where natural
factors (say land), which play an important
role, are limited.
- Helps manager in identifying rational and
irrational stages of operation

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Law of Variable Proportions
- It provides answers to questions such as:
a) How much to produce?
b) What number of workers (and other
variable factors) to employ in order to
maximize output
In our example, firm should employ a
minimum of 7 workers and maximum of 10
workers (where TP is still rising)


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Law of Variable Proportions
- Stage III has very high L-K ratio- as a
result, additional workers not only prove
unproductive but also cause a decline in
TPl.
- In Stage I capital is presumably under-
utilised.
- So a firm operating in Stage I has to
increase L and that in Stage III has to
decrease labour.

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Law of Returns to Scale
In the long run, all factors are variable.
Production can be increased by adding
both L and K.
Relationship between inputs and output is
depicted in the form of isoquant curves.
Isoquant curves represent different
combinations of K and L that lead to the
same level of output.
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ISOQUANT CURVES

Units of L
U
n
i
t
s

o
f

K

o X
Y
IQ100
IQ200
IQ300
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Law of Returns to Scale
Isocost line:
Assume that labour costs Rs.10 per unit and
capital, Rs. 7 per unit.
Suppose the company has a budget of Rs. 70.
It can buy 7 units of labour (with no capital), or
10 units of K (with no labour), or some in-
between combination.
By joining the two extreme points we get an
isocost line
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Law of Returns to Scale

7
10
X
o
Units of L
Y
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Law of Returns to Scale
1
0
0
1
9
Q1=100
Q2=200
B
Labour
C
a
p
i
t
a
l

Y
X
O
Y


Producer has a constraint-
namely, budget.

Producer attains equilibrium
when he reaches highest
attainable level of output.
Q3=300
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Law of Returns to Scale
Point of tangency between isoquant and
isocost is the point of least cost
combination of inputs.
At point B, labour and capital are
combined in a proportion that maximises
the output for a given budget.
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Law of Returns to Scale
= q/ q n /n
where
q/ q indicates proportionate change in output
n /n indicates proportionate change in input

If >1, then we have increasing returns to scale
=1, then we have constant returns to scale
<1, then we have decreasing returns to scale


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Law of Returns to Scale
Firm is subject to
increasing,
Constant and
Decreasing returns
to scale.
Explanation for these
phases is provided
Through concepts
Called economies
And diseconomies
Of scale.
L
K

A
B
C
B
D
E
F
Q 20
Q40
Q60
Q80
Q100
Q120
X
Y
o
Q140
G
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ECONOMIES OF SCALE
ECONOMIES OF SCALE are advantages
enjoyed by a firm from large scale
production.

Causes of increasing returns to scale
Internal and external


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INTERNAL ECONOMIES
INTERNAL: Those advantages and
disadvantages that accrue to the firm as a
result of its scale of operation
Indivisibilities- if some of the factors are
indivisible, then it would be technically and
economically undesirable to use the
indivisible factor for a smaller scale of
production e.g., Cant use a conveyor belt
to unload a small truck, but need one for
unloading a train or ship

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INTERNAL ECONOMIES
Dimensional economies
A mere change in the size of capital can
lead to a change in output which is
proportionately more than the cost of
enlarged input. e.g., Doubling the
diameter of a pipeline more than doubles
the water flow without doubling the cost;
doubling the dimensions of a ship more
than doubles its capacity without doubling
costs
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INTERNAL ECONOMIES
Specialisation- In large scale production,
a process can be broken into sub
processes - specialised labour and
specialised machines lead to increase in
productivity and decrease in average cost
of production.
Managerial economies
Commercial economies-bulk purchases
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INTERNAL ECONOMIES
Financial economies -Lower rate of
interest, liberal terms and conditions
because of reputation individual investors
also like to invest money.
Risk bearing economies:
Diversification of output, markets and
sources of supply
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INTERNAL DISECONOMIES
Internal Diseconomies
Effective supervision no longer possible
Unwieldy administration and ego clashes
Industrial unrest
Problems of re-conversion, storage and
standing costs in case of stoppage of
work or lack of demand

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External Economies of Scale

External Economies of Scale
Arise out of sharing and cooperation
received from other firms in a given
industry.
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External Economies of Scale

Economies of concentration
Supply of skilled labour in a region
Common services
Specialised institutions like training
schools and research centres (Indian
School of mines in Dhanbad),
Reputation of a region
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External Economies of Scale

Economies of Information
Trade associations, journals, seminars

Economies of disintegration
An ancillary firm may specialise in the
production of only one part
Waste and byproducts of all firms in the
industry may be dealt with by a specialised
firm.
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External Diseconomies of Scale


As firms expand along with expansion of the
industry, after a point economies turn into
diseconomies
Excessive concentration leads to bottlenecks
and diseconomies

Most firms experience these phases but some
continue to defy these laws due to innovations
and technological progress.

The Cobb-Douglas production
function
The Cobb-Douglas production model was
identified by the economist Paul Douglas
(who was Senator from Illinois, 1948-
1964) with the help of a mathematician
colleague at the University of Chicago
However, it had been known and applied
in economics previously.

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The Cobb-Douglas Production
Function
The simplest production function is the Cobb-Douglas
model. It has the following form:

Q=aL
b
C
c

where Q stands for output, L for labor, and C for
capital. The parameters a, b, and c (the latter two being
the exponents) are estimated from empirical data.

If b + c = 1, the Cobb-Douglas model shows constant
returns to scale. If b + c > 1, it shows increasing
returns to scale, and if b + c < 1, diminishing returns to
scale.

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Case study: Masterjis Grocery
Shop
Masterjis shop is very popular and stocks all
kinds of goods- from rice and wheat to
processed food, imported chocolates and
cheese. There is a small section which
has a photocopying machine and a STD
booth. Masterji runs the shop with the help
of his children.
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Case study: Masterjis Grocery
Shop
The family noticed
that the number of
shoppers varied
between times and
days (See table)
During weekdays,
masterji could
manage with his
children, but not in
week ends.
Morn After
noon
Even
Mon-
Fri
50 40 65
Sat/
Sun
165 85 30
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Case study: Masterjis Grocery
Shop
Sunday morning buyers were value
crowd- bulk buyers, spent extra on
something new and attractive but wanted
a pleasant experience and were upset at
the overcrowded shop
At certain times there were not many
shoppers


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Case study: Masterjis Grocery
Shop
Masterji employed 3 assistants during
week ends, but that did not solve the
problem as the shop had a small floor area
and only one billing machine
1.Can you explain masterjis problem in
terms of law of variable proportions?
2. Pl. suggest in detail how masterji can
improve the functioning of the shop.

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Measuring Productivity
US Bureau of Labor Statistics has been
conducting studies of output per hour in
individual industries as well as overall economy
since 1800s- earlier because of apprehensions
of human labor being displaced- this fear of
unemployment was replaced by concern for
making the most efficient use of labour in 1920s
and 30s- In recent years interest in productivity
measurement and enhancement has grown
because it is recognised as an important
indicator of economic growth.
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Labor productivity: Ratio of output per
worker hour. Improvements in worker
productivity
Multifactor productivity: Output is related to
combined inputs of labor, capital and
intermediate purchases.
Advances in productivity reflect the ability
to produce more output per input