18 : Theory of Production

Recap from last session

Defining Input, Output, Production

Production function
Short Run Production Function
Law of Diminishing Return
Prof. Trupti Mishra, School of Management, IIT Bombay

Session Outline
Long Run Production Analysis
Return to Scale
Isoquants, Isocost
Choice of input combination
Expansion path
Economic Region of Production
Prof. Trupti Mishra, School of Management, IIT Bombay

Returns to Scale

The law of production describes the technically possible ways

of increasing the level of output by changing all factors of
production, which is possible only in the long run.
Law of return to scale refers to long run analysis of
production.

Prof. Trupti Mishra, School of Management, IIT Bombay

Returns to Scale

It refers to the effects of scale relationship which implies

that is long run output can be increased by changing all
factors by the same or different proportion.

Prof. Trupti Mishra, School of Management, IIT Bombay

Returns to Scale

Q = F (L,K)
ZQ = f(pL, pK)
If all inputs are increased by a factor of p & output goes up
by a factor of z then, in general, a producer experiences:

Prof. Trupti Mishra, School of Management, IIT Bombay

Returns to Scale
Increasing returns to scale if z > p; output goes up
proportionately more than the increase in input usage
Decreasing returns to scale if z < p; output goes up
proportionately less than the increase in input usage
Constant returns to scale if z = p; output goes up by the
same proportion as the increase in input usage
Prof. Trupti Mishra, School of Management, IIT Bombay

Returns to Scale and Homogeneity of the Production Function

Q = F (L,K)
ZQ = f(pL, pK)

If p can be factored out , then the new level of output can be

expressed as ZQ = p v f(L, K) or ZQ = p v Q
This is called as homogeneous production function.
Prof. Trupti Mishra, School of Management, IIT Bombay

Returns to Scale and Homogeneity of the Production Function

The power of v of p is called the degree of homogeneity of the

function and is a measure of the returns to scale.If
v = 1 Constant Return to Scale, Linear homogeneous
production function
v >1 Increasing Return to Scale
v < 1 Decreasing Return to Scale

Prof. Trupti Mishra, School of Management, IIT Bombay

Returns to Scale -Example

Q = K0.25L0.50
If K and L are multiplied by k, and output increases by a multiple
of h, then hQ = (kK)0.25(kL)0.50.
factoring out k, hQ = k0.25 + 0.50[K0.25L0.50]
= k0.75[K0.25L0.50]
h = k0.75 and r = 0.75, implying that r < 1, and, h < k. It follows
that the production function shows decreasing returns to
scale.
Prof. Trupti Mishra, School of Management, IIT Bombay

Returns to Scale - Example

Q = f(K, L, X) = K0.75 L1.25 X0.50

Multiplying K, L, and X by k, Q increases by a multiple of h:
hQ = (kK)0.75 (kL)1.25 (kX)0.50
Again factoring out k, hQ = k(0.75+1.25+0.50)[K0.75 L1.25 X0.50]
= k2.5[K0.75 L1.25 X0.50]
Observe that in this case, h = k2.5 and r = 2.5, so that h > k.
Thus, production function depicts increasing returns to scale.

Prof. Trupti Mishra, School of Management, IIT Bombay

Isoquant

In the long run, all inputs are variable & Isoquant are used
to study production decisions
- An Isoquant is the firms counterpart of the consumers
indifference curve.

Prof. Trupti Mishra, School of Management, IIT Bombay

Isoquant

An Isoquant is a curve showing all possible input

combinations capable of producing a given level of
output
Isoquant are downward sloping; if greater amounts of
labor are used, less capital is required to produce a
given output
Prof. Trupti Mishra, School of Management, IIT Bombay

Typical Isoquants

Prof. Trupti Mishra, School of Management, IIT Bombay

Marginal Rate of Technical Substitution

The MRTS is the slope of an Isoquant & measures the rate at
which the two inputs can be substituted for one another
while maintaining a constant level of output
MRTS

K
L

Prof. Trupti Mishra, School of Management, IIT Bombay

Marginal Rate of Technical Substitution

If the law of diminishing marginal product operates, the
Isoquant will be convex to the origin.
A convex Isoquant means that the MRTS between L and k
decreases as L is substituted for K.
Prof. Trupti Mishra, School of Management, IIT Bombay

Marginal Rate of Technical Substitution

The MRTS can also be expressed as the ratio of two marginal
products:
MRTS

MPL
MPK

Prof. Trupti Mishra, School of Management, IIT Bombay

Marginal Rate of Technical Substitution

As labor is substituted for capital, MPL declines &
MPK rises causing MRTS to diminish
MRTS

K
L

MPL
MPK

Prof. Trupti Mishra, School of Management, IIT Bombay

Isocost Lines
Shows various combination of inputs which may be purchased
for given level of cost and price of inputs.
Co = w.L + r.K
This equation will be satisfied by different combinations of L
and K. the locus of all such combinations is called equal cost
line/ or isocost line.
Prof. Trupti Mishra, School of Management, IIT Bombay

Isocost Lines
K
A

C0/r

L
Co/w

Slope of Isocost line = OA/OB= co/r/ co/w = w/r

Prof. Trupti Mishra, School of Management, IIT Bombay

Optimal Combination of Inputs

Minimize total cost of producing Q by
choosing the input combination on the
isoquant for which Q is just tangent to an
isocost curve

Prof. Trupti Mishra, School of Management, IIT Bombay

Optimal Combination of Inputs

Two slopes are equal in equilibrium
Implies marginal product per dollar spent on last unit of
each input is the same
MPL
MPK

w
r

or

MPL
w

MPK
r

Prof. Trupti Mishra, School of Management, IIT Bombay

Expansion path
The expansion path is locus of all input combinations
for which the MRTS is equal to the factor price ratio.
The locus of all such points of tangencies between the
Isoquant and the parallel Isocost lines is the expansion
path for the firm.
Prof. Trupti Mishra, School of Management, IIT Bombay

Expansion path

Expansion path gives the efficient (least-cost) input

combinations for every level of output
Along expansion path, input-price ratio is constant &
equal to the marginal rate of technical substitution
Prof. Trupti Mishra, School of Management, IIT Bombay

Expansion Path

Prof. Trupti Mishra, School of Management, IIT Bombay

Expansion path
If both the factors of production are non-inferior, the
expansion path will be upward rising. In this case more
of both the factors will be required for producing more
of output.

Prof. Trupti Mishra, School of Management, IIT Bombay

Expansion path
If the production function is homogeneous the
expansion path will be a straight line through the origin
whose slope depends on the ratio of factor prices.

If the production function is non-homogeneous then

the optimal expansion path will not be a straight line ,
even if the ratio of factor prices remain constant.

Prof. Trupti Mishra, School of Management, IIT Bombay

Economic Region of Production

There exist a range over which one input can be substituted

for the other, within that range isoquants are negatively
sloped.
Efficient range of output: the range over which the marginal
products of the factors are diminishing but positive.

Prof. Trupti Mishra, School of Management, IIT Bombay

Economic Region of Production

Production does not take place when MP of the factor is

negative.
The locus of points of isoquants where the marginal products
are zero form the Ridge line.
Prof. Trupti Mishra, School of Management, IIT Bombay

Economic Region of Production

Production techniques are technically efficient inside the
ridge line. Outside the ridge lines the marginal products of
the factors are negative and the method of production are
inefficient as they require more quantity of both the factors
for producing a given level of output.
The range of isoquants over which they are convex to origin
defines the range of efficient production.

Prof. Trupti Mishra, School of Management, IIT Bombay

Economic Region of Production

The upper ridge line implies that MP of capital is zero and
lower ridge line implies MP of labor is zero.
In isoquant Q0, A1 and A2 be the point where tangents are
drawn are parallel to the vertical and horizontal axes
respectively.

Prof. Trupti Mishra, School of Management, IIT Bombay

Economic Region of Production

That portion of the isoquant which lies between A1 and A2 ,

is the portion within which substitution takes place.
Between A1 and A3, at A3 more of both factors required to
produce the same level of output .

Prof. Trupti Mishra, School of Management, IIT Bombay

Economic Region of Production

Along the isoquant Qo, proceeding downwards, the

marginal product of labor will decrease and MP of
capital will increase, and vice versa.
At the point of A1 and A2, the slope of isoquant Qo is
infinity and Zero respectively.

Prof. Trupti Mishra, School of Management, IIT Bombay

Economic Region of Production

Slope = - MPL/MPK. This means that at point A1, MPK=

0, and at point A2 , MPL = 0.
So the portion A1A2 lies within the ridge lines and
called the economic region of production.
Prof. Trupti Mishra, School of Management, IIT Bombay

Economic Region of Production

It is only within A1 and A2 that both MPL and MPK are
positive and the isoquant is downward sloping.
The equation of upper ridge line is given by MPK = 0, and
the equation of the lower ridge line is given by MPL =0
Prof. Trupti Mishra, School of Management, IIT Bombay

Session References

Managerial Economics; D N Dwivedi, 7th Edition

Managerial Economics Christopher R Thomas, S Charles
Maurice and Sumit Sarkar
Micro Economics : ICFAI University Press

Prof. Trupti Mishra, School of Management, IIT Bombay

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