Unit:III

THEORY OF PRODUCTION

Production
In economics production means a process by which resources are transformed
into a different and more useful commodity or service. Transporting men and
materials from one place to another is a productive activity. An intangible input
to produce intangible output. For eg: production of legal, medical , consultancy
services.
Fixed and Variable Inputs:-
-In the economic sense Fixed input is one whose supply is inelastic in the short
run. So all of its users together cannot buy more of it in the short-run. For. Eg:
machinery, plant etc….
-A Variable input is defined as one whose supply in the short-run in elastic.
For.eg. labor and raw material etc…
Short –Run and Long-Run:-
-The short run refers to a period of time in which the supply of certain inputs is
fixed or is inelastic. So in the short run production of a commodity can be
increased by increasing the use of only variable inputs like labor and raw
materials.
The Long run refers to a period of time in which the supply of all the inputs is
elastic. In Long run all the inputs are variable. So production of a commodity
can be increased by employing more of both variable and fixed inputs.

Production Function:
Production function is a tool of analysis used to explain the input-output
relationship. It deals with the quantitative relationships between inputs and
output. So production of commodity depends on certain specific inputs.
-For convenience and simplicity, economist have reduced the number of
variable in the production function into two such as capital(K) and labor(L)
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Assumptions of a Production function:-
1. Perfect divisibility of both inputs and output.
2. There are only two factors of production-labor and capital.
3. Limited substitution of one factor for the other.
4. A given technology.
5. Inelastic supply of fixed factors in the short-run.

Cobb-Douglas Production Function:-

-In the Cobb-Douglas(C.W.Cobb &Paul H.Douglas) production function- the
marginal product of labor decreases as the amount of labor input increases and
it increases as the amount of capital increases.
-In the same way, the marginal product of capital decreases as the amount of
capital input increases.
-According to this production function constant return can be ensured by
increasing the inputs in the same proportion.
-Formula for Cobb-Douglas Production Function: Q =ALª Kβ
L- labour , K- capital
A- total factor productivity (real output per unit of inputs. A= Q\Lª Kβ) ,
β
ª - output elasticity of labour , - output elasticity of capital
Assumption of Cobb-Douglas Production:-
i. The inputs and outputs are divisible.
ii. Each type of input can be substituted by another to a certain extent.
iii. Technology remains constant level.
iv. The supply of variable inputs is elastic and supply of fixed inputs is
inelastic in both the short-run and long-run.
Limitation of Cobb-Douglas Production Function:-
1. This production function includes only two factor inputs like labor and
capital.
2. It assumes constant returns to scale. But it is not possible in general.
3. It assumes that there is perfect competition in the factor market. Which is
unrealistic.
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The Laws of Production
The theory of production studies the marginal input-output relationship under
short-run and long-run conditions. In short run input-output relations are studied
with one variable input and other inputs remain constant. The laws of
production under this conditions are called “The Laws of Variable
Proportions”. In the long run input-output relations are studied assuming all the
input to be variable. So long run input-output relations studied under “ Laws of
return to scale”.
1. Short- run Law of Production.
In the short-run the firm can employ varying quantities of variable inputs
against a given quantity of fixed factors. The laws which bring out the
relationship between varying factor propositions and output are known as the
law of diminishing return.
The law of diminishing returns :- It states that when more and more units
of a variable input are applied to a given quantity of fixed inputs, the total
output may initially increase at an increasing rate and then at a constant rate but
it will eventually increasing at diminishing rates.
-That is the marginal increase in total output eventually decreases when
additional units of variable factors are applied to a given quantity of fixed
factors.
Assumptions for law of diminishing return :-
1. The state of technology remain unchanged.
2. Labor is homogeneous., 3. Inputs prices are given.
Three stages of Production and law of returns to Scale in one
variable inputs:-

Stage 1:- Total product increases at increasing rate. This is indicated by the
rising marginal product till the employment of the 5 th worker because 6th worker
produced as much as the fifth worker. The 5 th and 6th workers represents an

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intermediate stage of constant returns to the variable factors. This stage shows
the law of increasing return.
-The main reason for this type of return is the indivisibility of fixed factor
( capital). It is due to the under utilization of capital if labor is less than its
optimum number.
-Suppose labor-capital combination is 1:6. If capital is indivisible and less than
6 workers are employed ,then capital remain under-utilized.
-Once the optimum capital-labor ratio is reached then employing additional
workers leads to per worker marginal productivity decreases.

Stage II :- Total product continues to increase but at diminishing rates ie,

marginal product begins to decline. In this stage shows law of diminishing
return to the variable factor. In this level total output reaches its maximum
level.
-Law of diminishing returns is an empirical law .This law may not apply
universally to all kinds of productive activities. So it not true as the law of
gravitation. This law is more operational in agricultural production.

Stage III :- In this stage total product begins to decline. The average product
continues to decline. This stage shows law of Negative returns.
Marginal , Average and Total Product :-
Marginal Product:- It refers to the product of the additional one unit of labor
employed in Production.
Average Product:- It refers to the output for one unit of labor. This can be
understand by dividing the total output by the number of units of labor
employed in production.
Total Product:- It refers total output of labor in production.

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Profit Maximization with One variable input:-
The firm can employ 10 workers only if workers are available free of cost.
When company pay wages to the workers ‘how many workers will firm
employ ?.
-Workers can employed depends on the output that maximizes firm’s profit.
-Profit is maximum when Marginal revenue(MR)= Marginal cost (MC).

No.of workers Total product Marginal product Average Product Stages of Production
(N) (TP1) (MP1) (AP1)
1 24 24 24 I
2 72 48 36
3 138 66 46 Increasing return
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66 II
8 528 66 66
Diminishing
9 576 48 64 return
10 600 24 60
11 594 -6 54 III
12 552 -42 46 Negative return
Table:1- Three Stages of Production.

2. Long Term Laws of Production :-

-It discuss the relationship between inputs and output under the condition
that both the inputs: capital , labor are variable factors. This is long run
phenomenon.
- In the long run supply of both the inputs is supposed to be elastic and firms
can hire larger quantities of both labor and capital.
The technological relationship between changing scale of inputs and output
is explained under the law of return to scales.
-The laws of returns to scale can be explained through Iso-quant curve
technique.
The Law of Returns to Scale

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 The laws of returns to scale operates in the long period. It explains the
production behaviour of the firm under the conditions when both the inputs
(labour and capital) are variable and they can be increased proportionately.
when there is a proportionate change in the amounts of. inputs, the behaviour
of output varies.
The output may increase by a great proportion, by in the same proportion or
in a smaller proportion to its inputs.
-This behaviour of output with the increase in scale of operation is termed as
increasing returns to scale, constant returns to scale and diminishing returns
to scale. The below figure shows returns to scale:

RS = Returns to scale curve

RP = Segment; increasing returns to scale
PQ = segment; constant returns to scale
QS = segment ; decreasing returns to scale

Stage:1- Increasing return to Scale : There is more than proportionate increase in out put
when compared to increase in inputs. During this stage, the firm enjoys various internal and
external economies (advantages) such as, economies of specialization, technical economies,
managerial economies and marketing economies.

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 Stage: II – Constant return to Scale : Out put increases in the same proportion as the
increase in inputs.During this stage, the economies in the first stage start vanishing and
diseconomies arise. Diseconomies refers to the limiting factors for the firm’s expansion.
Emergence of diseconomies is a natural process when a firm expands beyond certain stage.

Stage-III - Decreasing returns to Scale : The output increases in smaller proportion than
the increase in inputs.This situation arises when a firm expands its operation even after the
point of constant returns. Decreasing returns mean that increase in the total output is not
proportionate according to the increase in the input.Because of this, the marginal output starts
decreasing. Important factors that determine diminishing returns are managerial inefficiency
and technical constraints.

Isoquant Curve:-
The term isoquant is derived from the greek word ‘Iso’ means equal and Latin
word ‘quantus’ means quantity. So Isoquant curve is also known as Equal
Product Curve or Production Indifference Curve. An Isoquant curve is locus of
points representing various combinations of two inputs – capital and labor –
yielding the same output.

Combination Factor C units Factor L Units Output -Units

A 10 10 100
B 8 15 100
C 6 22 100
D 4 32 100
Table- 2 Capital Labor Combination and Output

12 A
10
8 B
Capital

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 6 C D
4 Isoquant( 100 units)
2
0
10 15 20 25 30 35
Labour

Properties of Isoquants:-
1. Isoquants have a negative slop or slop downwards:- It shows an increase
in employment of one factor of production and other factor decrease.
2. Isoquants are convex to the origin:- Marginal rate of technical
substitution is the rate at which one input factor is substituted by another
input factor in order to get the same output. The slop of Isoquants indicate
the rate of technical substitution. Formula for marginal rate of technical
substitution is MRTS = ΔC /ΔL (change in capital and labour.).
3. Isoquants cannot intersect or be tangent to each other:- The Isoquants
cannot cut each other. Because particular combination of inputs cannot
produce different levels of output.

Isocost Curve
It means different combinations of inputs which a firm can buy, given a certain
amount of money .The below figure shows that the firm may spend Rs 1000 for
10 unit of capital and 25 units of labor so on.

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 14 Isocost curve - Rs.1000
Capital
10

0 15 25 35
Labour

Economies of Scale
The term economies of scale refers to the benefits of large scale operation.
When a firm expands its size or increase the scale of operation the average cost
of production decreases and it ultimately leads to profit maximization.
Economies of scale are grouped into two internal and external economies.

Internal Economies:- Internal economies are associated with the size of the
business. Internal economies are: technical economies, labor economies ,
managerial economies , commercial economies, financial economies and risk-
bearing economies. The firm attains maximum economy when it operates at the
optimum level.

External Economies:- External economies refer to the benefits common to

all the firms located in a particular area.
External economies are such as:-
-Improvement in transportation and communication facilities.
-Development of banking system and increase of credit facilities.

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 -Establishment of firms for supply of raw materials.
- Establishment of technical institutions and training centres etc…

Diseconomies of Scale
The economies of scale will not remain always. When a firm expands
beyond optimum size lead to loses of economies of scale. The loss due to the
increase in the scale of operation is known as diseconomies of scale.
For eg: when number of workers are more than optimum.

Optimum Combinations of Inputs

The combination which is most economical or which bears the least cost is the
optimum input combination. The optimum input combination is found out with
the help of isoquant and isocost curves. The least cost input combination lies at
the point of tangency between the isoquant curve and isocost curve.

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 Y A Isoquant
I

C R
K1

E Isocost
Z
K
S
Q -100Units
K2

F D B
0
L1 L L2 X
Rs.100
It is clear that in the three feasible combinations , the one on the Isocost line
CD ie, Z is least cost input combinations.

Resource Allocation
In economics resource allocation is the assignment of available resources to
various uses.  Resource allocation is the process of assigning
and managing assets in a manner that supports an organization's strategic goals.
Resource allocation involves balancing competing needs and priorities and
determining the most effective course of action in order to maximize the
effective use of limited resources and gain the best return on investment. 
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Cost Analysis
In economics, the Cost Analysis refers to the measure of the cost – output
relationship, i.e. the economists are concerned with determining the cost
incurred in hiring the inputs and how well these can be re-arranged to increase
the productivity (output) of the firm. In other words, the cost analysis is
concerned with determining money value of inputs (labor, raw material), called
as the overall cost of production which helps in deciding the optimum level of
production.

Types of cost concepts in Economics:

1.Fixed Cost 8. Incremental Cost

2. Variable Cost 9. Sunk Cost
3. Total Cost 10. Historical Cost
4. Average Cost 11.Replacement Cost
5. Marginal Cost 12. Private Cost
6. Short-run Cost 13. Social Cost
7. Long-Run Cost

Fixed Cost
The Fixed Cost is the cost that remains fixed for a certain volume of output. In
other words, the cost that does not change with the change in the output or sales
revenue.

Variable Cost
The Variable cost is the cost proportionally related to the level of output, i.e. it
increases with the increase in the production and contracts with the decrease in
the total output. It means, the cost which varies with the change in the total
output is called the variable cost.

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Total Cost
The Total Cost is the actual cost incurred in the production of a given level of
output.

Average Cost
The Average Cost is the per unit cost of production obtained by dividing the
total cost (TC) by the total output (Q). By per unit cost of production, we mean
that all the fixed and variable cost is taken into the consideration for calculating
the average cost. Thus, it is also called as Per Unit Total Cost.

Marginal Cost
 
The Marginal Cost refers to the change in the total cost as a result of the
production of one more unit of the product. In other words, the marginal cost is
the increase or decrease in the total cost due to the production of one additional
unit of the product.

Short-run Cost
The Short-run Cost is the cost which has short-term implications in the
production process, i.e. these are used over a short range of output. These are
the cost incurred once and cannot be used again and again, such as payment of
wages, cost of raw materials, etc.

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Long-run Cost
The Long-run Cost is the cost having the long-term implications in the
production process, i.e. these are spread over the long range of output. These
costs are incurred on the fixed factors, Viz. Plant, building, machinery, etc. but
however, the running cost and the depreciation on plant and machinery is a
variable cost and hence is included in the short-run costs.

Incremental Cost
The Incremental Cost refers to the additional cost that a company incurs in
undertaking certain actions such as expanding the level of production or adding
a new variety of product to the product line, etc.

Sunk Cost
A Sunk Cost is the cost already incurred by the firm and cannot be recovered or
refunded. The cost which was incurred in the past and is now permanently lost
is called as a Sunk Cost.

Historical Cost
The assets and liabilities recorded in the balance sheet with its original
acquisition cost, the i.e. amount spent at the time of its acquisition are called as
the Historical Cost. In other words, the historical cost is an accounting method
in which the assets of the firm are recorded in the books of accounts at the same
value at which it was first purchased.

Replacement Cost
The Replacement Cost is the cash outlay that firm has to pay in order to
replace an old asset at the current market price. Simply, the amount paid to

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replace the existing property with the new one having the similar utility, without
considering the depreciation constitutes the replacement costs.

Private Cost
The Private Cost is the cost related to the working of the firm and is used in the
cost-benefit analysis of the business decisions. These costs are borne by the firm
itself.

Social Cost
The Social Cost is the cost related to the working of the firm but is not
explicitly borne by the firm instead it is the cost to the society due to the
production of a commodity. The social cost is used in the social cost-benefit
analysis of the overall impact of the operations of the business on the society as
a whole and do not normally figure in the business decisions.

Long run and short run cost functions

A cost function is a function of input prices and output quantity whose value is

the cost of making that output given those input prices. Companies often use

the cost curve to minimize cost and maximize production efficiency.

In the long run, the firm can vary all its inputs. In the short run, some of these

inputs are fixed. The firm is constrained in the short run, and not constrained in

the long run. The long run cost TC(y) of producing any given output y is not

greater than the short run cost STC(y) of producing that output.

ie : TC(y)   STC(y) for all y.

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In short run one of the firm's inputs is fixed. The firm uses two inputs, and the

amount of input 2 is fixed at k (2(L):1(C)). For many (but not all) production

functions, there is some level of output, say y0, such that the firm

would choose to use k units of input 2 to produce y0, even if it were free to

choose any amount it wanted. For this level of output, the short run total cost,

when the firm is constrained to use k units of input 2 is equal to the long run

total cost: STCk(y0) = TC(y0). We generally assume that for any level at which

input 2 is fixed, there is some level of output for which that amount of input 2 is

appropriate. so : TC(y) = STCk(y) for some y.

The below figure shows the relations between STC and TC.

Examples of long run and short run cost functions

Cost price

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 Cost price is the total amount of money that it costs a manufacturer to produce a

given product or provide a given service. A cost price includes all outlays that

are required for production, including property costs, materials, power, research

and development, testing, worker wages and anything else that must be paid for.

Cost-Output Relationship

A proper understanding of the nature and behavior of costs is a must for

regulation and control of cost of production. The cost of production depends on

money forces and an understanding of the functional relationship of cost to

various forces will help us to take various decisions. Output is an important

factor, which influences the cost.

The cost-output relationship plays an important role in determining the optimum

level of production. Knowledge of the cost-output relation helps the manager in

cost control, profit prediction, pricing, promotion etc. The relation between

cost and its determinants is technically described as the cost function.

C= f (S, O, P, T ….)

Where;

 C= Cost (Unit or total cost)

 S= Size of plant/scale of production

 O= Output level

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 P= Prices of inputs

 T= Technology

Considering the time period the cost function can be classified as (1) short-run

cost function and (2) long-run cost function. In economic theory, the short-run

is defined as that period during which the physical capacity of the firm is fixed

and the output can be increased only by using the existing capacity allows to

bring changes in output by physical capacity of the firm.

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