Theory of Production

Theory of Production: Meaning and Concept of Production, Factors of

Production and Production function. Fixed and Variable Factors, Law of Variable
Proportion (Short Run Production Analysis), Law of Returns to a Scale (Long
Run Production Analysis) through the use of ISO QUANTS.
Concept of Cost, Cost Function, Short Run Cost, Long Run Cost, Economies
and Diseconomies of Scale, Explicit Cost and Implicit Cost, Private and Social
Cost
 CONCEPTS
• INPUT
• OUTPUT
• FIXED INPUTS
• VARIABLE INPUTS
• SHORT RUN
• LONG RUN
• TP, MP, AP
 Factors of Production
• Variable Factors are the factors that can be changed during
the course of the short run. Variable factors vary with the
level of output. An increase in variable factors leads to
more production and vice-versa. Employment of variable
factors is not required when there is no production.
Variable factors include labour, power, fuel, etc.
• Fixed Factors are the factors that can not be changed in the
short run. The number of fixed factors always remains
constant even when is zero production. Fixed factors include
land, capital, building, etc.
•
• Graphical Representation of Production
Function
• For example, When there are 4 units of labour
and 5 units of capital, the equation for the
production function is Q = f(4,5).
 PRODUCTION FUNCTION
• In economics, a production function is a
mathematical formula that shows the
relationship between the physical inputs and the
output of a production process. It measures how
efficiently a firm can produce output using
specific inputs.
• We can write the production function as :
• q = f (L,K)
• whereas, L is labour and K is capital and q is the
utmost output that can be manufactured.
 Types of Production Function

• Production function on the basis of the time period can be divided into two
categories: Short Run Production Function and Long Run Production Function. In
these production functions, the combination and behaviour of variable factors and
fixed factors are different.
• 1. Short Run Production Function: Short Run is a period of time where output can
only be changed by changing the level of variable inputs. In the short run, some
factors are variable and some are fixed. Fixed factors remain constant in the short
run like land, capital, plant, machinery, etc. Production can be raised by only
increasing the level of variable inputs like labour. Therefore, the situation where
the output is increased by only increasing the variable factors of input and keeping
the fixed factors constant is termed as Short Run Production Function. This
relationship is explained by the ‘Law of Variable Proportions.’
• 2. Long Run Production Function: Long Run is a span of time where the output can
be increased by increasing all the factors of production whether it is fixed (land,
capital, plant, machinery, etc.) or variable (labour). Long run is enough time to
alter all the factors of production. All factors are said to be variable in the long run.
Therefore, the situation where the output is increased by increasing all the inputs
simultaneously and in the same proportion is termed Long Run Production
Function. This relationship is explained by the ‘Law of Returns to Scale.’
 PRODUCTION FUNCTION
• A long run production function is a model that shows how
to produce a given level of output when all factors of
production can be changed simultaneously and in the same
proportion. It's based on the theory of returns to scale.
• In the long run, companies can adjust the quantities of all
inputs, including labor, capital, and raw materials, to
maximize output and optimize their production process.
• The long run production function differs from the short run
production function, which is the relationship between the
quantity of output and a specific variable input. In the short
run, only one factor is variable, while the others remain
fixed.
 Features of Production Function

• 1. Complementary: A producer will have to combine the

inputs to produce outputs. Outputs can not get generated
without the use of inputs.
• 2. Specificity: For any given output, the combination of
inputs that may be used is clearly defined. What type of
factors are needed for the production of a particular
product is clearly mentioned before the actual production
gets started.
• 3. Production Period: The period of the production process
is clearly explained to the production unit. Each stage of
production is given some specific time. Production
generally gets completed over a long period of time.
 LAWS OF PRODUCTION
• SHORT RUN LAWS OF PRODUCTION/ ONE
VARIABLE FACTOR/LAW OF VARIABLE
PROPORTIONS/ LAW OF RETURNS TO
VARIABLE INPUT

• LONG RUN LAWS OF PRODUCTION/ LAW OF

RETURNS TO SCALE
 THE LAW OF VARIABLE PROPORTION
• Returns to a Factor: The Law of Variable Proportions

Consider a situation when land is a fixed factor and labour is a variable factor, and the farmer
is producing wheat. Since land is a fixed factor, he can produce more of wheat only by using
more and more of labour.
• Here comes an important question: Will every additional unit of labour employed on the
given land yield the same amount of additional output of wheat? In other words, will MP
of the labour remain constant for each and every additional unit of labour employed?
• If MP of labour was to remain constant (no matter how much of labour is employed), then a
country like India would have produced more and more of wheat using more and more of
labour on the same piece of land. It would have never faced any food problem (or the
problem of unemployment). The fact of the matter is that MP must eventually diminish. The
logic is simple: always there is some ideal factor ratio. If L and K are the two factors and if K is
constant, the ideal ratio is struck by variation in the use of L. MP should be maximum, once
the ideal ratio is attained. But once the ideal ratio is reached, any increase in L would mean
excessive employment of the variable factor. Or, it would mean I would mean over-
exploitation of the fixed factor. Accordingly, MP must start declining. We may ultimately
reach a point when another additional unit of labour (on the same land) adds nothing to total
output. Implying that MP, becomes zero. In exceptional situations, MP may even become
negative, as noted earlier. This is the essence of the law of variable proportions or the law of
diminishing returns.
• CAN MP EVER RISE? Yes, MP of the variable factor can
rise, but only in a situation when the fixed factor is not
fully utilised.

• If ideally, 4 full time workers are needed to cultivate 2

hectares of land, MP, may increase when initially less
than 4 workers are employed. MP should be maximum
when 4 workers are employed, and must start
diminishing when more than 4 workers are employed.
• Causes of Increasing Returns to a
Factor:
• (1) Fuller Utilisation of the Fixed Factor:
In the initial stages, fixed factor (such as
machine) remains underutilised. Hence,
initially (so long as fixed factor remains
underutilised) additional units of the
variable factor add more and more to
total output, or marginal product of the
variable factor tends to increase.
• (2) Division of Labour and Increase in
Efficiency: Additional application of the
variable factor (Labour) enables
process-based division of labour.
Specialised workers may be used for
different processes of production. This
increases efficiency or productivity of
the variable factor. Accordingly,
marginal productivity tends to rise.
• (3) Better Coordination between the
Factors: So long as fixed factor remains
underutilised, additional application of
the variable factor tends to improve the
degree of coordination between the
fixed and variable factors. As a result,
marginal product (MP) increases and
total product (TP) increases at the
increasing rate.
 Causes of Diminishing Returns to a
Factor
• (1) Fixity of the Factor: Fixity of the factor(s) is the principal cause
behind the law of diminishing returns. As more and more units of
the variable factor are combined with the fixed factor, the latter
gets excessively utilized. It suffers greater wear & tear and loses its
efficiency. Hence, the diminishing returns.
(2) Imperfect Factor Substitutability: Factors of production are
imperfect substitutes of each other. More and more of labour
cannot be continuously used in place of capital. Accordingly,
diminishing returns are bound to set in if only the variable factor is
increased to increase output.
• (3) Poor Coordination between the Factors: Increasing application
of the variable factor (along with the fixed factor) eventually
disturbs the ideal factor ratio. This results in poor coordination
between the fixed and variable factors. Hence, the diminishing
returns.
 Returns to Scale
• For understanding Returns to Scale we need
to learn about ISOQUANT AND ISOCOST
 ISOQUANT CURVE
• An isoquant curve is locus of points representing various combinations
of two inputs-capital and labour-yielding the same output. A 'isoquant
curve' is analogous to an 'indifference curve', with two points of
distinction:
• (a) an indifference curve is made of two consumer goods while
isoquant curve is constructed of two producer goods (labour and
capital), and
• (b) while an indifference curve measures 'utility', an isoquant
measures 'output
Isoquant curves are drawn on the basis of the following assumptions:
• (i) there are only two inputs, viz., labour (L) and capital (K), to produce
a commodity X;
(ii) the two inputs-L and K-can be substituted one for another but at
diminishing rate; and
(iii) the technology of production is given and labour and capital can
be substituted only to a certain extent.

• The term 'isoquant' has been derived from the Greek word iso
meaning 'equal' and Latin word quan meaning 'quantity'. The 'isoquant
curve' is, therefore, also known as 'Equal Product Curve' 'Production
Indifference Curve'.
 Properties of Isoquants
• Isoquants have a negative slope. The negative slope of the isoquant implies
substitutability between the inputs. It means that if one of the inputs is reduced,
the other input has to be so increased that the total output
remains unaffected.
• Isoquants are convex to the origin. Convexity of isoquants implies not only the
substitution between the inputs but also diminishing marginal rate of technical
substitution (MRTS) between the inputs. The MRTS is defined as
MRTS = - (ΔK / ΔL) = slope of the isoquant
In plain words, MRTS is the rate at which one input can substitute the other,
output remaining the same. This rate is indicated by the slope of the isoquant. The
MRTS decreases for two reasons: (i) no factor is a perfect substitute for another,
and (ii) inputs are subject to diminishing marginal return. Therefore, more and
more units of an input are needed to replace each successive unit of the other
input.
• Isoquants do not intersect nor are tangent to each other. The intersection or
tangency between any two isoquants implies that a given quantity of a commodity
can be produced with a smaller as well as a larger input- combination.
• Upper Isoquant represents higher level of output
 Isoquant map, ridge lines and
economic region
• An isoquant map is a graph that shows multiple
isoquants, each representing a different
quantity of output.

• The upper ridge line indicates zero marginal

product of capital, and the lower ridge line
indicates zero marginal product of labor. The
ridge lines A and B demarcate the technically
efficient region of production. Above the line
OA and below the line OB slope of the isoquants
is positive which means that increases in both
capital and labour are required to produce a
given fixed quantity of output. The ridge lines
are the combination of points where marginal
product (MPLK) of one of the factors is zero.

• The economic region of production is the area

between the ridge lines, where both inputs
have positive marginal products. Production
outside the ridge lines is considered inefficient.
Other forms of Isoquants
 Kinked or Linear Programming
Isoquants
• Let us suppose that for producing 10 units of a commodity,
X, there are four different techniques of production
available. Each techniques has a different fixed factor-
proportion, as given in Table 7.3.
• The four hypothetical production techniques, as presented
in Table 7.3, have been graphically presented in Fig. 7.9.
The ray OA represents a production process having a fixed
factor-proportion of 10K: 2L. Similarly, the three other
production processes having fixed capital-labour ratios 6:3,
4:6 and 3:10 have been shown by the rays OB, OC and OD,
respectively. Points A, B, C and D represent four different
production techniques. By joining the points, A, B, C and D,
we get a kinked isoquant, ABCD.
 Isocost line
• An isocost line is a graph showing various possible combinations of
inputs (labor and capital) that can be purchased for an estimated
total cost. Any combination of inputs on an isocost line provides the
same total cost for the output.
• An isocost line is a graph that depicts potential input (labor and
capital) combinations that can be acquired at an estimated total
cost.
• The equation of the isocost line is:
• C=r×K+w×L
• The slope of line is marginal rate of exchanges(MRE) between K & L.
• -ΔK/ ΔL
•
 Importance of Least-Cost Combination
in Business Decision Making
• Business decision making
• When it comes to business decision making, finding the least-cost combination is crucial. It is the process of determining the optimal combination of
inputs required to produce a particular level of output, while minimizing the cost of production. This is where Isoquant Curve Analysis comes into
play. It is a graphical representation of the different combinations of two factors of production that can produce a certain level of output.
The analysis helps businesses to make informed decisions by comparing the cost of different production methods and choosing the most efficient
one.
• There are several reasons why finding the least-cost combination is important for businesses. Firstly, it helps in minimizing the cost of production,
which in turn leads to higher profits. By finding the optimal combination of inputs, businesses can reduce wastage and increase efficiency, lowering
the cost of production. Secondly, it helps businesses to remain competitive in the market. By producing goods at a lower cost, businesses can offer
their products at a more competitive price, attracting more customers and increasing their market share. Lastly, it enables businesses to allocate
their resources effectively. By analyzing the different combinations of inputs, businesses can determine the most effective way to allocate their
resources, ensuring they are being used in the most efficient way possible.
• To fully understand the importance of finding the least-cost combination, here are some key insights:
• 1. Helps in achieving economies of scale: Economies of scale occur when a business can produce goods at a lower cost due to an increase in
production. By finding the least-cost combination, businesses can produce more goods at a lower cost, which leads to higher economies of scale.
Higher economies of scale lead to increased profits and a competitive advantage in the market.
• 2. Increases profitability: Finding the least-cost combination helps businesses to reduce their production costs, which increases their profitability. By
lowering the cost of production, businesses can offer their products at a more competitive price, which leads to an increase in demand and
ultimately, higher profits.
• 3. Enables effective resource allocation: By analyzing the different combinations of inputs, businesses can determine the most effective way to
allocate their resources. This ensures that resources are being used in the most efficient way possible, reducing wastage, and increasing efficiency.
• 4. Allows for flexibility in production: By finding the least-cost combination, businesses can be more flexible in their production methods. They can
produce goods in a variety of ways, choosing the one that is most efficient and cost-effective. This allows businesses to adapt to changing
market conditions and consumer demand.
• Finding the least-cost combination is crucial for businesses. It helps in minimizing the cost of production, remaining competitive in the market,
and allocating resources effectively. By using Isoquant Curve Analysis, businesses can make informed decisions and optimize their production
methods, leading to higher profits and a competitive advantage in the market.
LONG-TERM LAWS OF PRODUCTION-II:
LAWS OF RETURNS TO SCALE
• The laws of returns to scale state the behaviour of output in
response to a proportional and simultaneous change in
inputs.
• Increasing inputs proportionately and simultaneously is, in
fact, an expansion of the scale of production.
• When a firm expands its scale, i.e., it increases both the
inputs proportionately, then there are three technical
possibilities:
(i) total output may increase more than proportionately;
• (ii) total output may increase proportionately; and
(iii) total output may increase less than proportionately.
 Economies of Large Scale
• The main reason behind Increasing Returns to Scale is Economies of
Large Scale. Economies mean the benefits because of the large
scale of production. Economies of scale are of two types; viz.,
Internal Economies and External Economies.
• Internal Economies: Internal Economies means the benefits of
large-scale production available to an organisation within its own
operation. For example, Managerial Economies are achieved by
dividing labour and specialisation.
• External Economies: External Economies mean the benefits of
large-scale production shared by all the firms of an industry when
the industry as a whole expands. For example, better infrastructural
facilities, better transportation, etc.
 Diseconomies of Large Scale
• The main reason behind Diminishing Returns to Scale
is Diseconomies of Large Scale. Diseconomies of Scale mean that
the firm has now become so large that it has become difficult to
manage its operations. Diseconomies of Scale are of two types; viz.,
Internal Diseconomies and External Diseconomies.
• Internal Diseconomies: Internal Diseconomies means the
disadvantages of the large-scale production that a firm has to suffer
because of its own operations. For example, Technological
Diseconomies because of the heavy cost of wear and tear.
• External Diseconomies: External Diseconomies mean the
disadvantages of large-scale production that all the firms of the
industry have to suffer when the industry as a whole expands. For
example, stiff competition, etc.
Assignment questions