Production Function

Contents:
1. Introduction

2. The Production Function

3. The Law of Variable Proportions

4. The Law of Returns to Scale

Introduction:
In traditional production theory resources used for the production of a
product are known as factors of production. Factors of production are now
termed as inputs which may mean the use of the services of land, labour,
capital and organization in the process of production. The term output
refers to the commodity produced by the various inputs.

Production theory concerns itself with the problems of combining various

inputs, given the state of technology, in order to produce a stipulated
output. The technological relationships between inputs and outputs are
known as production functions.

Production:
Production in economic, terms is generally understood as the
transformation of inputs into outputs. The inputs are what the firm buys,
namely productive resources, and outputs are what it sells. Production is
not the creation of matter but it is the creation of value. Production is also
defined as producing goods which satisfy some human want. Production is
a sequence of technical processes requiring either directly or indirectly the
mental and physical skill of craftsman and consists of changing the shape,
size and properties of materials and ultimately converting them into more
useful articles.

Methods of Production:
There are three methods of production:
a) Unit production

b) Mass production

c) Batch production

The unit production is otherwise known as job-order production. This type

of production is used for things which cannot be produced on large scale,
things of high artistic nature, i.e. production of exclusive goods. This is a
method to meet the individual requirements of customers. This type of
production requires lot of flexibility in operation.

Mass production uses mechanical aids for material handling. This type of
production requires specially planned layout, special purpose machines,
jigs and fixtures, automatic machines, etc. Mass production is continuous
production, i.e. it does not have any non-producing time.

Batch production is generally adopted in medium size enterprises. It is a

stage in-between unit production and mass production. It is bigger in scale
than unit production while it is smaller than mass production. In this type of
production, variety of products is manufactured in lots at regular interval.
Therefore, this is known as batch production. The theory of production
centres round the concept of production function which we explain now.

The Production Function:

The production function expresses a functional relationship between
quantities of inputs and outputs. It shows how and to what extent output
changes with variations in inputs during a specified period of time. In the
words of Stigler, “The production function is the name given to the
relationship between rates of input of productive services and the rate of
output of product.

It is the economist’s summary of technical knowledge.” Basically, the

production function is a technological or engineering concept which can be
expressed in the form of a table, graph and equation showing the amount
of output obtained from various combinations of inputs used in production,
given the state of technology. Algebraically, it may be expressed in the
form of an equation as

Q =f (L, M, N, К, T)…………. (1)

where Q stands for the output of a good per unit of time, L for labour, M for
management (or organisation), N for land (or natural resources), К for
capital and T for given technology, and refers to the functional relationship.

The production function with many inputs cannot be depicted on a diagram.

Moreover, given the specific values of the various inputs, it becomes
difficult to solve such a production function mathematically. Economists,
therefore, use a two-input production function. If we take two inputs, labour
and capital, the production function assumes the form

Q = f (L, K) ….(2)

The production function as determined by technical conditions of

production is of two types:
It may be rigid ox flexible. The former relates to the short run and the latter
to the long run.
The Nature of Production Function:
The production function depends upon the following factors:
(a) The quantities of inputs to be used.

(b) The state of technical knowledge.

(c) The possible processes of production.

(d) The size of the firm.

(e) The prices of inputs.

Now if these factors change the production function automatically changes.

Attributes of Production Function:

The following are the important attributes of production function:
(i) The production function is a flow concept.

(ii) A production function is a technical relationship between inputs and

outputs expressed in physical terms.

(iii) The production function of a firm depends on the state of technology

and inputs.

(iv) From the economic point of view, a rational firm is interested not in all
the numerous possible levels of output but only in that combination which
yields maximum outputs.

(v) The short run production function pertains to the given scale of
production. The long run production function pertains to the changing scale
of production.

The Short-Run Production Function:

In the short run, the technical conditions of production are rigid so that the
various inputs used to produce a given output are in fixed proportions.
However, in the short run, it is possible to increase the quantities of one
input while keeping the quantities of other inputs constant in order to have
more output. This aspect of the production function is known as the Law of
Variable Proportions. The short-run production function in the case of two
inputs, labour and capital, with capital as fixed and labour as the variable
input can be expressed as

Q=f (L,K)

where K refers to the fixed input. … (3)

This production function is depicted in Figure 1 where the slope of the

curve shows the marginal product of labour. A movement along the
production function shows the increase in output as labour increases, given
the amount of capital employed K;. If the amount of capital increases to K,
at a point of time, the production function Q = f (L, K 1) shifts upwards to Q
= f (L,K2 ), as shown in the figure.

On the other hand, if labour is taken as a fixed input and capital as the
variable input, the production function takes the form Q =f (KL) …(4)
This production function is depicted in Figure 2 where the slope of the
curve represents the marginal product of capital. A movement along the
production function shows the increase in output as capital increases, given
the quantity of labour employed, L2 If the quantity of labour increases to
L2 at a point of time, the production function Q = f (K,L 1) shifts upwards to
Q=f(KL2).

The Long-Run Production Function:

In the long run, all inputs are variable. Production can be increased by
changing one or more of the inputs. The firm can change its plants or scale
of production. Equations (1) and (2) represent the long-run production
function. Given the level of technology, a combination of the quantities of
labour and capital produces a specified level of output.

The long-run production function is depicted in Figure 3 where the

combination of OK of capital and OL of labour produces 100 Q. With the
increase in inputs of capital and labour to OK1 and OL1, the output
increases to 200 Q. The long-run production function is shown in terms of
an isoquant such as 100 Q.
In the long run, it is possible for a firm to change all inputs up or down in
accordance with its scale. This is known as returns to scale. The returns to
scale are constant when output increases in the same proportion as the
increase in the quantities of inputs. The returns to scale are increasing
when the increase in output is more than proportional to the increase in
inputs. They are decreasing if the increase in output is less than propor-
tional to the increase in inputs.

Let us illustrate the case of constant returns to scale with the help of our
production function.

Q = (L, M, N, К, T)

Given T, if the quantities of all inputs L, M, N, K are increased n-fold, the

output Q also increases и-fold. Then the production function becomes nQ –
f (nL, nM, nN, nK).

This is known as linear and homogeneous production function, or a

homogeneous function of the first degree. If the homogeneous function is
of the Kth degree, the production function is nk.Q = f (nL, nM, nN, nK) If k is
equal to 1, it is a case of constant returns to scale; if it is greater than 1, it is
a case of increasing returns of scale; and if it is less than 1, it is a case of
decreasing returns to scale.
Thus a production function is of two types:
(i) Linear homogeneous of the first degree in which the output would
change in exactly the same proportion as the change in inputs. Doubling
the inputs would exactly double the output, and vice versa. Such a
production function expresses constant returns to scale,

(ii) Non-homogeneous production function of a degree greater or less than

one. The former relates to increasing returns to scale and the latter to
decreasing returns to scale.

Conclusion:
The production function exhibits technological relationships between
physical inputs and outputs and is thus said to belong to the domain of
engineering. Prof. Stigler does not agree with this commonly held view. The
function of management is to sort out the right type of combination of inputs
for the quantity of output he desires.

For this, he has to know the prices of his inputs and the technique to be
used for producing a specified output within a specified period of time. All
these technical possibilities are derived from applied sciences, but cannot
be worked out by technologists or engineers alone. ‘The entrepreneurs also
provide productive services and they are far from standardized.

Some men can get gang of workers to do their best, others are better at
luring customers, still others at borrowing money, and each will have a
different production function. If we take account of activities such as selling,
settling strikes and anticipating future styles of product, it is clear that large
segments of what we mean by technique are matters of business
knowledge and talents, not to be acquired in the best engineering schools.”
The production function is, in fact, “the economist’s summary of
technological knowledge,” as pointed out by Prof. Stigler.

The Law of Variable Proportions:

If one input is variable and all other inputs are fixed the firm’s production
function exhibits the law of variable proportions. If the number of units of a
variable factor is increased, keeping other factors constant, how output
changes is the concern of this law. Suppose land, plant and equipment are
the fixed factors, and labour the variable factor.

When the number of laboures is increased successively to have larger

output, the proportion between fixed and variable factors is altered and the
law of variable proportions sets in. The law states that as the quantity of a
variable input is increased by equal doses keeping the quantities of other
inputs constant, total product will increase, but after a point at a diminishing
rate.

This principle can also be defined thus:

When more and more units of the variable factor are used, holding the
quantities of fixed factors constant, a point is reached beyond which the
marginal product, then the average and finally the total product will
diminish. The law of variable proportions (or the law of non-proportional
returns) is also known as the law of diminishing returns. But, as we shall
see below, the law of diminishing returns is only one phase of the more
comprehensive law of variable proportions.

Its Assumption:
The law of diminishing returns is based on the following
assumptions:
(1) Only one factor is variable while others are held constant.
(2) All units of the variable factor are homogeneous.

(3) There is no change in technology.

(4) It is possible to vary the proportions in which different inputs are

combined.

(5) It assumes a short-run situation, for in the long-run all factors are
variable.

(6) The product is measured in physical units, i.e., in quintals, tonnes, etc.
The use of money in measuring the product may show increasing rather
than decreasing returns if the price of the product rises, even though the
output might have declined.

It’s Explanation:
Given these assumptions, let us illustrate the law with the help of Table 1,
where on the fixed input land of 4 acres, units of the variable input labour
are employed and the resultant output is obtained. The production function
is revealed in the first two columns. The average product and marginal
product columns are derived from the total product column.

The average product per worker is obtained by dividing column (2) by a

corresponding unit in column (1). The marginal product is the addition to
total product by employing an extra worker. 3 workers produce 36 units and
4 produce 48 units. Thus the marginal product is 12 i.e., (48-36) units.
An analysis of the Table shows that the total, average and marginal
products increase at first, reach a maximum and then start declining. The
total product reaches its maximum when 7 units of labour are used and
then it declines. The average product continues to rise till the 4th unit while
the marginal product reaches its maximum at the 3rd unit of labour, then
they also fall. It should be noted that the point of falling output is not the
same for total, average and marginal product.

The marginal product starts declining first, the average product following it
and the total product is the last to fall. This observation points out that the
tendency to diminishing returns is ultimately found in the three productivity
concepts.

The law of variable proportions is presented diagrammatically in Figure 4.

The TP curve first rises at an increasing rate up to point A where its slope
is the highest. From point A upwards, the total product increases at a
diminishing rate till it reaches its highest point С and then it starts falling.
Point A where the tangent touches the TP curve is called the inflection
point up to which the total product increases at an increasing rate and from
where it starts increasing at a diminishing rate. The marginal product curve
(MP) and the average product curve (AP) also rise with TP. The MP curve
reaches its maximum point D when the slope of the TP curve is the
maximum at point A.

The maximum point on the AP curves is E where it coincides with the MP

curve. This point also coincides with point В on TP curve from where the
total product starts a gradual rise. When the TP curve reaches its maximum
point С the MP curve becomes zero at point F. When TP starts declining,
the MP curve becomes negative. It is only when the total product is zero
that the average product also becomes zero. The rising, the falling and the
negative phases of the total, marginal and average products are in fact the
different stages of the law of variable proportions which are discussed
below.

Three Stages of Production:

Stage-I: Increasing Returns:
In stage I the average product reaches the maximum and equals the
marginal product when 4 workers are employed, as shown in the Table 1.
This stage is portrayed in the figure from the origin to point E where the MP
curve reaches its maximum and the AP curve is still rising. In this stage, the
TP curve also increases rapidly.

Thus this stage relates to increasing returns. Here land is too much in
relation to the workers employed. It is, therefore, profitable for a producer to
increase more workers to produce more and more output. It becomes
cheaper to produce the additional output. Consequently, it would be foolish
to stop producing more in this stage. Thus the producer will always expand
through this stage I.

Causes of Increasing Returns:

1. The main reason for increasing returns in the first stage is that in the
beginning the fixed factors are larger in quantity than the variable factor.
When more units of the variable factor are applied to a fixed factor, the
fixed factor is used more intensively and production increases rapidly.

2. In the beginning, the fixed factor cannot be put to the maximum use due
to the non-applicability of sufficient units of the variable factor. But when
units of the variable factor are applied in sufficient quantities, division of
labour and specialization lead to per unit increase in production and the law
of increasing returns operates.

3. Another reason for increasing returns is that the fixed factors are
indivisible which means that they must be used in a fixed minimum size.
When more units of the variable factor are applied on such a fixed factor,
production increases more than proportionately. This points towards the
law of increasing returns.
Stage-II: Diminishing Returns:
It is the most important stage of production. Stage II starts when at point E
where the MP curve intersects the AP curve which is at the maximum.
Then both continue to decline with AP above MP and the TP curve begins
to increase at a decreasing rate till it reaches point C. At this point the MP
curve becomes negative when the TP curve begins to decline, table 1
shows this stage when the workers are increased from 4 to 7 to cultivate
the given land.

In figure 1, it lies between BE and CF. Here land is scarce and is used
intensively. More and more workers are employed in order to have larger
output. Thus the total product increases at a diminishing rate and the
average and marginal product decline. This is the only stage in which
production is feasible and profitable because in this stage the marginal
productivity of labour, though positive, is diminishing but is non-negative.

Hence it is not correct to say that the law of variable proportions is another
name for the law of diminishing returns. In fact, the law of diminishing
returns is only one phase of the law of variable proportions.

The law of diminishing returns in this sense has been defined by Prof.
Benham thus: “As the proportion of one factor in a combination of factors is
increased, after a point, the average and marginal product of that factor will
diminish.”

Its Causes: The Law in General Form:

But the law of diminishing returns is not applicable to agriculture alone;
rather it is of universal applicability. It is called the law in its general form,
which states that if the proportion in which the factors of production are
combined, is disturbed, the average and marginal product of that factor will
diminish.

The distortion in the combination of factors may be either due to the

increase in the proportion of one factor in relation to others or due to the
scarcity of one in relation to other factors. In either case, diseconomies of
production set in, which raise costs and reduce output.

For instance, if plant is expanded by installing more machines, it may

become unwieldy. Entrepreneurial control and supervision become lax, and
diminishing returns set in. Or, there may arise scarcity of trained labour or
raw material that leads to diminution in output.

In fact, it is the scarcity of one factor in relation to other factors which is the
root cause of the law of diminishing returns. The element of scarcity is
found in factors because they cannot be substituted for one another.

Mrs Joan Robinson explains it thus : “What the Law of Diminishing Returns
really states is that there is a limit to the extent to which one factor of
production can be substituted for another, or, in other words, that the
elasticity of substitution between factors is not infinite.” Suppose there is
scarcity of jute, since no other fibre can be substituted for it perfectly, costs
will rise with production, and diminishing returns will operate.

This is because jute is not in perfectly elastic supply to the industry. If the
scarce factor is rigidly fixed and it cannot be substituted by any other factor
at all, diminishing returns will at once set in. If in a factory operated by
electric power, there being no other substitute for it, frequent power
breakdowns occur, as is commonly the case in India, production will fall
and costs will rise in proportion as fixed costs will continue to be incurred
even if the factory works for less hours than before.
According to Wicksteed, the law of diminishing returns “is as universal as
the law of life itself.’ The universal applicability of this law has taken
economics to the realm of science.

Stage-III: Negative Marginal Returns:

Production cannot take place in stage III either. For in this stage, total
product starts declining and the marginal product becomes negative. The
employment of the 8th worker actually causes a decrease in total output
from 60 to 56 units and makes the marginal product minus 4. In the figure,
this stage starts from the dotted line CF where the MP curve is below the
A’-axis. Here the workers are too many in relation to the available land,
making it absolutely impossible to cultivate it.

The Best Stage:

In stage I, when production takes place to the left of point E, the fixed factor
is excess in relation to the variable factors which cannot be used optimally.
To the right of point F, the variable input is used excessively in Stage III.
Therefore, no producer will produce in this stage because the marginal
production is negative.

Thus the first and third stages are of economic absurdity or economic
nonsense. So production will always take place in the second stage in
which total output of the firm increases at a diminishing rate and MP and
AP are the maximum, then they start decreasing and production is
optimum. This is the optimum and best stage of production.

The Law of Returns to Scale:

The law of returns to scale describes the relationship between outputs and
scale of inputs in the long-run when all the inputs are increased in the same
proportion. In the words of Prof. Roger Miller, “Returns to scale refer to the
relationship between changes in output and proportionate changes in all
factors of production. To meet a long-run change in demand, the firm
increases its scale of production by using more space, more machines and
labourers in the factory’.

Assumptions:
This law assumes that:
(1) All factors (inputs) are variable but enterprise is fixed.

(2) A worker works with given tools and implements.

(3) Technological changes are absent.

(4) There is perfect competition.

(5) The product is measured in quantities.

Explanation:
Given these assumptions, when all inputs are increased in unchanged
proportions and the scale of production is expanded, the effect on output
shows three stages: increasing returns to scale, constant returns to scale
and diminishing returns to scale. They are explained with the help of Table
2 and Fig. 5.

1. Increasing Returns to Scale:

Returns to scale increase because the increase in total output is more than
proportional to the increase in all inputs.

The table reveals that in the beginning with the scale of production of (1
worker + 2 acres of land), total output is 8. To increase output when the
scale of production is doubled (2 workers + 4 acres of land), total returns
are more than doubled. They become 17. Now if the scale is trebled (3
workers + о acres of land), returns become more than three-fold, i.e., 27. It
shows increasing returns to scale. In the figure RS is the returns to scale
curve where R to С portion indicates increasing returns.

Causes of Increasing Returns to Scale:

Returns to scale increase due to the following reasons:
(i) Indivisibility of Factors:
Returns to scale increase because of the indivisibility of the factors of
production. Indivisibility means that machines, management, labour,
finance, etc. cannot be available in very small sizes. They are available
only in certain minimum sizes. When a business unit expands, the returns
to scale increase because the indivisible factors are employed to their
maximum capacity.

(ii) Specialisation and Division of Labour:

Increasing returns to scale also result from specialisation and division of
labour. When the scale of the firm is expanded there is wide scope of
specialization and division of labour. Work can be divided into small tasks
and workers can be concentrated to narrower range of processes. For this,
specialised equipment can be installed. Thus with specialisation, efficiency
increases and increasing returns to scale follow.

(iii) Internal Economies:

As the firm expands, it enjoys internal economies of production. It may be
able to install better machines, sell its products more easily, borrow money
cheaply, procure the services of more efficient manager and workers, etc.
All these economies help in increasing the returns to scale more than
proportionately.

(iv) External Economies:

A firm also enjoys increasing returns to scale due to external economies.
When the industry itself expands to meet the increased long-run demand
for its product, external economies appear which are shared by all the firms
in the industry.

When a large number of firms are concentrated at one place, skilled labour,
credit and transport facilities are easily available. Subsidiary industries crop
up to help the main industry. Trade journals, research and training centres
appear which help in increasing the productive efficiency of the firms. Thus
these external economies are also the cause of increasing returns to scale.

2. Constant Returns to Scale:

Returns to scale become constant as the increase in total output is in exact
proportion to the increase in inputs. If the scale of production in increased
further, total returns will increase in such a way that the marginal returns
become constant. In the table, for the 4th and 5th units of the scale of
production, marginal returns are 11, i.e., returns to scale are constant. In
the figure, the portion from С to D of the RS curve is horizontal which
depicts constant returns to scale. It means that increments of each input
are constant at all levels of output.

Causes of Constant Returns to Scale:

Returns to scale are constant due to:
(i) Internal Economies and Diseconomies:
But increasing returns to scale do not continue indefinitely. As the firm
expands further, internal economies are counterbalanced by internal
diseconomies. Returns increase in the same proportion so that there are
constant returns to scale over a large range of output.

(ii) External Economies and Diseconomies:

The returns to scale are constant when external diseconomies and
economies are neutralised and output increases in the same proportion.

(iii) Divisible Factors. When factors of production are perfectly divisible,

substitutable, and homogeneous with perfectly elastic supplies at given
prices, returns to scale are constant.

3. Diminishing Returns to Scale:

Returns to scale diminish because the increase in output is less than
proportional to the increase in inputs. The table shows that when output is
increased from the 6th, 7th and 8th units, the total returns increase at a
lower rate than before so that the marginal returns start diminishing
successively to 10, 9 and 8. In the figure, the portion from D to S of the RS
curve shows diminishing returns.
Causes of Diminishing Returns to Scale:
Constant returns to scale is only a passing phase, for ultimately returns to
scale start diminishing. Indivisible factors may become inefficient and less
productive. Business may become unwieldy and produce problems of
supervision and coordination. Large management creates difficulties of
control and rigidities. To these internal diseconomies are added external
diseconomies of scale.

These arise from higher factor prices or from diminishing productivities of

the factors. As the industry continues to expand, the demand for skilled
labour, land, capital, etc. rises. There being perfect competition, intensive
bidding raises wages, rent and interest. Prices of raw materials also go up.
Transport and marketing difficulties emerge. All these factors tend to raise
costs and the expansion of the firms leads to diminishing returns to scale
so that doubling the scale would not lead to doubling the output.

Conclusion:
For the management increasing, decreasing or constant returns to scale
reflect changes in production efficiency that result from scaling up
productive inputs. But returns to scale is strictly a production and cost
concept. Management’s decision on what to produce and how much to
produce must be based upon the demand for the product. Therefore,
demand and other factors must also be considered in decision making.