Dr.

Prerna Jain

Production is the process of transformation of inputs into goods and services of utility to consumers and producers.

Technology It is one of the most important inputs in any production process. Technology determines the type, quantity and proportion of inputs. In a fully automated plant, more of machines and less of people would be needed, as compared to a partially automated or manually run plant. Technology determines the maximum limit of total output from a given combination of inputs.

Fixed and Variable Inputs Fixed input is one that cannot be varied in short run, e.g., land, machine, technology, skill set, etc. Variable Input is one that can be made to vary in the short run, e.g., raw material, unskilled/semi skilled labour etc.

Land in economics is defined as anything which is a gift of nature and not the result of human effort. Land not only includes the dry surface of earth, but also all natural resources on or under the earths surface like forests, rivers, minerals etc. Since these are fixed in supply therefore the return from land is called rent.

Labour : The physical or mental effort of human being that undertakes the production process is labour. The return of labour is termed as wages and salary.

Capital is that wealth which is used for further production, it is not a gift of nature, but is produced by human beings. Capital is the output of one production process that generally goes as input in another. Physical capital comprises of tangible resources like equipments, buildings, machines, and intermediary goods; Human capital constitutes of knowledge, skills and investments made by people through education, experience and training that help to produce more or better goods or services. Return for capital is interest.

Enterprise The ability and action to collect, coordinate and utilise all the factors of production for the purpose of economic gains is known as enterprise. The special feature of this factor of production is that the returns herein are expected, but not certain. All the other factors contribute to production process for definite returns, without any risk and uncertainity. Therefore entreprenurship is also defined as the ability to take risk. Hence the entrepreneurs remuneration is profit.

Production function is a technological relationship between physical inputs and physical outputs over a given period of time. A commodity may be produced by various methods using different combinations of inputs, with given state of technology. Ex: Cloth may be produced using cotton or silk or polymer as raw material with handloom, powerloom or even computerised machines. Thus, various types of raw materials and technology options will create several possible ways of producing the same product.

Normally a production function is written as:

Q= f (x1, x2, xn)
Q = f (L, K, l, R, E) Q = output; L = labour; K= capital; l = land, R = raw material, E = efficiency parameter

Technical Efficiency: Production of the maximum level of output that can be obtained from a given combination of inputs. Economic Efficiency: Production of a given amount of output at the lowest possible cost

In short run some inputs are like plant size, machine and equipments cannot be changed; therefore a producer trying to increase output in the short run will have to do so by increasing only the variable inputs. On the contrary, in the long run input options are very wide.

On the basis of such characteristic of inputs, production functions are normally divided into two broad categories: i) with one variable input or variable proportion production function; and ii) with two variable inputs.

In the short run producers have to optimise with only one variable input. Let us consider a situation in which there are two inputs, capital and labour, capital is the fixed and labour is the variable input

Law of variable proportions states that as the quantity of the variable factor is increased with other fixed factors, the marginal product and average product of the variable factor will eventually decline. With small increase in units of labour, capital being constant, extra units of labour manifests through an increase in output. But after a certain point when there are too many workers with fixed capital, a part of workforce becomes ineffective and the MP of labour starts falling.

As we increase units of labour, total output increases, but not necessarily at a constant rate. It is seen that in the beginning output increases at an increasing rate and finally it increases at a diminishing rate. Thus we have increasing marginal returns and diminishing marginal returns. However it must be understood that if one input is increased keeping others as constant, ultimately output will increase at a diminishing rate. Therefore law of variable proportions is also called as law of diminishing marginal returns.

Labour (00 units) 1 2 3

TP (000 tonnes) 20 50 90

MP 30 40

AP 20 25 30

Stages Increasing Returns

4
5 6

120
140 150

30
20 10

30
28 25

Diminishing Returns

7
8 9

150
130 100

0
-20 -30

21.5
16.25 11.1 Negative Returns

Increasing Returns to the variable factor: In this stage when additional units of labour are employed, the total output increases more than proportionally; so marginal product rises. Stage I would begin from the origin and continue to a point where APL attains its maximum value. In this range MP>0 and MP>AP. This stage is known as increasing returns to the variable factor.

Diminishing Returns to the Variable factor: In the second stage, total output increases, but less than proportionate to increase in labour. Given the amounts of all other production factors, use of increasing amounts of a variable factor in a production process beyond some point will result in diminishing marginal returns in total output. In stage II, MP falls. Here both AP and MP are positive but declining. Here MP > 0 <AP. Thus TP is increasing at a diminishing rate.

Negative Returns to the Variable Factor: This is the stage in which MP < 0 and TP is falling. This is a technically inefficient stage of production and a rational firm will never operate in this stage.

NOTE : AP first rises then falls. When AP is increasing, MP is greater than AP. When AP is decreasing, MP is less than AP. The average must increase when the marginal is above the average and decrease when the marginal is below the average. If you have scored 6 and 8 in two tests, your average marks are 7. If in your third test marks are higher than 7 (marginal mark is above the average, so your average mark increases). Conversely, if your third test marks are less than 7, (the marginal grade is below the average your average falls) In production theory, if each additional worker adds more than the average, AP rises, if each additional worker adds less than the average, AP falls.

In the long run all the inputs are variable. Thus the firm has the opportunity to select that combination of inputs which maximises returns. An isoquant is the locus of all technically efficient combinations for producing a given level of output. Isoquants are similar in concept to indifference curves, the only distinction being that isoquants are different combination of two inputs that correspond to the same level of output.

Returns to scale refer to the degree by which the level of output changes in response to a given change in all the inputs in a production system. What would be the level of output when all inputs are increased by exactly the same proportion in the long run? There are three possible outcomes: constant returns, increasing returns and decreasing returns.

We shall illustrate the three outcomes in three different panels. Assume that the firm is using 2L and 2K respectively producing 50Q units of output, shown at point A in each of the panels. Doubling of each input would henceforth imply 4L and 4K respectively.

If a proportional increase in all inputs yields an equal proportional increase in output, then there would be constant returns to scale. That is, if Labour and capital are doubled in a production process, output also gets doubled. Panel a Doubling of inputs has lead to doubling of output from 50Q to 100Q to 150Q.

If a proportional increase in all inputs yields a less than proportional increase in output, then there is decreasing returns to scale. In other words if inputs are doubled, output is less than doubled. Panel b Doubling of inputs has lead to less than doubling of output from 50Q to 90Q to 125Q.

If a proportional increase in all inputs yields a more than proportional increase in output, the phenomenon is known as increasing returns to scale. Panel c Doubling of inputs has lead to more than doubling of output from 50Q to 150Q to 400Q.