Theory of production

Production
Types of Inputs
Factors of Production
Production Function
Production Function with One Variable Input
Law of Variable Proportions
Production Function with Two Variable
Inputs
Producers Equilibrium

Production
The process of transformation of
resources (like land, labour, capital and
entrepreneurship)
into
goods
and
services of utility to consumers and/or
producers.
Goods includes all tangible items such
as furniture, house, machine, food, car,
television etc

Services include all intangible items,

like banking, education,
consultancy, transportation.

management,

Types of Inputs
Technology
determines the type, quantity and proportion
of inputs.
also determines the maximum limit of total
output from a given combination of inputs.
at any point of time, technology will be given;
impact of technology can be seen only over a
period of time.

Fixed and Variable Inputs

Variable input : that can be made to vary in
the
short
run,
e.g.
raw
material,
unskilled/semi skilled labour, etc.
Fixed input: that cannot be varied in the

Factors of Production
Land
Anything which is gift of nature and not the result of human
effort, e.g. soil, water, forests, minerals
Reward is called as rent

Labour
Physical or mental effort of human beings that undertakes
the production process. Skilled as well as unskilled.
Reward is called as wages/ salary

Capital
Wealth which is used for further production as machine/
equipment/intermediary good
It is outcome of human efforts
Reward is called as interest

Enterprise
The ability and action to take risk of collecting, coordinating,
and utilizing all the factors of production for the purpose of
uncertain economic gains
Reward is called as profit

Production Function
A technological relationship between
physical inputs and physical outputs over a
given period of time.
shows the maximum quantity of the
commodity that can be produced per unit
of time for each set of alternative inputs,
and with a given level of production
technology.
Normally a production function is written
as:
Q = f (L,K,I,R,E)
where Q is the maximum quantity of output
of a good being produced, and L=labour;
K=capital; l=land; R=raw material; E=

Production Function with One

Variable Input
Also termed as variable proportion production
function
It is the short term production function
Shows the maximum output a firm can produce
when only one of its inputs
Q f ( L,can
K ) be varied, other
inputs remaining fixed:
where Q = output, L = labour and KTP
=L fixed
f ( K ,Lamount
)
of capital

Total product isTPa function of labour:

AP

L
Average Product
(AP) is total product per unit of
variable input
L

TP
is Lthe

MPL =

Marginal Product (MP)

addition in total
output per unit change in variable input

Law of Variable Proportions

Labour
(00
units)
1
2
3
4
5
6
7
8

Total
Product
(000
tonnes)
20
TP
50
90
120
140
150
150
130

100

MP

AP

Stages

20 Increasing
returns
25
30
30
40
30 Diminishin
30
g returns
28
20
25
10
0 21.5
-20 16.3
11. Negative
returns
1

-30

As the quantity of the variable factor is increased with other

fixed factors, MP and AP of the variable factor will eventually
decline.
Therefore law of variable proportions is also called as
law of diminishing marginal returns.

Law of Variable Proportions

Total
Outpu
t

First stage

Increasing Returns to
the Variable Factor

TPL

MP>0 and MP>AP

Second stage

Labour

Total
Output Stage I

A*

Stage II

Stage
III

B*

C*
MPL

APL
Labour

Diminishing Returns
to a Variable Factor
MP>0 and MP<AP

Third Stage
Negative Returns
MP<0 while AP is
falling but positive
Technically inefficient
stage of production
A rational firm will
never operate in this
stage

Production Function with Two Variable

Inputs
Capital (Rs.
Labour
All inputs are variable in
long run and only two
inputs are used
Firm has the opportunity to
select that combination of
inputs which maximizes
returns
Curves
showing
such
production
function
are
called isoquants or isoproduct curves.
An isoquant is the locus of
all technically efficient
combinations of two inputs
for producing a given level

crore)

(00 units)

40
28
18
12
8

6
7
8
9
10

Characteristics of Isoquants

Downward sloping
Convex to the origin
A higher isoquant represents a higher output
Two isoquants do not intersect
Capita
l

Capital

C
B

Q2
Q0

Q1
Labour

Q1
Q2
Labour

Marginal Rate of Technical Substitution

Measures the reduction in one
input, due to unit increase in the
other input that is just sufficient to
Kof output.
maintain the
same
level
MRTS LK
L
It is also equal to the ratio of the
marginal product of one input to the
marginal product of other input

MRTS LK

K
MP
L
MPK
L

Isocost Lines
Total Cost is sum of Labour cost and
Capital cost
The isocost line
represents
the
Capita
locus
of
points
of
l
A
all the different
A
combinations of
A
two inputs that a
O
B B B
Labou
firm
can
procure,
r
given the total
The (absolute) slope of this line
is equal to the ratio of the input
cost and prices
prices.
of the inputs.
2

Producers Equilibrium
AB is the isocost line
Any point below AB is feasible but
not desirable

Capital
A
C

K*

D
O

L*

Q
Q2 3

Q1

Q0
B

Labou
r

Maximization of output
subject to cost constraint
Necessary condition for
equilibrium
Slope of isoquant = Slope of
isocost line

E is the point of tangency of Q2

with isocost line AB
Corresponds to the highest
level of output with given cost
function.
Firm would employ L* and K* units
of labour and capital
Q3 is beyond reach of the firm
Points C and D are also on the
same isocost line, but they are on
isoquant Q1, which is lower to Q2.
Hence show lower output.
E is preferred to C and D, which is
on the highest feasible isoquant.

Producers Equilibrium
Capital

A2
A

A1
K

E
S

O
L

B1 B

B2

Labou
r

Minimization of cost for a

given level of output
Necessary condition for
equilibrium
Slope of isoquant = Slope of
isocost line

Firm has decided the level output

to be produced shown by the
isoquant Q
Will be indifferent between
output combinations shown by
R, S, E on isquant Q.
Has to ascertain that combination
of inputs Labour and Capital which
minimizes the cost of production
Hence a map of isocost lines will be
prepared
The isocost lines are parallel to
each other because price of the
inputs is given.
A1B1 line is not feasible
It will use OK and OL of capital and
labour respectively, at point E
which is also on AB, the lowest
possible isocost line.
R, S are not desirable because they