Production Theory

Mahendra Budha Chhetri

Economics Department
Herald International College
Production
Function
Production Function
 Production Function
The production function shows the technical or mathematical relationship
between inputs used and the output produced by the firm. The equation is
expressed as follows:
Q = f (K, L, N, T, M, t …)
Where,
Q = Output, K = Capital, L = Labor, N = Land, T = Technology, M = Materials, t
= Time
Now the production function can be expressed as;
Q = f (K, L)
Types of Production
Function
1. Short-Run Production Function
2. Long run Production Function
Short-Run Production Function:
It refers to the short period of time. In production theory, it refers to
the period of time during which at least one input remains fixed while
other inputs are variable. The short run production function may be
expressed as;
Q = f (KK, L)
Where,
KK = Fixed input, capital and
L = Variable input, labor.
 Long-Run Production Function

It refers to the long period of time. In production theory, it refers to

the period of time during which all inputs are variable. The long run
production function may be written as:
Q = f (K, L)
Where both Labor (L) and Capital(K) are variable inputs.
Concept of Total Product (TP),
Marginal Product (MP) and
Average Product (AP)
Total Product (TP):
The total volume or quantity of goods and services produced by a firm
with a given amount of factor inputs and technology over a given time
period is known as total product.
TP = ∑MP
 Average Product (AP):
•
Average product is the per unit product of the variable factor. In other
words, average product is obtained by dividing total product by the total
units of variable factor used. Thus,
AP
Where,
L = Labor, i.e., units of variable factor.
Marginal Product (MP):
Marginal
• product is defined as the change in total product resulting from the employment
of an additional unit of a variable inputs i.e. labor.
MP
Where,
ΔTP=Change in total product
ΔL = Change in units of labor
It can also be expressed as,
MP = TPn – TPn-1
Where,
TPn = Total product at nth units of variable inputs.
TPn-1 = Total product at (n-1)th units of variable inputs.
LAW OF VARIABLE PROPORTION
LAW OF VARIABLE PROPORTION

This is the short run analysis of production

theory. The law of variable proportion says that if
some factors are held constant and more and
more units of a variable factor are employed, the
marginal product of the variable factor
eventually decreases.
The law is based on the following assumptions:
 The technology of production is given and unchanged.
 At least one factor of production should be fixed or can’t be changed.
 It is assumed that labor is a single variable factor.
 All units of variable factor, labour, are homogeneous or of same quality; and
 There must be possibility of varying the proportion of factors of production.

Let us take a case of commodity X which requires two inputs – fixed input,
capital (K) and variable input, labor (L). The law of variable proportion has
been shown in the following table and figure.
Units of Total Marginal Average
Units of product of labor product of
Capital Product Stages
Labor (L)
(K) (TP) (MPL) labor (APL)

10 1 10 10 10 Stage–I
10 2 30 20 15 (Increasing
10 3 60 30 20 Returns)
10 4 80 20 20
10 5 90 10 18 Stage–II
(Diminishing
10 6 90 0 15 Returns)
Stage–III
10 7 80 -10 11.4 (Negative
Returns)
K L TP MPL APL

10 1 10 10 10

10 2 30 20 15

10 3 60 30 20

10 4 80 20 20

10 5 90 10 18

10 6 90 0 15

10 7 80 -10 11.4
Stage I. Stage of Increasing Return: The stage
I of production ranges from origin to the point
where the AP is maximum. In this stage TPL
rises at an increasing rate up to the point of
inflexion. After this, TP starts to rise at a
decreasing rate. Here AP is increasing but less
than MP. After point of inflexion MP starts to
decline but is greater than AP. When AP=MP
attends stage I is over. This stage indicates the
rising average product for the variable factor.
A rational producer will not operate in this stage
because the producer always has an incentive to
expand through Stage I of labour because rising
APL means the average cost decreases as output
is increased. It is a non-economic range.

Causes of Increasing Return:

 The division and specialization of variable
factor increase its efficiency.
 The fixed inputs are also utilized more
intensively and effectively thereby raising
their efficiency.
Stage II. Stage of Diminishing Returns:
Stage II of production begins when
average product curve starts decline and
ends when marginal product becomes
zero or total product reaches its maximum
level. In this stage TP increases at
decreasing rate. MP and AP both are
decreasing but still remain positive. As
both AP and MP decline, this stage is
known as stage of decreasing or
diminishing returns. The rate of decrease
in MP is greater than decrease in AP. A
rational producer will always operate in
this Stage because he wants to maximize
efficiency of scarce factor, labor.
Causes of Diminishing Returns:
 Insufficiency of fixed factors in
relation to variable factors.
 Indivisibility of fixed factors.
 Optimum use of fixed factor.
Stage III: Stage of Negative
Returns: Stage III covers the entire range
over which MP is negative. As MP
becomes negative this stage is known as
stage of negative returns. In this stage, total
product declines because of negative
marginal product for variable factor and
therefore the TP curve slopes downward.
AP shows a steady decline, but never
becomes zero. The phenomenon of negative
return emerges as result of application of
excessive number of units of variable factor
in relation to fixed factor.
A rational producer will not operate in this
stage, even with free labour, because he
could increase his output by employing
less labour. It is a non-economic and an
inefficient stage.
Causes of Negative Returns:
 Over utilization of fixed capital.
 Quantity of variable factor is too much
in relation to the fixed factor. This lead
to reduction in MP and TP.
Rational Stage of Production
It may be noted from the numerical illustration and diagram; both the stage I and III
are similar. Under stage I, the fixed factor is too much in relation to the variable
factor; therefore, marginal product of fixed factor is negative. In stage III, variable
factor is too much in relation to the fixed factor, therefore, marginal product of
variable factor is negative. Adding more labor employment means decline in output.
This stage is also ruled out on ground of technical inefficiency.
Thus a rational producer will never choose to produce in Stage I and III. Stage II,
however, presents the range of rational production decision; where both AP and MP
falling but AP is greater than MP throughout this stage. At the end of this stage, MP
of variable factor is zero and TP is maximum. It means production occurs only in
stage II where producer maximizes profit. So, the rational decision must be to
produce the output in second stage.
ISOQUANT
 ISOQUANT
An isoquant is a curve representing the various
combinations of two inputs (i.e. Labor ‘L’ and Capital
‘K’) which are capable to produce same level of
output.
Isoquant curve is also known as an iso-product curve
or equal product curve i.e. all the combinations
provided by an isoquant curve, are capable to produce
same level of output.
Assumptions of Isoquant Curve
• Only two factors of production Viz. Labor and capital are taken into the
consideration.
• These factors can be substituted for each other.
• The factors of production can be divided into small parts.
• It is assumed that technology remains constant.
• The shape of the Iso-quant depends on the level of substitutability between the
factors of production.
Suppose there are two input factors Viz. Labor and Capital. The different
combinations of these factors are used to have the same level of output as shown
in the schedule below:
Combinations Labor Capital Total Output
A 1 20 100 Meters
B 2 14 100 Meters
C 3 9 100 Meters
D 4 5 100 Meters
E 5 2 100 Meters
 K

20 A

15 B
Capital

10 C
D
5 E
IQ

0 1 2 3 4 5 L
Labor
Isoquant Map
An isoquant map shows a set of iso-product
curves. Each isoquant represents a different
level of output. A higher isoquant shows a
higher level of output and a lower isoquant
represents a lower level of output.
Capital

K2
IQ3
K1 IQ2
IQ1
0 L2 L1
Labour
Properties of Isoquants

1. An Isoquant Slopes Downward to the Right

2. Higher Isoquant shows Higher Output Level
3. Isoquants Cannot Intersect Each Other
4. Isoquants are Convex to the Origin
5. Isoquant never touches any axis
6. Isoquant need not to be parallel to each other
1. An Isoquant Slopes Downward to the Right

An Isoquant slopes
downward because
MTRS of labour for

Capital
K2
capital diminishes.
K1
IQ1
0 L2 L1
Labour
2. Higher Isoquant shows Higher Output Level
Higher isoquant
represents higher
level of output

Capital
because any
combination on K2
that higher IQ
shows the producer K1
IQ2
is using more of IQ1
both or at least one 0 L1 L2
of the factor. Labour
3. Isoquants Cannot Intersect Each Other

The intersection or
tangency of two
isoquants implies that
the same amount of

Capital
labour and capital can A
produce two levels of
IQ2= 200
outputs (example, 100 IQ1 = 100
and 200 units, here), 0 Labour
which is impossible.
4. Isoquants are Convex to the Origin
The isoquants are
convex to the origin due

Capital
to diminishing marginal
rate of technical
substitution(MRTSLK).
IQ
0 Labour
5. Isoquant never touches either of any axis

An isoquant cannot
touch either of the two
axis, it means the
producer is using only
one factor and none of

Capital
other. This is against IQ1 IQ2
its assumptions.

0 Labour
6. Isoquant need not to be parallel to each other
Isoquants are not
necessary to be parallel
to each other as though
MRTS between two

Capital
factors diminishes, the
rate of diminishing is IQ3
not necessary to be IQ2
same. IQ1
0
Labour
Marginal Rate of Technical Substitution (MRTS)
Marginal Rate of Technical Substitution (MRTS)

•The marginal rate of technical substitution (MRTS) is the rate for

which one input can be substituted for another without changing
the level of output.

Negativity implies that MRTS goes on declining.

 Y Com. L K MRTSL,K
A
12
A 1 12 -
Capital

B
8
B 2 8 4:1
5 C
3
D
E C 3 5 3:1
2 IQ
0 1 2 3 4 5 X
D 4 3 2:1
Labor
E 5 2 1:1
Iso-Cost Line
An iso-cost line is a graphical representation of various combinations of
two factors (labor and capital) which the firm can afford or purchase with
a given amount of money or total outlay and factor prices.
Let w and r be the price of inputs L and K respectively, and CO be the total
outlay (cost) of production then the equation of iso-cost line is,

Co = w.L + r.K
where:
w = price of input L (PL)
r= price of input K (PK)
L = quantity of input L
K = quantity of input K
Co = isocost(TC)
Co = w.L + r.K Combination L K Total cost
Now suppose that a
producer has a total A 0 10 100
budget of Rs 100 and and
for producing a certain B 1 8 100
level of output, he has to
spend this amount on two C 2 6 100
factors labor and capital.
Price of factors labor and D 3 4 100
capital are Rs. 20 and Rs. E 4 2 100
10 respectively. All the
possible combination of F 5 0 100
two inputs are as follows:
Combination L K Total Y
cost
10 A
A 0 10 100
B
8
B 1 8 100

Capital
C
6
C 2 6 100 4 D

D 3 4 100 E
2
F
E 4 2 100 0 1 2 3 4 5
X
Labor
F 5 0 100
Mathematically
Mathematically, an Iso-cost line can be expressed as
Co = w L + r K
or, r K = Co - w L
………….(i)
Differentiating equation (i) w. r. t. ‘L’, we get,
= Slope of Iso-cost line
Shift in Iso-cost Line
An Iso-cost line may shift due to two reasons. They are
1. Change in total outlay to be made by the firm
2. Change in price of a factor-input
1. Change in total outlay to be made by the firm
1. Change in total outlay to be
made by the firm
Change in Price of a Factor-Input
When price of factor-input changes, the Iso-cost line swings or rotates. The
direction in which the Iso-cost line will swing depends upon the factor whose
price has changed.
• Case I: Change in Price of Labor
• Case II: Change in Price of Capital
Case I: Change in Price of Labor
Case I: Change in Price of Labor
Case II: Change in Price of Capital
Case II: Change in Price of Capital
Producer’s Equilibrium (Optimum
Combination of Factors)
Producer’s Equilibrium (Optimum
Combination of Factors)
A producer is said to be in equilibrium when he maximizes his profit. A rational
producer earns maximum profit when he is producing a maximum level of output
at least possible cost. Producer’s maximum profit is determined at the point where
Iso-cost line is tangent to highest possible Isoquant curve. The producer’s
equilibrium condition is based on the following assumptions:
• There are two factors of production (i.e. labour and capital)
• The price of both factors is given and constant
• All units of labour and capital are homogeneous.
• Goal of producer is to maximize the level of output (profit).
• The firm produces a single product.
• There is perfect competition in factor market.
Producer’s Equilibrium

•Technically there are two condition must be fulfilled for the producer to be
in equilibrium.
• Necessary Condition: Iso-quant must be tangent to iso-cost line. It means,
slope of iso-quant is equal to slope of iso-cost line

• Sufficient Condition: Iso-quant curve must be convex to the origin at the

point tangency.
Producer’s EquilibriumCont.

The fact that how a producer produces output by selecting optimal

combinations of inputs depends upon two conditions:
• Minimization of Cost for Given Level of Output
• Maximization of Output for a Given level of Cost
Minimization of Cost for Given Level of Output (Least Cost
Combination of Factors)
What is producer’s equilibrium? How does producer attain equilibrium under
Given Level of Output ?
Minimization of Cost for Given Level of Output (Least Cost Combination of
Factors)

A producer is in equilibrium when he is producing the given level of output at

the least possible cost. The least cost combination of factor refers to the
combination of factors with which a firm can produce specific quantity of
output at lowest possible cost.

As we know, there are various combinations of factor which can produce a

given level of output. The producer has to choose one combination out of
these which produces a given level of output with least possible cost. This
will be the optimal combination for it.
 In this case we have a single Isoquant which denotes the desired level of output, but we have a
set of Iso-cost curve. The equilibrium situation can be explained by the following figure:

Cost is minimized when you choose the combination To produce the

where the desired isoquant is tangent to the lowest isocost given level of
E TC3 line. output, the cost
C will be
TC2 Producer Equilibrium - minimum at
is the point where slope
point E where
Capital

A of the isoquant is equal

TC1 to the slope of the the given
isocost. isoquant curve
K*
E
MPL/PL = MPK/PK (IQ) is tangent
to the lowest
IQ possible iso-
cost line (CD).
0 L* B D F
Labour
Maximization of Output for a Given level of Cost
What is producer’s equilibrium? How does producer attain equilibrium under
Given Total Cost Outlay?
Maximization of Output for a Given level of Cost

A producer is in equilibrium when he produces the maximum level of output with

given level of cost.

As we know, there is a single Iso-cost line and the producer will have to choose a
factor combination lying on the given Iso-cost line which produces a maximum
level of output.

In this case we have a single Iso-cost line which denotes the given level of cost,
but we have a set of Isoquant curve. The equilibrium situation can be explained
by the following figure:
 Y Output is maximized when you choose the combination where
the Iso-cost line is tangent to highest possible Isoquant curve

Producer Equilibrium - is
A the point where slope of the
isoquant is equal to the
R slope of the isocost.
Capital

MPL/PL = MPK/PK

K* E
IQ3 =300
IQ2 = 200
S
IQ1 = 100
0 L* B X
Labour
Producer choose the factor combination E where the given Isocost line AB is tangent to the Isoquant curve
(IQ2). The factor combination E enables the producer to reach the higher possible Isoquant IQ 2 that
produces 200 units of output.
Laws of Returns to Scale
Law of Returns to Scale is a long run concept. Here all factors of
production are variable. The change in the production of a
commodity due to change in all factors of production in the same
proportion (i.e., keeping the factor proportions unaltered) is
known as ‘returns to scale’.
The following three cases explain the change in output with
change in scale.
• Increasing Returns to Scale
• Constant Returns to Scale
• Decreasing Returns to scale
Increasing Returns to
Scale:
When inputs are increased in a Y
given proportion and output

Capital
increases in a greater proportion,
the returns to scale are said to be C
increasing. 2K B
Output A IQ3
Inputs (Units) 1K
(Units) IQ IQ2
1 capital 1 Labor 100 1

2 Capital 2 Labor 300

0 1L 2L X
Labour

In fig. the consecutive distance between the isoquants 1Q, 2Q and 3Q is decreasing, i.e.,
OA>AB>BC.
Constant Returns to Scale
If the change in inputs by Y
a given proportion leads

Capital
to the change in output in C
the same proportion 3K
return to scale is said to B
be constant. 2K IQ3
Output A
Inputs (Units)
(Units)
1K IQ2
1 Capital 1 Labor 100 IQ1
2 Capital 2 Labor 200 0 1L 2L 3L X
Labour

The successive isoquants lie at equal distance, i.e., OA=AB=BC.

Decreasing Returns to Scale
If a proportionate increase in Y
all inputs results in less than
C

Capital
proportionate increase in
output, the returns to scale is 3K
said to be decreasing.
B IQ3
2K
Output A
Inputs (Units)
(Units) 1K IQ2
1 Capital 1 Labour 100 IQ1
2 Capital 2 Labour 150 0 1L 3L
2L X
Labor
Here, the successively multiple level of isoquants lies farther and farther as the scale of
operation increases, i.e., OA<AB<BC.
Cobb-Douglas Production Function
Cobb-Douglas Production Function
Q = A Kα Lβ ………………………………………… (i)
Where,
Q = Total production
L = Labor input
K = Capital input (the real value of all machinery, equipment and buildings)
A = Efficiency parameter (total factor productivity or indicator of state of technology).
The magnitude of A will proportionately affects the level of Q.
α and β = α and β are the parameters of the production function which measures output
elasticity of capital and labor, respectively.

The values of A, α and β are constant determined by technology. The firm produces Q amount
of output by using two factors labor(L) and capital (K). This is called a Cobb-Douglas
production function.
Features of Cobb-Douglas production function
1. Linearly homogeneous production function:
1. Linearly homogeneous production function:

Q = A Kα Lβ ……………………………………… (ii)
Varying K and L by λ-fold the right hand side of (ii) becomes:
A (λK)α (λL)β = A λα Kα λβ Lβ
= λα+β A Kα Lβ
= λα+β Q
That is Cobb-Douglas production is homogeneous of degree (α + β).
If α + β = 1 then it is linearly homogeneous production function.
2. Returns to Scale:
2. Returns to Scale:
Cobb- Douglas production function shows constant return to scale. The sum of the
exponent (powers) of factors in Cobb-Douglas production function, that is, α + β
measures returns of scale. So,
 If α + β = 1, it exhibits constant returns to scale.
 If α + β > 1, it exhibits increasing returns to scale.
 If α + β < 1, it exhibits decreasing returns to scale.
3. Marginal Productivity:
3. Marginal Productivity:
Marginal product is the change in output due to one unit change in the use of a
particular input. So, marginal productivity of labor (MP L) is
MPL ==
= β A Kα Lβ-1

Similarly, marginal productivity of capital (MPk) is

MPK = =
= α A Kα-1 Lβ
4. Relative factor intensity
4. Relative factor intensity
The relative factor intensity can be analyzed on the basis of ratio of α and
β. For example,
 If > 1, it exhibits capital intensive production technique.
 If < 1, it exhibits labor intensive production technique.
 If = 1, it exhibits equal factor intensities.
5. Efficiency of Production:
5. Efficiency of Production:
The efficiency of production can be measured by the coefficient A.
 If the value of A is higher, there is higher degree of efficiency of production.
 If the of A is lower, there is lower degree of efficiency of production.