THEORY OF PRODUCTION A production function process transforms inputs

into outputs and the theory of production function further understands, analyses
and determines the relationship between inputs and outputs.

It helps us to answer the following questions:

1. How much capital and how much labour need to be employed to produce a
product?

2. Can the production be increased bky increasing a single input or all the inputs?

3. What is the most efficient combination of inputs to produce the product?

4. How will the cost be affected by the level of production? Thus, the theory of
production function provides valuable inputs to a producer’s decision making.

PRODUCTION FUNCTION The production function shows a technical or

engineering relationship between the physical inputs and physical outputs of a
firm, for a given state of technology. A production function has the following
attributes:

1. It indicates the functional relationship between physical inputs and physical

outputs of the firm, i.e. X=f (L,K)

2. The production function is always in relation to a period of time. This is because

a firm can increase output either by employing some additional factors of
production or increasing all the factors of production depending whether its short
run or long run.

3. The production function shows either the maximum output that can be produced
from a given set of inputs or the minimum quantity of inputs required to produce a
given level of output.

4. The production function includes all the technically efficient methods of

production as it is a purely technical relationship.

5. Output in production function is the result of joint use of factors of production.

Thus, the productivity of a factor is always measured in the context of this factor
being employed in combination with other factors.
PRODUCTION FUNCTION WITH ONE VARIABLE FACTOR (Short Run)

RETURNS TO A FACTOR deals with a simple two factor production function of

the form:

Q = F (K, L)

We normally assume capital (K) is the fixed factor, and labour (L) is the variable
factor.

LAW OF VARIABLE PROPORTIONS states that as more and more units of a

variable factor are applied with fixed factors, in the beginning total output
increases at an increasing rate. Beyond a certain point, it rises at a diminishing rate.
And finally, total production starts declining with every increase in the variable
input. In other words, the law of variable proportions exhibits the direction and the
rate of change in the firm’s output, when the quantity of only one factor of
production is changed.

Assumptions:

1. One factor in production is variable and other factors are fixed.

2. It is possible to change factor proportions.

3. All units of a variable factor are homogeneous.

4. Technology is assumed to be given and constant.

5. The law applied only in the short period.

6. Factors of production are not perfect substitutes for each other.

Product:- It is the output, produced by combining various inputs.

Total Physical Product:- It is the total number of output produced.

Marginal Physical Product:- It is the increase in total product when a unit of

variable input is increased.

MP = TPn – TPn-1

Average Physical Product:- It is the average output produced by one unit of

variable input. Average Product is Total Product divided by number of variable
factor inputs, which is Labour in as assumed.
 AP = TP / L

Increasing Returns to a Factor

1. Total Product increases at an increasing rate up to point

2. Q2. The Marginal Product and the Average Product are increasing up to this
point.
3. Total Product increases at a diminishing rate after this point and the Marginal
Product starts to fall. The Average Product continues to increase and becomes
maximum at point Q5 where the stage ends.

homogeneous
4. 3. Reasons:
1. Fuller utilization of Fixed Factor
2. Specialization of Labour

Constant Returns to a Factor

1. Total Product continues to increase at a decreasing rate and both the Average
Product and the Marginal Product are falling.
27i5. The stage ends where Total Product reaches its maximum at point C where the
corresponding value of Marginal Product is zero.
3. The stage where a firm operates.
4. Reasons:
1. Imperfect factor substitutability
2. Disturbing the optimum proportion

Diminishing Returns to a Factor

1. Total Product starts falling in this stage and the Marginal Product becomes
negative. The Average Product is also falling but remains positive.
2. This is the stage where employing an additional unit of variable factor results in
negative marginal product.
3. Reasons:
1. Overcrowding
2. Management Problems
PRODUCTION FUNCTION WITH TWO VARIABLE FACTORS (Long Run)
Isoquants Isoquants, which are also called equal product curve, are similar to the
indifference curves ofthe theory of consumer’s behaviour. An isoquant represents
all those factor combinations which are capable of producing same level of output.
The isoquants are thus contour lines which trace the loci of equal outputs.

Properties of isoquants

1. Isoquants like indifference curves, slope downward from left to right i.e., they
have a negative slope. 2. No two isoquants can intersect each other.

3. Isoquants, like indifference curves, are convex to the origin.

Isocost line

The prices of factors are represented by the iso-cost line. The iso-cost line plays an
important part in determining what combination of factors the firm will choose for
production. An isocost line shows various combinations of two factors that the firm
can buy with a given outlay.

Marginal Rate Of Technical Substitution Marginal rate of technical substitution in

the theory of production is similar to the concept of marginal rate of substitution in
indifference curve analysis of consumer’s demand. It indicates the rate at which
factors can be substituted at the margin without altering the level of output.
Marginal rate of technical substitution of labour for capital mat be defined as the
number of units of capital which can be replaced by one unit of labour, the level of
output remaining unchanged

Marginal rate of technical substitution of labour for capital = slope= ∆K/∆L

Returns to scale It refers to changes in output resulting from a proportional

change in all inputs (where all inputs increase by a constant factor). If output
increases by that same proportional change then there are constant returns to
scale (CRS). If output increases by less than that proportional change, there are
decreasing returns to scale (DRS). If output increases by more than that
proportional change, there are increasing returns to scale (IRS). Thus the returns
to scale faced by a firm are purely technologically imposed and are not influenced
by economic decisions or by market conditions.

Assumptions to this law:

1. Technology remains unchanged.

2. All factors vary in a fixed proportion.

3. Only scale of production changes keeping the fixed factor proportions

Increasing returns to scale

1. Higher degree of specialization of factors of production

2. Indivisibilities of factors of production

3. Technical Economies due to large scale production

4. Other internal economies.

Constant Returns to scale: (diagram Above)

1. Absence of any advantage or disadvantage from increase in scale of

operation
2. 2. Economies of scale have disappeared and Diseconomies of scale are yet to
appear.
Decreasing returns to scale

1. Problem and complexities of management occur when the scale of

operation is expanded
2. Exhaustibility of natural resources

Ridge line It is the locus of points where Marginal Product of the factors of
production is zero.

Expansion Path It is the set of combinations, of two factor inputs, that meet the
efficiency condition.

Least cost combination In order to determine the best combination of capital and
labour to produce that output, one has to know the amount of finance available to
the producer to spend on the inputs and also the prices of the input. Suppose that
the producer has at its disposal Rs. 10,000 for the two inputs, and that the prices of
the two inputs as Rs. 1000 per unit of capital and Rs. 200 per unit of labour. The
firm will have three alternative possibilities before it.
a) To spend the money only on capital and secure 10 units of it.
b) To spend the amount only on labour and secure 50 unit of labour
c) To spend the amount partly on capital and partly on labour

Types of production function

Leontief Production Function

1. It implies that a fixed proportion in which factor inputs are to be used

X = Minimum (K/a, L/b)
Empirical Production Function:-
1. Linear Production Function
Q = a + bL
2. Quadratic Production Function
Q = a + bL - cL2
3. Cubic Production Function
Q = a + bL - cL2 – dL3 4.
4. Power Production Function
Q = a + aLb

Cobb-Douglas Production Function

1. It is widely used to represent the relationship of an output to inputs.
2. It was proposed by Knut Wicksell (1851–1926), and tested against statistical
evidence by Charles Cobb and Paul Douglas in 1900–1928.
3. For production, the function is Q = ALαKβ 1. Attributes: 1. Both, α and β
are positive and α + β = 1 2. This function is homogeneous of degree 1 3. A is
the efficiency parameter and indicates the level of technology

1. Attributes: 1. Both, α and β are positive and α + β = 1 2. This function is

homogeneous of degree 1 3. A is the efficiency parameter and indicates the
level of technology.