Theory of Production

Factors of production
• Land, Labour, Capital, Entrepreneurship
What we need for Production?
• For example:-Land, labour, capital, time, space, materials, power, fuel,
managerial skills etc
Capital Intensive and Labour Intensive
• Capital Intensive-requires more equipment and machinery to produce
goods; therefore, require a larger financial investment.
• Labour Intensive- higher labor input than capital required
• Input and output
• Fixed and Variable inputs
• Time Duration
Laws of Production
• Rate at which a given quantity of input is transformed into
output. Quantitative relation between input and output
Meaning of production
–action of making/manufacturing/processing
In economics-An activity by which resources are transformed
into a different or more useful commodity or service
Cost of Production
Inputs- Costs are not free
Production of any commodity is based on cost of Production
Cost –output relationship in Production
Rate at which production of a commodity changes with cost of
production
Production process
 Production Function
To explain input output relation
A production function is a mathematical statement used to describe
the technological relationship between input and out put.
Production function in general
• Q=f(LB, L, K, M, T, t)
• Where LB = Land and building; L =Labour; K=Capital; M=Materials;
T=Technology; and t=Time
In economics the number of variables in Production function
considered to be two
• hence the Production function :- Q=f(L, K )
• Where:- Q=quantity of commodity produced; L =Labour; K=Capital
• Assumptions of Production Function
• There are only two factors of production L =Labour; K=Capital
• Perfectly divisible of both inputs
• Limited substitution of one factor for other
• Labour and capital are imperfect substitutes
• A given technology
• Inelastic supply of fixed factors in the short run
Short run and Long run
Short run-Some factors are fixed and Some factors are variable
•Firm can increase/decrease the no of labour in the short run
because capital is fixed.
Long run-All factors of production are variable.
• Supply of Capital is inelastic in short run and elastic in long
run
•Short run production function:- Q=f(K, L )
Capital is constant and Labour varies
•Long run Production function:- Q=f(K, L )
Both Capital and Labour varies
• The long run of a firm -to expand or contract, its entire scale of
operation. The firm can then choose those’ quantities of all factors of
production that seem suitable.
• In particular it can opt for a new factory, advanced Technology which
is feasible for the firm. Once the Planning decision has been carried out
– the plant built, machines purchased-Becomed Fixed Factors/inputs.
• Machines, factory buildings, plants, permanent employees etc. are the
examples of fixed factors.
• Raw materials, labour, fuel, power etc. are the examples of variable
factors
• In Long Run Firm can decide-More capital and less labour or more
labour and less capital can be used to produce a fixed amount of
output.
 Production with one variable input:

Short run Law of Production

• Law of Variable Proportion: also known as Law of return to a variable
input; and the Law of diminishing marginal returns
• The law of variable proportion states that when total output or
production of commodity is increased by adding units of a variable
input while the quantities of other inputs are held constant, the increase
in total production becomes after some point smaller and smaller
• In other words as the quantity of one factor is increased, keeping the
other factors fixed, the marginal product of that factor will eventually
decline.
• Assumptions to Law
• State of technology remains the same
• All unit of variable factor are homogeneous
• There must be any fixed inputs which cannot be increased in the
short run
• Only one factor is variable other are constant
Three Stages of the Law

• Stage (i) Increasing returns.

• Stage (ii) Diminishing returns.

• Stage (iii) Negative returns.

Relationship between TP, AP, MP
• When TP increases initially MP and AP increases
• MP reaches its maximum, TP reaches an inflexion point
• When TP is Maximum, MP=0
• When AP is Maximum , then AP=MP
• When TP falling, MP is negative
• As long as TP is positive, AP is positive
• Both AP and MP are inverted U shape
• When MP > AP, i.e AP rising
• When MP = AP, i.e AP constant
• When MP < AP, i.e AP falling
 Production with two variable input:
Long run Law of Production
• Q=f(K, L )
• Simultaneous increase in both capital and Labour
• The law of returns to scale
• In the long run all factors of production are variable. No factor is
fixed. Accordingly, the scale of production can be changed by
changing the quantity of all factors of production.
• “The term returns to scale refers to the changes in output as all
factors change by the same proportion.” Koutsoyiannis
• In the long run, output can be increased by increasing all factors in
the same proportion. Generally, laws of returns to scale refer to an
increase in output due to increase in all factors in the same
proportion. Such an increase is called returns to scale.
• The law of returns to scale states that when all factors of
production are increased in same proportion , the output will
increase, but the increasing may be increasing , constant and
decreasing
• Stages of Returns to scale are:

• Stage 1. Increasing Returns to scale.

• Increase in output is more than proportional to increase in
input

• Stage 2. Constant Returns to Scale

• Increase in output is proportional to increase in input

• Stage 3. Diminishing/decreasing Returns to Scale

• Increase in output is less than proportional to increase in input
 ISOQUANTS
ISOQUANT-derived from greek word iso-equal and latin word
quantus-quantity
Isoquant curve is also called equal product curve and production
indifference curve
• Combination of two inputs (L, K) for same quantity of a
commodity

Definition:
An Isoquant curve is locus of point representing different
combinations of two inputs (labour and capital) yielding same
output
“Iso-product curve shows the different input combinations that will
produce a given output.” Samuelson
Assumptions
• Two input labour and capital to produce a commodity
• Input can be substituted for another at a diminishing rate upto
certain limit
• Production function is continious, implying labour and capital
are perfectly divisible and can be substituted in any small
quantities.
• Constant Technique
•q
Properties of Isoquant curves
 Isoquant have negative slop
 Isoquant are convex to the origin
 Isoquant cannot intersect or tangent to each other
 Upper isoquant represent higher level of output
• Marginal rate of technical substitution
• is the amount by which the quantity of one input has to be reduced
when one extra unit of another input is used, so that output remains
constant.
•
 Isoquant Map
• An Isoquant map can be defined
as the set of isoquant curves that
show technically efficient
combinations of inputs that can
produce different levels of
output. i.e, IQ, IQ1, IQ2 etc.
 Types of Isoquants
• Linear isoquants:
• Refers to a straight line isoquant.
• perfectly substitutability between
inputs.
• It implies that a product can be
produced by using either capital or
labor or using both, if capital and
labor are perfect substitutes of each
other.
• Therefore, in a linear isoquant,
MRTS between inputs remains
constant.
• Fixed factor proportion/L shaped Isoquant
• Refers to an isoquant in which the
combination between capital and labor are
in a fixed proportion.
• It assumes zero substitutability or perfect
complimentarily between inputs
• The L-shaped isoquant represents that
there is no substitution between labor and
capital and they are assumed to be
complementary goods.
• It represents that only one combination of
labor and capital is possible to produce a
product with a fixed proportion of inputs.
For increasing the production, an
organization needs to increase both inputs
proportionately.
• Kinked isoquants
• Refers to an isoquant that represents
different combinations of labor and
capital.
• These combinations can be used in
different processes of production, but
in fixed proportion.
• L-shaped isoquant, there would be
only one combination between capital
and labor in a fixed proportion.
However, in real life, there can be
several ways to perform production
with different combinations of capital
and labor.
• Economic Region of
production
• The firm will produce only in those
segments of isoquants which are
convex to the origin and lie between
the ridge lines.

• Ridge lines
• The ridge lines are the locus of points
of isoquants where the marginal
products (MP) of factors are zero.
•
• The upper ridge line implies zero MP of capital
• the lower ridge line implies zero MP of labour
• Production techniques are only efficient inside the ridge lines.
• Outside the ridge lines.
• The marginal products of factors are negative and the methods
of production are inefficient
 Law of Returns to Scale-using Isoquants

• Law of Increasing Returns to

Scale
• - output may increase more than
proportinately

• 100 units of output require 3C +3L

• 200 units of output require 5C + 5L
• 300 units of output require 6C + 6L
• Law of constant returns to scale-
output may increase
proportionately
• 100 units of output require 1 (2C +
2L) = 2C + 2L
• 200 units of output require 2(2C +
2L) = 4C + 4L
• 300 units of output require 3(2C +
2L) = 6C + 6L
• Law of Decreasing returns to scale
• -output may increase less than
proportionately
• 100 units of output require 2C + 2L
• 200 units of output require 5C + 5L
• 300 units of output require 9C + 9L
 Expansion Path

• Law of Returns to
Scale-using Isoquants
• a, b, c, d are optimal
input combination
points in the expansion
path;
 Isocosts
• Cost Function of a firm
• The firms Cost function may be expressed as
• C=KxPK+ L xPL
• For example remuneration of the factors of production-Wage and
Rental
• Since inputs have price
• Firm has limited money to spend to produce the output
• Isocost line is an important component when analysing producer’s
behaviour. The curve which represent the alternative combinations of K
and L that can be hired from a given total cost (C) is called Isocost.
Isocost curves are also called Budget line/Budget constrains of the
producer
• Slope of Isocost line is marginal rate
of
• Exchange (MRE)
PL
• MRE= -
PK
Suppose a producer has a total budget of Rs 120 and for producing a
certain level of output, he has to spend this amount on 2 factors Labour
and Capital. Price of factors Labour and Capital are Rs 10. and Rs. 15.

•. Com Units Capital Labour Total

Units of
binat of Price = Price = expenditure
Labour
ions Capital Rs 15 Rs 10 ( in Rupees)

A 8 120 0 0 120
B 6 90 3 30 120
C 4 60 6 60 120
D 2 30 9 90 120
E 0 0 12 120 120
Producers Equilibrium
• Producer’s equilibrium
• or optimisation occurs when he earns maximum profit with
optimal combination of factors. A profit maximisation firm faces
two choices of optimal combination of factors (inputs).
• The least cost combination of factors refers to a firm producing
the largest volume of output from a given cost and producing a
given level of output with the minimum cost when the factors are
combined in an optimum manner. i.e to
minimize its cost for a given
output
Firm (Profit
Maximizing) maximize the output from a
given total cost
• In the theory of production, the profit maximisation firm is in
equilibrium when, given the cost-price function, it maximises its profits
on the basis of the least cost combination of factors.
• Assumptions:
• There are two factors, labour and capital.
• All units of labour and capital are homogeneous.
• The prices of units of labour (w) and that of capital (r) are given and
constant.
• The cost outlay is given.
• The firm produces a single product.
• The price of the product is given and constant.
• The firm aims at profit maximization
• There is perfect competition in the factor market.
• The point of least-cost combination of
factors for a given level of output is where
the isoquant curve is tangent to an iso-cost
line.
• First order and Second order condition
• The first condition is that the slope of the
iso-cost line must equal the slope of the
isoquant curve.
• i.e MRE=MRTS

• The second condition is that at the point of

tangency, the isoquant curve must be
convex to the origin
 Expansion Path
• The expansion path or scale line –
is a curve in a graph with
quantities of two inputs labour
and capital plotted on the axis.
• The path connects optimal input
combination as the scale
production expands
• The point of tangency of isocost
line and isoquant
 Labour and Capital intensive
• labour intensive technique is Capital intensive technique refers
that which uses comparatively to that technique in which larger
larger amount of labour and amount of capital is comparatively
small doses of capital used