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TOPIC 3A THEORY OF PRODUCTION

PART ONE: Introduction

Production can be defined as the transformation of resources into products or the process whereby inputs
are turned into outputs through technological innovations. The efficiency of this process depends upon
three factors

• The proportion in which the various inputs are employed

• The absolute level of each input
• The productivity of each input at different input levels and ratios.

Various concepts in production

• Factors of production: There are four factors of production – Land, Labour, Capital and
Organization. Additionally, we can categorize the factors of production as variable inputs and fixed
inputs.
• Fixed inputs: A fixed input is defined as one whose quantity cannot be readily changed when
market conditions indicate that an immediate change in output is desirable. Although no input is
ever absolutely fixed but frequently for analytical simplicity we hold some inputs fixed.
• Variable inputs: A variable input is the one whose quantity can be changed almost instantaneously
in response to desired changes in output. Example can be labour hours.
• Short run: In a short run the quantities of one or more factors of production cannot be changed.
• Long run: Long run production corresponds to the time that is needed to make all production inputs
variable. Usually long run represents the scenario when firms decide to expand the scale of
operations or branch out into new products.
• Fixed vs Variable proportions: variable proportion production implies that output can be changed in
the short run by changing the amount of variable inputs used in co-operation with the fixed inputs.
Naturally as the amount of one input is changed the other remaining constant, the ratio of inputs
changes too. Secondly, when production is subject to variable proportions, the same output can be
produced by various combinations of inputs – i.e. by different input ratios. This may apply only to
the long run but it is relevant to the short run when there is more than one variable input.

A) FACTORS OF PRODUCTION:
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Production is the result of co-operation of four factors of production viz., land, labour, capital and
organization. Therefore, the producer combines all the four factors of production in a technical
proportion. Factors of production are the resources people use to produce goods and services; they are
the building blocks of the economy.

a) Land as a Factor of Production

Land is short for all the natural resources available to create supply. It includes raw property and
anything that comes from the ground. It can be a non-renewable resource. Once man changes it from its
original condition, it becomes a capital good. For example, oil is a natural resource, but gasoline is a
capital good. Farmland is a natural resource, but a shopping center is a capital good. The income earned
by owners of land and other resources is called rent. these resources can be renewable, such as forests,
or non-renewables such as oil or natural gas. Although land is undeniably crucial to most forms of
production, just how essential it really is varies depending on the industry. Characteristics of Land as a
Factor of Production are

• The land is a free gift of nature. (ii) The land has no cost of production.
• It is immobile. (iv) The land is fixed and limited in supply.

b) Labor as a Factor of Production

Labor is the work done by people. The value of the workforce depends on workers' education, skills, and
motivation. It also depends on productivity that measures how much each hour of worker time produces
in output. The reward for labor or income for labor is wages. Labor, as a factor of production, involves
any human input. It is any work done by people contributing to production. The quality of labor depends
on the workforce’s skills, education, and motivation. Generally speaking, the higher the quality of labor,
the more productive the workforce.

labor range from the very physical to primarily mental work that goes into production. On the mental
side of this factor of production are laborers like artists producing art, or programmers creating software.
On the more physical side of labor might be food service workers, construction workers, or factory
workers. The income earned by labor resources is called wages. It is the largest source of income for
most people.

. Characteristic of labour

i) It is a human factor. (ii) One cannot store labour. (iii) No two types of labour are the
same.

c) Capital as a Factor of Production

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Capital is short for capital goods. These are man-made objects like machinery, equipment, building and
chemicals that are used in production. That's what differentiates them from consumer goods. For
example, capital goods include industrial and commercial buildings, but not private housing. A
commercial aircraft is a capital good, but a private jet is not. The income earned by owners of capital
goods is called interest. Here capital refers not to money (which is not a factor of production), as you
might expect, but to manufactured resources such as factories and machines.

Some other examples of capital include hammers, forklifts, conveyor belts, computers, and delivery
vans. But it is not just this kind of machinery; office furniture like conference tables and desk chairs also
fall under the umbrella of capital. An increase in capital goods means an increase in the productive
capacity of the economy.

. Characteristics

i) Capital is a manmade factor of production. ii) It is mobile.

ii) It is a passive factor of production.

d) Entrepreneurship as a Factor of Production

Entrepreneurship is the drive to develop an idea into a business. An entrepreneur combines the other
three factors of production to add to production. The most successful are innovative risk-takers. The
income entrepreneurs earn is profits.

An entrepreneur is someone who takes on the economic risk involved in bringing the other three factors
of production together. Entrepreneurs are a vital engine of economic growth at all scales, helping to
build many of the largest firms in the world as well as some of the small businesses in your
neighborhood. Entrepreneurs help contribute to economic growth, so governments typically do their best
to encourage entrepreneurship using the right combination of policies to make starting a business
accessible. The payment an entrepreneur receives is referred to as profit, and functions as a reward for
the risk they take. Characteristics

(i) He has great administrative power.

(ii) An entrepreneur must be a man of action.
(iii) An entrepreneur must have the ability to organize.
(iv) He should be a knowledgeable person.
(v) He must have a professional approach.

B) PRODUCTION FUNCTION:
Production Function: A production function is a mathematical equation showing the maximum amount
of output that can be produced from any specified set of inputs given the existing technology. In other
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words, production functions describe what is technically feasible when the firm operates efficiently i.e.
when the firm uses each combination of inputs as effectively as possible. Production function refers to
the functional relationship between the quantity of a good produced (output) and factors of production
(inputs). production function reflects how much output we can expect if we have so much of labour and
so much of capital as well as of labour etc. In other words, we can say that production function is an
indicator of the physical relationship between the inputs and output of a firm.

Q = f( L, K, N, O) where L is labour, K is capital, N is land and O is organization

Features of Production Function: the main features of production function:

1. Substitutability: The factors of production or inputs are substitutes of one another which make it
possible to vary the total output by changing the quantity of one or a few inputs, while the quantities of
all other inputs are held constant. It is the substitutability of the factors of production that gives rise to
the laws of variable proportions.
2. Complementarity: The factors of production are also complementary to one another, that is, the two
or more inputs are to be used together as nothing will be produced if the quantity of either of the inputs
used in the production process is zero.
3. Specificity: It reveals that the inputs are specific to the production of a particular product. Machines
and equipment’s, specialized workers and raw materials are a few examples of the specificity of factors
of production. The specificity may not be complete as factors may be used for production of other
commodities too. This reveals that in the production process none of the factors can be ignored and in
some cases ignorance to even slightest extent is not possible if the factors are perfectly specific.
In the production function, variation in total output by varying the quantities of all inputs is possible
only in the long run whereas the variation in total output by varying the quantity of single input may be
possible even in the short run.
NOTE: Production analysis can be analyzed both in the short run and long run
(1) SHORT RUN PRODUCTION ANALYSIS
The short run production function gives the total (maximum) output obtainable from different amounts
of the variable input given a specified amount of the fixed input.
The short run production assumes there is at least one fixed factor input. We use these three measures of
production and productivity: There are three main product curves in economic production: the total
product curve, the average product curve and the marginal product curve.

a). Total product or total output (TP): The total product curve is a reflection of the firm’s overall
production and is the basis of the two other curve. Total output can also graphically be described as the
locus of different output levels produced by using different combinations of factor inputs.
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b). Average Product(AP): The average product curve is the quantity of the total output produced per
unit of a "variable input," such as hours of labor.

It given by TP/ Q of labour

c). Marginal product (MP): Marginal product represents the quantity of additional units of output
produced by one additional unit of input. In other words, the marginal product of an input is the addition
to total product attributable to the addition of one unit of the variable input, keeping the fixed inputs
constant.

Economists recognize three distinct stages of production, which are defined by a concept known as the
law of diminishing marginal returns. The idea of the three stages of production helps companies set
production schedules and make staffing decisions

The Three Stages of Production Process-In the short run, a firm can change the output by changing
the quantities of the variable factors while quantities of other factors remain unchanged. The behavior of
output can be explained in three stages which is given below: The stages are given by the relation
among Average product (AP), Marginal product (MP) and Total product (TP)):

In the short-run production function--let the variable factor be labour and -land be the fixed factor
(fixed at one acre)

The origin of stage 3 starts from the maximum point of the TP curve. In this stage, the marginal product
is declining and its negative, also both TP and AP are declining at the same time.
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STAGE 1: TPL increases at an increasing rate up the point of inflection. APL Starts at the same point
as the TPL, It rises reaching a maximum at the end of stage one. MPL rises in the beginning and reaches
its maximum point before and then it starts to decline. MPL intersects the APL at its maximum point.

In stage I, the amount of fixed factor is abundant in relative to the variable factor. Since fixed factor is
not fully utilized therefore producer has an incentive to increase the output by employing more and more
units of the variable factor. This will result in more efficient use of fixed factor. Thus, a rational
producer will not choose to operate in this stage because by expanding the level of output, he can further
reduce its average cost.

The two important reasons for increasing returns at this stage are:

1. Indivisibility of Fixed Factor- It means a minimum size of fixed factor need to be employed
irrespective of the level of output. In initial stages, the minimum size of fixed factor is too large than its
actual utilization. This results in underutilization of fixed factor. By employing more and more units of
the variable factor, the fixed factor is utilized effectively and efficiently. This causes output ton increase
at an increasing rate.

2. Specialization- Specialization is theanother reason for increasing returns. When the quantity of
variable factor increases, the scope of specialization also increases. The various advantages offered by
specialization include productivity, efficiency, better skill etc

STAGE II: (Stage of Diminishing Returns): TPL increases at a decreasing rate and reaches its maximum
point when this stage two. Both APL and MPL declines, however, PML declines to zero when TPL is a
maximum. This is the reason why this stage is known as stage of diminishing returns. At this stage APL
is greater than MPL throughout this stage. The stage comes to an end when MPL is zero.

Stage II is the relevant stage of operation for producer as efficiency of the scarce factor i.e. labour can
be maximized.

The two important reasons for diminishing returns are given below:

1. Once the optimum combination of variable and fixed factors is reached, further employment of labour
leads to non-optimal proportion of fixed factor with the variable factor. As a result, efficiency of
variable factor starts decreasing as fixed factor or indivisible factor is being used to full extent.

2. Elasticity of Substitution between the Factors is Finite – If the fixed factor is perfectly substituted by
the variable factor, then the inadequacy of the former could be compensated by increasing the use of
latter. But, elasticity of substitution between factors is finite. Therefore, if firm employs additional
variable factors beyond the optimum combination, then productivity of variable factors decline as the
availability of indivisible factor per unit of variable factor decreases.
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STAGE 111: TPL starts to decline. APl also decline, however it will remain positive as long as TPL is
positive although declining. MPL becomes negative and falls below the X- axis. A rational producer
would not like to operate in this stage as the efficiency of both fixed and variable factors decreases and
the proportion between factors is highly sub optimal.

The two important reasons for negative returns are given below:

1. Sub Optimal Ratio – In this stage, the quantity of variable factor is too much in relative to the fixed
factor. As a result, the efficiency of not only variable factor but also fixed factor starts declining. As a
result, total product starts falling.

2. Moving beyond Optimum Degree of Specialization- If the limit to optimum degree of specialization is
crossed, then the efficiency of variable factor declines

THE LAW OF DIMINISHING RETURNS: Also referred to as The Law of Variable Proportions

It states that as the amount of variable input is increased, the amount of fixed or other inputs held
constant, a point is reached beyond which marginal product declines. After some optimal level of
capacity utilization, the addition of any larger amounts of a factor of production will inevitably yield
decreased per-unit incremental returns.

For example, if a factory employs workers to manufacture its products, at some point, the company will
operate at an optimal level; with all other production factors constant, adding additional workers beyond
this optimal level will result in less efficient operations.

The assumptions law of diminishing marginal returns are as follows:

▪ Assumes the state of technology to be constant. A variable state of technology would impact the
marginal and average product. In that case, we would not be able to accurately study the relationship
between output and the fixed input.
▪ Assumes only one input should be variable. keeping other inputs constant. This law does not apply to
cases when all the inputs vary proportionately.
▪ The law assumes that labor to be homogeneous or similar in quality.

Causes for the Operation of Law of Diminishing

The causes for the operation of law of diminishing returns are discussed below:
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1. Increasing labour costs: If labour costs suddenly increase, the level of output your employer might
produce before facing diminishing returns decrease. They might then increase prices to cover these
costs, creating disincentives for consumers to buy their products. For example, if the government
increases the minimum wage, you might earn a higher income, increasing employers' costs without
experiencing an equivalent rise in productivity. If you repeat this trend across the economy, they might
also spend more to acquire raw materials, as general price rises lead to rising inflation .

2. Low employee productivity: Low employee productivity might lead to diminishing returns, as it
hinders the firm's overall growth potential. For example, if you're working long hours in a low-paid
position, you may find it difficult to motivate yourself to work productively. Firms might then receive a
below-par return on their wage costs, increasing productive inefficiency as a result. If this problem
remains unresolved, firms might either raise sale prices or replace you to account for falling revenue.
Either way, these costs can reduce a firm's overall competitiveness.

3. Falling demand: Given their reliance on consumer spending, businesses can be vulnerable to changing
market trends, such as shifting demand. For example, in a recession, high-end fashion firms may find it
hard to convince consumers to spend their income on luxury goods. Overall revenue may then decrease,
forcing firms to cut sale prices to attract more business. If this strategy is unsuccessful, they may be
unable to cover variable production costs, such as staff wages or material costs. They might then cut
output to remain solvent, further reducing returns as a result.

4. Scarce Factors: In case of certain factors especially land which is itself limited cannot be increased the
law of diminishing return will apply. It may also happen in case of other factors of production. For
example, sometimes, labour, specially technical or capital or even enterprise cannot be increased in
individual cases. As a result, the adjustment of factors of production will be disturbed and the output
cannot be achieved at increasing rates.

5. Lack of Perfect Substitutes: There is another reason due to which the law of diminishing returns does
not apply i.e., lack of perfect substitutes of factors of production. It means that one factor of production
cannot be substituted for another factor. Substitute for every factor of production is not always available.
In the absence of such substitute, the law of diminishing returns will apply.
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Application of The Law: Marshall has stated that the law of diminishing returns applies quickly to
agriculture, mining, forests, fisheries and building industries.
1. Application of the Law in Agriculture: In agriculture, nature dominates, so the law of dominates, so
the law of diminishing returns applies quickly. In agriculture, more and more doses of labour and capital
can be employed with the fixed factor (i.e. land) to produce more. Land being fixed cannot be increased
or reduced as per the choice of the agriculturist. Thus as more and more variable factors are employed
with the fixed factors, the marginal product falls and hence the law of diminishing returns apply.
2. Application in Extractive Industries: The law of diminishing returns applies quickly to the extractive
industries like:

(a) Mines: As more and more minerals are extracted from the mines, the levels of minerals go down. For
deep extraction, there is need of light, oxygen, water, more labourers etc. All this would involve more
expenses and hence the law of diminishing returns would operate quickly.

(b) Fisheries: In a river or in a sea, as we go on catching more and more fish, the number of fish would
fall around the bank or shore. Now for more catch of the fish, we have to go deep into river or sea. This
would involve wastage of time in going into deep water and then coming back to the bank or shore. Also
in deep sea, the number of catching may not be too big. Thus it is clear that the law of diminishing
returns apply quickly to fisheries.

(c) Buildings: The law of diminishing returns applies quickly to multi-storey building. As the more and
more high rise building are put up, the expenses on upper storeys increase as compared to lower storeys.
Thus the law of diminishing returns apply to buildings too.

3. Application in Industries: In industries, labour and capital play more role than land and these can be
increased to any level. It is due to this reason that the law of increasing returns apply in industries. But
this does not continue for very long. A stage reaches when the quality of these variable factors
deteriorates or the prices of these variable factors increase. These two factors result in diminishing
returns.
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PART TWO: LONG RUN PRODUCTION ANALYSIS

The long-run is a period of time in which all factors of production and costs are variable. In the long
run, firms are able to adjust all costs, whereas, in the short run, firms are only able to influence prices
through adjustments made to production levels. In the long run production function, the relationship
between input and output is explained under the condition when both, labor and capital, are variable
inputs.

In the long run, the supply of both the inputs, labor and capital, is assumed to be elastic (changes
frequently). Therefore, organizations can hire larger quantities of both the inputs. If larger quantities of
both the inputs are employed, the level of production increases. In the long run, the functional
relationship between changing scale of inputs and output is explained under returns to scale.

The returns to scale can be explained with the help of isoquant technique.

Isoquant Curve: “An isoquant is a curve showing all possible combinations of inputs physically
capable of producing a given level of output” OR, “An isoquant curve may be defined as a curve
showing the possible combinations of two variable factors, labor and capital that can be used to
produce the same total product

On the basis of these assumptions, an isoquant curve can be drawn with the help of different
combinations of capital and labor. The combinations are made such that it does not affect the output
level.
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IQ1 is the output for four combinations of capital and labor. Figure shows that all along the curve for
IQ1 the quantity of output is same that is, 200 with the changing combinations of capital and labor. The
four combinations on the IQ1 curve are represented by points A(L1,K1), B(L2,K3), C(L3,K4), and
D(L4,K1).

Some of the properties of the isoquant curve are as follows:

i. Negative Slope: Implies that the slope of isoquant curve is negative. This is because when capital (K)
is increased, the quantity of labor (L) is reduced or vice versa, to keep the same level of output. As the
quantity of labor is increased from one unit to two units, the quantity of capital is decreased from four to
three, to keep the level of output constant, which is 200.

ii. Convex to Origin: Shows the substitution of inputs and diminishing marginal rate of technical
substitution (which is discussed later) in economic region. This implies that marginal significance of one
input (capital) in terms of another input (labor) diminishes along the isoquant curve.

iii. Non-intersecting and Non-tangential: Implies that two isoquant curves (as shown in Figure-4)
cannot cut each other. The two isoquants intersect at point A implying that they give the same level of
satisfaction. but the intersection of two isoquants implies that BL2 and CL2 are equal with respect to
their output, which is not possible. Therefore, it is stated that isoquant curves cannot intersect; otherwise
the law of production would not be applicable.
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iv. Upper isoquant have high output: Implies that upper curve of the isoquant curve produces more
output than the curve beneath. This is because of the larger combination of input result in a larger output
as compared to the curve that is beneath it.

Marginal Rate of Technical Substitution(MRTS):

“The marginal rate of technical substitution is the amount of an input that a firm can give up in order to
increasing the amount of the other input by one unit and still remain on the same isoquant.”

Marginal Rate of Technical Substitution (MRTS) is the quantity of one input (capital) that is reduced to
increase the quantity of the other input (L), so that the output remains constant. The MRTS is equal to
the slope of isoquants.

The principle of marginal rate of technical substitution (MRTS ) is based on the production function
where two factors can be substituted in variable proportions in such a way as to produce a constant level
of output.

The isoquant reveals that as the units of labour are successively increased into the factor-combination to
produce 100 units of good X, the reduction in the units of capital becomes smaller and smaller. It means
that the marginal rate of technical substitution is diminishing.

Marginal rate of factor substitution: As one moves down the isoquant, output remains the same. Therefore
the output gained from employing more labour must equal the output lost from employing more capital.
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RETURNS TO SCALE:

Returns to scale describes the relationship between variable inputs and output when all the inputs, or
factors are increased in the same proportion. It has been observed that when there is a proportionate
change in the amounts of inputs, the behavior of output varies.

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 changes in output as a result of changes in the scale can be studied in 3 phases. They are: Increasing
returns to scale, Constant returns to scale and Decreasing returns to scale

a) Increasing Returns to Scale:

Increasing returns to scale or diminishing cost refers to a situation when all factors of production are
increased, and output increases at a higher rate. It means if all inputs are doubled, output will also
increase at a faster rate than double. Hence, it is said to be increasing returns to scale. This increase is
due to many reasons like division of labour and external economies of scale.

A movement from a to b indicates that the amount of input is doubled. Now, the combination of inputs
has reached to 2K+2L from 1K+1L. However, the output has increased from 10 to 25, which is more
than double. Similarly, when input changes from 1K+1L to 3K + 3L, then output changes from 10 to 50,
which is greater than change in input. This shows increasing returns to scale.
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There a number of factors responsible for increasing returns to scale.

Some of the factors are as follows:

i. Technical and managerial indivisibility: implies that there are certain inputs, such as machines and
human resource, used for the production process are available in a fixed amount. These inputs cannot be
divided to suit different level of production. For example, an organization cannot use the half of the
turbine for small scale of production.

ii. Specialization: Implies that high degree of specialization of man and machinery helps in increasing
the scale of production. The use of specialized labor and machinery helps in increasing the productivity
of labor and capital per unit. This results in increasing returns to scale.

iii. Concept of Dimensions: Refers to the relation of increasing returns to scale to the concept of
dimensions. According to the concept of dimensions, if the length and breadth of a room increases, then
its area gets more than doubled. For example, length of a room increases from 15 to 30 and breadth
increases from 10 to 20. This implies that length and breadth of room get doubled. In such a case, the
area of room increases from 150 (15*10) to 600 (30*20), which is more than doubled.
b. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation, where if all the factors of
production are increased in a given proportion, output increases in a smaller proportion. It means, if
inputs are doubled, output will be less than doubled. If 20 percent increase in labour and capital is
followed by 10 percent increase in output, then it is an instance of diminishing returns to scale.
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(NOTE: The Horizontal Axis Should Read Diminishing Returns to Scale –NOT CONSTANT)

When the combination of labor and capital moves from point a to point b, it indicates that input is
doubled. At point a, the combination of input is 1k+1L and at point b, the combination becomes 2K+2L,
However, the output has increased from 10 to 18, which is less than change in the amount of input.
Similarly, when input changes from 1K+1L to 3K + 3L, then output changes from 18 to 24, which is
less than change in input. This shows the diminishing returns to scale.

Diminishing returns to scale is due to diseconomies of scale, which arises because of the managerial
inefficiency. Generally, managerial inefficiency takes place in large-scale organizations.

Another cause of diminishing returns to scale is limited natural resources. For example, a coal mining
organization can increase the number of mining plants, but cannot increase output due to limited coal
reserves.

c. Constant returns to scale

Constant returns to scale or constant cost refers to the production situation in which output increases
exactly in the same proportion in which factors of production are increased. In simple terms, if factors of
production are doubled, output will also be doubled. In this case internal and external economies are
exactly equal to internal and external diseconomies. This situation arises when after reaching a certain
level of production, economies of scale are balanced by diseconomies of scale.
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When there is a movement from a to b, it indicates that input is doubled. Now, when the combination of
inputs has reached to 2K+2L from IK+IL, then the output has increased from 10 to 20.

Similarly, when input changes from 1K+1L to 3K + 3L, then output changes from 10 to 30, which is
equal to the change in input. This shows constant returns to scale. In constant returns to scale, inputs are
divisible and production function is homogeneous.

Calculating constant returns to scale is important because it helps companies measure the correlation
between their inputs and outputs to notice how their processes are affecting the average cost of
production in the long run. A constant return to scale is the goal of most companies because it means
their investments are generating consistent returns. As they invest more capital, resources and labor into
a project, they're seeing the benefits returned to them at the same rate.

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