Business Economics

Unit IV: Production Function

THEORY OF PRODUCTION

MEANING OF PRODUCTION:

Production is defined as “the transformation of input into output”. It refers to the production of
goods and services. The factors of production and all other things which the producer buys to
carry out production are called inputs. The final goods and services produced are known as
output. In economics, the term production is not the same as in common language where it is
usually taken to mean ‘creation’ of something. In economics, the term production carries a
wider connotation. It stands for creation of ‘value’, which can be of two varieties, namely ‘use
value’ and ‘exchange value’. Thus, production is the activity which creates or adds utility and
value.

FACTORS OF PRODUCTION:

The resources needed to produce a given product are called factors of production. Production
of goods and services needs various inputs which are known as ‘Factors of Production’.
According to Marshall, the four major factors of production are:
– Land
– Labour
– Capital
– Organisation

The level of production depends upon both the quantity of inputs and the efficiency with which
they are employed in the process of production. It is also noteworthy that economic growth of
a country, in a way, represents its productive capacity which, in turn, depends upon the
technology and amounts of productive resources.

1. Land: Land is not created by mankind but it is a gift of nature available to us free of cost. So,
it is called as natural factor of production. It is also called as original or primary factor of
production. Land includes earth’s surface and resources above and below the surface of the
earth. It includes following natural resources:-
– On the surface (e.g. soil, agricultural land, etc.)
– Below the surface (e.g. mineral resources, rocks, ground water, etc.)
– Above the surface (e.g. climate, rain, etc.)

Land is the sum total of those productive resources which are provided ‘free of cost’ by nature to
us that is to say those resources on which no human effort has been expended to make them
actually usable in a productive process.

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Unit IV: Production Function

2. Labour: The term labour refers to only human effort (or activity) which can be physical,
mental or a mixture of the two. It does not include the work performed by animals or machines
or nature.
Labour is also known as human resource. All companies need labor in order to carry out
production. Everyone from the manual workers, to the owner of the company falls under the
classification of human resources.

3. Capital: Capital is another important factor which plays a huge role in the production. Capital
includes things like tools, machines, and other things that a business uses in order to produce
their goods or services. Capital is that part of wealth which is used for production. It is one of
the factors of production/ input.

4. Organizations: Factors of production viz. land, labour and capital are scattered at different
places. These cannot produce economic goods and services by themselves. They have to be
brought together and, in a coordinated way, made to pass through a productive process to
create output. All these factors have to be assembled together. This work is done by
organization.

PRODUCTION FUNCTION:

The functional relationship between input and output is known as production function.
The production function states the maximum quantity of output which can be produced from
any selected combination of inputs.

The production function can be expressed in form of an equation in which the output is the
dependent variable and inputs are the independent variables. The equation is expressed as
follows:

Y = f(R, L, K, O)

Where, Y = Output

R = Land

L = Labour

K = Capital

O = Organization

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Unit IV: Production Function

These are called factors of production. They can be classified into fixed factors and variable
factors. Generally land is considered as fixed factors and labour, capital and organizations are
considered as variable factors.

Assumptions of Production Function:

There are three main assumptions underlying any production function:

i) The relationship between inputs and outputs exists for a specific period of time.
ii) The level of technology remains constant.
iii) Whatever input combinations are included in particular function, the output
resulting from their utilization is at the maximum level.

There are two types of production function - short run production function and long run
production function.

Short run is defined as that time period over which a firm is unable to vary the quantities of all
inputs. In contrast, long run is defined as that time period over which a firm can vary quantities
of all factors of production and therefore, can switch between different scales. In the long run
production function all inputs are variable.

There are two alternative theories to these production functions i.e.

– Law of Diminishing Returns or Laws of Variable Proportions (to analyze production in the
short period)
– Law of Returns to Scale (to analyze production in the long period)

Concept of Total Product (TP), Average Product (AP) and Marginal Product (MP):

Total Product (TP): Total product is the total quantity of output a firm obtains from a given
quantity of inputs.

Average Product (AP): Average product refers to per unit of a variable factor. It is calculated by
dividing total product by the total number of units of variable factor. We calculate it as:

OR

Where, AP = Average Product

TP = Total Product

L = No of units of variable factor

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Unit IV: Production Function

Marginal Product (MP): Marginal Product can be defined as the addition to total product by the
employment of an additional unit of a factor. We obtain marginal product by using the
following formula:

MP = TPn – TPn-1

Where, MP = Marginal Product

TPn = Total product of ‘n’ units

TPn-1 = Total product of ‘n-1’ units

Quantity of labour Total Product (TP) Average Product (AP) Marginal Product (MP)
1 100 100 100
2 210 105 110
3 330 110 120
4 440 110 110
5 520 104 80
6 594 99 74
7 616 88 22
8 616 77 0
9 603 67 -13

Relationship between Marginal Product and Average Product:

Both average product and marginal product are derived from total product. Average product is
obtained by dividing total product by the number of units of variable factor and marginal
product is the change in total product from a unit increase in the quantity of variable factor.
The various points of relationship between average product and marginal product can be
summed up as follows:

i) When average product rises as a result of an increase in the quantity of variable

input, marginal product is more than the average product.
ii) When average product is maximum, marginal product is equal to average product. In
other words, the marginal product curve cuts the average product curve at its
maximum.
iii) When average product falls, marginal product is less than the average product.

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Unit IV: Production Function

LAW OF VARIABLE PROPORTIONS/LAW OF DIMINISHING RETURNS:

The law of variable proportions or the law of diminishing returns states “as the proportion of
variable factor is increased, the total production at first increases more than proportionately,
then proportionately and finally less than proportionately”. It refers to input-output
relationship, when the output is increased by varying the quantity of variable input.

The law of variable operates under certain assumptions which are as follows:
1. The technology remains constant. If there is an improvement in the technology, due to
inventions, the average and marginal product will increase instead of decreasing.
2. There are two factors of production. One factor is variable and other factor is kept
constant.
3. All the units of the variable factor are equally efficient.
4. It is possible to change factor proportion.
5. The law operates in the short run.

There are three stages of law of variable proportions

Stage 1: Stage of Increasing Returns
Stage 2: Stage of Diminishing Returns
Stage 3: Stage of Negative Returns

Table 3.1:
Stage 1: Stage of Increasing Returns: In this stage, total product increases at an increasing rate
upto a point (in figure upto point F), marginal product also rises and is maximum at the point
corresponding to F and average product goes on rising. From point F onwards during this stage,
the total product goes on rising but at a diminishing rate. Marginal product falls but is positive.
The stage 1 ends where Average product curve reaches its maximum.

Causes for the law of increasing returns: The law of increasing returns operates when the
quantity of a fixed factor is abundant in relation to the quantity of the variable factor. When
more and more units of the variable factors are added to the constant quantity of the fixed

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factor it is more effectively and intensively used. As a result, the production increases at a rapid
rate. Again when more units of the variable factors are employed to work on it, output
increases considerably due to effective and fuller utilization of the variable factor.

Stage 2: Stage of Diminishing Returns: In stage 2, the total product continues to increase at a
diminishing rate until it reaches its maximum point H, where the second stage ends. In this
stage, both marginal product and average product of the variable factor decline, but remain
positive. At the end of this stage i.e., at point M, the marginal product of the variable factor is
zero. This stage is known as diminishing returns because both the average product and
marginal products of the variable factors continuously fall during this stage.

Causes for the law of diminishing returns: The second stage of the law operates when the fixed
factor becomes insufficient relative to the quantity of the variable factor. When more and more
units of variable factors are employed, the fixed factor becomes inadequate relative to the
quantity of the variable factor. This causes marginal and average product to decline.

Stage 3: Stage of Negative Returns: At this stage, total product starts declining and marginal
product becomes negative. This stage is called stage of negative returns since the marginal
product of the variable factor is negative during this stage.

Causes for the law of increasing returns: The law of negative returns operates when the number
of variable factor becomes too excessive relative to the fixed factor.

Stage of Operation: A rational producer will never produce in Stage 3 where marginal product
of the variable factor is negative. This is because a producer can always increase his output by
reducing the amount of variable factor.

A rational producer will also not produce in Stage 1 as he will not be making the best use of
fixed factors and he will not be utilizing fully the opportunities of increasing production by
increasing the quantity of the variable factor whose average product continues to rise through
stage 1.

Thus, a rational producer will never produce in Stage 1 and stage 3. These stages are called
Stages of economic absurdity or economic non-sense.

A rational producer will always produce in Stage 2 where both marginal product and average
product of the variable factors are diminishing, but remain positive.

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Unit IV: Production Function

LAW OF RETURNS TO SCALE

Law of Returns to Scale is a long run concept. In the long run, all factors of production become
variable as the firm is able to alter its stock of inputs. Law of returns to scale explains the
physical relationship between input and output in the long run. It explains the behaviour of
output when quantities of all input are changed in the same proportion.

A return to scale is the rate at which the output increases with the increase in all inputs
proportionately. There are three cases of returns to scale:
i) Increasing Returns to Scale
ii) Constant Returns to Scale
iii) Diminishing Returns to Scale

Increasing Returns to Scale: When inputs are increased in a given proportion and output
increases in a greater proportion, the returns to scale are said to be increasing. In other words,
proportionate increase in all factors of production results in a more than proportionate
increase in output is a case of increasing returns to scale.
When a firm expands, increasing returns to scale are obtained in the beginning. Reason for
increasing returns to scale is the indivisibility of factors. Some factors are available in large and
lumpy units and can, therefore, be utilized with utmost efficiency at a large output. If all factors
are perfectly divisible, increasing returns may not occur. Returns to scale may also increase
because of greater possibilities of specialization of land and machinery.

Constant Returns to Scale: When inputs are increased in a given proportion and output
increases in the same proportion, the returns to scale are said to be constant.
It has been found that production function for the economy as a whole corresponds to
production function exhibiting constant returns to scale. Also, it has been found that an
individual firm passes through a long phase of constant returns to scale in its lifetime.
Constant return to scale is also known as “Linear Homogeneous Production Function”.

Decreasing Returns to Scale: If a proportionate increase in all inputs results in less than
proportionate increase in output, the returns to scale are said to be decreasing. When a firm
goes on expanding by increasing all inputs, diminishing returns to scale set in. Decreasing
returns to scale eventually occur because of increasing difficulties of management,
coordination and control. When the firm has expanded to a very large size, it is difficult to
manage it with same efficiency as before.

Examples:
Unit of input % Unit of output %
10 100
100 120 Increasing Returns to Scale
20 220

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Unit IV: Production Function

10 100
100 100 Constant Returns to Scale
20 200

10 100
100 80 Decreasing Returns to Scale
20 180

OPTIMAL FACTOR COMBINATION:

Normally, a firm is interested to know what combination of factors of production (or inputs)
would minimize its cost of production. This can be known with the help of isoquants and iso-
cost lines.

Isoquants:
 Isoquants represent all those combinations of inputs which are capable of producing the
same level of output.
 Isoquants are also called equal-product or iso-product curves.
 Since isoquant curve represents all those combination of inputs which yield an equal
quantity of output, the producers is indifference between them. Therefore, another
name of isoquants is production-indifference curve.

Factor Combination Factor X Factor Y

A 1 12
B 2 8
C 3 5
D 4 3
E 5 2

When we plot them, we get a curve IQ as shown in Figure 2.

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Iso-cost or Equal Cost Lines:

 Iso-cost line represents the prices of factors
 It shows various combinations of two factors which the firm can buy with the given
outlay.
 For instance, a firm has ₹100 to spend on the two factors X and Y. If the price of factor X
is ₹10 and that of Y is ₹20, the firm can spend its outlay on X and Y in various ways. It
can spend the entire amount on X and thus buy 10 units of X and zero units of Y or it can
spend the entire outlay on Y and buy 5 units of it with zero units of factor X. In between,
it can have any combination of X and Y.

We can show iso-cost line diagrammatically also. The X-axis shows the units of factor X and Y-
axis shows the units of factor Y. When entire amount of ₹100 is spent on factor X we get OB
and when entire amount is spent on factor Y we get OA. The straight line AB which joins points
A and B will pass through all combinations of factors X and Y which the firm can buy with outlay
of ₹100. The line AB is called iso-cost line.

The above figure shows various iso-cost lines representing different combination of factors with
different outlays. A rightward shift of iso-cost lines from A’B’ to A’’B’’ indicates an increase in
total outlay. A leftward shift of iso-cost lines from A’B’ to AB shows a decrease in total outlay.
Thus, higher the iso-cost line, higher is the cost and vice-versa.

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Unit IV: Production Function

Suppose the firm has decided to produce 500 units of output using two combinations, say
Labour and Capital, represented by isoquant curve. These units can be created by any factor
combination lying on isoquant curve such as C, E, D, etc. The cost of producing 500 units would
be minimum at the factor combination represented by point E, where the iso-cost line A’A’ is
tangent to the given isoquant curve. At all other points such as C and D, the cost are more as
these points lie on higher iso-cost lines than A’A’. Thus, the factor combination represented by
point E is the optimal combination for the producer. It represents least-cost of producing 500
units of output.

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