Theory of Production

⮚ Define Production

In general, production means creation of utility. In other words, Production is the act of creating an
output, a good or service which has value and contributes to the utility of individuals.

Production refers to the transformation of resources into different goods or services. In other words,
production is a process of combining various material inputs and immaterial inputs (Plans,
Know-How) in order to make something for consumption (Output).
For example: General Motors hires workers who use machinery in factories to transform steel,
plastic, rubber and so on… into auto mobile.

⮚ Factors of Production

In economics, factors of production or resources or inputs are what’s used in the production
process to produce output – that is, finished goods and services.
Factors of production have been classified as:
● Land
● Labour
● Capital &
● Entrepreneur
Which are described below:

1. Land:

The term “Land” has been given a special meaning in economics. It doesn’t mean soil as in the
ordinary speech but it is used in a much wider sense. In economics, Land refers to all-natural
resources which are free gifts of nature. Land, therefore, includes all gifts of nature available to
mankind – both on the surface and under the surface, e.g., Soil, rivers, water, forests, Mountains,
mines, sea, deserts, climate, rains, air, sun etc.

The supply of land is inelastic or fixed, land is a free gift from nature and its’ quantity is also
fixed by nature. Therefore, more land can’t be produced in response to greater demand for it.
Whatever the rent, high or low, for the use of land, its’ supply to the economy as a whole remains
unchanged.

2. Labour:
 Human efforts done mentally or physically with the aim of earning income is known as labour.
Thus, labour is a physical or mental effort of human being in the process of production. Where
land and capital are material factors of production, labour is a human factor.

Labour exhibits the following characteristics:

I. Labour cannot be separated from the labourer himself.
II. The labourer does not sell himself; he only sells his labour.
III. Labour is perishable factor and it is not possible to store it for future use.
IV. Labour cannot be engaged continuously in production like a machine.
V. Efficiency of labour varies a good deal.

3. Capital:

Capital refers to the human made equipment required to produce goods and services. Example of
capital is the paper company’s factory, machinery, office buildings and delivery trucks. Sometimes
capital is also defined to include the money used to buy such equipment and to start and maintain
business operations.

Capital has been rightly defined as produced means of production; so, land and labour are not
produced factors, they are primary factors of production.
Capital can be divided into three categories:
a) Fixed Capital:
Fixed capital is durable-use produce goods which are used in production again and again till they
wear out. For example: Machinery, tools, railways, tractors, factories etc.

b) Working Capital:

Working capital are the single-use producers’ goods. Like, raw materials, fertilizer, fuel and so
on.

c) Human Capital:

By Human Capital, we mean the stock of people equipped with education, skills, health etc.

4. Entrepreneur:

An entrepreneur is a person who organizes the other factors and undertakes the risks and
uncertainties involved in the production. He hires the other factors, bring them together, organizes
and coordinates them so as to earn maximum profit. He is also called an organizer, manager & a risk
taker.
 ⮚ Define Production Function

The act of production involves the transformation of inputs into outputs. The production function is a
purely technical relation which connects factor inputs and outputs. It describes the laws of
proportion, that is, the transformation of factor inputs into products (outputs) at any particular time
period.

The functional relationship between physical inputs and physical outputs of a firm is also known as
production function.

A production function can be written as –

Q = f (L, N, K, M)

Where, Q stands for quantity of outputs, L, N, K & M stands for the quantity of land, labour, capital
& raw materials respectively.

The above equation shows that the quantity (Q) of output produce depends upon the quantities of the
factors used. More precisely, the production function states the maximum output that can be
produced with any given quantities of various inputs.

According to “Bruce Beattie” & “Robert Taylor” a production function is a quantitative or

mathematical description of the various technical production possibilities faced by a firm.

Decision Period Relate theory of Production Analysis

In analyzing the behavior of producers or a production process, we have to take into account the time
factor involves in the production process. Two different time periods involved in the theory of
production.

1. short-run production
2. long-run production

Short-run Production Function:

A short-run can be defined as the production period in which at least one of the inputs is fixed. In
other words, short run is period of time in which variable factors, such as labour or raw material
input, can be changed easily but fixed factor cannot.
For example: when the quantities of some inputs such as capital and land are kept constant and the
quantity of the inputs such as labour (or quantity of few inputs) is varied is called short-run
production function. In short-run, production is a function of both fixed and variable factor.

When one factor is fixed factor and the other is a variable factor, production function may be
specified as follows:

QX = f (L, 𝑘 )

Here,
QX = Output of Good X
L = Labour, a variable factor

𝑘 = Capital, a fixed factor

In this type of production function, output can be increased only by increasing the application of L
(The variable factor)

The Long-run Production Function:

The long-run production function refers to that time period in which all the inputs of the firm are
variable. In other words, when the quantities of all inputs are varied is called long-run production
function. In long-run, all factors of production are variable.

When all factors are variable factor, the production mat be specified as follows:
QX = f (L, K)
Here,
QX = Output of Good X
L & K = Labour and Capital Both are variable
In this type of production function, Output can be increased by increasing the application of both L
& K.
Example of MP: Suppose, when two workers are employed to produce wheat in an agricultural farm
and they produce 170 quantities of wheat per year. Now, instead of two workers, three workers are
employed and as result total production is increased to 270 quantities, the third worker added 100
quantities of wheat to the total production. Thus, 100 quantities are the MP of the third worker.

Graphical Presentation of Marginal Product

Where,
AP = Average product of labour
TP = Total output produced by labour
L = Total number of labour.
Example of AP: Suppose that the total product is 100 and the total labour employed is 10. Then the
Average Product of labour is: 100/10 = 10. In that case, average product is the output per unit of
labour.
Numerical of Example of Total Product, Average Product & Marginal Product of
Labour:
Land Capital Stage
Labour TP MPL APL
(Acre) (TK)
1 1000 0 0 - - 1st
1 1000 1 6 6 6
1 1000 2 16 10 8
1 1000 3 30 14 10
1 1000 4 40 10 10 2nd
1 1000 5 45 5 9
1 1000 6 48 3 8
1 1000 7 48 0 6.86
1 1000 8 46 -2 5.75 3rd
1 1000 9 40 -6 4.44
1 1000 10 30 -10 3

❖ Graphical Relationship Between Total Product, Average Product & Marginal Product /
Three stages of Production/ Law of Variable Proportion
As one input varies and all others remain constant, the factor ratio or the factor proportion varies.
Let’s look at an example to understand this better:

Let’s say that you have 10 acres of land and 1 unit of labour for production. Therefore, the
land-labour ratio is 10:1. Now, if you keep the land constant but increase the units of labour to 2, the
land-labour ratio becomes 5:1.

Therefore, as you can see, the law analyses the effects of a change in the factor ratio on the amount
of output and hence called the Law of Variable Proportions.

The law states that as we go on adding one factor with the fixed factor, the total product initially will
increase at an increasing rate, then it increases at a decreasing rate, and after reaching the maximum,
it will fall.
In the short production process, we get three types of marginal productivities
1. Increasing MPL
2. Decreasing MPL
3. Negative MPL
1. Increasing MPL – Every additional unit of L increases the TP, AP, and MP. This is shown in
the graph by increasing the slope of the TP curve.

2. Decreasing MPL – Every additional unit of L decreases MP though TP still increases. This
is shown in the graph by the negative slope of MP and decreasing the positive slope of the TP
curve.

3. Negative MPL – Every additional unit decreases MP as well as TP. This is shown in the
graph by the negative slope of MP as well as TP curves.

Based on the relationship between TP, AP, and MP of the variable factor, three stages of production
can be defined as shown in the graph below:

1. Stage I – The TP increases at an increasing rate and the MP increases too. The MP
increases with an increase in the units of the variable factor and reaches the maximum
point and then start to decline. In this stage AP Increases through and reaches
its maximum point. At the endpoint of the stage AP=MP. Therefore, it is also called the
stage of increasing returns. In this example, the Stage I runs between the points O and
N.

2. Stage II – The TP continues to increase but at a diminishing rate. However, the

increase is positive. Further, the MP and AP decreases with an increase in the number of
units of the variable factor. Hence, it is called the stage of diminishing returns. In this
 example, Stage II runs between the points N and M. This stage reaches a point where TP
is maximum and MP becomes zero.

3. Stage III – Now, the TP starts declining, MP decreases and becomes negative. And
AP continues to decline but remain positive. Therefore, it is called the stage of negative
returns. In this example, Stage III runs from the point M onwards.

Explanation of the three stages of Production at a Glance

Stages TP MP AP

Stage I Increases at an increasing First increases and reaches Increases through and
MP>AP rate and later at a the maximum point and then reaches
decreasing rate. start to decline. its maximum point. At
the endpoint of the stage
AP=MP.

Stage II It increases at a Decreases gradually and After reaching its

MP<AP diminishing rate and become zero at point maximum
reaches the point begins to
its maximum point. decrease.

Stage II It begins to fall. Becomes negative. Continues to decline but

MP<0 remains positive.

The best stage of Production

Stage I goes from origin to the point where the AP maximizes. In this stage, MP raises, reaches a
maximum, and then falls.

Stage II goes from the point where AP is highest to the point where MP is zero. In this stage, the
marginal product falls till it becomes zero while the average product keeps on falling but is positive.

Stage III occurs when the marginal product is negative.

A rational producer will not operate in stages 1 and 3.

In this stage I, the marginal product increases with an increase in the variable factor. Therefore, the
producer can employ more units of the variable to efficiently utilize the fixed factors. Hence, the
producer would prefer to not stop in Stage I but will try to expand further.

Producers do not like to operate in Stage III either. In this stage, there is a decline in total product and
the marginal product becomes negative. In order to increase the output, producers reduce the amount
of variable factor. However, in Stage III, he incurs higher costs and also gets lesser revenue thereby
getting reduced profits.
The only stage where the production can take place is stage 2, where both marginal and average
products are declining, but they are positive. To determine the exact point where the producer
operates within this stage depends on the price of output and the cost of variable inputs.

However, if the output maximization is the goal, and there are no constraints, then the end of stage II,
i.e., the point where the MP curve cuts the horizontal axis (MP = 0) will be the most efficient input
combination.

Relationship between Average Product and Marginal Product

There exists an interesting relationship between Average Product and Marginal Product. We can
summarize it as under:

● When Average Product is rising, Marginal Product lies above Average Product.

● When Average Product is declining, Marginal Product lies below Average Product.

● At the maximum of Average Product, Marginal and Average Product equal each other.

Relationship between Total Product and Marginal Product

1. When the Marginal Product (MP) increases, the Total Product is also increasing at an increasing
rate. This gives the Total product curve a convex shape in the beginning as variable factor inputs
increase. This continues to the point where the MP curve reaches its maximum.

2. When the MP declines but remains positive, the Total Product is increasing but at a decreasing
rate. This give ends the Total product curve a concave shape after the point of inflexion. This
continues until the Total product curve reaches its maximum.
3. When the MP becomes zero, Total Product reaches its maximum.

4. When the MP is declining and negative, the Total Product declines.

⮚ Production Process and Isoquant

The production function is a purely technical relation which connects factor inputs and outputs. It
describes the laws of proportion, that is, the transformation of factor inputs into products (outputs) at
any particular time period. The production function represents the technology of a firm of an
industry, or of the economy as a whole. The production function includes all the technically efficient
methods or production (see below).
A method of production (process, activity) is a combination of factor inputs required for the
production of one unit of output. Usually, a commodity may be produced by various methods of
production. For example, a unit of commodity x may be produced by the following processes:

Activities may be presented graphically by the length of lines from the origin to the point determined
by the labour and capital inputs. The three processes above are shown in figure 3.1.
A method of production A is technically efficient relative to any other method B, if A uses less of at
least one factor and no more from the other factors as compared with B. For example, commodity
can be produced by two methods:

Method B is technically inefficient as compared with A. The basic theory of production concentrates
only on efficient methods. Inefficient methods will not be used by rational entrepreneurs. If a process
A uses less of some factor(s) and more of some other(s) as compared with any other process B, then
A and B cannot be directly compared on the criterion of technical efficiency. For example, the
activities

are not directly comparable. Both processes are considered as technically efficient and are included
in the production function (the technology). Which one of them will be chosen at any particular time
depends on the prices of factors. The theory of production describes the laws of production. The
choice of any particular technique (among the set of technically efficient processes) is an economic
one, based on prices, and not a technical one.

From the concept of production process, we get two terms technical efficiency and Economic
efficiency –
Technical Efficiency: Technical efficiency happens when a firm produces a given level of output by
using least amount of inputs.
Economic Efficiency: Economic efficiency happens when a firm produces a given level of output at
least cost. So economically efficient method of production depends on the relative costs of resources.

Suppose there are three methods of production for producing 100 unit of output and all are
technically efficient then how a producer makes production decision?
Suppose,
Price of labour= 5 Per unit
Price of capital= 10 Per unit.
And the three process are-
Process 1- 100 units of output = 8 unit of labour and 12 unit of capital = (8*5+12*10) =160
Process 2-100 units of output = 12 unit of labour and 8 unit of capital = (12*5+8*10) =140
Process 3-100 units of output = 10 unit of labour and 10 unit of capital = (10*5+10*10) =150
NB: An economically efficient method of production process is also technically efficient. But a
technically efficient method of production may not be economically efficient one.

⮚ Isoquant and Its Types

Isoquant: An isoquant includes (is the locus of) all the technically efficient methods (or all the
combinations of factors of production) for producing a given level of output. The production
isoquant may assume various shapes depending on the degree of substitutability of factors.

⮚ Linear isoquant: This type assumes perfect substitutability of factors of production: a given
commodity may be produced by using only capital, or only labour, or by an infinite
combination of K and L (figure 3.2).

⮚ Input-output isoquant: This assumes strict complementarity (that is, zero substitutability) of
the factors of production. There is only one method of production for any one commodity. The
isoquant takes the shape of a right angle (figure 3.3). This type of isoquant is also called
'Leontief isoquant' after Leontief, who invented the input output analysis.
⮚ Kinked isoquant: This assumes limited substitutability of K and L. There are only a few
processes for producing any one commodity. Substitutability of the factors is possible only at
the kinks (figure 3.4). This form is also called 'activity analysis-isoquant' or
'linear-programming isoquant', because it is basically used in linear programming.

⮚ Smooth, convex isoquant: This form assumes continuous substitutability of K and L only
over a certain range, beyond which factors cannot substitute each other. The isoquant appears
as a smooth curve convex to the origin (figure 3.5).
 LAWS OF RETURNS TO SCALE: LONG-RUN ANALYSIS OF PRODUCTION

In the long run expansion of output may be achieved by varying all factors. In the long run all factors
are variable. The laws of returns to scale refer to the effects of scale relationships. In the long run
output may be increased by changing all factors by the same proportion, or by different proportions.
Traditional theory of production concentrates on the first case, that is, the study of output as all
input’s changes by the same proportion. The term 'returns to scale' refers to the changes in output as
all factors change by the same proportion.

• Suppose we start from an initial level of inputs and output

X0 = f (L, K)
and we increase all the factors by the same proportion t. We will clearly obtain a new level of output
X*, higher than the original level X0,
X* = f (tL, tK)
If X* increases by the same proportion t as the factors, we say that there are constant returns to scale.
If X* increases less than proportionally with the increase in the factors, we have decreasing returns
to scale.
If X* increases more than proportionally with the increase in the factors, we have increasing returns
to scale.

Returns to Scale and Homogeneity of The Production Function

Suppose we increase both factors of the function
 X0 = f (L, K)
by the same proportion t, and we observe the resulting new level of output X*
X* = f (tL, tK)
If t can be factored out (that is, may be taken out of the brackets as a common factor), then the new
level of output X* can be expressed as a function of t (to any power v) and the initial level of output
X* = tv f (L, K)
or X*= tv x0
and the production function is called homogeneous. If t cannot be factored out, the production
function is non-homogeneous. Thus:
A homogeneous function is a function such that if each of the inputs is multiplied by t, then t can be
completely factored out of the function. The power v of t is called the degree of homogeneity of the
function and is a measure of the returns to scale:
If v = 1 we have constant returns to scale. This production function is sometimes called linearly
homogeneous.
If v < 1 we have decreasing returns to scale.
If v > 1 we have increasing returns to scale.

Example of Non- homogeneous production Homogeneous Production function with

function constant returns to scale

X0 = f (L, K) =L+K2 Q =K 0.3 L0.7

= tL+t2 K2 = (tK) 0.3 (tL0.7)
=t (L+tK2) =t0.3 K 0.3 t 0.7 L0.7
X* ≠ t X0 = t0.3 t 0.7 (K 0.3 L0.7)
=t1 (K 0.3 L0.7)
Q* =t1 Q

Q= K 0.3 L0.2 Q= K2 + L2 Q=2k2+L+KL Q=2k2+L2+KL Q=4k+4L2

For a homogeneous production function, the returns to scale may be represented graphically in an
easy way. Before explaining the graphical presentation of the returns to scale it is useful to introduce
the concepts of product line and isocline.
 Product lines:
To analyze the expansion of output we need a third dimension, since along the two-dimensional
diagram we can depict only the isoquant along which the level of output is constant. Instead of
introducing a third dimension it is easier to show the change of output by shifts of the isoquant and
use the concept of product lines to describe the expansion of output. A product line shows the
(physical) movement from one isoquant to another as we change both factors or a single factor. A
product curve is drawn independently of the prices of factors of production. It does not imply any
actual choice of expansion, which is based on the prices of factors and is shown by the expansion
path. The product line describes the technically possible alternative paths of expanding output. What
path will actually be chosen by the firm will depend on the prices of factors. The product curve
passes through the origin if all factors are variable. If only one factor is variable (the other being kept
constant) the product line is a straight line parallel to the axis of the variable factor (figure 3.15). The
K/L ratio diminishes along the product line.

Graphical Presentation of The Returns to Scale for a Homogeneous Production Function

The returns to scale may be shown graphically by the distance (on an isocline) between successive
'multiple-level-of-output' isoquants, that is, isoquants that show levels of output which are multiples
of some base level of output, e.g., X, 2X, 3X, etc.

1. Constant returns to scale: Along any isocline the distance between successive multiple
isoquants is constant. Doubling the factor inputs achieves double the level of the initial
output; trebling inputs achieves treble output, and so on.
 Figure 3.18: Constant returns to scale

2. Decreasing returns to scale: The distance between consecutive multiple-isoquants

increases. By doubling the inputs, output increases by less than twice its original level. In
figure 3.19 the point a', defined by 2K and 2L, lies on an isoquant below the one showing 2X.

Figure 3.19: Decreasing returns to scale

3. Increasing returns to scale: The distance between consecutive multiple-isoquants

decreases. By doubling the inputs, output is more than doubled. In figure 3.20 doubling K
and L leads to point b' which lies on an isoquant above the one denoting 2X.
 Figure 3.20: Increasing returns to scale

Book: 1. Modern_Microeconomics_by_Koutsoyiannis. Chapter-3, Theory of Production- Page 68

2. Economics by Paul Samuelson, William Nordhaus. Chapter-6, Production and Business
Organization, Page-107; Chapter-7, Analysis of Costs, Page-126- 130
3. Practical Guide To Contemporary Economics, Page 54-4.3 short run and long run Concepts
You tube link: https://youtu.be/swjwXTbEV6E for law of variable proportion