Theory of Production

• What is the Production Function?

The functional relationship between physical inputs (or factors of
production) and output is called production function. It assumed
inputs as the explanatory or independent variable and output as the
dependent variable. Mathematically, we may write this as follows:
Q = f (L,K)
Here, ‘Q’ represents the output, whereas ‘L’ and ‘K’ are the inputs,
representing labour and capital (such as machinery) respectively.
Note that there may be many other factors as well but we have
assumed two-factor inputs here.
“The production function is purely a technical relation which connects
factor inputs and output.” Prof. Koutsoyiannis.
Land , labour, capital and organisation or enterprise
Prices of land rent, prices of labor is called wage, prices of capital
interest, prices of enterprise profit
Theory of Production
• The general mathematical form of production function is
• Y= f( L, K, R, S, v, A)
• Where, Y=output
• L= labour input
• K= capital input
• R= raw materials
• S=land input
• v= returns to scale, Decreasing returns to scale,
increasing returns to scale, constant returns to scale,
L=10,K=10,Q=10, L=20, K=20, Q= 15, L=20,K=20,Q=20,
L=20,K=20 Q=25
• A = efficiency parameter(Technological development)
Theory of Production
• Cob-Douglas production function:
• Many economist have studied actual production functions and
have used statistical methods to find out relations between
changes in physical inputs and physical outputs. A most
familiar empirical production function found out by statistical
methods is Cobb- Douglas production function. Originally ,
Cobb-Douglas production function was applied not to the
production process of an individual firm but to the whole of the
manufacturing industry. Output in this function is thus
manufacturing production. In Cobb-Douglas production
function, there are two inputs, labour and capital, Cobb-
Douglas production function takes the following mathematical
form:
• Q= A𝐿𝛼 𝐾𝛽
• Where Q is the manufacturing output, L is the quantity of labour
employed, K is the quantity of capital employed, and A,
𝛼 𝑎𝑛𝑑 𝛽 are positive constant.
Theory of Production
• Properties of cobb- Douglas production function:
• Cobb-Douglas production function has the following
useful properties:
• 1.The sum of the exponents of Cobb- Douglas production
function, that is, 𝛼 + 𝛽 measures the returns to scale.
If α+β=1, returns to scale are constant
If α+β>1, returns to scale are increasing
If α+β<1, returns to scale are decreasing
Theory of Production

increase

decrease
Theory of Production
• What Is the Short Run?
The short run is a concept that states that, within a
certain period in the future, at least one input is fixed
while others are variable. The short run does not refer to
a specific duration of time but rather is unique to the firm,
industry or economic variable being studied.
Theory of Production
• What Is the Long Run?
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. Additionally, while
a firm may be a monopoly in the short term, they may
expect competition in the long run.
Key Differences Between Short Run and Long Run Production Function
The difference between short run and long run production function can be drawn
clearly as follows:
The short run production function can be understood as the time period over which
the firm is not able to change the quantities of all inputs. Conversely, long run
production function indicates the time period, over which the firm can change the
quantities of all the inputs.
While in short run production function, the law of variable proportion operates, in
the long-run production function, the law of returns to scale operates.
The activity level does not change in the short run production function, whereas
the firm can expand or reduce the activity levels in the long run production
function.
In short run production function the factor ratio changes because one input varies
while the remaining are fixed in nature. As opposed, the factor proportion
remains same in the long run production function, as all factor inputs vary in the
same proportion.
In short run, there are barriers to the entry of firms, as well as the firms can shut
down but cannot exit. On the contrary, firms are free to enter and exit in the long
run.
Theory of production
• Total Physical Product of Labour(𝑇𝑃𝑃𝐿 ):
• Total product of labour is defined as the amount of output
produced by a certain quantity of labour while the amount
of capital is fixed whatever the amount of capital, at zero
employment of labour total product would be zero hence
total product stems from the point origin.
Theory of Production
• Total Product
• In simple terms, we can define Total Product as the total volume or
amount of final output produced by a firm using given inputs in a given
period of time.
• Marginal Product
• The additional output produced as a result of employing an additional unit
of the variable factor input is called the Marginal Product. Thus, we can
say that marginal product is the addition to Total Product when an extra
factor input is used.
• Marginal Product = Change in Output/ Change in Input
• Thus, it can also be said that Total Product is the summation of Marginal
products at different input levels.
• Total Product = Ʃ Marginal Product
• Average Product
• It is defined as the output per unit of factor inputs or the average of the
total product per unit of input and can be calculated by dividing the Total
Product by the inputs (variable factors).
• Average Product = Total Product/ Units of Variable Factor Input
Theory of Production
TPP
Theory of Production
• Average Physical product of Labour (𝐴𝑃𝑃𝐿) :
• Total product per unit of labour is called average
product of labour. Suppose 10 units of labour
produce 150 units of output then the average product
would be 150/10. 𝐴𝑃𝑃𝐿=𝑇𝑃𝑃
𝐿

Marginal Physical Product of Labour (𝑀𝑃𝑃𝐿)

Change in total product due to one unit change in
labour assuming all other factor inputs fixed is called
marginal product of labour .
𝜕𝑄
MPPL=
𝜕𝐿
Theory of Production
• Theory of production
Theory of production
What Is the Law of Diminishing Marginal Returns Or Law of
Variable Proportion?
Law of variable proportions occupies an important place in
economic theory. This law examines the production
function with one factor variable, keeping the quantities of
other factors fixed. In other words, it refers to the input-
output relation when output is increased by varying the
quantity of one input.
If capital (K) is kept unchanged but labour (L) is
continuously increased , total product in the beginning
increases at an increasing rate, Then at a decreasing rate
and ultimately total product falls. This is known as the law
of variable proportion because of the variability in factor
proportion.
Theory of production
• Assumptions of the Law:
• The law of variable proportions or diminishing returns, as
stated above, holds good under the following conditions:
• 1. First, the state of technology is assumed to be given and
unchanged. If there is improvement in the technology, then
marginal and average products may rise instead of diminishing.
• 2. Secondly, there must be some inputs whose quantity is kept
fixed. This is one of the ways by which we can alter the factor
proportions and know its effect on output. This law does not
apply in case all factors are proportionately varied. Behaviour
of output as a result of the variation in all inputs is discussed
under “returns to scale”.
Theory of production
• 3. Thirdly the law is based upon the possibility of varying the
proportions in which the various factors can be combined to
produce a product. The law does not apply to those cases
where the factors must be used in fixed proportions to yield a
product.
• When the various factors are required to be used in rigidly fixed
proportions, then the increase in one factor would not lead to
any increase in output, that is, the marginal product of the
factor will then be zero and not diminishing. It may, however, be
pointed out that products requiring fixed proportions of factors
are quiet uncommon. Thus, the law of variable proportion
applies to most of the cases of production in the real world.
• The law of variable proportions is illustrated in the Table and
Fig.2. We shall first explain it by considering Table Assume
that there is a given fixed amount of land, with which more
units of the variable factor labour, is used to produce
agricultural output.
Theory of production
Returns to labor
Units of labour Total Marginal Average
product(quintals) Product(quintals) product(quintals)
L Q ∆𝑄 𝑄
∆𝐿 𝐿
1 80 80 80
2 170 90 85
3 270 100 90
4 368 98 92
5 430 62 86
6 480 50 80
7 504 24 72
8 504 0 63
9 495 -9 55
10 480 -15 48
Theory of production
• With a given fixed quantity of land, as a farmer raises employment of
labour from one unit to 7 units, the total product increases from 80
quintals to 504 quintals of wheat. Beyond the employment of 8 units
of labour, total product diminishes. It is worth noting that up to the use
of 3 units of labour, total product increases at an increasing rate.
• This fact is clearly revealed from column 3 which shows successive
marginal products of labour as extra units of labour are used.
Marginal product of labour, it may be recalled, is the increment in total
output due to the use of an extra unit of labour.
• It will be seen from Col. 3 , that the marginal product of labour initially
rises and beyond the use of three units of labour, it starts diminishing.
Thus when 3 units of labour are employed, marginal product of labour
is 100 and with the use of 4th and 5th units of labour marginal product
of labour falls to 98 and 62 respectively.
• Beyond the use of eight units of labour, total product diminishes and
therefore marginal product of labour becomes negative. As regards
average product of labour, it rises upto the use of fourth unit of labour
and beyond that it is falling throughout.
Law of variable proportion
• Three Stages of the Law of Variable Proportions:
• The behavior of output when the varying quantity of one
factor is combined with a fixed quantity of the other can
be divided into three distinct stages. In order to
understand these three stages it is better to graphically
illustrate the production function with one factor variable.
• This has been done in Fig.2. In this figure, on the X-axis
the quantity of the variable factor is measured and on the
Y-axis the total product, average product and marginal
product are measured. How the total product, average
product and marginal product a variable factor change as
a result of the increase in its quantity, that is, by
increasing the quantity of one factor to a fixed quantity of
the others will be seen from Fig. 2.
Theory of production
Theory of Production
• In the top Danel of this figure, the total product curve TP of variable factor goes on
increasing to a point and alter that it starts declining. In the bottom pane- average
and marginal product curves of labour also rise and then decline; marginal
product curve starts declining earlier than the average product curve.
• The behavior of these total, average and marginal products of the variable
factor as a result of the increase in its amount is generally divided into three
stages which are explained below:
• Stage 1:
• In this stage, total product curve TP increases at an increasing rate up to a point.
In Fig.2. from the origin to the point F, slope of the total product curve TP is
increasing, that is, up to the point F, the total product increases at an increasing
rate (the total product curve TP is concave upward upto the point F), which means
that the marginal product MP of the variable factor is rising.
• From the point F onwards during the stage 1, the total product curve goes on
rising but its slope is declining which means that from point F onwards the total
product increases at a diminishing rate (total product curve TP is concave down-
ward), i.e., marginal product falls but is positive.
• The point F where the total product stops increasing at an increasing rate and
starts increasing at the diminishing rate is called the point of inflection. Vertically
corresponding to this point of inflection marginal product is maximum, after which
it starts diminishing.
Theory of Production
• Thus, marginal product of the variable factor starts diminishing
beyond OL amount of the variable factor. That is, law of
diminishing returns starts operating in stage 1 from point D on
the MP curve or from OL amount of the variable factor used.
• This first stage ends where the average product curve AP
reaches its highest point, that is, point S on AP curve or CW
amount of the variable factor used. During stage 1, when
marginal product of the variable factor is falling it still exceeds
its average product and so continues to cause the average
product curve to rise.
• Thus, during stage 1, whereas marginal product curve of a
variable factor rises in a part and then falls, the average
product curve rises throughout. In the first stage, the quantity of
the fixed factor is too much relative to the quantity of the
variable factor so that if some of the fixed factor is withdrawn,
the total product will increase. Thus, in the first stage marginal
product of the fixed factor is negative.
Theory of Production
• Stage 2:

• 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 the
marginal product and the average product of the variable factor are diminishing
but remain positive.
• At the end of the second stage, that is, at point M marginal product of the variable
factor is zero (corresponding to the highest point H of the total product curve TP).
Stage 2 is very crucial and important because as will be explained below the firm
will seek to produce in its range.

• Stage 3: Stage of Negative Returns:

• In stage 3 with the increase in the variable factor the total product declines and
therefore the total product curve TP slopes downward. As a result, marginal
product of the variable factor is negative and the marginal product curve MP goes
below the X-axis. In this stage the variable factor is too much relative to the fixed
factor. This stage is called the stage of negative returns, since the marginal
product of the variable factor is negative during this stage.
• It may be noted that stage 1 and stage 3 are completely symmetrical. In stage 1
the fixed factor is too much relative to the variable factor. Therefore, in stage 1,
marginal product of the fixed factor is negative. On the other hand, in stage 3 the
variable factor is too much relative to the fixed factor. Therefore, in stage 3, the
marginal product of the variable factor is negative.
Theory of Production
• Explanation of Negative Marginal Returns to a Factor:
• As the amount of a variable factor continues to be increased to
a fixed quantity of the other factor, a stage is reached when the
total product declines and the marginal product of the variable
factor becomes negative.
• This phenomenon of negative marginal returns to the variable
factor in stage 3 is due to the fact that the number of the
variable factor becomes too excessive relative to the fixed
factor so that they obstruct each other with the result that the
total output falls instead of rising.
• Besides, too large a number of the variable factor also impairs
the efficiency of the fixed factor. The proverb “too many cooks
spoil the broth” aptly applies to this situation. In such a
situation, a reduction in the units of the variable factor will
increase the total output.
Theory of Production
• Returns to scale : Returns to scale describes the rate of increase
in production relative to the associated increase in the factors of
production in the long run. At this point, all factors of production are
variable (not fixed) and can scale. Therefore, the scale of production
can be changed by changing the quantity of all factors of production.
• The difference between economies of scale and returns to scale is
that economies of scale show the effect of an increased output level
on unit costs, while return to scale focus only on the relation between
input and output quantities.
• The Law of Returns to Scale
• It is actually governed by three laws:
• Law of Increasing Returns to Scale
• If production increases by more than the proportional change in
factors of production, there are increasing return to scale.
• Law of Constant Returns to Scale
• If production increases by that same proportional change as all
factors of production change then there are a constant return to scale.
Theory of Production
• Law of Diminishing returns to Scale
• If production increases by less than that proportional change in factors of
production, there are decreasing return to scale.
• Increasing Returns to Scale
• Increasing returns to scale happens when all the factors of production
are increased, then the output increases at a higher rate.
• For example, if all inputs are doubled, then the output should increase at
the faster rate than two times.
• Diminishing Returns to Scale
• Decreasing returns occurs when all the factors of production are
increased in a given proportion, but the output increases at a smaller
rate.
• For example, if the factors of production are doubled, then the output will
be less than doubled.
• Constant Returns to Scale
• Constant returns to scale occurs when the output increases exactly in the
same proportion as the factors of production. For example, if the factors
of production are doubled then the output will also be doubled.
Theory of Production
Theory of Production
Theory of production
• Definition: An iso-quant Curve shows all the possible
combinations of input factors that yield the same quantity of
production. In other words, an iso-quant curve is a geometric
representation of the production function, wherein different
combinations of labor and capital are employed to have the
same level of output.
• The iso-quant curve is also known as Iso-Product Curve. The
term “Iso” means same and “quant” or “product” means
quantity produced.
• The slope of an iso-quant curve is called the rate of technical
substitution, which means how much capital are to be
substituted for the labor to give the same quantity of production
if the labor is reduced by 1 unit. Thus, the input factors can be
substituted for one another to have an unchanged level of
output.
Theory of production

(K,L)

(K1, L1)
A

Iso- quant curve or iso- product curve

Theory of Production
• Slope of Iso quant curve:
• Q= f(K,L)
• All points of an isoquant stand for a given amount of output. Thus
there is no change in output along an isoquant, dQ=o. It follows
𝜕𝑄 𝜕𝑄
• dK+ 𝑑𝐿 =0
𝜕𝐾 𝜕𝐿
• 𝑀𝑃𝑃𝐾 dK+𝑀𝑃𝑃𝐿 dL=0
• 𝑀𝑃𝑃𝐾 dK = -𝑀𝑃𝑃𝐿 dL
𝑑𝐾 𝑀𝑃𝑃𝐿
• Or, =
𝑑𝐿 𝑀𝑃𝑝𝐾
• This is the slope of isoquant curve which is negative.
Theory of Production
• Marginal Rate of Technical Substitution(MRTS):
• MRTS is defined as the quantity of one factor that is to be given up in
order to hire one additional unit of another factor such that total output
remains unchanged.
• Decrease in output = increase in output
• ∆𝐾 × 𝑀𝑃𝑃𝐾 = ∆𝐿 × 𝑀𝑃𝑃𝐿
∆𝐾 𝑀𝑃𝑃𝐿
• =
∆𝐿 𝑀𝑃𝑃𝐾
• L K MRTS
• 1 12
• 2 8 4
• 3 5 3
• 4 3 2
• 5 2 1
Theory of production
• Total Product
• In simple terms, we can define Total Product as the total volume or
amount of final output produced by a firm using given inputs in a given
period of time.
• Marginal Product
• The additional output produced as a result of employing an additional unit
of the variable factor input is called the Marginal Product. Thus, we can
say that marginal product is the addition to Total Product when an extra
factor input is used.
• Marginal Product = Change in Output/ Change in Input
• Thus, it can also be said that Total Product is the summation of Marginal
products at different input levels.
• Total Product = Ʃ Marginal Product
• Average Product
• It is defined as the output per unit of factor inputs or the average of the
total product per unit of input and can be calculated by dividing the Total
Product by the inputs (variable factors).
• Average Product = Total Product/ Units of Variable Factor Input
Theory of production
• Total Product
• In simple terms, we can define Total Product as the total volume or
amount of final output produced by a firm using given inputs in a given
period of time.
• Marginal Product
• The additional output produced as a result of employing an additional unit
of the variable factor input is called the Marginal Product. Thus, we can
say that marginal product is the addition to Total Product when an extra
factor input is used.
• Marginal Product = Change in Output/ Change in Input
• Thus, it can also be said that Total Product is the summation of Marginal
products at different input levels.
• Total Product = Ʃ Marginal Product
• Average Product
• It is defined as the output per unit of factor inputs or the average of the
total product per unit of input and can be calculated by dividing the Total
Product by the inputs (variable factors).
• Average Product = Total Product/ Units of Variable Factor Input
Theory of production
• Assumptions:
• The main assumptions of Iso-quant curves are as follows:
• 1. Two Factors of Production:
• Only two factors are used to produce a commodity.
• 2. Divisible Factor:
• Factors of production can be divided into small parts.
• 3. Constant Technique:
• Technique of production is constant or is known before hand.
• 4. Possibility of Technical Substitution:
• The substitution between the two factors is technically possible.
That is, production function is of ‘variable proportion’ type
rather than fixed proportion.
• 5. Efficient Combinations:
• Under the given technique, factors of production can be used
with maximum efficiency.
Theory of production
• Iso-Product Schedule:
• Let us suppose that there are two factor inputs—labour and
capital. An Iso-product schedule shows the different
combination of these two inputs that yield the same level of
output as shown in table 1.
• The table 1 shows that the five combinations of labour units
and units of capital yield the same level of output, i.e., 200
metres of cloth. Thus, 200 metre cloth can be produced by
combining.
• (a) 1 units of labour and 15 units of capital
• (b) 2 units of labour and 11 units of capital
• (c) 3 units of labour and 8 units of capital
• (d) 4 units of labour and 6 units of capital
• (e) 5 units of labour and 5 units of capital
Theory of production
Theory of production
Theory of production
• Iso-Product Curve:
• From the above schedule iso-product curve can be drawn
with the help of a diagram. An. equal product curve
represents all those combinations of two inputs which are
capable of producing the same level of output. The Fig. 1
shows the various combinations of labour and capital
which give the same amount of output. A, B, C, D and E
Theory of production
• 1. Iso-Product Curves Slope Downward from Left to
Right:
• They slope downward because MTRS of labour for capital
diminishes. When we increase labour, we have to
decrease capital to produce a given level of output.
• The downward sloping iso-product curve can be
explained with the help of the following figure:
Theory of production
Theory of production
• The possibilities of horizontal, vertical, upward sloping
curves can be ruled out with the help of the following
figure 4:
• (i) The figure (A) shows that the amounts of both the factors of
production are increased- labour from L to Li and capital from K
to K1. When the amounts of both factors increase, the output
must increase. Hence the IQ curve cannot slope upward from
left to right.
• (ii) The figure (B) shows that the amount of labour is kept
constant while the amount of capital is increased. The amount
of capital is increased from K to K1. Then the output must
increase. So IQ curve cannot be a vertical straight line.
• (iii) The figure (C) shows a horizontal curve. If it is horizontal
the quantity of labour increases, although the quantity of capital
remains constant. When the amount of capital is increased, the
level of output must increase. Thus, an IQ curve cannot be a
horizontal line
Theory of production
Theory of production
• 2. Isoquants are Convex to the Origin:
• Like indifference curves, isoquants are convex to the origin. In order to understand this fact,
we have to understand the concept of diminishing marginal rate of technical substitution
(MRTS), because convexity of an isoquant implies that the MRTS diminishes along the
isoquant. The marginal rate of technical substitution between L and K is defined as the
quantity of K which can be given up in exchange for an additional unit of L. It can also be
defined as the slope of an isoquant.
• It can be expressed as:
• MRTSLK = – ∆K/∆L = dK/ dL
• Where ∆K is the change in capital and AL is the change in labour.
• Equation (1) states that for an increase in the use of labour, fewer units of capital will be
used. In other words, a declining MRTS refers to the falling marginal product of labour in
relation to capital. To put it differently, as more units of labour are used, and as certain units
of capital are given up, the marginal productivity of labour in relation to capital will decline.
• This fact can be explained in Fig. 5. As we move from point A to B, from B to C and from C to
D along an isoquant, the marginal rate of technical substitution (MRTS) of capital for labour
diminishes. Everytime labour units are increasing by an equal amount (AL) but the
corresponding decrease in the units of capital (AK) decreases.
• Thus it may be observed that due to falling MRTS, the isoquant is always convex to
the origin.
Theory of production
Theory of production
• 3. Two Iso-Product Curves Never Cut Each Other:
• As two indifference curves cannot cut each other, two iso-
product curves cannot cut each other. In Fig. 6, two Iso-
product curves intersect each other. Both curves IQ1 and
IQ2 represent two levels of output. But they intersect each
other at point A. Then combination A = B and combination
A= C. Therefore B must be equal to C. This is absurd. B
and C lie on two different iso-product curves. Therefore
two curves which represent two levels of output cannot
intersect each other.
Theory of production
Theory of production
• 4. Higher Iso-Product Curves Represent Higher Level
of Output:
• A higher iso-product curve represents a higher level
of output as shown in the figure 7 given below:
• In the Fig. 7, units of labour have been taken on OX axis
while on OY, units of capital. IQ1 represents an output
level of 100 units whereas IQ2 represents 200 units of
output
Theory of production
Theory of production
• Difference between Indifference Curve and Iso-Quant Curve:
• The main points of difference between indifference curve and Iso-
quant curve are explained below:
• 1. Iso-quant curve expresses the quantity of output. Each curve refers to
given quantity of output while an indifference curve to the quantity of
satisfaction. It simply tells that the combinations on a given indifference
curve yield more satisfaction than the combination on a lower
indifference curve of production.
• 2. Iso-quant curve represents the combinations of the factors whereas
indifference curve represents the combinations of the goods.
• 3. Iso-quant curve gives information regarding the economic and
uneconomic region of production. Indifference curve provides no
information regarding the economic and uneconomic region of
consumption.
• 4. Slope of an iso-quant curve is influenced by the technical possibility of
substitution between factors of production. It depends on marginal rate of
technical substitution (MRTS) whereas slope of an indifference curve
depends on marginal rate of substitution (MRS) between two
commodities consumed by the consumer.
Price Line
Isocost Lines/Outlay Line/Price Line/Factor Cost Line:

Definition:
A firm can produce a given level of output using efficiently
different combinations of two inputs. For choosing efficient
combination of the inputs, the producer selects that
combination of factors which has the lower cost of
production. The information about the cost can be
obtained from the isocost lines.
Price Line
Explanation:

An Isocost line is also called outlay line or price line or factor

cost line. An Isocost line shows all the combinations of labor
and capital that are available for a given total cost to-the
producer. Just as there are infinite number of Isoquant, there
are infinite number of Isocost lines, one for every possible level
of a given total cost. The greater the total cost, the further from
origin is the Isocost line.

Example:
The Isocost line can be explained easily by taking a simple
example.
Theory of production
• Slope of iso cost line:
• C = k𝑃𝐾 + 𝐿𝑃𝐿 or, C= wL+rK, C=wL, C=rK, K/L= w/r,
• Slope of iso cost line, dk/dL= w/r
𝑃𝐿
• dk/dL=
𝑃𝐾
• dc=0
𝜕𝐶 𝜕𝐶
•→ dK + dL = 0
𝜕𝐾 𝜕𝐿
Price Line
Price Line
Let us examine a firm which wishes to spend $100 on a combination of two factors labor
and capital for producing a given level of output. We suppose further that the price of
one unit of labor is $5 per day. This means that the firm can hire 20 units of labor. On
the other hand if the price of capital is $10 per unit, the firm will purchase 10 units of
capital. In the fig. 12.7, the point A shows 10 units of capital used whereas point T
shows 20 units of labor are hired at the given price. If we join points A and T, we get a
line AT. This AT line is called isocost line or outlay line. The isocost line is obtained with
an outlay of $100.
Let us assume now that there is no change in the market prices of the two factors labor
and capita! but the firm increases the total outlay to $150. The new price line BK shows
that with an outlay of $150, the producer can purchase 15 units of capital or 30 units of
labor. The new price line BK Shifts upward to the right. In case the firm reduces the
outlay to $50 only, the isocost line CD shifts downward to the left of original isocost line
and remains parallel to the original price line.
The isocost line plays a similar role in the firm's decision making as the budget line does
in consumer's decision making. The only difference between the two is that the
consumer has a single budget line which is determined by the income of the consumer.
Whereas the firm faces many isocost lines depending upon the different level of
expenditure the firm might make. A firm may incur low cost by producing relatively
lesser output or it may incur relatively high cost by producing a relatively large quantity.
Producer Equilibrium
• Production Equilibrium
• Isoquant curves, as we learned above, show us input
combinations that we can employ to produce certain levels of
output. Furthermore, Isocost lines help us determine
combinations of two factors in which we can invest our outlays
to produce output. A combination of these two graphs is what
gives us the optimum production level, i.e. the producer’s
equilibrium.
• Using this equilibrium, the producer can determine different
combinations to increase output. He can also use this
information to find ways to cut costs using the same inputs and
consequently generate more profit. We can find out the least
expensive combinations of factors by superimposing Isoquant
curves on Isoquant lines.
Producer Equilibrium
• Plotting Producer’s Equilibrium
• The graph below shows how we can use isoquant curve
and iso cost lines to determine optimum producer’s
equilibrium.
• In the figure shown above, the iso quant curve represents
targeted output, i.e. 200 units. Iso cost lines EF, GH and
KP show three different combinations in which we can
utilize the total outlay of inputs, i.e. capital and labour.
Producer Equilibrium
Producer Equilibrium
• The iso quant curve crosses all three isocost lines on points R,
M and T. These points show how much costs we will incur in
producing 200 units. All three combinations produce the same
output of 200 units, but the least costly for the producer will be
point M, where isocost line GH is tangent to the iso quant
curve.
• Points R and T also cross the iso quant curve and equally
produce 200 units, but they will be more expensive because
they are on the higher isocost line of KP. At point R the
producer will spend more on capital, and labour will be more
expensive on point T.
• Thus, point M is the producer’s equilibrium. It will produce the
same output of 200 units, but will a more profitable combination
as it will cost less. The producer must, therefore, spend OC
amount on capital and OL amount on labour.
Theory of production
1 1
You are given a production function Q=100𝐾 𝐿 and cost constraint,
2 2
1200=30L+40K. Find out equilibrium level of output.

1 1
Maximize, Q=100𝐾 𝐿 2 2

Subject to cost constrained: 1200=30L+40K

−1 1
𝜕𝑄
1
𝑀𝑃𝐾 = = 2 100𝐾 2 𝐿2
𝜕𝐾
1 −1
1
𝑀𝑃𝐿=𝜕𝑄 = 100𝐾 2 𝐿 2
𝜕𝐿
2
MPL/MPK= K/L, K/L= 30/40, K/L= ¾, 3L= 4k
L= 4/3.K
MPPL/MPPK= PL/PK
For output maximization,
𝑀𝑃𝐾 𝑟
=𝑤
𝑀𝑃𝐿
Theory of Production
𝐿 40
• =
𝐾 30
4𝐾
•→ L= putting the value on cost-constrained,
3
4𝑘
• 1200= 30. + 40k
3
• 1200= 80k
• K= 15
4.15
• Then, L= =20
3
1 1
• Q=100(15) (20) 2 2