UNIT-II

THEORY OF PRODUCTION AND COST ANALYSIS

MEANING OF PRODUCTION
Production is transformation of inputs into (such as capital, equipment, labour,
and land etc.) outputs such as goods or services. For example- transporting sand,
operating a jeweller store, drilling for oil, recruiting new employees, designing
a system to measure air pollution, producing biscuits, cultivation, trading
and soon.
DEFINITION OF PRODUCTION
“Production is the organized activity of transforming resources into finished
products in the form of goods and services; the objective of production is to satisfy the
demand for such transformed resources” - Bates and Parkinson
FACTORS OF PRODUCTION
Factors of production are an economic term that describes the inputs used in the
production of goods or services in order to make an economic profit. These include
any resource needed for the creation of a good or service.
The factors of production include land, labour, capital and
entrepreneurship. The state of technological progress can influence the total
factors of production and account for any efficiency not related to the four typical
factors.

CLASSIFICATION OF FACTORS OF PRODUCTION

(1) Land
In economics the term land is used in a broad sense to refer to all
natural resources or gifts of nature. “Land in economics is taken to
mean not simply that part of the earth’s surface not covered by water,
but also all the free gifts of nature’s such as minerals, soil fertility, as also the
resources of sea. Land provides both space and specific resources”.

(2) Labour
Like land, labour is also a primary factor of production. The distinctive feature
of the factor of production, called labour, is that it provides a human service. It
refers to human effect of any kind—physical and mental— which is directed to
the production of goods and services. ‘Labour’ is the collective name given to the

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productive services embodied in human physical effort, skill, intellectual
powers, etc.

(3) Capital
Capital, the third agent or factor is the result of past labour and it is used
to produce more goods. Capital has, therefore, been defined as ‘produced means of
production. It is a man-made resource.
In a board sense, any product of labour-and-land which is reserved for use
in future production is capital.
(4) Enterprise (Organization)
Organization, as a factor of production, refers to the task of bringing land,
labour and capital together. It involves the establishment of co-ordination and co-
operation among these factors. The person in charge of organization is known as
an organizer or an entrepreneur.

PRODUCTION FUNCTION
The production function expresses a functional relationship between physical
inputs and physical outputs of a firm any particular time period. The output is thus a
function of inputs. Mathematically, such a basic relationship between inputs and
outputs may be expressed as:
Q = f( L, L,C, O ) or Q = f (A, B, C, D)

Where
Q = Quantity of output; L = Land; L = Labour
C = Capital; O = Organization

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 PRODUCTION FUNCTION-ASSUMPTIONS
 The production function is related to a particular period of time.
 There is no change in technology.
 The producer is using the best techniques available.
 The factors of production are divisible.
 Production function can be fitted to a short run or to long run.
COBB-DOUGLAS PRODUCTION FUNCTION
The Cobb-Douglas production function is based on the empirical study of the
American manufacturing industry made by Paul H. Douglas and C.W. Cobb. It is a linear
homogeneous production function of degree one which takes into account two
inputs, labour and capital, for the entire output of the manufacturing industry.
The Cobb-Douglas production function is expressed as:
α β
Q = AL K
Where
L = quantity used of labour K = quantity used of capital
Q = quantity of output produced A, α, β = positive constants.
Cobb-Douglas production function-Assumptions
The function assumes that output is the function of two factors viz. capital and
labour.
 It is a linear homogenous production function of the first degree.
 The function assumes that the logarithm of the total output of the
economy is a linear function of the logarithms of the labour force
and capital stock.
 There are constant returns to scale.
 All inputs are homogenous.
 There is perfect competition.
 There is no change in technology.

ISO QUANT
The term Iso quants is derived from the words ‘Iso’ and ‘quant’- ‘Iso’ means equal
and ‘quant’ implies quantity. Iso quant therefore, means equal quantity. Isoquant is also
called as “Equal product curve” or “Production Indifference curve” or “Constant
product curve”. Isoquant indicates various combinations of two factors of production
which give the same level of output per unit of time.

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The above table can be explain in the following:
 Combination ‘A’ represent 1 unit of labour and 10 units of capital and
produces ‘50’ quintals of a product.
 All other combinations in the table are assumed to yield the
same given output of a product say ‘50’ quintals by employing
any one of the alternative combinations of the two factors labour and
capital.
ISO QUANT CURVE

PROPERTIES OF ISO QUANTS

Isoquants are Negatively Sloped: They normally slope from left to right means
they are negatively sloped. The reason is when the quantity of one factor is
reduced, the same level of output can be achieved only when the quantity of
other is increased.
Higher Isoquants Represents Larger Output: Higher isoquant is one
that is further from the point of origin. It represents a larger output hat is
obtained by using both same amount of one factor and the greater amount of
both the factors.
No Two Isoquants Intersect or Touch each other: Isoquant do no intersect
or touch each other because they represent different level of output.
Isoquants are convex to the origin: In most production processes the factors of
production have substitutability. Labour can be substituted for capital and vice-versa.

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ISO COST LINE
Isocost line shows various combinations of inputs that a firm
can purchase or hire at a given cost. By the use of Isocosts and
isoquants, a firm can determine the optimal input combination to maximize
profit.
It is a graphical representation of various combinations of inputs i.e., Labour
(L) and Capital (K) which give an equal level of output per unit of time.
Output produced by different combinations of L and K is say, Q, then Q=f
(L, K). A higher isoquant refers to a larger output, while a lower isoquant
refers to a smaller output.
Isocost line: Suppose a firm uses only labour and capital in production.

The total cost or expenditures of the firm can be represented by:

C = wL + rK
Where, C = Iso cost line; L= Labour; K= Capital
INPUT – OUTPUT RELATIONSHIP UNDER LAW OF PRODUCTION
LAW OF PRODUCTION
Production analysis in economics theory considers two types of input and
output relationships.
 When quantities of certain inputs, are fixed and others are variable
and
 When all inputs are variable.
 These two types of relationships have been explained in the form
of laws.
 Law of variable proportions
 Law of returns to scale
LAW OF VARIABLE PROPORTION

This law exhibits the short-run production functions in which one factor varies
while the others are fixed. Thus law of variable proportions is the new
name for the famous”Law of Diminishing Returns” of classical economics.
It is also known as ‘Law of Returns’ or ‘Returns to Variable Factor’.
MEANING OF LAW OF VARIABLE PROPORTION
In the short run the level of production can be changed by changing the
factor proportions. “This law examines the production function with on factor
variable, keeping the other factors quantities fixed”.

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Assumptions of Law of Variable Proportions
 It operates in short run as factors are classified as variable and fixed factor
 The law applies to all fixed factors including land
 Under law of variable proportions different units of variable factor can be
combined with fixed factor
 This law applies to the field of production only
 The effect of change in output due to change in variable factor can be easily
determined
 It is assumed that factors of production become imperfect substitutes of each
other beyond a certain limit
 The state of technology is assumed to be constant during the operation of
this law
 It is assumed all variable factors are equally efficient

Stages of Law of Variable Proportions

There are three stages of law of Variable Proportions.

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Total Product

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.
Marginal Product = Change in Output/ Change in Input
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
As the figure shows TP curve goes on increasing up to a point and after
that it starts declining. AP and MP
Reasons for Law of Variable Proportion

I. Increasing Returns to a factor

 Better utilization of Fixed factor
 Increased Efficiency of Variable Factor
II. Diminishing Returns to a factor
 Optimum combination of factors

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  Imperfect substitutes curves first rise and then decline; MP curve
starts declining earlier than the AP curve.
III. Negative Returns to a factor
 Limitations of fixed Factor
 Poor coordination between Variable and fixed factor
 Decrease in Efficiency
LAW OF RETURNS TO SCALE
It is based on long run production function. It shows change in the scale
of production when all factors are changed simultaneously. In the long run
all factors of production are variable. No factor is fixed.
ASSUMPTIONS OF LAW OF RETURNS TO SCALE
 All factors are variable but enterprise is fixed.
 Input (Labour & Capital) are used in fixed proportion.
 No change in state of technology.
 There is perfect competition.
 The product is measured in quantities.
SCALES OF LAW OF RETURNS TO SCALE
Law of returns can be classified into three categories:
1. Increasing Returns to Scale:
If the proportional change in the output of an organization is greater than
the proportional change in inputs, the production is said to reflect
increasing returns to scale.
For example, to produce a particular product, if the quantity
of inputs is doubled and the increase in output is more than double, it is
said to be an increasing returns to scale.
2. Constant Returns to Scale:
The production is said to generate constant returns to scale when
the proportionate change in input is equal to the proportionate change in output.
For example, when inputs are doubled, so output should also be
doubled, then it is a case of constant returns to scale.
3. Diminishing Returns to Scale:
Diminishing returns to scale refers to a situation when the
proportionate change in output is less than the proportionate change in input.
For example, when capital and labor is doubled but the output
generated is less than doubled, the returns to scale would be termed as
diminishing returns to scale.

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