THEORY OF PRODUCTION

Samir K Mahajan, M.Sc, Ph.D.,UGC-NET

Assistant Professor (Economics)
Department of Mathematics & Humanities
Institute of Technology
Nirma University

Email: samir.mahajan@nirmauni.ac.in
https://sites.google.com/a/nirmauni.ac.in/2hm203-
_-eebm_even_2014/
 Production: Meaning

Any activity which creates value is production.

In other words, production is transformation of inputs (such as capital, equipment, labour, and
land etc ) into output such as good or service .

e.g. – transporting sand, operating a jeweller store, drilling for oil, recruiting new employees,
designing a system to measure air pollution, producing biscuits, cultivation, trading and so on.
 Production Function

Production function express the technological relationship between physical inputs and
physical output of a firm under given technology.

A production function may be write as follows

Q = f(N, L, K, E,…..)

where
Q = output (total product)

N (land), L(labour), K(capital), E(entrepreneurship) , .. are the inputs.

 Inputs (Factors)of Production/ Factor Inputs/Factors/Inputs

Factors of production are broadly classified as :

Land:
Anything which is gift of nature and not the result of human effort, e.g. soil, water, forests, minerals. Owner of land
is called landlord. Reward of land is called as rent.

Labour:
Physical or mental effort of human beings that undertakes the production process. Labour is supplied by the
workers. Labour can be skilled as well as unskilled, physical or intellectual. Reward/price of labour is called as
wages/ salary.

Capital:
Wealth which is used for further production as machine/ equipment/intermediary good. It is outcome of human
efforts meaning capital is man-made. Reward of capital is called as interest

Enterprise/Entrepreneurship/organisation:
The ability and action to take risk of collecting, coordinating, and utilizing all the factors of production for the
purpose of uncertain economic gains. Owner of enterprise is entrepreneur. Reward of entrepreneurship is called as
profit.
 Concept of Time
Alfred Marshal introduced the element of time in production decision. Time can categorize as under:

Market Period or Very Short Period:

Market Period or Very Short Period is a period during which all factors of production and hence cost remains fixed.
As such, outputs as well as supply also remain fixed.

Short Run:
Short run a period so brief that the amount of at least one input is fixed. Thus we have both fixed as well as
variable factors.

Long Run:
Long Run is a period of time sufficient enough for all inputs (or factors of production), to be variable as far as an
individual firm is concerned.

❑The length of time necessary for all inputs to be variable may differ according to the nature of the industry and
the structure of a firm.
 Factors (Inputs) of Production: Classification

Factors inputs are classified as fixed and variable.

Fixed factors :
Fixed factors are not related to volume of output. The cost of these factors remain fixed
whether output is more or less or even zero.

Variable factors:
Variable factors are directly related to volume of output. E.g. Unskilled labour, raw
materials, fuel.

❑Distinction between fixed and variable factors is restricted to short period only. For
instance, in the short run plants, machines or equipment are regarded as fixed.

❑In the long period, all factors are supposed to be variables.

 Concept of Product

There are three concepts of product such as:

❑Total Product

❑Average Product

❑Marginal Product
 Concept of Product contd.

Total Product :
Total Product refers (TP) to the total volume of goods and services produced by a firm
during a given period of time.

Where L is quantity of a factor

AP is the average productivity of a factor.

MP is marginal productivity of a factor .

 Concept of Product contd.

Average Product:
Average Product (AP) is output (total product) per unit of a factor.

Q
i.e. APL =
L
Where

Q is total product
L is quantity of a factor input.
 Concept of Product contd.

Marginal Product:
Marginal Product (MP) is rate of change in total product with respect to a
factor.

i.e. MPL = dQ
dL

Where

dQ is change in total product

dL is change in quantity of a factor input.
 Laws of Production

Theory of production is the study of production functions.

There are two theories of production. Such as:

❑ Law of Variable Proportions/ Law of Return to a Factor/ Short Run Production Function

❑ Law of Return to scale / Long Run Production Function

 LAW OF VARIABLE PROPORTIONS/
LAW OF RETURN TO A FACTOR/
SHORT RUN PRODUCTION FUNCTION

Laws of variable proportion studies reaction of output to changes in a variable factor

such as labour while others factor inputs are fixed in short turn.

Hence, short-run production function can be written as:

ഥ 𝑵,
𝑸 = 𝒇(𝑳, 𝑲 ഥ 𝑬ഥ , …)
where
ഥ 𝑵,
Q = output (total product), L is labour and 𝑲, ഥ 𝑬
ഥ are fixed capital, fixed land, fixed
entrepreneurship respectively.
 LAW OF VARIABLE PROPORTIONS (contd.)

Statement:
Law of variable proportion states as more and more quantities of a factor
(say labour) is employed with fixed quantities of other factors in short run,
total output increases at
o an increasing rate (increasing return to a factor),
o decreasing rate (decreasing return to a factor),
o and finally diminishes after reaching its maximum point (negative returns
to a factor) .

Assumptions:
1. There is short run
2. State of technology is given and unchanged
3. Capital is fixed
4. Factor-proportion (ratio of variable input to fixed inputs) is variable
 LAW OF VARIABLE PROPORTIONS (contd.)

TP
Law of Max TP Explanation: Three
stages of law of
Variable Portions
ഥ𝑵
TP(𝑸) = 𝒇(𝑳, 𝑲 ഥ, 𝑬
ഥ , …)

Stage I

Stage II Stage III As the variable input

Pt. Of
Inflexion (Labour) is increased
while keeping the
other factors,
behavior of output
O
Labour exhibits three
AP, distinct stages. These
MP stages are illustrated
Max MPL graphically as follows.
Max APL

APL
O
Labour
MPL
 LAW OF VARIABLE PROPORTIONS (contd.)

Stage I: First stage starts from origin and ends at maximum average of the variable factor
(APL). Total Product (TP) is increasing at an increasing rate up to the point of inflexion at
which means marginal product of variable factor (MPL) attains its maximum point. After
point of inflexion, TP increases at a decreasing rate meaning MPL is falling. MPL
continues to fall until becomes equal to maximum APL. At this stage, MP of fixed factor is
zero. This stage is called the stage of increasing returns as APL is increasing.

Stage II: Second stage starts from maximum APL and ends at maximum TP or zero MPL.
TP continues to increase at a decreasing rate meaning MPL continuing to fall. When TP
reaches maxim point, MPL becomes zero. APL starts falling from its maximum point. This
is stage of diminishing returns because both MPL and APL fall from this stage.

Stage III: Third stage starts from maximum TP or zero MPL at this stage TP starts falling for
which MPL negative. APL continues to fall but would never become equal to zero. This
stage is called the stage of negative returns since MP of variable factor is negative.
 LAW OF VARIABLE PROPORTIONS (contd.)

Stage of Operation: Decision Making by a Rational Producer

A rational producer will choose none of stage I or stage III (which are completely
symmetrical). In stage I, the fixed factor is abundant relative to variable factor and hence,
MP of fixed factor is negative. In stage III, variable factor is to much compared to fixed
factor, and hence MP of variable factor is negative.

Thus, stage I and stage III are called the stages of economic absurdity or economic non-
sense, represent non-economic region in production function.

A rational producer will seek to produce at stage II where both MP and AP of variable
factor are diminishing returns. Stage II represents the range of rational production
decision.
 LAW OF RETURNS TO SCALE /
LONG RUN PRODUCTION FUNCTION

“Returns to scale” studies the behavior of output or returns when all factor inputs
are increased or decreased simultaneously, and in the same proportion in the
long-run.

Statement :
When scale (set of all inputs) is expanded in the same proportion, effect on
output may take tree forms such as:

o increasing returns to scale

o constant returns to scale
o diminishing returns to scale

The concept of Returns to Scale helps a producer to work out the most desirable
combination of factor inputs so as to maximize his output and minimize his
production cost.
 LAW OF RTURNS TO SCALE contd.

Assumptions:

o All factors (inputs) are variable but enterprise is fixed

o A worker works with given tools and implements

o Technological changes are absent

o There is perfect competition

o The product is measured in quantities

o Factor proportion (ratio of labour to capital) is given
 LAW OF RTURNS TO SCALE contd.

Law of returns to scale using isoquant

1. Increasing returns to scale:-

When a given proportional change in all inputs (i.e.

in scale of production) in the long run results in
more than proportionate change in output, it is
called increasing returns to scale.

In the above figure, OR is the product line.

The various isoquants; IQ1, IQ2, IQ3 are
drawn which represent 100, 120, and 140
units of output respectively. A small increase
in labor and capital has increased the output
by a more amount. I.e. OA>AB>BC is greater
than OL1>L1L2> L2L3 and OK1>K1K2> K2K3.
 LAW OF RTURNS TO SCALE contd.

Law of returns to scale using isoquant

2. Constant returns to scale:-

When a given proportional change in all

inputs (i.e. in scale of production) in the
long run results in the same proportional
change in output, it is called constant
returns to scale.

In the above figure, OR is the

product line. The various
isoquants; IQ1, IQ2, IQ3 are drawn
which represent 10, 20, and 30
units of output respectively.
Thus, the successive isoquants
are equidistant from each other
I.e. OA=AB=BC, OL1=L1L2= L2L3
and OK1=K1K2= K2K3.
 LAW OF RTURNS TO SCALE contd.

Law of returns to scale using isoquant

3 Decreasing returns to scale

When a given proportional change in all

inputs (i.e. in scale of production) in the
long run results in less than proportionate
change in output, it is called decreasing
returns to scale.

In the above figure OR is the product

line. The various isoquants; IQ1, IQ2, IQ3
are drawn which represent 10, 15, and 18
units of output respectively. The
successive isoquants are farther from
each other. I.e. OA<AB<BC is less than
OL1<L1L2< L2L3 and OK1<K1K2<K2K3.
 Difference Between Law Variable Proportion & Law of Returns to Scale

Point of Difference Law Variable of Proportion Law of Return to Scale

Period of Time Short Run Long Run

Variability of Inputs Only one factor input say All factor Inputs are
labour, is variable others variables
are fixed
Factor Proportion Variable Fixed

Relationship Studies how output reacts Studies how output reacts

to changes variable input, to a give proportionate
while other inputs are kept change in all inputs (scale
fixed. of production)
COST OF PRODUCTION

Samir K Mahajan, M.Sc, Ph.D.,UGC-NET

 COST FUNCTION

Economists have treated cost as a function of output both in short run and long run.

SHORT RUN COST FUNCTION

In the short run, capital, land, factors prices, technology etc remain fixed. Hence,
short run cost function can be written as

ഥ Pഥf, 𝑻
C= 𝒇(𝑸, 𝑲 ഥ, …)

where
C is cost of production
Q is Output (total output)
ഥ are capital and other fixed factor
𝑲,
Pഥf is factor prices
ഥ is given technology
𝑻

Thus short run cost function can be written as

C=f (Q)
 COST FUNCTION(contd)

LONG RUN COST FUNCTION

The long run cost function can be written as

C=C (Q, K, T ,Pf )

Where C is cost of production

Q is output
T is technology
K is capital
Pf is factor prices

In studying the relationship between long run cost and level of output in a two
dimensional diagram, we keep technology and output as constant.

Thus , long run cost function, traditionally, is written as

C= C (Q)
 CONCEPT OF COSTS(SHORT RUN)

Total Fixed Cost (TFC):

Total Fixed Cost (TFC)/ Fixed Costs are the expenses on fixed factors of production. Fixed cost
do not vary with output. They remain the same what ever be the output in short run.

They typically include rents, salaries of permanent employees, insurance, depreciation etc.

Total variable cost (TVC)

Total variable cost (TVC) /Variable costs are expenses on variable factors of production.
Variable costs do vary with output. As output changes, TVC also changes.
Examples of typical variable costs include fuel, raw materials, and casual labour costs.

Total Cost:
Total cost is the sum of fixed and variable costs at each level o output.
i.e. TC=TFC+ TVC
 CONCEPT OF COSTS(contd)
TFC, TVC, TC curves
TC
Cost
TVC

Fixed Cost

Variable Cost
Total
Cost

TFC
O Output
 CONCEPT OF COSTS(contd)

Average Fixed Cost (AFC) : Average fixed cost is the fixed cost per unit of
output.
TFC
i.e. AFC=
Q
Where Q is output.
 CONCEPT OF COSTS(contd)

Average Variable Cost (AVC) : Average variable cost is the variable cost
per unit of output.
TVC
i.e. AVC=
Q

Where Q is output.
 CONCEPT OF COSTS(contd)

Average Cost (AC) : Average cost is the cost per unit of output.

TC
i.e. AC=
Q

TFC+ TVC
=
Q

Or, AC= AFC + AVC

Where Q is output.
 CONCEPT OF COSTS(contd)

Marginal cost (MC) : Marginal cost is the extra cost for producing an
additional unit of output.
d(TC)
i.e. MC=
dQ

d(TFC + TVC)
MC=
dQ

d(TVC)
MC=
dQ

It is important to note that marginal cost is derived solely from variable costs, and not
from fixed costs.
 CONCEPT OF COSTS(contd)
AFC, AC, AVC, MC curves

Cost

MC AC
AVC

AFC
O Output
 RELATIONSHIP BETWEEN AC AND MC
Cost

MC AC

AVC

Minimum AC
Minimum MC
Minimum AVC

O
Output

❑Minimum MC comes before, Minimum AC.

❑When AC falls, MC < AC
❑When AC increases, MC > AC
❑When AC is at its minimum, MC equals AC. i.e. MC=Minimum AC.
 CONCEPT OF COSTS(contd)

AVERAGE FIXED COST (AFC) FALLS WITH INCREASE IN OUTPUT

AFC curve is downward sloping from left to right.

REASONS

As total fixed cost is divided by an increasing output, AFC will continue to fall. AFC
may be very close to zero, but will never be equal to zero.
 CONCEPT OF COSTS(contd)

AVERAGE VARIABLE COST CURVE , AVERAGE COST CURVE , AVERAGE COST CURVE are
IS U-SHAPED

With the increase in output each of these curves will slope down at frist from left to
right, then reach a minimum point, and rise again.

‘U’ shaped AVC , MC, AC curve can be attributed to the principle of variable
proportion.

AVC = TVC/Q = (L W) /Q = w/( Q/L) = w/(AP )

MC = d(TVC)/dQ= d(Lw)/dQ= w( dL/dQ) = w /(dQ/dL) = w /MP

 LONG RUN AVERAGE COST FUNCTION
Or
LONG RUN AVERAGE COST (LAC) CURVE

The long run cost function/LAC curve depicts the least possible average cost for
producing various levels of output when inputs of production are variable (in the long
run).

The LAC is constructed from a series of short run average cost curves associated
with a series of different output levels. In short run, capital (say plant) is fixed, and
labour is variable. As such, each of the short run average cost (SAC) curves corresponds
to a particular plant. When a new plant is installed, the SAC curve shifts to a new
location.

The LAC curve is the envelope of an infinite number of SAC curves, with each SAC
curve tangent to the LAC curve at a single point corresponding to a particular output
level.
 LONG RUN AVERAGE COST FUNCTION (contd)
Let us consider the short run curves given by SAC1, SAC2, SAC3 and SAC4 as
in the following figure.

To produce Q0, the firm will use SAC1 curve where cost is P0. To produce a
higher level of output at Q1, the firm will again use SAC1 curve at which the
 LONG RUN AVERAGE COST FUNCTION (contd)

To produce Q2, if the firm continues to use SAC1 curve, then the cost will
increase to P2(P2>PO). So, it would be better for the firm to bring a second plant
into the production with cost curve SAC2. Here, cost of producing Q2 would be
P1, much less than P2.
Similarly, to Produce Q3, the firm can either use SAC3 or SAC4 curve. If it uses
SAC3 curve, the cost of production would be P3 which is higher than P4 at SAC4.
Hence, the firm will use SAC4 curve, as it has low cost(P4).
 LONG RUN AVERAGE COST FUNCTION (contd)

The above description confirms that, in long run, a firm will use the
level of inputs that can produce a given level of output at the lowest possible
average cost. The envelope relationship explains that at the planned output
level, SAC equals LAC; but at all other levels of output, SAC is higher than
LAC. This is reflected in LAC curve which is always be less than or equal to
short-run average cost.