Chapter Two

Theory of Production
2.1 Production
In economics, the term ‘production’ means an activity by which resources (men, material, time
and so on) are transformed into a different and more useful commodity or value-added service. In
general, production means transforming inputs (labour, machines, raw materials, time and so on)
into an output. Production of goods and services involves transforming resources—such as labor
power, raw materials, and the services provided by facilities and machines—into finished products.

A firm uses a technology or production process to transform inputs or factors of production into
outputs. An input is anything—a good or a service—that is used in the process of production.
Inputs, which are also called factors of production, include anything that the firm must use as part
of the production process. In other words, inputs are economic resources that can be used in the
production of goods and services. All inputs used in production are broadly classified into four
categories: land, labour, capital and entrepreneurship. The inputs can also be divided into two main
groups – fixed and variable inputs. A fixed input is one whose quantity cannot be varied during
the period under consideration. Plant and equipment are examples of fixed inputs. A factor that a
firm cannot vary practically in the short run is called a fixed input. An input whose quantity can
be changed during the period under consideration is known as a variable input. Raw materials,
labour, power, transportation, etc., whose quantity can often be increased or decreased on short
notice, are examples of variable inputs. Outputs are outcomes of the production process. An output
is any good or service that comes out of production process. An output may be tangible or
intangible.

Period of Production

The variability of an input depends on the length of the time period under consideration. The
shorter the time period, the more difficult it becomes to vary the inputs. Economists classify time
periods into two categories: the short-run and the long-run. Short-run refers to the period of time
over which the amount of some inputs, called the ‘fixed inputs’, cannot be changed. For example,
the amount of plant and equipment, etc., is fixed in the short-run. This implies that an increase in
output in the short-run can be brought about by increasing those inputs that can be varied, known

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as ‘variable inputs’. Here it should be noted that short run periods of different firms have different
durations. For example, if a producer wishes to increase output in the short-run, she/he can do so
by using more of variable factors like labour and raw material.

Long-run is defined as the time period during which all factors of production can be varied. A firm
can install a new plant or raise a new factory building. Long-run is the period during which the
size of the plant can be changed. Thus, all the factors are variable in the long-run. Economists use
another term, i.e., (very long run) which refers to a period in which the technology of production
is also supposed to change. In the very long-run period, the production function also changes. The
technological advances result in a larger output from a given quantity of inputs.

It is important to note here that ‘short run’ and ‘long run’ are economists’ jargon. They do not refer
to any fixed time period. While in some industries short run may be a matter of few weeks or few
months, in some others (e.g., electricity and power industry, automobiles and so on), it may mean
three or more years.

2.2 The Production Function

A production function describes the relationship between the quantities of inputs used and the
maximum quantity of output that can be produced, given current knowledge about technology and
organization. A production function indicates the highest output Q that a firm can produce for
every specified combination of inputs.

The production function is written mathematically as:

Q = f (X1, X2, X3, ....., Xn)

where X1, X2, X3, ....., Xn are different inputs and Q is amount of output.

The production function is based on two main assumptions,

• Technology does not change,

• Producers utilize their inputs at maximum levels of efficiency.

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2.2.1 Short-Run Production: One Variable and One Fixed Input

Although in practice firms use a wide variety of inputs, we will keep our analysis simple by
focusing on only two, labor L and capital K. Consider a firm that uses two inputs: capital and
labour. In the short run, we assume that capital is a fixed input and that labor is a variable input.
So, the firm can increase output only by increasing the amount of labor it uses. In the short run,
the firm’s production function is

̅ , L)
Q = F(𝐾

where Q is the quantity of output, L is the quantity of labor used, and K is the quantity of capital
employed. This expression tells us that the maximum quantity of output the firm can get depends
on the quantities of labor and capital it employs. In production, the contribution of a variable input
can be described in terms of total product (TP), marginal product (MP) and average product (AP).

Total product of a factor (i.e. labour) refers to the amount of output (or total product) that a given
amount of the factor (i.e labour) can produce, holding the quantity of other inputs fixed. Average
product of a factor is output per unit of a particular factor or input. Average product of labor is the
average amount of output per unit of labor. Marginal product refers to additional output produced
from using an extra unit of an input. The marginal product of labor (MPL) is the change in total
output resulting from using an extra unit of labor, holding other factors (capital) constant. It
measures the slope of the total product curve at a given point.

Consider the following production with one variable input, labour and one fixed input, capital.
Imagine, for example, that you are managing a clothing factory. Although you have a fixed amount
of equipment, you can hire more or less labor to sew and to run the machines. You must decide
how much labor to hire and how much clothing to produce. To make the decision, you will need
to know how the amount of output q increases (if at all) as the input of labor L increases.

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Table 2.1: Production with one variable input, labour

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Figure 2.1: TP, AP, and MP Curves

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Figure 2.1 (a) shows that as labour increases, output increases until it reaches the maximum output
of 112; thereafter, it falls. The portion of the total output curve that is declining is drawn with a
dashed line to denote that producing with more than eight workers is not economically rational; it
can never be profitable to use additional amounts of a costly input to produce less output. When
labor input is zero, output is also zero. Output then increases as labor is increased up to an input
of 8 units. Beyond that point, total output declines. Although initially each unit of labor can take
greater and greater advantage of the existing machinery and plant, after a certain point, additional
labor is no longer useful and indeed can be counterproductive. Figure 2.1 (b) shows the average
and marginal product curves. Note that the marginal product is positive as long as output is
increasing, but becomes negative when output is decreasing. The average product increases
initially but falls when the labor input becomes greater than four. Like the average product, the
marginal product first increases then falls.

The Relationship between Total Product, Marginal Product, and Average Product

The relationship between TP and MP:

• When TP increases at an increasing rate, marginal product increases,
• While TP increases at a diminishing rate, MP declines,
• When TP reaches its maximum, MP becomes zero,
• When TP begins to decline, MP becomes negative

The relationship between MP and AP:

• When MP is greater AP, the AP is increasing.
• When MP is equal to AP, AP reaches its maximum
• When MP is less than AP, AP is decreasing.

The graphical relationship between average and marginal products

• When MPL curve lies above (is greater than) APL curve, the average product of labor
increases.
• When MPL curve intersects APL curve, the average product reaches its maximum
• When MPL curve lies below APL, the average product is decreasing.

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The Law of Diminishing Marginal Returns

The law of diminishing marginal returns (or diminishing marginal product) holds that if a firm
keeps increasing an input, holding all other inputs and technology constant, the corresponding
increases in output will eventually become smaller. That is, if only one input is increased, the
marginal product of that input will eventually diminish. The marginal product of labor diminishes
with increased labor if the second partial derivative of the production function with respect to labor
is negative. Note that the law operates only if technology does not change and the law starts to
operate after the MP curve reaches its maximum. This law is also called the law of variable
proportions.

2.2.2 Long-Run Production: Two Variable Inputs

We have completed our analysis of the short-run production function in which one input, labor, is
variable, and the other, capital, is fixed. Now we turn to the long run, for which both labor and
capital are variable. The firm can now produce its output in a variety of ways by combining
different amounts of labor and capital. In this section, we will see how a firm can choose among
combinations of labor and capital that generate the same output.

With both factors’ variable, a firm can produce a given level of output by using a great deal of
labor and very little capital, a great deal of capital and very little labor, or moderate amounts of
each. That is, the firm can substitute one input for another while continuing to produce the same
level of output, in much the same way that a consumer can maintain a given level of utility by
substituting one good for another.

Consider table 2.2. Let us assume a firm wants to produce 20 units of output by using two variable
Inputs. It can do so by employing different combinations of L and K. combination A consisting of
1 unit of labour and 12 units of capital produces the given 20 units of output. Similarly,
combination B consisting of 2 units of labour and 8 units of capital, combination C consisting of
3 units of labour and 5 units of capital, combination D consisting of 4 units of labour and 3 units
of capital, and combination E consisting of 5 units of labour and 2 units of capital are capable of
producing the same amount of output, i.e., 20 units. A tabular representation of the various
combinations of two variable inputs which give the same level of output is called an isoquant
schedule or equal product schedule.

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Table 2.2: Factor Combinations to Produce a Given level of Output (Isoquant Schedule)

An isoquant is a curve representing the various combinations of two inputs that produce the same
amount of output. An isoquant is also known as an iso-product curve, equal-product curve, or
production indifference curve.

Figure 2.2: An Isoquant

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 Figure 2.3: Isoquant Map

An isoquant map is a combination or group of a number of isoquants. An isoquant map is another

way of describing a production function, just as an indifference map is a way of describing a utility
function. Each isoquant corresponds to a different level of output, and the level of output increases
as we move up and to the right in the figure.

Properties of Isoquants
Isoquants have most of the same properties as indifference curves. The main difference is that an
isoquant holds quantity constant, whereas an indifference curve holds utility constant.

i) Isoquants are downward sloping: If more of one factor is used, less of the other factor is
needed for producing the same level of output. A firm can substitute capital for labor and
keep its output unchanged. If an isoquant sloped upward, the firm could produce the same
level of output with relatively few inputs or relatively many inputs.
ii) Isoquants are convex to the origin: The property of convexity implies that the slope of the
isoquant diminishes from left to right along the curve. Convexity of an isoquant is the result
of the principle of diminishing marginal rate of technical substitution (MRTS) of one factor
in place of the other.

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iii) The farther an isoquant is from the origin, the greater the level of output. That is, the more
inputs a firm uses, the more output it gets if it produces efficiently.

Figure 2.4: Higher Isoquant and Lower Isoquant

iv) Isoquants do not cross. If two isoquants intersect or touch each other it means that there is
a common point on the two curves (point A in Figure 2.5). This common point would imply
that the same amount of labour and capital can produce two levels of outputs (example, 60
and 70 units, here), which is impossible.

Figure 2.5: Intersection of Isoquants (Impossible Condition)

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Marginal Rates of Technical Substitution
It measures the rate at which a firm will have to substitute one input for another in order to keep
output constant. It is the slope of an isoquant. Marginal rate of technical substitution of labor for
capital (MRTSL, K) is the amount by which the input of capital can be reduced when one extra unit
of labor is used, so that output remains constant.

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝐾 𝑟𝑒𝑑𝑢𝑐𝑒𝑑 ∆𝐾

𝑀𝑅𝑇𝑆𝐿, 𝐾 = =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝐿 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑑 ∆𝐿
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝐿 𝑟𝑒𝑑𝑢𝑐𝑒𝑑 ∆𝐿
𝑀𝑅𝑇𝑆𝐾, 𝐿 = =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝐾 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑑 ∆𝐾

𝑀𝑃𝐿 𝑀𝑃𝐾
𝑀𝑅𝑇𝑆𝐿, 𝐾 = − , 𝑀𝑅𝑇𝑆𝐾, 𝐿 = −
𝑀𝑃𝐾 𝑀𝑃𝐿
Table 2.3: Marginal rate of technical substitution of labor for capital (MRTSL, K)

Each of the input combinations, A, B, C, D and E, yields the same level of output. Moving down
the table from combination A to combination B, 4 units of capital are replaced by 1 unit of labour
in the production process without any change in the level of output. Therefore, MRTS of labour
for capital is 4 at this stage. Switching from input combination B to input combination C involves
the replacement of 3 units of capital by an additional unit of labour, to keep output remaining the
same. Thus, MRTS is now 3. Likewise, MRTS between factor combinations C and D is 2, and
between factor combinations D and E is 1.

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Diminishing Marginal Rate of Technical Substitution

It states that the marginal rate of technical substitution of labor for capital diminishes as the
quantity of labor increases along an isoquant. I.e. marginal rate of technical substitution diminishes
as more and more labour is substituted for capital along an isoquant.

2.2.2.1 Special Production Functions (Isoquants)

Perfect Substitutes

In some production processes, the marginal rate of technical substitution of one input for another
may be constant. Sometimes a firm may find that one input may be perfectly substituted for another
type. The isoquants of perfect substitutes are straight lines. Two factors are perfect substitutes
when the marginal rate of technical substitution of one for the other is a constant. Isoquants for
perfect substitutes are straight lines, and the marginal rate of technical substitution is constant. In
figure 2.6, points A, B, and C represent three different capital-labor combinations that generate the
same output q3.

Capital

Labour
Figure 26: Isoquants When Inputs Are Perfect Substitutes

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Perfect complements

In some production processes, it is impossible to make any substitution among inputs. Each level
of output requires a specific combination of labor and capital: Additional output cannot be obtained
unless more capital and labor are added in specific proportions. As a result, the isoquants are L-
shaped. When the isoquants are L-shaped, only one combination of labor and capital can be used
to produce a given output (as at point A on isoquant q1, point B on isoquant q2, and point C on
isoquant q3). Adding more labor alone does not increase output, nor does adding more capital
alone. In Figure 2.7, points A, B, and C represent technically efficient combinations of inputs.

Capital

Labour
Figure 2.7: Isoquants of Perfect Complements

2.2.2.2 Returns to Scale

If all the factors of production are changed, then the firm will be able to operate at a different scale.
Returns to scale describes how much output changes if a firm changes all its inputs proportionately.
Returns to scale tells us the percentage change in output when a firm changes all of its input
quantities by a given percentage amount. In other words, returns to scale is the rate at which output
increases as inputs increase proportionately.

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There are three types of returns to scale:
i) Increasing Returns to Scale: It occurs when output increases by a greater proportion
than the proportion of increase in all the inputs. If output more than doubles when inputs
are doubled, there are increasing returns to scale. This might arise because the larger
scale of operation allows managers and workers to specialize in their tasks and to make
use of more sophisticated, large-scale factories and equipment.
ii) Constant Returns to Scale: It happens when output increases by the same proportion as
of inputs increase. If output doubles when all inputs are doubled, there are constant
returns to scale.
iii) Diminishing Returns to Scale: It occurs when output increases by a smaller proportion
than the proportion of in input increases. If output less than doubles when all inputs are
doubled, we call it decreasing returns to scale.
One reason for decreasing returns to scale is that the difficulty of organizing,
coordinating, and integrating activities increases with firm size.

Consider the following example

Table 2.4: Returns to Scale

Increasing Returns to Scale
Combinations Inputs (In Units) Output (In Units) % in inputs % in Output
A 1L + 1K 100
B 2L + 2K 300 100% 300%
C 3L + 3K 600 50% 100%
Constant Returns to Scale
A 1L + 1K 100
B 2L + 2K 200 100% 100%
C 3L + 3K 300 50% 50%
Decreasing Returns to Scale
A 1L + 1K 100
B 2L + 2K 150 100% 50%
C 3L + 3K 190 50% 26.67%

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Suppose that a firm uses two inputs, labor L and capital K, to produce output Q. Now suppose that
all inputs are “scaled up” by the same proportionate amount λ, where λ > 1 (i.e., the quantity of
labor increases from L to λL, and the quantity of capital increases from K to λK). Let θ represent
the resulting proportionate increase in the quantity of output Q (i.e., the quantity of output increases
from Q to θQ). Then:

• If θ > λ, we have increasing returns to scale.

• If θ = λ, we have constant returns to scale
• If θ < λ, we have decreasing returns to scale

Example: Under what conditions does a general Cobb-Douglas production function, Q = ALα Kβ
exhibit decreasing, constant, or increasing returns to scale. where A, α and β are constants. Let L1
and K1 denote the initial quantities of labor and capital, and let Q1 denote the initial output, so Q1
= AL1αK1 β. Now let’s increase all input quantities by the same proportional amount λ, where λ >
1, and let Q2 denote the resulting volume of output: Q2 = A (λ L1) α (λ K1) β = λα+ β AL1αK1 β = λα+ β
Q1. From this, we can see that if:
• α + β > 1, then λ α + β > λ, and so Q2 > λQ1 (increasing returns to scale).
• α + β = 1, then λα + β = λ, and so Q2 = λQ1 (constant returns to scale).
• α + β < 1, then λα + β < λ, and so Q2 < λQ1 (decreasing returns to scale).
This shows that the sum of the exponents α + β in the Cobb–Douglas production function
determines whether returns to scale are increasing, constant, or decreasing.

2.3 Effect of Technological Change on Production Function

Technological change refers to a change in the underlying techniques of production. It occurs when
a new process of production is invented or an old process is improved. Technological progress
refers to a situation in which a firm can achieve more output from a given (the same) combination
of inputs, or equivalently, the same amount of output from less quantities of inputs. Thus, advances
in technology increase productivity. At the same time some techniques may become inefficient
and drop out from the production function.

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 Figure 2.9: Technological Progress Shifts Production Function Upward

Graphically, the effect of innovation in processes (technological advancement) is shown with an

upward shift of the production function. This shift shows that the same output may be produced
by using fewer factor inputs, or more output may be obtained with the same inputs.

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