STUDY PACK

ECO 101 ECONOMIC THEORIES AND PRINCIPLES I

Lecturer in Charge: Dr. M. I. Azeez

Study session 6: THEORY OF PRODUCTION

Introduction
Theory of production, in economics, an effort to explain the principles by which a
business firm decides how much of each commodity that it sells (its “outputs” or
“products”) it will produce, and how much of each kind of labour, raw material,
fixed capital good, etc., that it employs (its “inputs” or “factors of production”) it
will use. The theory involves some of the most fundamental principles of economics.
These include the relationship between the prices of commodities and the prices (or
wages or rents) of the productive factors used to produce them and also the
relationships between the prices of commodities and productive factors, on the one
hand, and the quantities of these commodities and productive factors that are
produced or used, on the other.

The various decisions a business enterprise makes about its productive activities can
be classified into three layers of increasing complexity. The first layer includes
decisions about methods of producing a given quantity of the output in a plant of
given size and equipment. It involves the problem of what is called short-run cost
minimization. The second layer, including the determination of the most profitable
quantities of products to produce in any given plant, deals with what is called short-
run profit maximization. The third layer, concerning the determination of the most
profitable size and equipment of plant, relates to what is called long-run profit
maximization.

Production in economics generally refers to the transformation of inputs into outputs.

Inputs are the raw materials or other productive resources used to produce final
products i.e., output.

In technical terms, production means the creation of utility or creation of want-

satisfying goods and services. Any good become useful for us or satisfies our want
when it is worth consumption. Thus, a good can be made useful by adding utility.
For instance, we cannot consume wheat flour raw when we are hungry (want), unless
it is turned into bread (output). This conversion of wheat flour into bread is the
process of creating utility. Utilities can be created in three ways of:
a. Form Utility

b. Time Utility

c. Place Utility

a. Form Utility: By changing form or shape and size of a good. The

powdery wheat flour has been changed to slices of bread. Thus form of the
good has been changed. Likewise, a carpenter giving shape of a chair to a
piece of wood or a chef turning a lump of dough into delicious pizzas, are the
examples of changing shape or size of a good/s and thereby creating utility.

b. Time Utility: Using the scarce goods and services in proper time when
they are most required. Government maintains a buffer stock so that during
the time of crisis, it releases food grains in the market to meet the demand.

c. Place Utility: By transferring a good from one place to another where its
use is worthwhile. Sand transferred from river side to construction site
increases its utility. Thus, production is the process of adding utility to a good
through form utility, place utility and time utility.

The production function

However much of a commodity a business firm produces, it endeavours to produce
it as cheaply as possible. Taking the quality of the product and the prices of the
productive factors as given, which is the usual situation, the firm’s task is to
determine the cheapest combination of factors of production that can produce the
desired output.

This task is best understood in terms of what is called the production function, i.e.,
an equation that expresses the relationship between the quantities of factors
employed and the amount of product obtained. It states the amount of product that
can be obtained from each and every combination of factors.

This relationship can be written mathematically as y = f (x1, x2, . . ., xn; k1, k2, . . .,
km). Here, y denotes the quantity of output. The firm is presumed to use n variable
factors of production; that is, factors like hourly paid production workers and raw
materials, the quantities of which can be increased or decreased. In the formula the
quantity of the first variable factor is denoted by x1 and so on. The firm is also
presumed to use m fixed factors, or factors like fixed machinery, salaried staff, etc.,
the quantities of which cannot be varied readily or habitually. The available quantity
of the first fixed factor is indicated in the formal by k1 and so on. The entire formula
expresses the amount of output that results when specified quantities of factors are
employed. It must be noted that though the quantities of the factors determine the
quantity of output, the reverse is not true, and as a general rule there will be many
combinations of productive factors that could be used to produce the same output.

Production function is also defined as the functional relationship between physical

inputs and physical outputs. According to Stigler, “the production function is name
given to the relationship between the rates of input of productive services and the
rate of output of product. It is the economist’s summary of technological
knowledge.” Production function can be expressed as follows:

Q = f (a, b, c, d…)

Where, Q stands for output, a, b, c, d…. are the productive resources or inputs that
help producing Q output; f refers to function. Thus Q is the function of a, b, c, d…,
which means Q depends upon a, b, c, d… Thus a production function shows the
maximum amount of output that can be produced from a given set of inputs in the
existing state of technology.

In other words, 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.

Returns to a Factor and Returns to Scale

The production function is differently defined in the short run and in the long run.
This distinction is extremely relevant in microeconomics. The distinction is based
on the nature of factor inputs.

Those inputs that vary directly with the output are called variable factors. These are
the factors that can be changed. Variable factors exist in both, the short run and the
long run. Examples of variable factors include daily-wage, labour, raw materials,
etc.
On the other hand, those factors that cannot be varied or changed as the output
changes are called fixed factors. These factors are normally the characteristics of the
short run or short period of time only. Fixed factors do not exist in the long run.

Consequently, we can define two production functions: short-run and long-run. The
short-run production function defines the relationship between one variable factor
(keeping all other factors fixed) and the output. The law of returns to a factor
explains such a production function.

For example, consider that a firm has 20 units of labour and 6 acres of land and it
initially uses one unit of labour only (variable factor) on its land (fixed factor). So,
the land-labour ratio is 6:1. Now, if the firm chooses to employ 2 units of labour,
then the land-labour ratio becomes 3:1 (6:2).

The long-run production function is different in concept from the short run
production function. Here, all factors are varied in the same proportion. The law that
is used to explain this is called the law of returns to scale. It measures by how much
proportion the output changes when inputs are changed proportionately.

Types of Production Functions

Basically, there are generally two types of production functions mostly used in
economics.

i. First, the production function when the quantities of some inputs are kept
fixed and the quantity of one or few input/s are changed. This kind of
production functions are studied under law of variable proportions. These are
also called short-run production functions. The short-run is a period during
which one or more factors of production are fixed in amount. There is no time
to change plants or equipment of an enterprise.

ii. Secondly, the production functions in which all inputs are changed. This
forms the subject matter of the law of returns to scale. These are also called
long-run production function. The long run is a period during which all factors
become variable. A new plant can be constructed in place of an old one.

Law of Variable Proportions/Law of Diminishing Returns

Law of variable proportions occupies an important place in the economic theory. It
examines the production function with one factor variable, keeping the quantities of
other factors constant. This law tells us how the total output or marginal output is
affected by a change in the proportion of the factors used. The law states that when
one factor is increased keeping others fixed, the marginal and average product
eventually declines.

According to Stigler, “As equal increments of one input are added; the inputs of
other productive services being held constant, beyond a certain point, the resulting
increments of product will decrease, i.e., the marginal products will diminish.” Thus,
an increase in the quantities of a variable factor to a fixed factor results in increase
in output to a point beyond which it eventually declines.

Assumptions of the law

The law assumes the following:

i. The state of technology is assumed to be constant.

ii. There must be some inputs whose quantity is kept fixed.

iii. The law is based upon the possibility of varying the proportions in which the
various factors can be combined to produce a product. It cannot be applied to
the cases where the factors must be used in fixed proportions to yield a
product.

Short-run Productivity of factor (Labour)

Labour productivity in the short-run can be examined in terms of Total, average and
marginal productivity.

i. Total Product of a factor (TPF) also called the total physical productivity of
factor (TPP), it shows the maximum level of output that can be produced by
employing some given units of labour on a fixed quantity of capital.

ii. Average Total Product of factor (ATP) also called the average physical
product of factor say labour or the average product of factor (AP) for short, it
refers to the output of one unit of labour. It is derived by dividing total product
of labour by the quantity of labour employed, i.e.

ATPL = TPL /L
Where L is units of labour employed. When only one unit of labour is employed TPL
is identical to ATPL.

iii. Marginal Product of factor (MP) also called the marginal physical product of
a factor say, labour (MPPL), it defines the addition to total product occasioned
by the employment of an extra unit of labour (the level of capital remaining
constant). Algebraically, if total product of labour in period n – 1 is TPn-1, the
marginal product of labour in period n is the total product in period n (TPn)
less the total product in period n – 1, divided by the additional units of labour
employed in period n, i.e.

MPn = TPn – TPn-1 = ∆TPL

Ln – Ln-1 ∆L

Where ∆TPL is change in TPL between period n – 1 and period n, and ∆L is change
in quantity of labour employed over the same period.

The law of variable proportions is explained with the help of following table:

No. of Workers Total Product Marginal Product Average Product

1 10 10 10
2 30 20 15
3 60 30 20
4 88 28 22
5 100 12 20
6 110 10 18.33
7 118 8 16.86
8 118 0 14.75
9 110 -8 12.22
10 100 -10 10

With a given fixed quantity of land, numbers of workers are increased from 1 to 10.
When there are 7 workers engaged, the output is maximum, i.e., 118 kgs. Beyond
this point, the total product starts diminishing. Up to 3rd unit of worker, the total
product increases at an increasing rate and after that at diminishing rate. This is clear
from the third (MP) column that marginal product is falling continuously after 3rd
unit of worker and even becomes negative beyond 8th unit
of worker. Average product increases up to 4th unit of labour and falls throughout
thereafter. The law can be also explained using Fig. 1 shown as under:
 Fig. 1:

In the above figure, variable input axis measures units of variable factor and product
axis measures output-total, marginal and average products. We observe three
different stages of law of variable proportions as explained below:

i. The first stage goes from the origin to point where the marginal output is the
maximum (point F). In this stage, marginal product increases. This stage is
known as the stage of increasing returns. The reason for increasing returns is
that when more and more units of the variable factor are added to the constant
quantity of fixed factor, then fixed factor is more effectively and intensively
used. This causes output to increase at a fast rate.

ii. The second stage goes from the point where the average output is maximum
to the point where marginal output is zero (point H). In this stage, marginal
product starts falling. When the fixed factor is most efficiently used, then
further increase in the variable factor causes marginal and average products
to decline because the fixed factor now is scarce relative to the quantity of
variable factor. Therefore, this stage is known as the stage of diminishing
returns.

iii. The third stage starts when the total product is maximum and marginal product
is zero. In this stage, marginal product becomes negative. In this stage, the
number of variable factors becomes too large relative to the fixed factor so
that the total output falls and marginal output becomes negative. This is the
reason why this stage is known as the stage of negative returns.
Relationship between Marginal Product and Total Product

The law of variable proportions is used to explain the relationship between Total
Product and Marginal Product. It states that when only one variable factor input is
allowed to increase and all other inputs are kept constant, the following can be
observed:

a. 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.

b. When the MP declines but remains positive, the Total Product is increasing
but at a decreasing rate. This gives ends to the total product curve as a concave
shape after the point of inflexion. This continues until the Total product curve
reaches its maximum.

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

d. When the MP becomes zero, Total Product reaches its maximum.

Relationship between Average Product (AP) and Marginal Product (MP)

There exists an interesting relationship between Average Product and Marginal

Product. We can summarize it as under:

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

Product.

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

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

1. Find the marginal productivity of the different inputs of factors of production for
each of the following production functions Q:
a. Q = 6x2 + 3xy + 2y2

b. Q = 0.5K2 – 2KL + L2

c. Q = 20 + 8x + 3x2 – 0.25x3 + 5y + 2y2 – 0.5y3

d. Q = x2 + 2xy + 3y2 + 1.5yz + 0.2z2

Required:

Find MPx, MPy, MPz, MPk, MPL in a, b, c, and d.

Assume y = 4, find the MPx when x = 5 and x = 8

Returns to Scale

Scale of production relates to size of plant. Every entrepreneur has to decide about
the size of his plant or business. The question is how large a business should be.
Because up to a certain size of plant what is called ‘economies of scale’ take place.
Economies of Scale refers to benefits arise due to the expansion of a business.
Economies of scale can be broadly divided into two categories:

i. Internal Economies

ii. External Economies

i. Internal economies are caused by some internal factors, which arise within the
firm and are not shared by other firms. Use of better technology, purchase of
raw materials at cheaper rates and selling the final goods at high price, easy
availability of finance from financial institutions etc, are some examples of
internal economies/benefits that a firm enjoys.

ii. External economies are those advantages which are available to all firms
located in an area. Development of transportation, good and fast
communication, good banking and insurance facilities, etc are the examples
of external economies. Too big or too small size of plant or business is not
viable in the economic sense. Optimum scale, which at least covers up cost
per unit of output, is more desirable than too small or too large plant.
The study of changes in output as a result of changes (increase or decrease) in the
scale is the subject matter of returns to scale. An increase/decrease in the scale refers
to increase/decrease in all inputs in the same proportion. Thus in returns to scale, we
study the effect of doubling or trebling and so on of all inputs on the total output.
The law can be explained with the help of the following figure and table shown:

S/N Scale TP MP Stage

1 Lab + 2 units of Land 3 3
2 Lab + 4 units of Land 7 4 I (Increasing Returns)
3 Lab + 6 units of Land 12 5
4 Lab + 8 units of Land 18 6
5 Lab + 10 units of Land 24 6 II (Constant Returns)
6 Lab + 12 units of Land 30 6
7 Lab + 14 units of Land 35 5
8 Lab + 16 units of Land 39 4 III (Decreasing Return)
9 Lab + 18 units of Land 42 3

Note: TP = Total Product; MP = Marginal Product and Lab = Labour

The Law of Returns to Scale - Isoquant Approach

Isoquant

The term "isoquant," broken down in Latin, means “equal quantity,” with “iso”
meaning equal and “quant” meaning quantity. Essentially, the curve represents a
consistent amount of output. The isoquant is known, alternatively, as an equal
product curve or a production indifference curve. It may also be called an iso-product
curve.

An isoquant curve is a concave-shaped line on a graph, used in the study of

microeconomics, that charts all the factors, or inputs, that produce a specified level
of output. This graph is used as a metric for the influence that the inputs, most
commonly, capital and labour, have on the obtainable level of output or production.

The isoquant curve assists companies and businesses in making adjustments to

inputs to maximize production, and thus profits.

Most typically, an isoquant shows combinations of capital and labour, and the
technological trade-off between the two i.e. how much capital would be required to
replace a unit of labour at a certain production point to generate the same output.
Labour is often placed along the X-axis of the isoquant graph, and capital along the
Y-axis.

Due to the law of diminishing returns, the economic theory that predicts that after
some optimal level of production capacity is reached, adding other factors will
actually result in smaller increases in output i.e. an isoquant curve usually has a
concave shape. The exact slope of the isoquant curve on the graph shows the rate at
which a given input, either labour or capital, can be substituted for the other while
keeping the same output level.

An isoquant curve has a convex shape and indicates production quantities. Consider
a specific example of the Cobb-Douglas production function, which is a standard
example as follows:

Q = AKαLβ. (A > 0; 0 < α, β < 1),

where Q is the quantity of output in physical units,

K is the quantity of capital, and
L is the quantity of labour.
α is the output elasticity of capital which measures the percentage change in Q for a
1 percent change in K while L is held constant.
β is the output elasticity of labour which is exactly parallel; A is an efficiency
parameter reflecting the level technology.

Classification of Cobb-Douglas Functions

There are basically two classifications as:
1. Strict Cobb-Douglas Function; and
2. Generalized Cobb-Douglas Function

1. A strict Cobb-Douglas function, in which α + β = 1, exhibit constant returns

to scale,
2. A generalized Cobb-Douglas means α + β ≠ 1; The production function
exhibits increasing returns to scale if α + β > 1 and decreasing returns to scale
if α + β < 1. A Cobb-Douglas function is optimized subject to a budget
constraint.

A mathematical example of strict Cobb-Douglas can be: Q = K0.5L0.5. Here, there

are two factors of production, capital (K) and labor (L).
For the purpose of illustration, setting Q=1 implies L=1/K. The table shows some of
the combinations of L and K that produce one unit of output. This is a downward-
sloping curve, which is a common property of isoquants. The curve is also convex
to the origin. An isoquant graph is shown by plotting L on one axis and K on the
other axis.

For example, in the graph below, Factor K represents capital, and Factor L stands
for labor. The curve shows that when a firm moves down from point (a) to point (b)
and it uses one additional unit of labor, the firm can give up four units of capital (K)
and yet remain on the same isoquant at point (b). If the firm hires another unit of
labor and moves from point (b) to (c), the firm can reduce its use of capital (K)
by three units but remain on the same isoquant.

Isoquant Curve

Thus there are three phases of returns to scale explained as under.

Stage I

Output increases in a greater proportion than the increase in inputs. Thus if all inputs
are increased by 10%, and as a result, output increases by 20%, then increasing
returns to scale operates. This is also shown in the Figure below.
 Fig. 1: Increasing Return to Scale

In the beginning when the scale is increased, increased division of labour is possible
and is undertaken, as result of which, output increases rapidly.

Stage II

If all inputs are increased in a given proportion and the output increases in the same
proportion then returns to scale is constant. More clearly, if all inputs are increased
by 10%, and as result output also increases by 10%, then constant returns to scale
prevails. Up to a certain point division of labour is possible. After such a point,
further increase in scale will make returns to remain constant. The figure below
shows constant return to scale:

Fig. 2: Constant Return to Scale

Stage III

If all inputs are increased in a given proportion and the output increases in less than
that proportion, then returns to scale is diminishing. That is, if all inputs are increased
by 10%, and as a result, output also increases by 6%, then diminishing returns to
scale prevails. When scale is increased to a point when division of labour is not
possible, returns begins to decline. See the figure below for decreasing return to
scale:
OA < AB < BC

Fig. 3: Decreasing Return to Scale