UNIT III

THEORY OF PRODUCTION
 Production
Meaning:

Production refers to the transformation of inputs into outputs

(or products).

It involves transformation of inputs such as capital, equipment,

labour, and land into output - goods and services.
 Period of Production
Short Period:Short run refers to a period of time which is too
short to allow an enterprise to change its, plant capacity, yet along
enough to allow a change.
The short run is a period of time when there is at least one fixed
factor input. This is the only period where both Fixed and Variable
factor distinction can be seen.

Long Period:Long run refers to a period of time which is long

enough to permit a firm or enterprise to alter all its resources or
inputs.
In the long run, all of the factors of production can change giving a
business the opportunity to increase the scale of its operations.
 Factors of Production

Land: In economics, land as a factor of production does

not refer only to the surface of land but to all gifts of nature,
such as rivers, oceans, climate, mountains, fisheries, mines,
forests, etc. In the words of Dr Marshall. By land is meant
materials and forces which nature gives freely for man’s aid,
in land, water, in air, light and heat.

Labour: Labour refers to all mental and physical work

undertaken for some monetary reward. It includes the
services of a factory worker, a doctor, a teacher, a lawyer, an
engineer, an officer, etc.
 Factors of Production

Capital: Capital means all man-made resources. It

comprises all wealth other than land which is used for
further production of wealth. It includes tools, implements,
machinery, seeds, raw materials and means of transport etc.

Entrepreneur : Factors of production viz. land, labour

and capital are scattered at different places. All these factors
have to be assembled together. This work is done by
enterprise through entrepreneur. This is an 'Organization
Function‘.
 Fixed Vs. Variable Factor
• Fixed inputs remain fixed (constant) up to certain level
of output. Their supply is inelastic in the short run. Example-
Buildings, major capital equipment and managerial
personnel.

• Variable inputs change with the change in output.

Their supply is elastic in the short run. Example- Raw
materials and labour services
 Production Function
Production Function is a mathematical
expression which defines the various
combination between the input that help in
producing optimum output.
Q = f (L, N,K,T, t)
Where,
Q= Production function
L= Land, K= Capital,
N= Labour, T=Technology and t= Time
 Law of Variable Proportion
Concept:
The law of variable proportion is one of the fundamental laws
of economics. The law of variable proportion is the study of
short run production function with some factors fixed and
some factors variable. It is also known as Law of Returns.
 Law of Variable Proportion
Assumptions of the Theory:
1) The state of technology is assumed be given and
unchanged.
2) The law specially operates in the short run because some
factors are fixed and the proportion between factors is
disturbed.
3) The law will hold good for short and given period.
4) Factors are indivisible in nature.
 Law of Variable Proportion
Assumptions of the Theory:
5) Variable factor units are homogeneous or identical in
amount and quality.
6) The law is based on the possibility of varying the
proportions in which the various factors can be combined to
produce a product.
7) Input prices remain unchanged.
8) Output is measured in physical units.
 Law of Variable Proportion
Explanation of Law: Total Product (TP): The total
Units of Total Marginal Average Stages of volume of goods and services
Labour Product Product Product Production
(TP) (MP) (AP)
produced by a firm in a given
period of time is known as total
1 2 2 2 Increasing product.
Returns
2 6 4 3
3 12 6 4 Marginal Product(MP): It is
defined as the change in the total
4 16 4 4
product due to the per unit change
5 18 2 3.6 Diminishing
in the variable input like labour.
Returns
6 18 0 3 MP= ∆TP/ ∆N
7 14 -4 2 Negative Average Product (AP):It defines
Returns the per unit production in a given
8 8 -6 1
period of time.
AP= TP/N
Where N= Total Labour Employed
 Law of Variable Proportion
Explanation of Law:
 Law of Variable Proportion
Explanation of Law:
Stages TP AP MP
of
Production
Increasing TP is increasing at It is increasing and MP is rising and
Return increasing rate. reaches its highest reaches it’s
point. highest point.

Decreasing TP is increasing at It’s start declining It’s started

Return decreasing rate and but it is positive. declining and
reaches its maximum become zero.
point.

Negative TP starts declining. It’s start declining MP becomes

Return but never become negative.
zero.
 Law of Variable Proportion
Causes of Operation of Law of Variable Proportion/ Why does
this law operate?
A)Reasons for Increasing Returns to a Factor (Phase 1)
 Better Utilization of the Fixed Factor
 Increased Efficiency of Variable Factor

B) Reasons for Diminishing Returns to a Factor (Phase 2)

 Optimum Combination of Factors

C) Reasons for Negative Returns to a Factor (Phase 3)

 Limitation of Fixed Factor
 Poor Coordination between Variable and Fixed Factor
 Decrease in Efficiency of Variable Factor
 ISOQUANT CURVE
• An isoquant (isoproduct) is a curve on which the various
combinations of labour and capital show the same
output.

Isoquant Schedule:
Total
Units of Units of Output (in
Combination Capital Labour units)
A 9 5 100
В 6 10 100
С 4 15 100
D 3 20 100
 PROPERTIES ISOQUANT CURVE
• Isoquants are negatively inclined: Isoquant must slope
downward to the right.

• An Isoquant lying above and to the right of another

represents a higher output level. No isoquant can touch
either axis. .
 PROPERTIES ISOQUANT CURVE

•No two isoquants can intersect each other

•In between two isoquants there can be a number of

isoquants showing various levels of output which the
combinations of the two factors can yield.
 PROPERTIES ISOQUANT CURVE

•No isoquant can touch •Each isoquant is convex to the

either axis. origin (Marginal Rate of Substitution
is applies
 Isocost Curves

• Each isocost curve represents the different

combinations of two inputs that a firm can
buy for a given sum of money at the given
price of each input.

• These curves are also known as outlay lines,

price lines, input-price lines, factor-cost
lines, constant-outlay lines.
Choice of Optimal Factor Combination/ Least Cost Combination of
Factors

The least cost combination of factors refers

to a firm producing the largest volume of
output from a given cost and producing a
given level of output with the minimum
cost when the factors are combined in an
optimum manner.
Choice of Optimal Factor Combination/ Least Cost Combination of
Factors

Assumptions:
1. There are two factors, labour and capital.
2.All units of labour and capital are
homogeneous.
3. The prices of units of labour (w) and that of
capital (r) are given and constant.
4. The cost outlay is given.
Least Cost Combination of Factors

5. The firm produces a single product.

6. The price of the product is given and
constant.
7. The firm aims at profit maximisation.
8. There is perfect competition in the factor
market.
Producer’s Equilibrium
There are two essential or second order conditions for the
equilibrium of the firm.

•The first condition is that the slope of the isocost line must
equal the slope of the isoquant curve.

• The second condition is that at the point of tangency, the

isoquant curve must he convex to the origin.

The point where the isocost line is tangent to an isoquant

represents the least cost combination of the two factors for
producing a given output. If all points of tangency like LMN are
joined by a line, it is known as an output- factor curve or least-
outlay curve or the expansion path of a firm.
Producer’s Equilibrium
 Law of Returns to Scale
Concept:
The concept of returns to scale explains the behavior of
output when changes are made in the scale of production.
Thus, the relationship between quantities of output and the
scale of production in the long run when all inputs are
increased in the same proportion, is called law of returns to
scale.
When inputs are increased proportionately i.e., scale is
increased, there are three possibilities
 Total output may increase more than proportionately as the inputs,
 Total output may increase at same proportion as the inputs
 Total output may increase less than proportionately as the inputs
 Law of Returns to Scale
Stages of Production in Long Run:
(1)Increasing Returns to Scale: If the output of a firm increases more
than in proportion to an equal percentage increase in all inputs, the
production is said to exhibit increasing returns to scale.

(2)Constant Returns to Scale: When all inputs are increased by a

certain percentage, the output increases by the same percentage,
the production function is said to exhibit constant returns to scale.

(3)Diminishing returns to scale: It refers to scale where output

increases in a smaller proportion than the increase in all inputs.
 Law of Returns to Scale
Stages of Production in Long Run:
(1)Increasing Returns to Scale: If the output of a firm increases
more than in proportion to an equal percentage increase in all
inputs, the production is said to exhibit increasing returns to
scale.
 Law of Returns to Scale
Stages of Production in Long Run:
(2)Constant Returns to Scale: When all inputs are increased by
a certain percentage, the output increases by the same
percentage, the production function is said to exhibit constant
returns to scale.
 Law of Returns to Scale
Stages of Production in Long Run:
(3)Diminishing returns to scale: It refers to scale where output
increases in a smaller proportion than the increase in all
inputs.
 Law of Returns to Scale

Causes of Operation of Increasing Returns to Scale

• Internal economies of scale

• Efficiency of labour and capital
• Improvement in large scale operation
• Division of labour and specialization
• Use of better and sophisticated technology
• External economies of scale
 Law of Returns to Scale

Causes of Constant Returns to Scale

• Internal economics of scale are equal to internal
diseconomies of scale.

• Balancing of external economics and diseconomies of scale.

 Law of Returns to Scale

Causes of Decreasing Returns to Scale

• Internal diseconomies of scale

• External diseconomies of scale
• Increase in business risk
• Lack of entrepreneurial efficiency
• Unhealthy management and organization
• Imperfect factor substitutability
• Transport bottlenecks and Marketing difficulties.
 Law of Return Vs. Law of Return to Scale
Law of Return Law of Return to Scale
1) Only one factor varies while all All or at least two factors vary.
the rest are fixed.

2) The factor-proportion varies as Factor proportion called scale does

more and more of the units of not vary. Factors are increased in
the variable factor are same proportion to increase
employed to increase output. output.

3) Returns to a factor or to Returns to scale end up in

variable proportions end up in decreasing returns
negative returns.

4) It is a short-run phenomenon. It is a long-run phenomenon.

COST ANALYSIS
MEANING OF COST
Cost represent that portion of acquisition of price of
goods, property and services which has being deferred
and not yet utilized in connection with the realization of
revenue.

COST ANALYSIS:
It refer to the study of behaviour of cost in relation to one
or more production criteria. Production criteria includes
size of plant, scale of operation, prices of factors of
production etc.
 TYPES OF COST
A)ON THE BASIS OF NATURE

Direct Cost:
Direct costs are expenses that a company can easily connect to a
specific "cost object," which may be a product, department or
project. It includes direct material, direct labour and direct
expenses.

Indirect Cost:
Indirect costs go beyond the costs associated with creating a
particular product to include the price of maintaining the entire
company.
 TYPES OF COST

C)ON THE BASIS OF BEHAVIOUR

Fixed Cost:
It includes those costs that are fixed in volume for a certain level
of output. Fixed costs are normally short-term concepts because,
in the long-run, all costs must vary.

Variable Cost:
It includes those cost that vary with variations in output. These
include: (i) Cost of raw materials; (ii) Running costs of fixed
capital, such as fuel, repairs, routine maintenance
 TYPES OF COST

D)ON THE BASIS OF MANAGERIAL

DECISION:

Historical Cost:
The historical cost of an asset refers to the actual cost incurred at
the time the asset was acquired.

Replacement Cost:
The replacement cost stands for the cost which must be incurred
if the asset is to be purchased today.

Private Cost:
The actual expenses of individuals/ firms which are borne or paid
 TYPES OF COST

D)ON THE BASIS OF MANAGERIAL

DECISION:

Social Cost:
Social Cost on the other hand includes Private Cost and also such
costs which are not borne by the firm but by the society at large.
Implicit Cost:
In the economic sense there are certain costs which are implicit
in nature. This refers to the value of the inputs owned and used
by the firm in its own production activity.
 TYPES OF COST

D)ON THE BASIS OF MANAGERIAL

DECISION:

Explicit Cost:
Explicit costs are those cost which are actually incurred and
therefore are recorded in the books of accounts by the company.
Example of it is rent paid, salary paid to workers, price paid for
raw materials etc. They are thus also known as accounting cost or
money cost, as these are actual monetary expenditures incurred
by the firm.
 COST FUNCTION
Cost Function express the relationship between the cost and its
determinants.

C=f(S,O,P,T,M)
Where,
S= Size of Plant
O=Output Level
P=Price of Input
T=Technology
M= Managerial Efficiency
 SHORT RUN COST
The short run costs are operating costs associated with the
change in output. In the short run, the production function
contains a set of fixed factor input and a set of variable inputs.
Short run costs vary in relation to the variation in the variable
input component only.

Behaviour of Costs in the Short-

run
Total Fixed Costs: The total obligations of the firm per time
period for all fixed inputs are called total fixed costs (TFC).
 SHORT RUN COST

Behaviour of Costs in the Short-

run
Total variable costs (TVC): On the other hand, TVC are the
total obligations of the firm per time period for all the variable
inputs that the firm use.

TC = TFC + TVC
 SHORT RUN COST
Important Characteristics of
Cost Curves
TOTAL FIXED COST CURVE : TFC remain fixed
for every volume of production in short run.TFC is a straight
horizontal line, parallel to the X-axis.
 SHORT RUN COST
Important Characteristics of
Cost Curves
TOTAL VARIABLE COST CURVE : It reflect the
typical behaviour of total variable cost. It initially rises
gradually but eventually becomes steeper, denoting a sharp
rise in total variable costs.
 SHORT RUN COST
Important Characteristics of
Cost Curves
TOTAL COST CURVE : It is derived by vertically
adding up TVC and TFC curves. The shape of the TVC and TC
are identical. The only difference between two is of distance
that is total fixed cost.
 SHORT RUN COST
Important Characteristics of
Cost Curves
AVERAGE FIXED COST CURVE : It is TFC
divided by total output. AFC decreases as output increases.
AFC curve is a rectangular hyperbola.

AFC = TFC/TQ
 SHORT RUN COST
Important Characteristics of
Cost Curves
AVERAGE VARIABLE COST CURVE : It is TVC
divided by total output. It is per unit cost of variable factors of
production. AVC first decreases and then increase as the
output increases.
AVC = TVC/TQ
AVC curve is dish shaped or U-shaped.
 SHORT RUN COST
Important Characteristics of
Cost Curves
AVERAGE VARIABLE COST CURVE : ATC is
the sum of AFC and AVC, it will decrease in the beginning as
both component decreases initially. After a point AVC start
increasing and pulls up the ATC along with it, out weighing the
influence of ever decreasing AFC.
 SHORT RUN COST
Important Characteristics of
Cost Curves
MARGINAL COST (MC) : Marginal Cost is the
addition made to the total cost by the production of one more
unit of commodity. Marginal cost is the rate of change in total
costs when output is increased by one unit.

MC= TC n - TC n-1
MC = ∆TVC / ∆TQ
 LONG RUN COST
A long run cost curve depicts the functional relationship between
output and the long run cost of production.
 LONG RUN COST
LAC is a ‘Planning Curve’ because on the basis of
this curve the firm decides what plant to set up in order to
produce at minimum cost the expected level of output. It is often
called ‘Envelop Curve’ because it envelops the SAC
curves.

U shape of LAC can be explained by the economies and

diseconomies of scale. Initially when the firm increases its scale
of production it reaps economies of scale. However beyond a
point, further expansion in the scale of production results
diseconomies of scale.
 LONG RUN COST
Long-Run Marginal-Cost Curve (LMC):

Like the short run marginal cost curve, the long run marginal cost
curve is also derived from the slope of total cost curve at the
various points relating to the given output each time. The shape
of LMC curve has also a flatter U shape indicating that initially as
output expands in the long run, LMC tend to decline.
 LONG RUN COST

From the above fig., the relationship between LAC and LMC may
be traced as follows:-
1. When LAC is decreasing, LMC is below LAC.
2. LMC is equal to LAC, when LAC is at its minimum point.
3. LMC is above LAC, when LAC is rising.
 ECONOMIES OF SCALE
Economies of scale are the cost advantages that a business
can exploit by expanding the scale of production

The effect is to reduce the long run average (unit) costs of

production.

These lower costs are an improvement in productive

efficiency and can benefit consumers in the form of lower prices.

They give a business a competitive advantage.

 ECONOMIES OF SCALE
The economies of Scale are classified as:
Internal Economies
External Economies
Reasons for Internal Economies
1)Production/Technical economies of scale:
Large-scale businesses can afford to invest
in expensive and specialist capital machinery..
Specialization of the workforce:
Economies of use of by-products.
 ECONOMIES OF SCALE
Reasons for Internal Economies
2) Marketing economies of scale:
3) Financial economies of scale
4) Network economies of scale
5) Risk and Survival economies
6) Managerial economies of scale
 ECONOMIES OF SCALE
External Economies
External economies of scale occur within an industry and from
the expansion of it.

Examples include the development of research and

development facilities.

Spending by a local authority on improving the transport

network for a local town or city.

Likewise, the relocation of component suppliers and other

support businesses close to the main centre of manufacturing are
also an external cost saving.
 DISECONOMIES OF SCALE
Internal Diseconomies:

1. Loss of Co-operation
2. Loss of control over costs
3. Managerial Inefficiency Diseconomies
4. Labour Inefficiency

External Diseconomies:

5. Diseconomies of Pollution:
6. Diseconomies of strains on infrastructure