Chapter 5- Production Concept-

Production Functions
Economies of Scale
Isoquant and
Isocost
Concepts:-

 Production- Production is transformation of

inputs or resources into outputs of goods and
services. Production is a flow concept.

 Inputs-These are the resources used in

production of goods and services. Eg: Labour,
capital , natural resources.
Concepts:-
 Fixed inputs-The inputs which cannot be readily
changed during the given time period except when
heavy expense is incurred. Eg: Heavy machinery,
Factory, Permanent workers.

 Variable inputs-The inputs which can be readily

changed during the given time period at a very short
notice. Eg: Contract labour, Raw material.
Concepts:-

 Short Run time period- The time period during

which at least one input is fixed.
Eg: Production in any industry using more labour
and raw material with old equipments.
 Long Run time period-The time period when all
inputs are variable. Eg: Increase in production in
any industry using latest automated equipment.
 Production Function
 States the relationship between inputs and outputs.
 Inputs – the factors of production classified as:

 Land – all natural resources of the earth – not just ‘terra firma’!
 Price paid to acquire land = Rent
 Labour – all physical and mental human effort involved in
production.
 Price paid to labour = Wages
 Capital – buildings, machinery and equipment not used for its
own sake but for the contribution it makes to production.
 Price paid for capital = Interest
 Organisation- Entrepreneur
 Production Function

Inputs Process Output

Land
Product or
Labour service
generated
– value
Capita added
l
 A production function defines the relationship between
inputs and the maximum amount that can be produced
within a given period with a given level of technology.
 That is the physical rate of input and output of a firm per
unit time.
 Mathematical representation of the relationship:
 Q = f (K, L, La)
 Output (Q) is dependent upon the amount of capital
(K), Land (L) and Labour (La) used.
 Short run production function: it shows the
maximum quantity of a good that can be produced
by a set of inputs assuming that the amount of
at least one of the input remain unchanged
 Long run production function: It shows the
maximum quantity of a good that can be produced
by a set of inputs assuming that the firm is free
to vary the amount of all the inputs being
used.
 Analysis of Production Function:
Short Run
 In the short run, factors can be fixed or variable but at
least one factor is fixed in supply but all other factors
capable of being changed.
 Reflects ways in which firms respond to changes in
output (demand).
 Can increase or decrease output using more or less of
some factors but some likely to be easier to change than
others.
 Increase in total capacity only possible in the long
run
 In times of rising sales
(demand) firms can
increase labour and
Analysis of Production capital but only up
to a certain level –
Function: they will be limited
by the amount of
Short Run space.
In this example, land is
the fixed factor which
cannot be altered in the
short run.
If demand slows
down, the firm can
reduce its variable
factors – in this
example it reduces
its labour and
capital but again,
land is the factor
which stays fixed.
.
 Analysing the Production Function:
Long Run
 The long run is defined as the period of time taken to
vary all factors of production.
 In long run all factors are variable
 The period of time varies according to the firm and
the industry
 By doing this, the firm is able to increase its total
capacity – not just short term capacity
 Associated with a change in the scale of
production
FUNCTIONS-
 Determine the least cost, optimum level of
production, production planning, returns to scale
Production Analysis
 Definition
 Production analysis involves
microeconomic techniques that are used to
analyze production efficiency, optimum
factor allocation, costs, economies of scale
and to estimate the firm's cost function.
 PRODUCTION ANALYSIS
 LAWS
 LAW OF VARIABLE PROPORTIONS.
 LAW OF DIMINISHING RETURN
 LAW OF RETURN TO SCALE.

 ANALYSIS TECHNIQUES

 PRODUCTION POSSIBILITY ANALYSIS.

 ISO-COST / ISO-QUANT ANALYSIS.
 PRODUCTION ANALYSIS

•DETERMINES MAX RESULT POSSIBLE WITHIN GIVEN RESOURCE

ALLOCATION.

• ANALYSIS OF ONE INPUT – TWO OUTPUT CASE

•DETERMINES MOST EFFICIENT COMBINATION OF Factors FOR

MAXIMISING RESULTS WITHIN GIVEN ONE INPUT.

• TECHNIQUE MAKES USE OF PRODUCTION POSSIBILITY

CURVE.
Total product
 Total product is the total output produced by a
given input when all other inputs held
are constant.
 As the input increases out put increases.
 In the beginning the total product

shows a rise at an increasing rate but as the

curve
variable input is increased further the curve
Starts rising at diminishing rate.
Average
product
 Average product is the total output
produced per unit of the factor
employed.
Total product
Average =
Number of units of a input
employed
product
 Marginal product of labour
(MP)
The additional output attributable to using
one additional worker with the use of all
other inputs fixed.

ΔQ
Marginal Product= ---------
ΔL
Average and marginal products

Average product

Marginal
product
Total, Average and marginal products
L Q AP=Q/L MP=ΔQ/
ΔL
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
1 Law of variable proportions
 “In the short run AS PROPORTION OF ONE FACTOR IN A
COMBINATION OF FACTORS IS INCREASED,
MARGINAL & AVERAGE OUTPUTS WILL INCREASE
THEN AFTER A POINT, FIRST MARGINAL AND THEN
AVERAGE OUTPUT WILL DIMINISH”.
 Based on the fact that all factors of production cannot be
substituted for one another
 One factor varied, all others constant, applicable in short run
 Scale of output, size and efficiency unchanged, all units
homogenous
 As additional units of a variable input are combined with a
fixed input, at some point the additional output (MP) starts to
diminish
 Law of variable proportions
 EFFECT ON OUTPUT: THREE STAGES
 INCREASING RETURNS – MARGINAL RETURN RISES
 CONSTANT RETURNS – MARGINAL RETURN FALLS
 DIMINISHING RETURNS – MARGINAL RETURN BECOMES
NEGATIVE
Stage 1: Stage of increasing returns
 1) Total product increases at increasing rate upto a point
then increases at diminishing rate
and
 2) Marginal product also rises in this
 stage
3) Average product rises at this stage
 Eg set of machines- min no of workers- for full efficiency-
increasing variable factors like workers optimizes efficiency-
Stage 2
 1) Total product increases but at a diminishing rate until it
reaches the maximum
 2) AP and MP are declining but positive
 3) This stage is considered important for business firm
 Later, fixed factor like machinery over utilized, imperfect
substitutability- diminishing returns
Stage 3
1) TP slopes downward in this stage
 2) MP curve enters the negative quadrant
 Variable much excess of fixed- excess use of
fertilizers spoil farm output
Total Products c

Stage I Stage II Stage III

bb’

Average product
Marginal
product
0 a’ b’ c’ cc’
Variable input TP AP MP
1 80 80 80
2 170 85 90

3 270 90 100
Increasing
4 368 92 98

5 430 86 62
6 480 80 50
7 504 72 24
8 504 62 0
Decreasing
9 495 55 -9
10 480 48 -15
Negative
2 Law of Diminishing RETURN-
 The relationship between the average product and
marginal product is shown in three stages-

Stage I- The range from origin to point bb’ where Average

product is maximum.
Stage II- The range from Highest APlto point where MP l
is zero.

Stage III- The range over which MP l is negative.

REFER previous slide

Law of Diminishing Return
 This postulates that if we use more and more units of
variable input with a given amount of fixed input, after a
point , we get diminishing returns (marginal product)
from the variable input.

 This law holds true when one gets less output even on
adding additional doses of an input while holding other
inputs fixed.
 The marginal product of each unit of input will decline as
the amount of that input increases, holding all other inputs
constant.
3 Economies of Scale
 Large scale production is economical as cost of
production is low. Low cost is a result of economies of
scale.
 A situation in which an increase in the quantity produced
decreases the long-run average cost of production.
 Economies of scale refer to cost savings associated with
spreading the cost of indivisible inputs and input
specialization.

 In the broad sense, anything which serves to minimize

average cost of production in the long run as the scale of
output increases is referred to as economies of scale
 Internal economies are those which arise from the
expansion of the plant size of the firm and are
internalized.
 Emerge within the firm itself as it expands
 Classification of internal economies of scale
 A) Economies in production: Technological
advantages and advantages of division of labour.
 B) Economies of marketing
 C)Managerial economies
 D) Economies of transport and storage
 External economies are those economies which are shared
by all the firms in an industry or in a group of industries
when their size expands.
 They are the result of the growth and expansion of any
particular industry or a group of industries as a whole
 Localization of industries
 Market intelligence
 By products use
 Diseconomies of

Scale
A firm experiences diseconomies of scale when an
increase in output leads to an increase in long-run
average.
 Diseconomies of scale may arise for two reasons:
Coordination problems and Increasing input costs
 These are disadvantages that arise due to the expansion of
production scale and lead to a rise in the cost of
production
 Internal diseconomies: Managerial inefficiency and
labour diseconomies
 External diseconomies: Rise in input demand
 Causing the input prices to rise. Infrastructural constraints
LAW OF RETURN TO SCALE
 As a firm in the long run increases the quantities of all
the factors employed, other things being equal, the
output may rise initially at a more rapid rate than the
rate of increase in outputs, then output may increase
in the same proportion of input, and ultimately output
increases less proportionately.

Assumptions-
 Technique of production is unchanged
 All units of factors are homogenous
 Returns are measured in physical terms
  The relationship between input and output in the long run
is explained by the law of returns to scale
 The law explains the relationship between input and output
through three stages
Increasing returns to scale: when the inputs are
increased in a certain proportion, the output tends to
increase at a higher rate.
Output more than doubles when all inputs are doubled.
 1. Larger output associated with lower cost
 2. One firm is more efficient than many
 3. The isoquants get closer together
 Input< Output
 Assumed in theory
 An increase in the input leads to an increase in the output
in the same scale
 Reason: perfect substitution of factors of production,
perfect divisibility of factors of production, elastic
supply of factors of production at a given price
output doubles when all inputs are doubled.
 1. Size does not affect productivity
 2. May have a large number of producers
 3. Isoquants are equidistant apart
 Input= output
 The increase in the output will be less than the increase in
inputs
 1. Diseconomies of scale arise due to too much
expansion of the firm
 2. problem of coordination, control and management due
to its huge size
 3. Factors of production are not perfect substitutes for each
other
output less than doubles when all inputs are doubled
 1. Decreasing efficiency with large size
 2. Reduction of entrepreneurial abilities
 3. Isoquants become farther apart
 Input> Output
Economies of
scale
 Economies of
 scale
Diseconomies of
scale
ATC E: Economies
D: Diseconomies
E>D E<D

E=D

Output
 Economies of Scale
Company- Star jeans manufacturers, Delhi
Product (1995-2007)- Denim jeans for Adult males
The company was producing jeans as per the orders. The cost of
production was always changing as per the order. The company faced 3
problems-
•Unused raw material was increasing cost of production.
•Due to unequal orders the labor cost was increasing
•Due to higher production cost the company was unable to sustain
competitors price pressures.

The solution for the company was to manufacture as per the present full
capacity. With this the company could reduce the additional cost and
beat the competitors as per the market rate.
 Economies of Scope

The company was doing very well in the business they found after
reaching economies of scale the company found still some scope for
better profits. They analysed two situations-
•The labour is sitting idle as one full consignment was over.
•The cloth was cut into pieces to make pants but some portion of
cloth was unused due to smaller size.

The company made skirts and shorts for the children with the
remaining raw material. The company made lot of profit through the
variety they introduced.
 Minimum Efficient Scale
 The minimum efficient scale describes the
output at which economies of scale are exhausted
and the long-run average cost curve becomes
horizontal.
 Once the minimum efficient scale has been
reached, an increase in output no longer
decreases the long-run average cost.
Production Possibility Curve
A production–possibility frontier (PPF),
sometimes called a production–possibility
curve is a graph that compares the production
rates of two commodities that use the same
fixed total of the factors of production.

A curve depicting all maximum output

possibilities for two or more goods given a set
of inputs (resources, labor, etc.).

The PPF assumes that all inputs are used

efficiently., points A, B and C represent the
points at which production of Good A and
Good B is most efficient.

Point X demonstrates the point at which

resources are not being used efficiently in the
production of both goods; point Y demonstrates
an output that is not attainable with the given
inputs. Represents a TRADE- OFF
 Isoquants
 A curve or locus of points showing all possible
combinations of inputs physically capable of producing a
given fixed level of output.
 An Isoquant shows various combinations of two inputs
(Labor, capital) that the firm can use to produce a
specific level of output.
 PRODUCTION ISOQUANTS
Characteristics-

 The combination of labour and capital can be changed

to get a fixed level of output.
 Two Isoquants never intersect.
 A group of Iso- quants is called an Isoquant map.
 All iso-quants lying above a given isoquant and to the
right indicate higher levels of output.
 Combinations other than on Isoquants can be used to
produce the given level of output but the combination
will not reflect “ maximum amount of output” due to
the wastage.
 Isoquants are negatively sloped in the economically
relevant range.
Production function with Two variable inputs

CAPITAL(K) 10 24 31 36 40 39
12 28 36 40 42 40

12 28 36 40 40 O36UTPUT(Q)

10 23 33 36 36
7 18 28 30 33
30 28
3 8 12 14 12
0 1 2 6
14
3 4
5
LABOUR
The lines connecting the points where the isoquants begin
to slope upward are called ridge lines.
Quantity of capital
used per unit of
time
r
i
d
g
e
l
i
n
e
s

Quantity of labor used per unit

CAPITAL 12Q
28Q
W 36Q
40Q
Stage III K
Z I 40Q 36Q
S
U
YStage II
Economic 28Q ISOQUANTS
Region Of V
T
production
R Stage III L RIDGE LINES
12Q
The Economic Region of Production is given by the –ve
slopeLsAegBmOenUtRof isoquants between ridge lines.
The firm will not produce in the positively sloped portion of the
isoquants
because it could produce the same level of output with less labor and less
CAPITAL
ofK
in e I
Stage III K ge L X
Rid W
of e of
H S L in
L dg
e
o r ly
Ri v e
of o n t i
i a
V HS e g g o n fL
S
R r ne gi e o
n t e Lin
K v a d
r e ofL
e g
e le p R id ine
s l o of
L
R S dg
e
U H Ri
Stage II L R of
S
RH
Q
Stage
P III L
O
LABOUR

PRODUCTION ISOQUANTS
 Marginal rate of technical
substitution (MRTS)
The absolute value of the slope of the isoquant is
called Marginal Rate of Technical substitution.

ΔK
MRTS = (-) ---------
Δ
L
If the firm wants to reduce the quantity of capital that
it uses in production, it must increase the quantity
of labour in order to remain on the same isoquant.
 Marginal rate of technical
substitution (MRTS)
 The MRTS of labour for capital is equal to MPL/ MPK.
 All points on an isoquant refers to the same level of output.
 For a movement down a given isoquant , the gain in output
resulting from the use of more labour must be equal to the loss in
output resulting from the use of less capital.
 The increase in the quantity of labour used (∆L) times the
marginal product of labour (MPL) must equal to the reduction in
the amount of capital used (-∆K) times the marginal product of
capital (MPK )
(∆L) (MPL) =- (∆K) (MPK )
Shape of Isoquant
Substitutes-
 The Isoquants are straight lines, the labour and capital are
perfect substitutes.
 For example –manual Loaders & cranes
 The curve shows absolute substitutability at both point A
and B.
Complementary products-
 The Isoquants are at right angle , the labour and capital are
perfect complements.
 For Ex-rigid combination of capital and labour, Driver and
the vehicle.
 Shape of Isoquant
CAPITAL
CAPITAL
B

A LABOUR
LABOUR Complements inputs
Perfect Substitute
•Smaller the curvature of an isoquant, the greater is the degree of
Substitutability of inputs in production.
•Greater the curvature of an isoquant the smaller is the degree of
substitutability
 Combinations Units of Units of Total expenditure
Capital Labour

ISOCOST Price = 150Rs Price = 100 Rs ( in Rupees)

A 8 0 120

B 6 3 120

C 4 6 120

D 2 9 120

E 0 12 120

The isocost line illustrates all

the possible combinations of
two factors that can be used
at given costs and for a given
producer’s budget.
In simple words, an isocost
line represents a combination
of inputs which all cost the
same amount
Returns and Input

1A firm produces 200Q with 1L and 1K and for the next

production schedule, it uses 2L and 2K and achieved 500 Q.
Explain the relationship between the returns and input with
suitable example.

2 Plot and analyze the data..

K Capital L Labor Q Quantity

5 8 3
10 16 6
20 32 12
40 64 24