Production Function

Short-run and Long-run Production Theory

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The previous sessions have focused on Total Revenue and how the manager of a company must
attempt always to maximize it and from now for the next few sessions we are going to attempt
to minimize the Total Cost (TC). So we now look at the firm more closely and look what
Microeconomics has in store for us, what is that this subject can show that can help a manager
to reduce cost.
When we ended the class on maximizing TR, we said that if the elasticity is greater than one, a
manager could increase volume. But in the process of increasing volume a firm needs to know
that costs would also increase, so a firm cannot increase volume without keeping costs in mind
and increase only when the benefit of selling more is more than the cost of producing more.

But what is cost?

Value paid for utilizing the input, so cost of input X amount of input utilized is TC.

So a manager can attempt to reduce either or both and that will reduce the TC.

Today we are going to concern ourselves with using inputs efficiently. Since after processing
inputs we get output, then a manager can read the efficiency of amount of inputs in terms of
amount of output, so in other words the manager has to attempt to get maximum output from
the given inputs.

In today’s session we will attempt to utilize our inputs in such a manner that we get the
maximum output.

A few inputs….

The various resources like RM, Premises, Machinery, Equipment, Power, Labour, Finance,
Transport, Communication etc. that are used in the production are called inputs.

What is productivity?
Productivity is a measure of efficiency of each resource in the process of production.
Getting more output per input utilized is productivity is the key to success.

What is production?

Production is the creation of goods and services or the output, from inputs or resources.
Production is not only turning wood into furniture but a wider concept that includes all services
like medical, retail, and entertainment as well. Even a school produces education, city police
produces protection, doctor produces medical service but when we analyze the production
function we mainly speak about the firms that use inputs to produce products.

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What is the production function?

A production function defines the relation between the physical units of inputs and the physical
units of output, given state of technology. It tries to quantify the attainable quantity of output
that depends on the quantities of the various inputs employed in production.

Technically, a production function is a schedule or a table or a mathematical equation showing

the maximum amount of output that can be produced from any specified set of inputs, given
the existing technology.

PRODUCTION FUNCTION

Q = f (RM, lab, power, machinery, equipment …..)

Q = f (X1, X2, X3……Xn)

Q = f (L, K) to keep things simple we take capital and labor as the two inputs

L = Labor and all other inputs that can be changed in the short period are called the variable
factors of production.

K = Capital and all other inputs that remain fixed in the short run are called the fixed factors of
production.

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What is short run?

Short run is a period when a change in the output is brought about by changing only the
variable factors. E.g. you can expand production by asking workers to work over time or add a
shift but do not change the set up.

What is long run?

Long run is a period when a change in the output is brought about by changing the variable as
well as the fixed factors. E.g. you expand production by adding capacity in form of additional
premise, machinery etc.
We can say that the long run consists of all possible short-run situations from which a firm can
choose, hence the long run is also called the planning horizon.

What are variable factors?

Variable factors include those inputs whose quantity can be varied (changed) to change the
level of output in the short period e.g. raw material, labour, power etc. If the demand is high,
keeping the fixed factors unchanged, the output can be increased to some extent by
increasing the variable factors.

What are fixed factors?

Fixed factors include those inputs whose quantity cannot be changed in the short period e.g.
machinery, capital equipment, premises, managerial personnel etc.

When we evolve a short run production function as follows we see that:

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 Q = f (L, K) where the quantity of output Q could be changed with the change in labour, the
variable factor. The K, which represents capital and technology and other factors, remained
same.

Features of the Short-run Production Function:

Total Product
In the short-run the total product change with changes in variable input only as one of the
inputs is considered as fixed. So in the short-run TP is a function of labor. From the table we can
see that TP increases up to the ninth worker and then starts to decline.
The Average and Marginal Product
The average product of labor is the TP divided number of workers employed.
In the table we can see that the AP reaches a maximum at the third worker and then starts to
decline.
The marginal product is  TP /  L (number of workers).
In the table we can see that the tenth worker actually has negative share in output i.e. after
employing the tenth unit of labour, TP reduces.
Additional information on TP, AP and MP.

We notice that as we employ more labor, initially the output increased at increasing rate, later
it increased at diminishing rate and further it stagnated and even turned negative. Why does
this happen?

Law of diminishing marginal returns (product).

Given that one input is fixed, when the variable input is increased there exists a point beyond
which the marginal product of variable input starts to decline.
Diminishing marginal product can be seen from the fact that the slope of TP falls as the amount
of labor used increases.

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Stages of production

Stage I: Amount of variable input is small with

respect to fixed input and the utilization of
fixed inputs is very high. When marginal
product is greater than the average product,
AP is rising. The MP cuts the AP when the AP
is at the highest point A stage where the
contribution of each input is more than that
of the previous.
Stage II: So obviously the manager will want
to keep adding more workers till due law of
diminishing marginal product MP becomes
negative and the TP starts to fall. A manager
must try to work his plant in this stage. Not
hire any more workers, which might lead him
to the third stage.
Stage III: The moment MP is zero, TP starts to
fall. Beyond this point the contribution of
additional unit of input is negative.

Do not confuse diminishing marginal product with negative marginal product.

Diminishing marginal product has set in at the third worker but marginal product does not
become negative till the tenth worker. So a manager may employ workers with diminishing
marginal product as long as the output is increasing but with the marginal product becoming
negative there is a fall in TP and that the manager cannot allow to happen.

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Why does the output follow this pattern?

The short run production function shows the operation of law of diminishing returns. The
expansion in output undergoes four distinct phases.
1. The first phase, % increases in output > % increases in inputs, the phase of increasing
returns.
2. The second phase, % increases in output = % increases in inputs, the phase of constant
returns.
3. The third phase, % increases in output < % increase in inputs, the phase of diminishing
returns.
4. The fourth phase, the output starts declining as a result of increase in inputs, the phase
of negative returns.

When do I take the decision of expansion?

If demand sustains at the higher level for a longer period of time and you are convinced about
its sustenance you would go for capital expenditure for expansion. You would invest in
additional machinery and premises to add capacities. The resulting expansion is known as
change in the ‘scale of production’.

How would I benefit when I go for large-scale production?

You would enjoy the economies of large-scale production when you change the scale.
Technical, labour, managerial, financial, marketing, risk-bearing economies would turn the

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expansion as an advantage. The output would expand more than proportionately to the
expansion in inputs.

Long run production decisions

Desire to increase scale of operations comes from wanting to enjoy economies of scale. You can
reduce cost by increasing production levels in the long run. Important tool we use when both
the inputs are variable, are Isoquants.

What are Isoquants?

Technically efficient combinations of all inputs give the same output, so that means that all the
inputs are now variable. The idea is that we can substitute one variable for the other while
keeping output constant. An isoquant is a curve showing all possible input combinations
capable of producing a given level of output.

The manager can view that various combinations from the production function table:

Isoquants are downward sloping; if greater amounts of labor are used, less capital is required to
produce a given output.

Rightwards and upwards moving isoquants depict higher levels of output, they do not intersect
and they are convex to the origin due to the law of diminishing marginal product.

In the long run, all inputs are variable and isoquants are used to make production decisions
MAINLY WHICH COMBINATION OF LABOUR AND CAPITAL TO PRODUCE A PARTICULAR LEVELOF
OUTPUT AT THE LEAST COST.

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 ISOQUANT and MRTS
Marginal Rate of Technical Substitution

The MRTS is the slope of an isoquant &

measures the rate at which the two inputs
can be substituted for one another while
maintaining a constant level of output. Rate
at which one input is substituted for the
other keeping output constant.

As we come down the isoquant, the MRTS diminishes, when capital is plentiful, more capital
must be discharged to get lesser labour in return.

Relation of MRTS to Marginal Products

The MRTS can also be expressed as the ratio of two marginal products: MPL
MRTS 
MPK
As we move down the isoquant and we substitute more labour for capital the Marginal Product
of labour has to fall to remain on the same isoquant. Similarly as we move up the isoquant, we
substitute more capital for labour and the Marginal Product of capital has to fall to remain on
the same isoquant.

K MPL
MRTS   
L MPK

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Isocost Line

The isocost line shows all the possible combinations of two inputs that can be used at given
costs and for a given producer’s budget. An isocost line represents a combination of inputs
which all cost the same amount.

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Finding least-cost combination levels of inputs

How much to produce at the lowest possible cost by choosing the input combination on the
isoquant for which Q is just tangent to the isocost curve. Two slopes are equal in equilibrium
which implies marginal product per rupee spent on last unit of each input is the same.

MPL w MPL MPK

 or 
MPK r w r
Either a manager produces a given
level of output at the lowest possible
cost: constrained minimization: least
cost combination for the output
needed: try to reach the lowest
isocost line that is tangent to the
given isoquant. At cost minimizing
output MRTS = w / r

Marginal product approach for cost

minimization: MUL / w = MUK / k.
Keep substituting labor for capital till
MUL/w = MUk/ r. The manager can reduce cost by substituting one for the other when MUL/w
>MUk/ r

Expansion path

The expansion path is the locus of

different points of firm’s equilibrium
when it changes its total outlay to
expand output while relative factor
prices remain constant. All the cost
minimizing input combinations for
each level of output, so parallel
isocosts with the same slope so –w/r
for all will be the same will be
tangent to input curves at the same
MRTS. Along expansion path, input-
price ratio is constant and equal to the marginal rate of technical substitution.

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The long run production function also shows similar experience with returns to scale. The
economic theory confirms the operation of diminishing returns even in this phase of expansion.

What are returns to scale?

In the long run a firm can increase output by increasing the fixed and variable inputs in
proportion. Returns to scale is the rate at which output increases as inputs are increased
proportionately.
How the output of a business responds to a change in factor inputs is called returns to scale
Numerical example of long run returns to scale
Units of Units of Total % Change in % Change in Returns to
Capital Labour Output Inputs Output Scale
20 150 3000
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing

Consider the table above that shows added capital and labour inputs:

When the factor inputs are doubled from (150L + 20K) to (300L + 40K) the % change in output is
150% - increasing returns
When the scale of production is changed from (600L + 80K) to (750L + 100K) then the
percentage change in output (13%) is less than the change in inputs (25%) i.e. decreasing
returns
Increasing returns to scale occur when the % change in output > % change in inputs E.g.
Automobile industry
Decreasing returns to scale occur when the % change in output < % change in inputs E.g.
difficulties in coordination in very large plants
Constant returns to scale occur when the % change in output = % change in inputs E.g. travel
agency.
Manufacturing plants are more likely to have greater returns to scale than the service sector.
Service sector is labor intensive so it can work as well in small and large size.

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The nature of the returns to scale affects the shape of a business’s average cost curve – when
there are sizeable increasing returns to scale, and then we expect to see economies of scale
from long run expansion.

Economic Region of Production

The economic region of production shows the combinations of factors at a certain cost that
make economic sense. Areas outside
the economic region of production
mean that at least one of the inputs
has negative marginal productivity.
This region is marked by what are
called ridge lines, which are simply
the boundaries beyond which one of
the two factors is being overused.
Therefore, outside the economic
region of production, there is clear
inefficiency, and the company would
be better off using less of one of the
two factors, bringing costs down
whilst maintaining equal production
output.

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