Production

• Production is the process of converting inputs

Theory of
into output

• Production is the process of transformation of

Production inputs like land, labour, capital and
entrepreneurship into goods and services of
utility to consumers and/or producers

• It is the process of creation of value or wealth

through the production of goods and services
that have economic value

Production Fixed Input & Variable Input

• Such process of adding value may • Typically the production analysis of a firm is
occur by done using two distinguished time frame, Short
Run (SR) and Long Run (LR)
– Change in form
• Input to output, say steel to car • In SR, supply or availability of some of the
inputs of production is fixed

– Change in place • In LR firm can vary all its inputs including

• Supply chain, say from factory to dealer technology

• Based on horizon, inputs are classified as

variable and fixed

Factors of Production
Fixed Input & Variable Input
• Land: It not only incorporate dry surface
• Fixed Input – Level cannot be altered of the earth but also natural resources
rapidly with production in short-run. e.g. on or under the earth surface like
Building, Plant, Technology forests, rivers, sunlight, minerals etc.
– Return from land is called rent

• Variable Input – Level can be altered • Labour: Physical or mental effort that
according to the changes in production undertakes the production process. It
level. e.g. Labour, Raw Material can be unskilled, semi-skilled or skilled
– Return for labour is called wages or salery

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 Factors of Production Production Function
• It is the technical relationship between inputs
• Capital: Wealth which is used for further
and output
production and of two types
• A commodity may be produced by various
– Physical capital: equipments, buildings, methods using different combination of inputs
intermediately goods with given state of technology
– Human capital: Knowledge, skills and – Power can be produced from coal, gas,
investment made by people through renewables etc with subcritical, super-critical or
education and training that help to produce SPV technology
better goods and services
• Production function includes all such
– Return for capital is interest
technically efficient methods

Production Function Production Function

• Output:
• Technical efficiency is defined as a
situation when using more of one input Q = f(L, K, Land…)
with either the same amount or more of • In short-run, inputs like plant size,
other input must increase output machine and equipments cannot be
• Production function is changed

– Always related to a given time period • Producer can increase output in SR by

– Always related to a certain level of technology increasing only variable inputs like
labour
• In long-run all the inputs can vary

Short run Production function Elasticity of Production

Q=f(L,K*); K* is fixed
• The elasticity of production, also
• Total Product (TP) – in short run when the called output elasticity, is
capital input is fixed, output can be increased
by increasing labour input – the percentage change in the production of a
good by a firm, divided the percentage change
– This is termed as TP of labour in an input used for the production of that
• Average Product, APL = TP/L good, for example, labor

• Marginal Product MPL – Additional output – ΔQ/Q / ΔL/L = (∂Q/∂K) / (Q/K)

obtained by increasing an unit of labour input, – the marginal product of capital, divided the
combined with other fixed factors of production.
In other words, MPL = ∆TP/∆L average product of capital

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 Table showing TP, AP & MP Production Function
L Q AP MP With One Variable Input
0 0 - - K=2 Total, Marginal, and Average Product of Labor, and Output Elasticity
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
10 314 31.4 -4

Production Function With One Variable Input

Law of Variable Proportion or
Law of Diminishing Returns
• As we increase units of labour, total output
increases but not at a constant rate
• In the beginning output increases at an
increasing rate and finally it increases at
a diminishing rate
• We also have increasing and then
diminishing marginal returns

Production Function With One Variable Input

Law of Diminishing Returns
• The law thus states that when increasing
amounts of the variable input are
combined with a fixed level of another
input, a point will be reached where the
marginal product of the variable input
will decline
• This law does not result from a theoretical
argument but is based on actual
observations of many production
processes

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 Law of Variable Proportion or Law of Variable Proportion or
Law of Diminishing Returns Law of Diminishing Returns
• G is the point of inflection in TP curve • AP starts falling to the right of H/
• G/ is the corresponding point on MPL curve where • G/ to J/  Region of diminishing returns;
MP attend its maximum value and starts falling MP>0
thereafter
• At point J, TP reaches its maximum value
• So, till G/ , increasing returns, MP max & and falling thereafter
MP>AP

• Point H in TP curve is where AP=MP (H/) &

• At J/ MP is zero and negative thereafter

• AP reaches its maximum value – Region of negative returns

Increasing, Diminishing & Negative Returns

Table showing TP, AP & MP

L Q MPL APL Stages

1 20 - 20 IR
2 50 30 25
3 90 40 30
4 120 30 30 DR
5 140 20 28
6 150 10 25
7 150 0 21.5
8 130 -20 16.25 NR
9 100 -30 11.1

Managerial Decisions Managerial Decisions

• Rational firm should operate in Stage II • Thus, good capacity planning requires
• Stage I represents under-utilization of firm’s
– Sophisticated techniques for estimating
fixed inputs relative to its variables one
and forecasting demand and demand
• Stage III represents overutilization of its fixed elasticity
inputs – Effective communication between
• Thus capacity planning is required at the production and marketing divisions as
beginning based on demand forecasting so production division proceed based on
that plant can operate in stage II technical point of view

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• A firm produces output according to the production
function Q = 10KL2 – L3, where K denotes capital stock
and L denotes no. of workers it hires. Suppose K = 10
Derive APL & MPL
At what level of labour does DMR sets in?
At what level of labour APL is highest?
Production in the long run
Ans:
MPL =∂Q/ ∂L = 200L – 3L2
APL = Q/L = 10KL – L2 = 100L – L2
DMRS ∂(MPL)/ ∂L=0200-6L=0; L=33.33
Av Product max ∂(APL)/ ∂L=0 L=50

Production in the long run An isoquant

a
Units Units Point on
Q=F(L,K), L, K are variable of K of L diagram
40 5 a
• An Isoquant (meaning equal quantity) is a 20 12 b
locus of points showing all possible
Units of capital (K)

10 20 c

combinations of the inputs physically

6 30 d
4 50 e
capable of producing a given (fixed)
level of output.
• Each point is technically efficient
– Technical efficiency is defined as a situation
when using more of one input with either the
same amount or more of other input must
increase output
Units of labour (L)

Production in the long run An isoquant

a
Units Units Point on
• Many combinations of inputs can produce of K of L diagram
the same level of output 40 5 a
20 12 b
Units of capital (K)

• Higher Isoquants show higher output 10 20 c

6 30 d
more & more away from the origin 4 50 e

• Firms will only use combinations of two

inputs that are in the economic region of
production
• Economic region of production is
defined by the portion of each isoquant
that is negatively sloped
Units of labour (L)

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 Diminishing marginal rate of factor substitution:
Properties of Isoquants (or marginal rate of technical substitution)

• The marginal rate of technical g

substitution (MRTS) is an economic theory MRTS = 2 MRTS = DK / DL
DK = 2

Units of capital (K)

that illustrates h

– the rate at which one factor must decrease DL = 1

so that the same level of productivity can j MRTS = 1
be maintained when another factor is DK = 1 k
increased
DL = 1
• MRTS=Absolute value of the slope of the
isoquant
isoquant
• MRTS of labour for Capital given by ∆K/∆L

Units of labour (L)

Economic Region of Production

• Ridge lines separate the economic zone Isoquants
from non-economic zones
K
• Ridge line is a locus of points on
different isoquants where MP of one of Upper Ridge Line
the factors is zero.
Economic Zone
– Upper part of ridge line implies that MPK is zero
– Lower part of ridge line implies that MPL is zero
• Production techniques are technically Lower Ridge Line
efficient only inside the ridge lines
– Outside the ridge lines, methods of production
require more quantity of both factors for L
producing a given level of output

Isoquants Linear Isoquants

• The downward sloping isoquants as we • When there is perfect substitutability

see earlier are most common between two factors, the isoquants
would be linear
• There, underline assumption is that the
inputs are substitute but not perfect • Q*=f(L. K) = αL + βK, where α & β are
Constant
• What will happen when inputs are
either perfect substitute or perfect • MPL = dQ/dL = α & MPk = dQ/dK = β
compliments, i.e. no substitutability?
• MRTS = α / β = Constant

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 Right Angled Isoquants Production With Two Variable Inputs
Perfect Substitutes Perfect Complements:
Fixed Coefficient Technology
• When capital is perfect compliment
for labour, implying non existence of
any substitutability between two factors,
such isoquants are right angled

• In this case, production technology

always involves inputs L & K in fixed
proportions to produce a unit of output

Elasticity of Substitution Power from gas

• Of the 24,508 Mw of gas grid-connected power
• It is now clear that MRTS is a measure of a generation capacity in the country, 14,305 Mw
degree of substitution of factors and it depends has no supply of domestic gas
on the units of measurements of the factors • An investment of about Rs 60,000 crore is at the
• A better measure of substitution is EoS which is threshold of becoming a non-performing asset
unit independent • The remaining capacity (9,845 Mw), involving an
• It measures the percentage change in factor investment of about Rs 40,000 crore, is working
at a sub-optimal level, based on the limited
proportion due to a change in MRTS quantity of domestic gas in India
• σ = [d(K/L)/K/L] / [d(MRTS)/MRTS] = measure
of curvature of Isoquant • Naphtha as substitute? Possible but costly
• https://www.livemint.com/Home-
• For Right Angled Isoquant, σ = 0 and for Page/YvxDPlp10TdNNNlDw7e2wL/Naphtha-cutting-short-power-
plants8217-life-cycle.html
Linear Isoquant, σ = infinity

Optimal Combination of Inputs

• Producer’s objective would be Isocost lines represent all combinations
of two inputs that a firm can purchase
• maximize output at a given cost with the same total cost.
(represented by isoquants) or
– to minimize cost of production a
given level of output
??

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 An isocost
Isocost Lines
Assumptions • So, isocost line is the locus of points of all the
r = Rs.20 000
different combination of capital and labour
w = Rs10 000 that a firm can employ, given the total cost
Units of capital (K)

TC = Rs 300000 and prices of inputs

a
• If the factor prices are constant, then for different
levels of total cost, there will be a set of isocost
lines, each representing a specific level of total
cost

TC = Rs300000 • The higher the total cost, the further the

isocost line will be from origin as more of
both inputs can be purchased by the firm
Units of labour (L)

Optimal Combination of Inputs Optimal Combination of Inputs

Isocost Lines
• The intercept of Isocost line on Capital Axis (Pt
AB C = 100, w = r = 10
A) is the maximum amount of capital employed
A’B’ C = 140, w = r = 10
when labour is not used in production process
A’’B’’ C = 80, w = r = 10
AB* C = 100, w = 5, r = 10
and is given by (C/r)

• Similarly the intercept on labour axis, point B,

(max amount of labour used in production
process when capital usage is zero) is (C/w)

• Line AB* shows a fall in w, thus more of labour

can be acquired

• Slope of AB* is (–w/r) = -(5/10) = -0.5

Producer’s Equilibrium
Producer’s Equilibrium
• To be economically efficient, a producer must
determine the combination of inputs that
produces the output at minimum cost • Combining isoquants and isocost lines
would help us to understand Producer’s
• The maximum output level for any firm is equilibrium
determined by isoquants,
• The lowest cost of producing a given
– but they would not give the minimum cost of level of output is the point where the
production, isoquant is tangent to isocost line
• For this we need isocost line

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 Optimal Combination of Inputs Producer’s Equilibrium
MRTS = w/r • The lowest cost of producing a given level of
output is given at point E, where the isoquant
corresponding to output 10Q is tangent to isocost
line AB

• At this point the firm would employ 5 units of

capital and labour each

• For line AB, 14Q is beyond the reach of the firm ,

whereas any point below AB is feasible but not
desirable

• So, necessary condition of producer’s equilibrium

is slope of isocost=slope of isoquant

Expansion Path
Optimal Combination of Inputs
• Thus, determination of optimal combination of • Expansion path is define as the line formed
imperfectly substitutable inputs depend on both by joining the tangency points between
their relative price and on the degree to which various isocost lines and the corresponding
they can be substituted for one another highest attainable isoquants

• Also defined as the locus of equilibrium points of

• Degree of substitution is based on their marginal the isoquant with lowest possible isocost line
products, so
• An expansion path is a long run concept and
[MPx / MPy ] = [Px /Py ]  [MPx /Px ] = MPy /Py ] each point of the expansion path represents a
combination of inputs that minimise cost

Optimal Combination of Inputs

Returns to Scale
MRTS = w/r
• It refers to the degree by which the
level of output changes in response
to a given change in all the inputs in
a production system

• It is a LR phenomenon

• Can be constant, increasing or

decreasing returns to scale

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 Returns to Scale Returns to Scale
Constant Increasing Decreasing
Production Function Q = f(L, K) Returns to Returns to Returns to
Scale (CRS) Scale (IRS) Scale (DRS)
Q = f(hL, hK)
If  = h, then f has constant returns to scale.
If  > h, then f has increasing returns to scale.
If  < h, the f has decreasing returns to scale.

Increasing returns to scale Empirical Production Functions

• When input prices remain constant, increasing
• In SR Q=f(L)K
returns to scale results in decreasing long-
run average costs (economies of scale) • In SR, if we incorporate increasing,
diminishing and negative marginal returns
• A firm that gets bigger experiences lower costs then
because of increased specialization, more
efficient use of large pieces of machinery (for Q = a + bL + cL2 – dL3
example, use of assembly lines), volume • In empirical estimation one uses linear
discounts, and other advantages of producing in production function Q = a + bL
large quantities
– Coke, Pepsi
• The function, however, exhibit no
diminishing retuns

Estimation of Production Functions

Empirical Production Functions
• Both capital and labor inputs must exist for Q to
• Cobb-Douglas production function is commonly be a positive number
used functional form
• Can be increasing, decreasing, or constant
returns to scale
• The function can exhibit increasing, decreasing
and constant returns b + c > 1, IRTS
b + c = 1, CRTS
• One can directly estimate elasticity of
b + c < 1, DRTS
production
Q = aLbKc • Elasticities of factors are equal to their exponents
• Estimated through regression analysis using Natural • Example: Q = 1.01 L0.76 K0.25
Logarithms ln Q = a + b ln K + c ln L

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 Indian Plywood manufactures and sells lumber, plywood, veneer,
particle board, medium-density fiberboard, and laminated beams.
The company has estimated the following multiplicative
production function for basic lumber products in the Pacific
Northwest market using monthly production data over the past
two and one-half years (30 observations): A. -0.4%
Q = b0 Lx Ky Ez (Lab, Cap, Energy)
Each of the parameters of this model was estimated by
regression analysis. Estimated coefficients with their std errors B. = 0.4(-0.05) + 0.2(-0.05) = -0.03 or -3%
in brackets are as follows
b0 = 0.9 (0.6); x= 0.4 (0.1); y= 0.4(0.2); and z= 0.2 (0.1)
A. Estimate the effect on output of a 1% decline in worker hours
(holding K and E constant).
C. x+y+z = 0.4 + 0.4 + 0.2 = 1 indicating
B. Estimate the effect on output of a 5% reduction in machine hours constant returns to scale. This means
availability accompanied by a 5% decline in energy input (holding that a 1% increase in all inputs will lead
L constant).
to a 1% increase in output
C. Estimate the returns to scale for this production system.

• Hydraulics Ltd. has designed a pipeline that provides a

throughput of 70,000 gallons of water per 24-hour A. The marginal rate of technical substitution is calculated
period. If the diameter of the pipeline were increased by by comparing the marginal products of "diameter," MPD,
1 inch, throughput would increase by 4,000 gallons per and "horsepower," MPH:
day. Alternatively, throughput could be increased by
6,000 gallons per day using the original pipe diameter MPD = ∂Q/ ∂D = 4,000/1 = 4,000 gal.
with pumps that had 100 more horsepower. MPH = ∂Q/ ∂H = 6,000/100 = 60 gal.
So, MRTSDH = MPD / MPH = -66.67
A. Estimate the marginal rate of technical substitution [ ∂Q/ ∂D]/[∂Q/ ∂H] = -66.67
between pump horsepower and pipe diameter.

B. Assuming the cost of additional pump size is $600 per This implies ∂H = -66.67 ∂D or ∂D = -0.015 ∂H.
horsepower and the cost of larger diameter pipe is This means, for example, that output would remain
$200,000 per inch, does the original design exhibit the constant following a one inch reduction in pipe diameter
property required for optimal input combinations? If so, provided that horsepower were increased by 66.67.
why? If not, why not?

B. Answer is No. Returns to Scale - Example

The rule for optimal input proportions is:
MPD /PD = MPH /PH Production Function
In this case,
MPD /PD = 4000/200000 = 0.02 Q = 10L0.4K0.9
MPH /PH = 60/600 = 0.1
So, MPD /PD ≠ MPH /PH
•Compute Production elasticity w.r.t. L
Here the additional throughput provided by the last dollar
spent on more horsepower (0.10 gallons/day) is five •Compute Production elasticity w.r.t. K
times the gain in output resulting from the last dollar
spent to increase the pipe diameter (0.02 gallons/day) •What can we say about the RTS?
Thus, horsepower and pipe diameter are not being
employed in optimal proportions in this situation.

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• MNREGA, labour shortage and farm
mechanization in Punjab  Substitution
https://www.tribuneindia.com/news/punjab/growers-feel-pinch-as-farm-wages-go-
up/608030.html

• Nokia & Smartphone  Technology

http://www.enterprisegarage.io/2015/12/case-study-how-nokia-lost-the-smartphone-battle/

• Clean energy and demand for copper, Lithium &

rare earth metals  factors of production
• https://energy.economictimes.indiatimes.com/energy-speak/india-in-the-spotlight-a-
complex-clean-energy-revolution/3438

• A manufacturing game changer: India’s duty

structure is inverted. It must be set right side
up for global competitiveness
• https://timesofindia.indiatimes.com/blogs/toi-edit-page/a-manufacturing-game-changer-
indias-duty-structure-is-inverted-it-must-be-set-right-side-up-for-global-competitiveness/

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