Production Theory

SYED
Session Outline
• Defining Input, Output, Production
• Production function
• Short Run Production Function
• Long run Production Function
• Law of Diminishing Return
What is Production?
• Production is basically an activity of transformation , which connects factor inputs and
outputs

• EG: Sugar Mill uses such inputs such as labour, raw material like sugarcane, and
capital investment in machinery, factory building to produce sugar.

• Modern factories take inputs such as energy, raw material, computerized machinery
and labor and use them to produce tractors, TVs, or tubes of tooth paste.

• An airline takes airplanes, fuel, labor, computerized reservation system and provides
passenger with the ability to travel quickly through its network of routes.

• An accounting firm takes pencil, computer, papers, office space, and labor produces
audit or tax returns for its client.
Cont..
• All the firms discussed before, always strive to produce efficiently,
that is at lowest cost.

• Attempts to produce the maximum level of output for a given dose of

inputs, avoiding waste where ever possible

• To increase the economic profits of firms in each case of firm

respectively.
Cont…

• The process of transforming inputs into outputs can be any of the

following kinds:

• Change in the Form(Raw material transformed to finished goods )

• Eg: Wood into Furniture

• Change in Place( Supply chain, Factory to Retailer)

• Eg: Rail transportation of goods
• With these three kinds of transformations, usability of the
• Change in time: good or materials increases.
• Eg: cold storage
• Production is an activity that increases consumer usability of
goods and services.
Factors of Production

They are four factors of production namely land, Labour, Capital and
Organization.
Cont..
• Land:
• It refers to all natural resources or those which are free gifts of
nature.
• It has no cost of production and its supply is inelastic or limited.

• Labour:
• In economics, it means any work, physical or mental which is
undertaken for remuneration. A person who renders labour is
known as labourer.
Cont..

Capital:
It means all man-made appliances and all types of wealth used in
production. Capital is of two types. viz.,
(a) fixed capital and
(b) Variable capital.

All durable capital goods which are used in production again and again
till they wear out is called fixed capital. e.g., Machinery, machine tools,
factory buildings etc.

On the other hand, variable capital refers to those materials which

exhausts with a single use. e.g., wages, electricity or power etc.
Owners of capital are called capitalists.
Cont..
• Organisation
• It refers to the organizational or entrepreneurial activity in the
process of production. It consists of bringing together and
coordinating all the factors of production.
• The person who undertakes organization is called an organizer or
entrepreneur.

• Though there are four factors production they can be aggregated into
two: 1. labour (labour & organization) 2. capital (land & physical
capital).
What are Inputs and Output of
Production????
• An input is a good or service that goes into the production process. As
economists refer to it, an input is simply anything which a firm buys
for use in its production process.

• An output, on the other hand, is any good or service that comes out
of a production process.
 Inputs :
Inputs can be divided into Fixed and Variable Input.

1. Fixed input – An input for which the level of usage cannot readily be changed
- In economic sense, a fixed input is one whose supply is inelastic in the short run.
- - In technical sense, a fixed input is one that remains fixed (or constant) for certain level of
output.

2) Variable input
• A variable input is one whose supply in the short run is elastic,

• example, labour, raw materials, and the like. Users of such inputs can employ a larger quantity in the
short run.

• Technically, a variable input is one that changes with changes in output. In the long run, all inputs are
variable.
Time period of Production
According to Time period, the production process can be classified as short run
and long run

Short run
– At least one input is fixed
– All changes in output achieved by changing usage of variable inputs

Long run
– All inputs are variable
– Output changed by varying usage of all inputs
Production Function
Production Function
• A tool of analysis used in explaining the input-output relationship.

• It describes the technical relationship between inputs and output in physical terms.

• In its general form, it holds that production of a given commodity depends on certain
specific inputs.

• In its specific form, it presents the quantitative relationships between inputs and outputs.

• A production function may take the form of a schedule, a graph line or a curve, an algebraic
equation or a mathematical model.

• The production function represents the technology of a firm.

• Production function – Maximum amount of output that can be
produced from any specified set of inputs, given existing technology

• Technical efficiency – Achieved when maximum amount of output is

produced with a given combination of inputs. A process of production
is technically efficient if it uses less of one factor and no more from
the other factor, compare to any other process of production.

• Economic efficiency – Achieved when firm is producing a given output

at the lowest possible total cost
Production Function
• An empirical production function is generally so complex to include a wide
range of inputs: land, labour, capital, raw materials, time, and technology.

• These variables form the independent variables in a firm’s actual production

function.

• A firm’s long-run production function is of the form:

Q = f(Ld, L, K, M, T, t)
where Ld = land and building;
L = labour; K = capital;
M = materials;
T = technology; and,
t = time.
Production Function
• For sake of convenience, economists have reduced the number of
variables used in a production function to only two: capital (K) and
labour (L).

Therefore, in the analysis of

input-output relations, the production function is expressed as:

Q = f(K, L)
Production Function
• Q = f(K, L) (Both Factors are variable)

Increasing production, Q, will require K and L, and whether the firm

can increase both K and L or only L will depend on the time period it
takes into account for increasing production, that is, whether the firm is
thinking in terms of the short run or in terms of the long run.

In the long run, the firm can employ more of both capital and labour,
as the supply of capital becomes elastic over time.
 Hypothetical Production Function
Units of Output Qty
Labour
6 46 61 80 88 95 86
5 50 65 85 95 100 90
La 4 45 60 80 90 96 85
bo 3 35 50 70 80 85 75
ur
2 15 30 50 60 65 55
1 5 20 40 50 55 45

1 2 3 4 5 6

Units of Capital
Short Run Production
• In the short run, capital is fixed – Only changes in the variable labor input
can change the level of output Economists believe that the supply of capital
(K) is inelastic (doesn't change in short run) in the short run and elastic in the
long run. Units of Labour Output Qty
6 46
5 50
• Thus, in the short run firms can increase
4 45
production only by increasing labour,
3 35
since the supply of capital is fixed in the short run.
2 15
1 5
• Short run production function Q = f(L)
Short Run Production : TP, MP, AP
• Total Product: It gives maximum of output that can be produced at
different levels of one input, assuming that the other input is fixed at a
particular level.

• Marginal Product: Change in the output resulting from a very small

change in one factor input , keeping the other factor inputs constant.

• Average Product: Total production for per unit of output.

Average & Marginal Products
• Average product of labor
– AP = Q/L

• Marginal product of labor

– MP = ΔQ/ L

• Average product of Capital

– AP = Q/K

• Marginal product of Capital

– MP = ΔQ/ K
Total, Average, & Marginal Products of
Labor, K = 2
Number of workers (L) Total product (Q) Average product Marginal product (MP=
(AP=Q/L) ΔQ/ L)
0 0 -- --
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
Law of production

1. One factor is variable while other variables remain

2. All the factors remain variable.
Law of Variable Proportion
 Law of Variable Proportion
• Prof Ben-ham explained this law.

• Law of variable proportion is also called as law of diminishing marginal

returns or law of variable factor proportion or law of non proportion
output.

• It is considered as modern version of Law of Diminishing Returns which

was originally explained by British classical economist like Thomas
Robert Malthus, David ricardo and john stuart mill. It was further
refined and elaborated at the hands of Alferd marshal.
Cont..
• The law of diminishing returns, states that with a given state of technology
if the quantity of one factor input is increased , by equal increment , the
quantities of other factor inputs remaining fixed , the resulting increment
of total product will first increase but decreases after a particular point.

It states that as we go on employing more of one factor of production,

other factor remaining same, the marginal productivity will diminish after
some point.

AS more of an input such as labor is added to a fixed amount of land,

machinery and other factors, the labor has less and less of the other
factors to work with.
Assumptions
• Short run: One factor is varied and all other factors remaining
constant at a given level

• Homogenous: all units of the factors input varied are homogenous,

I.e; all units have identical characteristics and equal efficiencies.

• Constant technology: The technique of production does not change

•
Fixed Inputs (Land Variable Total Marginal      Product Average
Capital) Resource Produce (TP   (MP Quintals) Product (AP
(labor) Quintals) Quintals)

30 1 10 10  Increasing 10
30 2 25 15 marginal 12.5
return

 
30 3 37 12 Diminishing 12.3
30 4 47 10 marginal 11.8
30 5 55 8 returns 11.0
30 6 60 5 10.0
30 7 63 3 9.0

 
30 8 62 -1 Negative 7.96.8
marginal
returns
Total, Average & Marginal Products It can never be profitable to use
additional amounts of a costly input to
product less output, i.e.
where MP<0
• MP > 0 as long as output is increasing.

AP and MP curves are closely related:

MP>AP if AP is increasing
MP<AP is AP is decreasing

• Why should we expect the MP curve

to rise and then fall?

• Principle of diminishing marginal

returns says that as the use of an input
increases with other inputs fixed, the
resulting additions to output will
eventually decrease.
Total, Average & Marginal Products
• At the point O, the factor input labor is equal to zero, the value of total product will
also be zero. Obviously the value of MP and AP will be zero. So all the three curves , TP,
AP and MP starts from the origin.

• TP curve is first convex from below and then concave.

As long as TP curve is convex, MP is increasing. When TP curve is Concave , MP is

decreasing.

• The point A on TP curve is called as point of inflexion. MP will be maximum

corresponding to this point of the TP curve.

• AP is maximum at the point B, and also AP = MP .

Total, Average & Marginal Products
• Corresponding to the maximum point of the TP curve, point C, MP is
equal to Zero.

• To the left of Point C, total product is increasing and marginal product

is positive. To the right of point C, TP curve is decreasing and marginal
product is negative.

• Since the MP curve must be decreasing when the average product is

maximum, the MP curve reaches maximum before the AP curve.
Marginal and Average Product

• When AP is rising, MP is greater than AP

• When AP is falling, MP is less than AP

• When AP reaches it maximum, AP = MP

The Three Stages of Production
• Stage I: Stage of Increasing Returns:
• AP is increasing and the MP is greater than the AP . Up to point B on the TP
curve Stage I exist.
• AP is increasing, but MP is increasing first up to point A then decreasing.

• Stage II: Stage of Decreasing Returns

• Both AP and MP is decreasing. But MP is positive.
• The portion of TP curve between B and C represents this stage.

• Stage III: Stage of Negative Returns

• TP is diminishing and the MP is negative.
• The portion of TP curve which lies to the right of point C represents this stage.
Summary
Stages of Total Product Marginal Product Average Product
Production

I Increases at an increasing rate. Increases and reaches Increases and Reaches

Later increasing at a decreasing maximum and starts Maximum
rate falling

II Increases at diminishing rate Continues to fall and Falls

becomes maximum become zero

III Decreases Becomes Negative Continues to Fall

The Three Stages of Production

• In which stage would the rational producer like to operate?

In Stage I, MP and AP both are rising, and the MP is
more than AP
• A given increase in variable factor leads to a more than proportionate increase in the output.

• The producer is not making the best possible use of the fixed factor. A particular portion of

fixed factor remains unutilized.

• As more and more units of the variable factor are added to the constant quantity of the fixed

factor, it is more intensively and effectively used. 

• Internal economies such as managerial and technical efficiency

• More and more labour if increased, the specialization of services increases.

• Till this stage it is profitable to employ additional units of labor.

The Three Stages of Production
• In Stage II, MP and AP both are falling and MP through positive, is less than AP.

• There is less than proportionate change in output due to change in labor force .

• Hence at this stage the producer will employ the variable factor in such a manner that
the utilization of fixed factor is most efficient.

• Due to imperfect substitutability of factors, when the fixed factors are over utilized,
there emerges internal diseconomies

• When the fixed factors are overutilized, there emerges internal diseconomies.
• In Stage III, MP of variable factor is negative and the TP is also
decreasing
• Overstaffing of salesman in departmental store.

• negative returns is an irrational stage, where no firm would like to

operate.
Example
• A good example of Diminishing Returns includes the use of
chemical fertilizers- a small quantity leads to a big increase in
output.

• However, increasing its use further may lead to declining

Marginal Product (MP) as the efficacy (Effectiveness) of the
chemical declines.
 Law of Diminishing Return –Example of
farm production
Number of Workers Units of Products Marginal Product Average
Produced Product
1 10 10 10
2 25 15 12.5
3 45 20 15
4 60 15 15
5 70 10 14
6 60 -10 10
 Law of Diminishing Return - Explanation of farm production

• It is with three workers that the farm production is most efficient because
the marginal product is at its highest.

• Beyond this point, the farm begins to experience diminishing returns and,
at the level of 6 workers, the farm actually begins to see decreasing returns
as production levels decline, even though costs continue to increase.

• In this example, the number of workers changed, while the land used,
seeds planted, water consumed, and all other inputs remained the same.

• If more than one input were to change, the production results would vary
and the law of diminishing returns may not apply if all inputs could be
increased.
Importance of Law of Variable Proportion
• Classical Economist confirmed the application of this law to agricultural
sector, but the modern economist extended it to all the sectors.

• It helps the managers to understand “till what point the production is

productive or profitable.

• When the returns diminish, it is irrational to run business. i.e third phase.

• The law tells us that any increase in the units of variable factor will lead to
increase in the total product at a diminishing rate. The elasticity of the
substitution of the variable factor for the fixed factor is not infinite
The End