Production Production TheoryTheory

ProductionProduction The process of transformation of resources The process of transformation of resources

(like land, labour, capital and (like land, labour, capital and entrepreneurship) into goods and services entrepreneurship) into goods and services of utility to consumers and/or producers. of utility to consumers and/or producers.

Goods includes all tangible items such as Goods includes all tangible items such as furniture, house, machine, food, car, furniture, house, machine, food, car, television etc television etc

Services include all intangible items, like Services include all intangible items, like banking, education, management, banking, education, management, consultancy, transportation.consultancy, transportation.

Types of InputsTypes of InputsTechnologyTechnology determines the type, quantity and proportion of determines the type, quantity and proportion of

inputs. inputs. also determines the maximum limit of total output also determines the maximum limit of total output

from a given combination of inputs. from a given combination of inputs. at any at any point point of time, technology will be given; impact of time, technology will be given; impact

of technology can be seen only over a of technology can be seen only over a periodperiod of of time. time.

Fixed and Variable InputsFixed and Variable Inputs Variable inputVariable input : that can be made to vary in the short run, : that can be made to vary in the short run,

e.g. raw material, unskilled/semi skilled labour, etc.e.g. raw material, unskilled/semi skilled labour, etc. Fixed input:Fixed input: that cannot be varied in the short run, e.g. land, that cannot be varied in the short run, e.g. land,

machine, technology, skill set, etc. machine, technology, skill set, etc.

Factors of ProductionFactors of Production LandLand

Anything which is gift of nature and not the result of human effort, Anything which is gift of nature and not the result of human effort, e.g. soil, water, forests, mineralse.g. soil, water, forests, minerals

Reward is called as Reward is called as rentrent LabourLabour

Physical or mental effort of human beings that undertakes the Physical or mental effort of human beings that undertakes the production process. Skilled as well as unskilled.production process. Skilled as well as unskilled.

Reward is called as Reward is called as wages/ salarywages/ salary CapitalCapital

Wealth which is used for further production as machine/ Wealth which is used for further production as machine/ equipment/intermediary goodequipment/intermediary good

It is outcome of human effortsIt is outcome of human efforts Reward is called as Reward is called as interestinterest

EnterpriseEnterprise The ability and action to take risk of collecting, coordinating, and The ability and action to take risk of collecting, coordinating, and

utilizing all the factors of production for the purpose of uncertain utilizing all the factors of production for the purpose of uncertain economic gainseconomic gains

Reward is called as Reward is called as profitprofit

Production FunctionProduction Function A technological relationship between physical A technological relationship between physical

inputs and physical outputs over a given period inputs and physical outputs over a given period of time.of time.

shows the shows the maximummaximum quantity of the commodity quantity of the commodity that can be produced per unit of time for each set that can be produced per unit of time for each set of alternative inputs, and with a given level of of alternative inputs, and with a given level of production technology.production technology.

Normally a production function is written as:Normally a production function is written as:

Q = f (L,K,I,R,E) Q = f (L,K,I,R,E) where Q is the maximum quantity of output of a where Q is the maximum quantity of output of a

good being produced, and L=labour; K=capital; good being produced, and L=labour; K=capital; l=land; R=raw material; E= efficiency parameter.l=land; R=raw material; E= efficiency parameter.

Production Function with One Production Function with One Variable InputVariable Input

Also termed as Also termed as variable proportion production variable proportion production functionfunction

It is the short term production function It is the short term production function Shows the maximum output a firm can produce when Shows the maximum output a firm can produce when

only one of its inputs can be varied, other inputs only one of its inputs can be varied, other inputs remaining fixed: remaining fixed: where Q = output, L = labour and K = fixed amount of where Q = output, L = labour and K = fixed amount of capitalcapital

Total product is a function of labour:Total product is a function of labour: Average Product (AP) is total product per unit of variable Average Product (AP) is total product per unit of variable

inputinput Marginal Product (MP) is the addition in total output per Marginal Product (MP) is the addition in total output per

unit change in variable inputunit change in variable input

),( KLfQ

),( LKfTPL

L

TPAPL

L

TPMPL

11.1-301009Negative returns

16.3-201308

21.501507

25101506

28201405

Diminishing returns

30301204

3040903

2530502

Increasing returns

20-201

StagesAPMPTotal Product (’000 tonnes)

Labour (’00

units)

-50

0

50

100

150

200

1 2 3 4 5 6 7 8 9

Labour

Out

put

Total Product(’000 tonnes)

MarginalProduct

AverageProduct

Law of Variable Proportions

As the quantity of the variable factor is increased with other fixed factors, MP and AP of the variable factor will eventually decline.

Therefore law of variable proportions is also called as law of diminishing marginal returns.

Labour

Total Output

OMPL

APL

Labour

Total Output

O

TPL

A*

A

Stage I

B*

B

Stage II

C

C*

Stage III

First stage Increasing Returns to

the Variable FactorMP>0 and MP>AP

Second stageDiminishing Returns to

a Variable FactorMP>0 and MP<AP

Third StageNegative ReturnsMP<0 while AP is falling

but positiveTechnically inefficient

stage of productionA rational firm will never

operate in this stage

Law of Variable Proportions

Production Function with Two Variable Production Function with Two Variable InputsInputs

All inputs are variable in long All inputs are variable in long run and only two inputs are run and only two inputs are usedused

Firm has the opportunity to Firm has the opportunity to select that combination of inputs select that combination of inputs which maximizes returnswhich maximizes returns

Curves showing such Curves showing such production function are called production function are called isoquantsisoquants or or iso-product curvesiso-product curves. .

An An isoquantisoquant is the locus of all is the locus of all technically efficient technically efficient combinations of two inputs for combinations of two inputs for producing a given level of producing a given level of outputoutput

108912818728640

Labour (’00 units)

Capital (Rs. crore)

05

1015202530354045

6 7 8 9 10

Labour ('00 units)

Capi

tal (

Rs. C

rore

)

Characteristics of Isoquants

Downward sloping Convex to the origin A higher isoquant represents a higher output Two isoquants do not intersect

O Labour

Capital

Q0

B

Q1

A

C

Q2

B Q1

OLabour

Capital

C

Q2

A

Marginal Rate of Technical SubstitutionMarginal Rate of Technical Substitution

Measures the reduction in one input, due Measures the reduction in one input, due to unit increase in the other input that is to unit increase in the other input that is just sufficient to maintain the same level just sufficient to maintain the same level of outputof output..

It is also equal to the ratio of the marginal It is also equal to the ratio of the marginal product of one input to the marginal product of one input to the marginal product of other input product of other input

L

KMRTSLK

L

KMPMPMRTS

K

LLK

Isocost LinesIsocost Lines

•The isocost line represents the locus of points of all the different combinations of two inputs that a firm can procure, given the total cost and prices of the inputs.

Total Cost is sum of Labour cost and Capital cost

The (absolute) slope of this line is equal to the ratio of the input prices.

B1

A1

B2

A2

Labour

Capital

O B

A

Producer’s EquilibriumProducer’s Equilibrium

Labour

Capital

O

A

B

Q2

Q3

Q0

Q1

C

E

L*

K*

D

Necessary condition for equilibriumSlope of isoquant = Slope of

isocost line

Maximization of output subject to cost constraint

AB is the isocost line

Any point below AB is feasible but not desirable

E is the point of tangency of Q2 with isocost line AB

Corresponds to the highest level of output with given cost function.

Firm would employ L* and K* units of labour and capital

Q3 is beyond reach of the firm

Points C and D are also on the same isocost line, but they are on isoquant Q1, which is lower to Q2. Hence show lower output.

E is preferred to C and D, which is on the highest feasible isoquant.

Producer’s EquilibriumProducer’s Equilibrium

B2

A2

B

A

B1

A1

L

K

OLabour

Capital

Q

Minimization of cost for a given level of output

Firm has decided the level output to be produced shown by the isoquant Q

Will be indifferent between output combinations shown by R, S, E on isquant Q.

Has to ascertain that combination of inputs Labour and Capital which minimizes the cost of production

Hence a map of isocost lines will be prepared

The isocost lines are parallel to each other because price of the inputs is given.

A1B1 line is not feasible It will use OK and OL of capital and

labour respectively, at point E which is also on AB, the lowest possible isocost line.

R, S are not desirable because they are on higher cost line A2 B2.

Necessary condition for equilibriumSlope of isoquant = Slope of

isocost line

E

R

S

Expansion Path

E2

E1

Expansion Path

O Labour

Capital

Line formed by joining the tangency points between various isocost lines and the corresponding highest attainable isoquants is known as Expansion Path.

For homogeneous production function and given factor prices (and hence factor ratio):

expansion path is a straight line through the origin. For non- homogeneous production function:

optimal expansion path is non linear.

Returns to ScaleReturns to Scale

Constant Returns to ScaleConstant Returns to Scale :: When a When a proportional increase in all inputs yields an equal proportional increase in all inputs yields an equal proportional increase in output proportional increase in output

Increasing Returns to ScaleIncreasing Returns to Scale :: When a When a proportional increase in all inputs yields a more proportional increase in all inputs yields a more than proportional increase in output than proportional increase in output

Decreasing Returns to ScaleDecreasing Returns to Scale :: When a When a proportional increase in all inputs yields a less proportional increase in all inputs yields a less than proportional increase in output than proportional increase in output

Returns to Scale show the degree by which the level of output changes in response to a given change in all the inputs in a production system.

Technical ProgressTechnical Progress

Refers to research and development and Refers to research and development and investments made to manage technical investments made to manage technical know how know how

Technical change may be Technical change may be Embodied or investment specific, Embodied or investment specific, where where

new capital is used in the production new capital is used in the production apparatus, which requires investment to apparatus, which requires investment to take place; or take place; or

Disembodied or investment neutral, Disembodied or investment neutral, wherewhere output increases without any increase in output increases without any increase in investment but by an innovation through investment but by an innovation through research and knowledge. research and knowledge.

Technical ProgressTechnical Progress Types of Technical Progress (Hicks)Types of Technical Progress (Hicks)

Neutral Technical Progress:Neutral Technical Progress: changes changes in the marginal product of labour (MPL) in the marginal product of labour (MPL) and capital (MPK) are sameand capital (MPK) are same

Labour augmenting Technical Labour augmenting Technical ProgressProgress: MPL increases faster than the : MPL increases faster than the MPKMPK

Capital augmenting Technical Capital augmenting Technical ProgressProgress : MPK increases faster than : MPK increases faster than MPLMPL