What is production?

Production is the process by which different inputs, including capital, labor, and land, are used to
create outputs in the form of products or services. Production is important to ensure the efficient
use of tangible and intangible resources, the generation of employment, and achieving economic
efficiency.

THE PRODUCTION FUNCTION

Firms can turn inputs into outputs in a variety of ways, using various combinations of labour,
materials, and capital. We can describe the relationship between the inputs into the production
process and the resulting output by a production function. A production function indicates the
highest output ‘q’ that a firm can produce for every specified combination of inputs.

Although in practice firms use a wide variety of inputs, we will keep our analysis simple by focusing
on only two, labour L and capital K. We can then write the production function as:

q = F (K, L)

This equation relates the quantity of output to the quantities of the two inputs, capital and labour. It
is important to keep in mind that inputs and outputs are flows. Because the production function
allows inputs to be combined in varying proportions, output can be produced in many ways. Also
note that equation applies to a given technology—that is, to a given state of knowledge about the
various methods that might be used to transform inputs into outputs. As the technology becomes
more advanced and the production function changes, a firm can obtain more output for a given set
of inputs.

Production functions describe what is technically feasible when the firm operates efficiently—that is,
when the firm uses each combination of inputs as effectively as possible. The presumption that
production is always technically efficient need not always hold, but it is reasonable to expect that
profit-seeking firms will not waste resources.

MAIN FEATURES OF PRODUCTION FUNCTION

i. Substitutability: The factors of production or inputs are substitutes of one another which make it
possible to vary the total output by changing the quantity of one or a few inputs, while the
quantities of all other inputs are held constant.

ii. Complementarity: The factors of production are also complementary to one another, that is, the
two or more inputs are to be used together as nothing will be produced if the quantity of either of
the inputs used in the production process is zero
iii. Specificity: It reveals that the inputs are specific to the production of a particular product.
Machines and equipment’s, specialized workers and raw materials are a few examples of the
specificity of factors of production.

HOMOGENEITY OF THE PRODUCTION FUNCTION

Suppose we increase both factors of the function

X0 = f (L, K)

by the same proportion ‘k’, and we observe the resulting new level of output X*

X* = f (kL, kK)
If k can be factored out (that is, may be taken out of the brackets as a common factor), then the new
level of output X* can be expressed as a function of k (to any power v) and the initial level of output:

X* = kv

f (L, K)

or

X*= kvX0

and the production function is called homogeneous. If k cannot be factored out, the production
function is non-homogeneous. Thus:

A homogeneous function is a function such that if each of the inputs is multiplied by k, then k can be
completely factored out of the function. The power ‘v’ of k is called the degree of homogeneity of
the function and is a measure of the returns to scale:

If v = 1 we have constant returns to scale. This production function is sometimes called linear
homogeneous.

If v < 1 we have decreasing returns to scale.

If v > 1 we have increasing returns to scale.

For a homogeneous production function the returns to scale may be represented graphically in an
easy way. Before explaining the graphical presentation of the returns to scale it is useful to introduce
the concepts of product line and [Link] analyse the expansion of output, it is easier to show the
change of output by shifts of the isoquant and use the concept of product lines to describe the
expansion of output.

A product line shows the (physical) movement from one isoquant to another as we change
bothfactors or a single factor. A product curve is drawn independently of the prices of factors of
production. It does not imply any actual choice of expansion, which is based on the prices of factors
and is shown by the expansion path.

The product line describes the technically possible alternative paths of expanding output. What path
will actually be chosen by the firm will depend on the prices of factors.

The product curve passes through the origin if all factors are variable. If only one factor is variable
(the other being kept constant) the product line is a straight line parallel to the axis of the variable
factor (Figure A). The K/L ratio diminishes along the product line.

Among all possible product lines of particular interest are the so-called isoclines. An isocline is the
locus of points of different isoquants at which the MRTS of factors is constant.

If the production function is homogeneous the isoclines are straight lines through the origin. Along
any one isocline the K/L ratio is constant (as is the MRTS of the factors). Of course the K/ L ratio (and
the MRTS) is different for different isoclines (Figure B).If the production function is non-
homogeneous the isoclines will not be straight lines, but their shape will be twiddly. The K/L ratio
changes along each isocline (as well as on different isoclines) (Figure C).
Non homogeneous production function

If the production function is non homogeneous the isoclines will not be straight lines,but their shape
will be [Link] K/L ratio changes along each isocline.

A form of non-homogeneous production function is utilized to compute marginal

productivities,various elasticities,optimum input ratios, and for different levels of inputs and
outputs.

COBB - DOUGLAS (C-D) PRODUCTION FUNCTION

If the homogenous production function is of degree one, we say that it is linearly homogenous
production function (i.e. it has constant returns to scale).

The two examples of linear homogenous production function are:

i. Cobb – Douglas Production Function

ii. Constant Elasticity of Substitution (CES) Production Function

The Cobb – Douglas Production Function is an empirical production function developed byCharles W.
Cobb (American Mathematician) and Paul H. Douglas (American Economist) based on empirical
studies of various manufacturing industries of the USA. This production function was published in
American economic Review in 1928 in the form of an article A Theory of Production.

It is a linear homogeneous production function of degree one which takes into account two inputs,
labour and capital, for the entire output of the manufacturing industry.

The Cobb-Douglas production function is expressed as:

Q = ALα Kβ

where;

Q is the total output of the industry

L and K are inputs of labour and capital respectively

A is the efficiency parameter or indicator of technology. It is always positive and is used to show the
change in output that is not the result of main production factors.

α and β are output elasticities* of labour and capital

The above equation tells that output depends directly on L and K, and that part of output which
cannot be explained by L and K is explained by A which is the ‘residual’, often called technical
change. It also tells that production requires both the inputs labour (L) and capital (K). if any of the
inputs becomes zero, production will also become zero.

The production function solved by Cobb-Douglas had 1/4 contribution of capital to the increase in
manufacturing industry and 3/4 of labour so that the C-D production function is:

Q = AL3/4 K1/4

This equation shows constant returns to scale because the sum of the exponents of L and K is equal
to one i.e. (α + β = 1).

*Output elasticity is the responsiveness of total output to changes in quantities of a variablefactor. It

is a percentage change in total output resulting from a percentage change in a variable factor,
keeping other factor constant. Thus, α measures the percentage increase in Q that would result from
a 1 per cent increase in L, while holding K as constant and β measures the percentage increase in Q
that would result from a 1 per cent increase in K, while holding L as constant.

The more capital or labour we use, the more of a good we are going to get, but it is not a one to one
conversion. It means that a 1 percent change in either factor would not result in a 1% change in total
production, but is rather dependent on the level of output elasticity associated with the factor. Each
of these values is a positive constant no bigger than 1 and is dependent on the level of available
technology (0 < = α < = 1, 0 < = β < = 1). In practice they have to be smaller than 1 because a perfect
production process does not exist - inefficiencies in labour and capital occur. The C-D production
function showing constant returns to scale is depicted in the following Figure:

Labour input is taken on the horizontal axis and capital on the vertical axis. It is clear from the

Figure that, when inputs are doubled, output also gets doubled (shown by equidistant isoquants).
PROPERTIES OF C-D PRODUCTION FUNCTION
IMPORTANCE OF C-D PRODUCTION FUNCTION

1. It has been used widely in empirical studies of manufacturing industries and in inter-industry
comparison.

2. It is used to determine the relative shares of labour and capital in total output.

3. It is used to prove Euler’s theorem.

4. It’s parameters α and β represent elasticity coefficients that are used for inter-sectoral
comparison.

5. This production function is helpful to measure returns to scale.

6. Economists have extended this production function to more than 2 variables.

CRITICISMS

The major criticisms of C-D production was made by Kenneth Joseph arrow, B.S Minhas, Robert
solow and Chenery. Later these 4 developed the Constant Elasticity of Substitution (CES).

Following are some of the criticisms:

1. It considers only 2 inputs – labour and capital and neglects some important inputs like raw
materials which are used in production.
2. In the C-D production function, the problem of measurement of capital arises because it takes
only the quantity of capital available for production.

3. It shows only constant returns to scale. But constant returns to scale are not an actuality.

4. It is based on the assumption of substitutability of factors and neglects the complementarity of

factors.

5. This function is based on the assumption of perfect competition in the factor market which is
unrealistic.

6. One of the weaknesses of C-D production is the aggregation problem. This problem arises when
this function is applied to every firm in an industry and the entire industry.

TECHNOLOGICAL PROGRESS AND THE PRODUCTION FUNCTION

Technological progress has been one of the major forces behind Economic growth overtime. It
enables output to rise even when the factors of production remain at a constant level. Technical
progress could be shown with an upward shift of the production function (Refer Fig. 5.10 A, where
with same level of Labour L1, more of output could be produced, X1 > X) or a downward movement
of the production isoquant (Refer Fig. 5.10 B, where the same level of output X could be produced
by fewer quantities of factors of production K1 and L1, with K1 < K0 and L1 < L0).

Hicks Classification of Technological Progress

Hicks had distinguished three types of technical progress depending on its effect on rate of
substitution of factors of production. They are as follows:

Capital Deepening Technical Progress

Technical progress is said to be capital-deepening (or Labour saving) when shifted Isoquant due to
technical progress has lower MRTSLK at the equilibrium points. This results as MPK increases more
than MPL. It simply means that the technical progress has resulted in increasing capital per worker
or capital intensity in the economy. Refer Fig. 5.11, where as we move closer to the origin, MRTSLK
falls along the equilibrium points.
Labour Deepening Technical Progress

Technical progress is said to be Labour-deepening (or Capital saving) when shifted Isoquant due to
technical progress has higher MRTSLK at the equilibrium points. This results as MPL increases more
than MPK. This results when technical progress decreases capital per worker or capital intensity in
the economy. Refer Fig. 5.12, where as we move closer to the origin, MRTSLKrises along the
equilibrium points.

Neutral Technical Progress

Technical progress is said to be neutral when for a shifted Isoquant due to technical progress
MRTSLK does not change at the equilibrium points. Here, MPK and MPL both increase at same
proportion. This is represented inFig. 5.13, where as we move closer to the origin, MRTSLK remains
constant along the equilibrium points.
CES Production Function
Another most popular neo classical production function is constant elasticity of
substitution (CES) production function. The CES production function was
developed by Arrow, Chenery, Minhas and Solow as a generalisation of the Cobb
Douglas production function that allows for non-negative and constant elasticity of
substitution. ." They developed a model to understand how the substitution
between capital and labor affects production and efficiency.
Functional Form: The standard CES production function can be written as:

The CES production function is linearly homogeneous and therefore exhibits

constant returns to scale. It is non linear in parameters, so cannot be estimated
using least squares method.

Properties of CES Production Function

1. Constant Returns to Scale: The Cobb Douglas production function

exhibits constant returns to scale.
2 .Positive and Diminishing Returns to Inputs: The marginal products of
the input are

They both are positive for K,L>0. With any small increase in capital or labor
increases the output but at a diminishing rate.
In conclusion, the marginal products of capital and labor are positive, indicating positive returns
to inputs. As the quantities of capital and labor increase, the marginal products of each input
decrease, indicating diminishing returns to inputs.

2. Inada Conditions
(The Inada conditions are a set of properties that a production function can satisfy to ensure
certain desirable characteristics, such as the stability of economic growth models. These
conditions are particularly relevant for neoclassical growth models.)

i . The marginal product of capital (labor) approaches infinity as

capital (labor) goes to zero.
ii . The marginal product of capital (labor) approaches zero as capital
(labor) goes to infinity.
 3. The Elasticity of Substitution is

(The elasticity of substitution (σ\sigmaσ) is a measure of how easily one input (e.g., capital K)
can be substituted for another input (e.g., labor LLL) in production)

The elasticity of substitution is calculated using formula:

INTRODUCTION
Production Function
Nature imposes technological constraints on firms; only certain combination of inputs are
feasible ways to produce a given amount of output, and the firm must limit itself to
technologically feasible production plans. The set of all combinations of inputs and outputs
that comprise a technologically feasible way is called a production function. The relation
between inputs and output of a firm is known as production function. Production function is a
purely technical relation which connects factor inputs and output. It shows the maximum
amount of output that can be produced from any specified set of inputs given the existing
technology. It is a flow concept so production refers to units of output over a period of time.
It refers to the relation between inputs and outputs of a firm.
It is a flow concept so production refers to units of output over a period of time

VARIABLE ELASTICITY OF SUBSTITUTION PRODUCTION

FUNCTION

VES production function was developed by Lu and Flecher in the 1968. In the earlier
production functions, we observed that elasticity of substitution is one or constant. However,
the VES function attempts to remedy this short coming by allowing the elasticity of substitution
to change with a change in inputs, ie; we relax the assumption of constant elasticity of
substitution and arrive at variable elasticity of substitution. The variability in elasticity of
substitution gives more flexibility in understanding the product behavior.
VES is a homogenous function. It can be used to model constant, increasing or decreasing
returns to scale depending on the value of the returns to scale parameter. The VES production
function reduces to the Cobb-Douglas production function when 𝜌 = 1.
The VES production function can be expressed as:

𝑌 = 𝛾𝐾^{𝛼(1−𝛿𝜌)}[𝐿 + (𝜌 − 1)𝐾]^{𝛼𝛿𝜌}

Where:
Y: Output
K: Capital
L: Labor
α,ρ,δ andγ: Parameters
 𝛾 > 0, α > 0
 0< δ <1
 0≤ ρδ ≤1
 L/K > 1−𝜌/1−ρδ
Here, α is the parameter of returns of scale. If the value of α is 1, the production function
exhibits constant returns to scale.
Elasticity of Substitution: The elasticity of substitution σ for the for the VES production
function is:

σ = σ(K, L) = 1 + 𝜌 – 1 K / 1 – 𝛿𝜌 L

The elasticity of substitution σ varies with the capital labour ratio around the
intercept term of unity.
The elasticity of substitution is greater than zero over the relevant range of K/L.

For σ>0 requires that 𝐿/𝐾>1−𝜌/1−𝛿𝜌 .

Properties of VES Production Function

i. Positive and Diminishing Returns to Inputs: The VES production function is increasing in
labor and capital i.e. positive marginal products.

∂Y/∂K > 0 𝑎𝑛𝑑 ∂Y/∂L > 0

𝑌 = 𝛾𝐾^{𝛼(1−𝛿𝜌)}[𝐿 + (𝜌 − 1)𝐾]^{𝛼𝛿𝜌}

𝑀𝑃𝐿 =∂Y/∂L= [𝛼𝛿𝜌] 𝑌/𝐿 + (𝜌 − 1)𝐾 > 0 𝑓𝑜𝑟 0 ≤ 𝛿𝜌 ≤ 1 𝑎𝑛𝑑 𝐿/𝐾 >1 – 𝜌/ 1 − 𝛿𝜌
𝑀𝑃𝐾 =∂Y/∂K= 𝛼(1 − 𝛿𝜌) 𝑌/𝐾 + 𝛼𝛿𝜌(𝜌 − 1) 𝑌 /𝐿+ (𝜌 − 1)𝐾 > 0
Here any small increase in capital will lead to a decrease in the marginal product of
capital. Any small increase in capital cause output to rise but at a
diminishing rate. The same is true for labor.
ii. VES Production Function reduced to Cobb Douglas and Linear
production Function
For 𝜌 = 0 » Harrod Domar Fixed Coefficient Model
For 𝜌 = 1 » Cobb Douglas Production Function
For 𝜌 = 1/𝛿(> 1) »Linear Production Function
iii. The Elasticity of Substitution can vary along an Isoquant: The VES
requires that the elasticity of substitution be the same only along a ray through
the origin.
VES production function can also be expressed as:

Q = AK^av [L + BaK]^ (1-a)v

Where:
V shows returns to scale
A is the efficiency parameter
a(alpha) and B(beta) are the shares of capital and labour respectively.

REFER TRANSLOG FROM E-PATHSHALA

____________________________________________________________________________________________________

Subject ECONOMICS

Paper No and Title 3: Fundamentals of Microeconomic Theory

Module No and Title 15: Special Production Functions- Cobb-Douglas, CES,

VES, Translog and their properties
Module Tag ECO_P3_M15

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Cobb Douglas Production Function
4. CES Production Function
5. VES Production Function
6. Translog Production Function
7. Summary

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

1. Learning Outcomes

After studying this module, you shall be able to

 Know the concept of various production functions and their properties

 Analyze the reason for the use of Cobb Douglas production function in economics
 Understand CES production function and its properties
 Understand VES production function and its form when assumption of constant
elasticity of substitution is relaxed
 Evaluate the Trans log production function and its various properties

2. Introduction
Production Function

Nature imposes technological constraints on firms; only certain combination of inputs are
feasible ways to produce a given amount of output, and the firm must limit itself to
technologically feasible production plans. The easiest way to describe feasible production
plans is to list them. The set of all combinations of inputs and outputs that comprise a
technologically feasible way is called a production function. The relation between inputs
and output of a firm is known as production function. Production function is a purely
technical relation which connects factor inputs and output. It shows the maximum
amount of output that can be produced from any specified set of inputs given the existing
technology. It is a flow concept so production refers to units of output over a period of
time.
 It refers to the relation between inputs and outputs of a firm.
 It is a flow concept so production refers to units of output over a period of time.

Mathematically, the production function can be expressed in a functional form as:-

Y  f ( X 1 , X 2 , , X n )
where
Y  Output
X 1 , X 2 ,, X n  Quantity of factor inputsSuch as land , labour, capital or raw material 
f shows the functional relationship between inputs and output.

Concept of Product: There are three important concepts regarding physical production
of factors:-

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
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a. Total Product of Labour (TPL)

b. Average Product of Labour (APL)

c. Marginal Product of labour (MPL)

a. Total Product of Labour (TPL): Total product of a variable factor is the

maximum amount of an output that can be produced by a given amount of
variable factors, keeping quantity of other factors such as capital, land fixed.
When the amount of the variable factor increases, the total product increases.

TPL  APL  L
or
TPL   MPL
Where TPL  Total product of labour
APL  Average product of labour
L  Labour or Variable factor
MP  MP of Labour
  SumTotal
Total Product (TPL) initially rises at an increasing rate (so the slope of the TP L curve is
rising in the beginning) but after a point TP L curve starts rising at a diminishing rate,
reaches a maximum and then starts falling as the usage of variable factor increases.

b. Average Product of Labour (APL): Average Product of a variable factor is the

total product divided by the amount of labour (variable factor) employed with a
given quantity of capital (fixed factor) used to produce a commodity. It measures
the average output per unit of the factor.

TPL
Thus, APL 
L
Where APL  Average Pr oduct of Labour
TPL  Total Pr oduct of Labour
L  Number of labour employed

Average Product (AP) is an inverted ‘U’ shape curve. The AP curve first rises, reaches a
maximum and then falls thereafter as the usage of the variable factor increases. Average
Product at any point on the total product curve is the slope of the straight line from the
origin to that point on the total product curve.

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

c. Marginal Product of Labour (MPL): Marginal Product of a variable factor is the

addition to the total product by the usage of one more unit of a variable factor. It
measures the rate at which output changes as a variable factor changes. Thus,

TPL Change in Total product

MPL  
L Changein Labour
or
MPL for nth unit  TPn  TPn1
Where n is the number of units of labor

It measures the slope of the total product curve. Marginal Product (MP) is an inverted ‘U’
shape curve. The MP curve first rises, reaches a maximum and then falls thereafter as the
usage of the variable factor increases. When total product starts falling, Marginal product
becomes negative. Marginal Product is the slope of the tangent line to the total product
curve.

Some of the special production functions are:

i. Cobb Douglas Production Function

ii. CES Production Function
iii. VES Production Function
iv. Translog Production Function

Let us now discuss these production functions in detail.

3. Cobb Douglas Production Function

In Economics, the Cobb Douglas production function is widely used to represent the
relationship between inputs and output in an economy. The two most important
neoclassical production functions are the Constant Elasticity of Substitution (CES) and
the Cobb Douglas. The Cobb Douglas production function was created by Charles Cobb
(Mathematician) and Paul Douglas (Economist) in 1927. But its functional form was
proposed by Knut Wicksell (Economist) in the 19th Century. The Cobb Douglas
production function lies between linear and fixed proportion production function with
elasticity of substitution equal to one. It is very popular among economist because of its
flexibility and ease of use.

Mathematical Form: The mathematical form of the Cobb Douglas production function
for a single output with two factors can be written as
𝑌 = 𝑓(𝐾, 𝐿, 𝐴) = 𝐴𝐾 𝛼 𝐿1−𝛼
where Y: Output
K: Capital input
L: Labour input
ECONOMICS Paper 3: Fundamentals of Microeconomic Theory
Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
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A: Level of technology or total factor productivity (A>0)

α: Constant between 0 and 1( 0< α <1)

Constant Returns to Scale: The return to scale is a long run concept when all the
factors of production are variable. In long run output can be increased by increasing all
the factor of production. An increase in scale means that all factors are increased in the
same proportion, output will increase but the increase may be at an increasing rate or at a
constant rate or at a decreasing rate.

Three situations of Return to the Scale

The three situations of Return to the Scale are:-

(i) Increasing Returns to scale: Increasing return to scale occurs when output
increases in a greater proportion than increase in inputs. If all factors are increased
by 20% then output increases by say 30%. So by doubling the factors, output
increases by more than double.

(ii) Constant Returns to scale: Constant Return to Scale occurs when output
increases in the same proportion as increase in input. If all factors are increased
by 20% then output also increases by 20%. So doubling of all factors causes a
doubling of output then returns to scale are constant. The constant return to scale
is also called linearly homogenous production function.

(iii) Decreasing Returns to scale Decreasing return to scale occurs when output
increases in a lesser proportion than increase in inputs. If all the factors are
increased by 20% then output increases by less than 20%.

The Cobb-Douglas production function exhibits constant returns to scale. Constant

returns to scale occurs when output increases in the same proportion as increase in input.
Under constant returns to scale the sum of two exponents for capital and labour is one i.e.
α + (1-α) =1.

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
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Fig 15.1 Constant Returns of Scale

The Constant Return to Scale occurs when output increases in the same proportion as
increase in input .

It is shown in Fig [Link] labour and capital is shown on X-axis and Y-axis. Y1, Y2 and
Y3 are the isoquant curves showing different levels of output. . Under constant return to
scale the distance between successive isoquants remain same as we expand output from
100 to 200 to 300 units. On straight line OR starting from origin the distance OA, AB and
BC all are equal.

If the sum of the two exponents for capital and labour is greater than one then the
function exhibits increasing returns to scale. And if the sum of the two exponents for
capital and labour is less than one then the function exhibits decreasing returns to scale.

Isoquant are Convex to the Origin: Under Cobb-Douglas production function, isoquant
are convex to the origin. Fig 15.2 represents an isoquant map. An isoquant map refers to
the family of isoquant curves where higher the isoquant, higher is the level of production.
In the figure, labor is measured on X-axis and capital on Y-axis. Y1, Y2 and Y3 are the
isoquant curves showing various possible combinations of inputs physically capable of
producing a given level of output. If you can operate production activities independently,
then weighted averages of production plans will also be feasible. Hence the isoquants will
have a convex shape.
The isoquant Y1 represents 100 units of output whereas isoquant Y2 represents 200 units
of output and the level of output is higher on isoquant Y2 than Y1. Isoquant Y3 shows 300

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
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units of output which is higher than the level of output as shown by isoquant Y1 and Y2
and so on. So, higher the isoquant, higher is the level of output.

Fig 15.2 Isoquants are convex to the origin

The isoquants under Cobb Douglas production function are convex to the origin. This
occurs because of diminishing marginal rate of technical substitution.

Here the isoquant are:-

 Downward sloping.
 Convex to the origin: Diminishing MRTS.
 Higher the isoquant, higher the level of output.

Marginal Products and Average Products:

(i) Under Cobb Douglas production function, the average product and marginal
products of factor depend upon the ratio in which the factors are combined to
produce output.
∂Y 𝛼−1 1−𝛼
𝐾 𝛼−1
𝑀𝑃𝐾 = = 𝐴𝛼𝐾 𝐿 = 𝐴𝛼 ( )
∂K 𝐿

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

Y 𝐴𝐾 𝛼 𝐿1−𝛼 𝐾 𝛼−1
𝐴𝑃𝐾 = = = 𝐴( )
K 𝐾 𝐿

The average product of capital depends on the ratio of capital and labor (K/L)
and does not depend upon the absolute quantities of the factors used. The
same is true for labor.

(ii) The marginal product is proportional to the output per unit of its factor.

∂Y 𝐾 𝛼−1 𝑌
𝑀𝑃𝐾 = = 𝐴𝛼𝐾 𝛼−1 𝐿1−𝛼 = 𝐴𝛼 ( ) = 𝛼( )
∂K 𝐿 𝐾

∂Y 𝛼 −𝛼
𝐾 𝛼 𝑌
𝑀𝑃𝐿 = = 𝐴(1 − 𝛼)𝐾 𝐿 = 𝐴(1 − 𝛼) ( ) = (1 − 𝛼) ( )
∂L 𝐿 𝐿

Linear in Logarithm: The Cobb-Douglas production function is linear in logarithm.

𝑌 = 𝑓(𝐾, 𝐿, 𝐴) = 𝐴𝐾 𝛼 𝐿1−𝛼
Now applying log both sides, we get
ln 𝑌 = ln 𝐴 + 𝛼 𝑙𝑛𝐾 + (1 − 𝛼) 𝑙𝑛𝐿
where,
 α is the partial elasticity of output w.r.t capital. It measures the percentage change
in output for, say, one percentage change in the capital input holding the labor
input constant.
 (1-α) is the partial elasticity of output w.r.t labour. It measures the percentage
change in output for, say, one percentage change in the labour input holding the
capital input constant.

The Cobb Douglas production function is linear in parameter. It can be estimated using
least squares method.

Properties of Cobb Douglas Production Function

i. Constant Returns to Scale: The Cobb Douglas production function exhibits

constant returns to scale. If the inputs capital and labor are increased by a
positive constant, λ, then output also increases by the same proportion i.e.
𝑓(λK, λL, A) = λ f(K, L, A) for all λ>0.

.
𝑌 = 𝑓(𝐾, 𝐿, 𝐴) = 𝐴𝐾 𝛼 𝐿1−𝛼
𝑓(λK, λL, A) = 𝐴(𝜆𝐾)𝛼 (𝜆𝐿)1−𝛼
= 𝐴𝜆𝛼 𝐾 𝛼 𝜆1−𝛼 𝐿1−𝛼

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

= 𝜆𝐴𝐾 𝛼 𝐿1−𝛼
= 𝜆𝑌
 If the function exhibits decreasing returns to scale then 𝑓(𝜆𝐾, 𝜆𝐿, 𝐴) <
𝜆𝑌 𝑓𝑜𝑟 𝑎𝑛𝑦 𝜆 > 1.
 If the function exhibits increasing returns to scale then 𝑓(𝜆𝐾, 𝜆𝐿, 𝐴) >
𝜆𝑌 𝑓𝑜𝑟 𝑎𝑛𝑦 𝜆 > 1.

ii. Positive and Diminishing Returns to Inputs: The Cobb Douglas production
function is increasing in labor and capital i.e. positive marginal products.

∂Y ∂Y
(i) > 0 𝑎𝑛𝑑 >0
∂K ∂L
𝑌 = 𝑓(𝐾, 𝐿, 𝐴) = 𝐴𝐾 𝛼 𝐿1−𝛼
∂Y
𝑀𝑃𝐾 = = 𝐴𝛼𝐾 𝛼−1 𝐿1−𝛼
∂K
∂Y
𝑀𝑃𝐿 = = 𝐴(1 − 𝛼)𝐾 𝛼 𝐿−𝛼
∂L
Assuming A, L and K are all positive and 0 < 𝛼 < 1, the marginal products are positive.
2
(ii) Diminishing Marginal Products with respect to each Input: ∂ Y2 <
∂K
2
0 𝑎𝑛𝑑 ∂ Y <0
2
∂L

2
∂ Y = 𝐴𝛼(𝛼 − 1)𝐾 𝛼−2 𝐿1−𝛼 <0 if α<1
2
∂K

Here, any small increase in capital will lead to a decrease in the marginal product of
capital. Any small increase in capital cause output to rise but at a diminishing
rate. The same is true for labor.

iii. Inada Conditions

(i) The marginal product of capital (labor) approaches infinity as capital
(labor) goes to zero.
∂Y ∂Y
lim = lim =∞
𝐾→0 ∂K 𝐿→0 ∂L

(ii) The marginal product of capital (labor) approaches zero as capital (labor)
goes to infinity.
∂Y ∂Y
lim = lim =0
𝐾→∞ ∂K 𝐿→∞ ∂L

iv. The Cobb Douglas production function has elasticity of substitution equal
to unity.

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

𝑑 𝐾/𝐿 𝑀𝑅𝑇𝑆
𝜎= 𝑥
𝑑 𝑀𝑅𝑇𝑆 𝐾/𝐿
where 𝑀𝑅𝑇𝑆 = 𝑀𝑃𝐿 /𝑀𝑃𝐾

𝑀𝑃 𝐴(1−𝛼)𝐾𝛼 𝐿−𝛼 (1−𝛼) 𝐾

𝑀𝑅𝑇𝑆 = 𝑀𝑃 𝐿 = =
𝐾 𝐴𝛼𝐾𝛼−1 𝐿1−𝛼 𝛼 𝐿

𝐾 𝛼
» 𝐿 = 1−𝛼 ∗ 𝑀𝑅𝑇𝑆,
𝑑(𝐾/𝐿) 𝛼
=
𝑑𝑀𝑅𝑇𝑆 1 − 𝛼
𝑑 𝐾/𝐿 𝑀𝑅𝑇𝑆
𝜎= 𝑥 =1
𝑑 𝑀𝑅𝑇𝑆 𝐾/𝐿

v. Constant Income Shares of Output: The exponent of capital (labor),α (1- α),
represents the contribution of capital (labor) to output. This is the same as the
portion of output distributed to capital (labor) i.e. capital (labor) income share.

𝑌 = 𝑓(𝐾, 𝐿, 𝐴) = 𝐴𝐾 𝛼 𝐿1−𝛼

The real wage of labour (w) is calculated by partially differentiating Y w.r.t. L, which is
nothing but marginal product of labor (𝑀𝑃𝐿 ).

∂Y 𝛼 −𝛼
𝐾 𝛼 𝑌
𝑤 = 𝑀𝑃𝐿 = = 𝐴(1 − 𝛼)𝐾 𝐿 = 𝐴(1 − 𝛼) ( ) = (1 − 𝛼) ( )
∂L 𝐿 𝐿
Total wage bill=𝑤. 𝐿 = 𝑀𝑃𝐿 . 𝐿 = 𝐴(1 − 𝛼)𝐾 𝛼 𝐿1−𝛼

𝑇𝑜𝑡𝑎𝑙 𝑊𝑎𝑔𝑒 𝐵𝑖𝑙𝑙

The labor share in real National Product is 𝑅𝑒𝑎𝑙 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡

𝑇𝑜𝑡𝑎𝑙 𝑊𝑎𝑔𝑒 𝐵𝑖𝑙𝑙 𝑤𝐿 𝐴(1−𝛼)𝐾𝛼 𝐿1−𝛼

=𝑅𝑒𝑎𝑙 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 = = =1−𝛼
𝑌 𝐴𝐾𝛼 𝐿1−𝛼

In the same way, the capital income share remains constant at 𝛼.

4. CES Production Function

Another most popular neo classical production function is constant elasticity of
substitution (CES) production function. The CES production function was developed by
Arrow, Chenery, Minhas and Solow as a generalisation of the Cobb Douglas production
function that allows for non-negative and constant elasticity of substitution.

Functional Form: The standard CES production function can be written as:

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

Y = A [δ𝐾 −𝜌 + (1 − δ) 𝐿−𝜌 ]−1/𝜌

where Y is output, K and L are capital and labor inputs, and A,δ,ρ are the parameters.
 A, technology determines the productivity and A𝜖[0, ∞).
 δ determines the optimal distribution of inputs and δϵ[0,1].
1
 Ρ determines the elasticity of substitution (σ) where ρϵ[-1,0)U(0,∞) and 𝜎 = 1+𝜌

Special Cases under CES Production Function

(i) For ρ→0, σ approaches 1» Cobb Douglas Production Function.
(ii) For ρ→+∞, σ approaches 0» Leontief Production Function.
(iii) For ρ→-1, σ approaches ∞» Perfect Substitutes.

The CES production function is linearly homogeneous and therefore exhibits constant
returns to scale. It is non linear in parameters, so cannot be estimated using least squares
method.

Properties of CES Production Function

i. Constant Returns to Scale: The Cobb Douglas production function exhibits

constant returns to scale.

Y = A [δ𝐾 −𝜌 + (1 − δ) 𝐿−𝜌 ]−1/𝜌

𝑓(𝜆𝐾, 𝜆𝐿, 𝐴)= A [δ(𝜆𝐾)−𝜌 + (1 − δ) (𝜆𝐿)−𝜌 ]−1/𝜌

= A λ[δ𝐾 −𝜌 + (1 − δ) 𝐿−𝜌 ]−1/𝜌

=λY.

ii. Positive and Diminishing Returns to Inputs: The marginal products of the
input are

∂Y 𝛿
𝑀𝑃𝐾 = = 𝜌 (𝑌/𝐾)𝜌+1
∂K 𝐴
∂Y 1 − 𝛿
𝑀𝑃𝐿 = = (𝑌/𝐿)𝜌+1
∂L 𝐴𝜌

They both are positive for K,L>0. With any small increase in capital or labor increases
the output but at a diminishing rate.

iii. Inada Conditions

(i) The marginal product of capital (labor) approaches infinity as
capital (labor) goes to zero.
∂Y ∂Y
lim = lim =∞
𝐾→0 ∂K 𝐿→0 ∂L

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

(ii) The marginal product of capital (labor) approaches zero as capital

(labor) goes to infinity.
∂Y ∂Y
lim = lim =0
𝐾→∞ ∂K 𝐿→∞ ∂L

𝟏
iv. The Elasticity of Substitution is 𝝈 = 𝟏+𝝆.
The elasticity of substitution is calculated using formula:

𝑑 𝐾/𝐿 𝑀𝑅𝑇𝑆
𝜎= 𝑥
𝑑 𝑀𝑅𝑇𝑆 𝐾/𝐿
where 𝑀𝑅𝑇𝑆 = 𝑀𝑃𝐿 /𝑀𝑃𝐾

𝑀𝑃𝐿 1 − 𝛿
𝑀𝑅𝑇𝑆 = = (𝐾/𝐿)𝜌+1
𝑀𝑃𝐾 𝛿

𝑑 𝑀𝑅𝑇𝑆 1 − 𝛿
= (𝐾/𝐿)𝜌 (1 + 𝜌)
𝑑 𝐾/𝐿 𝛿
𝑑 𝐾/𝐿 𝑀𝑅𝑇𝑆 1
𝜎= 𝑥 =
𝑑 𝑀𝑅𝑇𝑆 𝐾/𝐿 1+𝜌

5. VES Production Function

In the last section we have read about CES production function. Once we relax the
assumption of constant elasticity of substitution we arrive at variable elasticity of
substitution (VES). The VES production function can be expressed as:
𝑌 = 𝛾𝐾 𝛼(1−𝛿𝜌) [𝐿 + (𝜌 − 1)𝐾]𝛼𝛿𝜌
Where
Y: Output
K: Capital
L: Labor
α,ρ,δ andγ: Parameters
 𝛾 > 0, α > 0
 0< δ <1
 0≤ ρδ ≤1
𝐿 1−𝜌
 > 1−ρδ
𝐾

Here, α is the parameter of returns of scale. If the value of α is 1, the production function
exhibits constant returns to scale.

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

Elasticity of Substitution: The elasticity of substitution σ for the for the VES production
function is
𝜌−1 𝐾
σ = σ(K, L) = 1 +
1 − 𝛿𝜌 𝐿
 The elasticity of substitution σ varies with the capital labor ratio around the
intercept term of unity.
 The elasticity of substitution is greater than zero over the relevant range of K/L.
𝐿 1−𝜌
 For σ>0 requires that 𝐾 > 1−𝛿𝜌 .

Properties of VES Production Function

i. Positive and Diminishing Returns to Inputs: The VES production function

is increasing in labor and capital i.e. positive marginal products.

∂Y ∂Y
(iii) > 0 𝑎𝑛𝑑 >0
∂K ∂L

𝑌 = 𝛾𝐾 𝛼(1−𝛿𝜌) [𝐿 + (𝜌 − 1)𝐾]𝛼𝛿𝜌
∂Y 𝑌 𝐿 1−𝜌
𝑀𝑃𝐿 = = 𝛼𝛿𝜌 > 0 𝑓𝑜𝑟 0 ≤ 𝛿𝜌 ≤ 1 𝑎𝑛𝑑 >
∂L 𝐿 + (𝜌 − 1)𝐾 𝐾 1 − 𝛿𝜌
∂Y 𝑌 𝑌
𝑀𝑃𝐾 = = 𝛼(1 − 𝛿𝜌) + 𝛼𝛿𝜌(𝜌 − 1) >0
∂K 𝐾 𝐿 + (𝜌 − 1)𝐾
Here any small increase in capital will lead to a decrease in the marginal product of
capital. Any small increase in capital cause output to rise but at a
diminishing rate. The same is true for labor.

ii. VES Production Function reduced to Cobb Douglas and Linear

production Function
 For 𝜌 = 0 » Harrod Domar Fixed Coefficient Model
 For 𝜌 = 1 » Cobb Douglas Production Function
 For 𝜌 = 1/𝛿(> 1) »Linear Production Function

iii. The Elasticity of Substitution can vary along an Isoquant: The VES
requires that the elasticity of substitution be the same only along a ray through
the origin.

6. Translog Production Function

The translog production function can be expressed as:
𝑌 = 𝑓(𝑥1 , 𝑥2 … . , 𝑥𝑛 )

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

𝑛 𝑛
1/2[∑𝑛
𝑗=1 𝛽𝑖𝑗 ln 𝑥𝑗 ]
= 𝛼0 ∏ 𝑥𝑖𝛼𝑖 ∏ 𝑥𝑖
𝑖=1 𝑖=1
Where
Y: Output
𝛼0 : Efficiency Parameter
𝛼𝑖 𝑎𝑛𝑑 𝛽𝑖𝑗 : 𝑃𝑎𝑟𝑎𝑚𝑒𝑡𝑒𝑟𝑠 (𝑈𝑛𝑘𝑛𝑜𝑤𝑛)
𝑥𝑗∶ 𝐼𝑛𝑝𝑢𝑡 𝑗
Logarithm Form: Taking log both sides, we obtain
𝑛 𝑛 𝑛

ln 𝑌 = 𝑙𝑛𝛼0 + ∑ 𝛼𝑖 ln xi + 1/2 ∑ ∑ 𝛽𝑖𝑗 ln xi 𝑙𝑛𝑥𝑗

𝑖=1 𝑖=1 𝑗=1
The translog production function is a generalisation of the Cobb Douglas production
function. For 𝛽𝑖𝑗 = 0, the log form of translog function reduces to a Cobb Douglas
production function. It is linear in parameters, so can be estimated using least squares
method.

Monotonicity and Translog Production Function: The marginal product i.e addition to
total product due to addition of one more factor is
∂Y ∂lnY 𝑌
𝑀𝑃𝑖 = = .
∂xi ∂lnxi 𝑥𝑖
∂lnY
Where ∂lnx is the production elasticity which can be calculated from log form.
i
𝑛
∂lnY
= 𝛼𝑖 + ∑ 𝛽𝑖𝑗 ln xj (i = 1,2, … . , n)
∂lnxi
𝑗=1
𝑛
Y
So, 𝑀𝑃𝑖 = [𝛼𝑖 + ∑ 𝛽𝑖𝑗 ln xj ]
𝑗=1 xi

 MP of xi can be positive for a range in values of xj but can be negative if 𝛽𝑖𝑗 > 0
(all i,j) and xj → 0.
 If there exist at least one 𝛽𝑖𝑗 < 0 then 𝑀𝑃𝑖 < 0 𝑎𝑠 xj → ∞.
Thus, the translog function is not monotonic.

Is Isoquants under Translog Function Convex: The isoquants are strictly quasi-convex
if the Bordered Hessian matrix is negative definite. In order to construct Bordered
Hessian matrix we need to derive second direct and cross partial derivatives using chain
rule.

𝑛 𝑛
2Y 𝑌
𝑓𝑖𝑖 = ∂ 2 = 2 [𝛽𝑖𝑖 + (𝛼𝑖 + ∑ 𝛽𝑖𝑗 ln xj − 1) (𝛼𝑖 + ∑ 𝛽𝑖𝑗 ln xj )
∂K 𝑥𝑖
𝑗=1 𝑗=1

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
____________________________________________________________________________________________________

2Y 𝑌
𝑓𝑖𝑗 = ∂ = [𝛽𝑖𝑗
∂xi ∂xj 𝑥𝑖 𝑥𝑗
𝑛

+ (𝛼𝑖 + ∑ 𝛽𝑖𝑗 ln xj ) (𝛼𝑗

𝑗=1
𝑛

+ ∑ 𝛽𝑖𝑗 ln xi )
𝑖=1
The Bordered Hessian matrix is
0 𝑓1 ⋯ 𝑓𝑛
[𝑓1 𝑓11 ⋱ ⋮ ]
𝑓𝑛 ⋯ 𝑓𝑛𝑛
Here the values of the first and second partial derivatives vary with input levels, there
is no guarantee that the isoquants are globally convex.

7. Summary

Nature imposes technological constraints on firms; only certain combination of inputs

are feasible ways to produce a given amount of output, and the firm must limit itself
to technologically feasible production plans. The easiest way to describe feasible
production plans is to list them. The set of all combinations of inputs and outputs that
comprise a technologically feasible way is called a production function. The relation
between inputs and output of a firm is known as production function. Production
function is a purely technical relation which connects factor inputs and output. The
two popular neoclassical production functions that are widely used in economics are
Cobb Douglas production function and CES production function. The Cobb Douglas
production function lies between linear and fixed proportion production function with
elasticity of substitution equal to one. Cobb Douglas production function is very
popular among economist because of its flexibility and ease of use. CES production
function is a generalization of the Cobb Douglas production function that allows for
non-negative and constant elasticity of substitution. The VES production function
requires that the elasticity of substitution be the same only along a ray through the
origin. The translog production function is also a generalization of the Cobb Douglas
production function. The log form of translog function reduces to the Cobb Douglas
production function.

ECONOMICS Paper 3: Fundamentals of Microeconomic Theory

Module 15: Special Production Functions- Cobb-Douglas, CES, VES,
Translog and their properties
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8. CHOICI OP OPTIMAL IXPANIION PATH

Wedilliquioh two cu.: apomioe of output wit11 oil l'lcton variable(the Jona nm~
ud apomioe o( output with - laclor(1) CODllallt (the lhort NII~

o.i-...-. ..... - .... _

In the Jona nm oll lacloro o( produc:tion an variable. There lo no limitation (tecbnical
o, llnancial) to theapomioe of output. The ftrm'1objoctivc u, thecboioooltheoptimll
wayorapu,diq iuoutpu~ 10 u IO muimioo ill pro6II. With si-laclO< pricol(w,r)
ud Ii- produc:tion llmction, the optimal apomioe poth u, determined by the poiDII
of taaflDCY of....,._.. UIOCOII line, ud , ~.. iooquanll.
Ir the produc:tioo llmction ii boaloee->uo the apomioe poth will be • ltfaisht line
wou,h the orip. wbooo olopo (whidl determi- the optimal K/L ratio) depend, 011
the ratio of tbe laclO< prioa In ftawe 3.39 the optimal apan,ioo poth wiU be 0A,

9)

FipnJ.39 Fi,un 3.40

ddlnool by the locuo of poinll of 11DfODCY or the iooquanll with ..-ivc poralld
ilocolt lina witll a olopo or w/r. Ir the ratio of the price, ;......., the ilocolt line,
. - Batter (r« eumpie, with • o1opo or.,,/r'I, ud the optimal aponaion poth will
be the otraipt line oa. or couroe, if the ratio or price, or r1Cton - iaitiolly .,,, ud
oubooqumtly ~ IO w'/r', the apomion poth cbanca: initiolly the flnn ...,_
aJoas OA, but after the chanp in the ractor price, it...,_ a1on1 OB.
Ir the produc:tion llmction ii ~ the optimal expomioe poth will DOI
be• llraiabt line, nm ii the ratio of price, or lacloro remain, comtant. 'l1lil ii lhown in
111,ft 3.-40. It ii due IO the lace that in equilibrium wc mllll equate the (CODllallt) w/r
ratio witll the AIIIS._., which ii the - 011 a ouned -iine ( - - 1 1 ) .

o.i-...-. ..... 1111--

.. the lhort run, capital ii [Link] ud the ftrm ii COffled to apu,d WIii a 1traipt
line poralld to the uio on which wc - ~ the variable l'lctor L. With the pricol o(
- - tlle ftrm - DOI - ill pn,1111 ID tho lhort ...... due to tlle
-..int of the si- capital. 'l1lil lituation ii lhown in fllun 3.41. The optimal
apomion poth would be 0A - it eoo,,ible to i - K. Oi- the capital equip-
- ~ the ftrm can expand only aJoas 11'.JI: in tho lhort nm.
Theabowdilcuaionolthecboioooloptimaloombinationortbelacloroolproduc:tioo
io-■ticaJly ~ OD p.94.

Fi,un l.41
EQUILIBRIUM OF A MULTIPRODUCT FIRM

Introduction

Equilibrium in a multiproduct firm refers to the optimal allocation of resources between the
production of different goods such that the firm’s revenue is maximized. This involves
determining the best combination of labour and capital to allocate to each product, ensuring that
the marginal rate of transformation between the products equals the ratio of their prices. By
analyzing production possibility curves and isorevenue curves, the firm can identify the most
efficient production levels that align with market prices and available resources.
A multi-product firm is a firm that produces more than one product.

For simplicity, we will consider a firm that makes two products, x and y. Given the inputs L and
K the firm employs, the choice of allocation of inputs becomes essential. The firm should choose
the quantity of labour and capital to be allocated to each output.

The firm produces the two products in such a way that the Marginal Rate of Transformation
between the products is equal to the ratio of their prices.

Tools used : Production possibility curve of the firm (production possibility curve is just another
way to express an isoquant) and Iso revenue curves.

Production Possibility Curve of the Firm

Each product is assumed to be produced by two factors, L and K. With the given inputs, the firm
produces both goods in different proportions. If the quantity of good x is increased, then the
quantity of y should be reduced. The rate at which one good must be sacrificed to produce one
extra unit of the other good is called the Marginal Rate of Transformation.

For each product, we have a production function:

x = f¹(L, K)
y = f²(L, K)

These production functions are represented with the help of isoquants derived from the
Edgeworth box.

Deriving PPC from Edgeworth Box

OxL- total quantity of factor L (measured along the X axis of the Edgeworth box).

OxK- total quantity of factor K (measured along the y axis of the Edgeworth box).

Points on the Edgeworth box represent: combinations of quantities of x and y produced by the
available factors of production.
A¹, A², A³, A⁴…….A⁸- Isoquants of x (convex to the origin Ox)
B¹, B², B³, B⁴…….B⁸- Isoquants of y (convex to the origin Oy).

Tangency of isoquants: Contract curve

Only points lying on the contract curve are efficient, in the sense that any other point shows the
uses all resources for producing a combination of outputs which includes less quantity of at least
one commodity.
Production at points away from the contract curve

For example, assume that initially, the firm produces at point Z, at which the quantity of x is A³
and the quantity of y is B⁶. The production of level A³ of x absorbs OxL¹ of labor and OxK¹ of
capital. The remaining resources, L¹L and K¹K, are used in the production of commodity y.

Production at points on the contract curve

 More of either x or y or both commodities can be produced by reallocating resources (any
point between V and W on the contract curve).

Point W: Same level of y (B⁶), but a higher level of x (A⁴).

Point V: Same quantity of x (A³), but more of y (B⁷).

Point C: It will attain higher levels of production of both x and y (isoquants near to B⁷ and A⁴).

Thus, points on the contract curve are efficient because any other point off this curve implies a
smaller level of output of at least one product.
The choice of the actual point on the contract curve depends on the ratio of the prices of the two
commodities.

Production-possibility curve is derived from the contract curve. Each point of tangency between
isoquants, that is, any one point of the contract curve, defines a combination of x and y levels of
output which lies on the production-possibility curve. For example, point V, representing the
output pair A³ from x and B⁷ from y, is point V’ in the below figure. Similarly, point W of the
contract curve is point W’ on the production-possibility curve. The optimal combination of the
output pair is the one which yields the highest revenue, given the production-possibility curve,
that is, given the total quantities of factors which define this curve.

The Isorevenue Curve of the Multiproduct Firm

An isorevenue curve is the locus of points of various combinations of quantities of y and x

whose sale yields the same revenue to the firm. The slope of the isorevenue curve is equal to the
ratio of the prices of the commodities. The further away from the origin an isorevenue curve is,
the larger the revenue of the firm will be.
Equilibrium of the Multiproduct Firm

The firm wants to maximize its profit given:

(i) the constraint set by the factors of production,

(ii) the transformation curve, and
(iii) the prices of the commodities (Px , Py) and of the factors of production (w , r).
Condition for equilibrium: Slope of PPC = Slope of iso revenue curve

Assuming that the quantity of the factors and their prices are given, then maximization of π is
achieved by maximizing the revenue, R. Graphically, the equilibrium of the firm is defined by
the point of tangency of the given product-transformation curve and the highest isorevenue
curve. At the point of tangency, the slopes of the isorevenue and the product-transformation
curves are equal.
Conclusion
In conclusion, achieving equilibrium in a multiproduct firm requires careful resource allocation
to balance the production of multiple goods. By ensuring that the marginal rate of transformation
between products equals the ratio of their prices, the firm can maximize its revenue. The use of
production possibility curves and isorevenue curves is essential in identifying the most efficient
production combinations, ultimately leading to optimal profitability given the available resources
and market conditions.
MODERN THEORY OF COST
ENGINEERING COST – MULTI PRODUCT FIRMS AND
DYNAMIC CHANGES IN COSTS (Learning Curve)

MODERN THEORY OF COSTS

* The modern theory of costs suggests the existence of “Built-in Reserve Capacity”
which imparts flexibility and enables the plant to produce larger output without
adding to the costs.

* Firms build industrial plants with some flexibility in their productive capacity so that
instead of a single output level, there is a whole range of output that can be produced
optimally at low cost unlike the traditional theory of cost.

* Thus, the ‘Built-in Reserve capacity’ provides ‘maximum flexibility in the

production process and this planned reserve capacity explaines the ‘saucer- shaped’
short run average variable costs.

ENGINEERING COST CURVE

* Engineering costs are derived from engineering production functions. Each productive
method is divided into sub-activities corresponding to the various physical – technical
phases of production for the particular commodity.

For each phase the quantities of factors of production are estimated and finally the cost of
each phase is calculated on the basis of the prevailing factor [Link] total cost of the
particular method of production is the sum of the costs of its different phases.

Such calculations are done for all available plant sizes. Production isoquants are
subsequently estimated, and from them, given the factor prices, the short-run and the
long-run cost functions may be derived.

It should be noted that engineering production functions and the cost functions derived
from them refer usually to the production costs and do not include the administrative
costs for the operation of any given plant.

* Engineering production functions are characterized by a limited number of methods

of production. The production isoquants are kinked, reflecting the fact that factor
substitutability is not continuous, but limited. Substitution of factors occurs directly at
the kinks of the isoquants, where one production technique is substituted for another.
(figure 4.25).On the straight segments of the production isoquant a combination of the
adjacent methods of production is employed. What happens in engineering production
functions along the segments of the isoquants is an indirect substitution of factors via
substitution of processes.
* Factors cannot be substituted for each other except by changing the levels at which
entire technical processes are used, because each process uses factors in fixed
characteristic ratios.

* Engineering production functions are the basis of linear programming. In this

approach process substitution plays a role analogous to that of factor substitution in
conventional analysis.
* Assume that there are two methods of production, P 1 and P 2 , using labour and
capital at a fixed ratio, denoted by the slopes of the rays representing the two
processes (figure 4.26). Assume that the factor prices are wand r, so that P 1 is chosen
initially and output X 1 is produced, with ab of capital unemployed. The firm will be
better off by using a combination of the two methods. Thus at point e (where K
intersects the higher isoquant X 2) all K is employed. P 1 and P 2 are used at the
levels OA and OB respectively, these levels being determined by drawing parallel
lines to P 1 and P 2 through e. A substitution of factors has become indirectly
possible (the K/ L is defined by the slope of Oe), although K is given and the
available technology does not allow substitution of K and L except by change of
technique. What happens at e is a substitution of processes: instead of using P 1 or P 2
alone to produce X 2 , we achieve the same result (X 2) by using a combination of P 1
and P 2 . Actually, given K and given the price ratio w/r, the output X 2 is technically
impossible to produce by using only P1, while X 2 is not economically profitable to
produce by using only P2 (given w/r), although with this process the level X 2 is
technically possible, since K. does not limit effectively the production of X 2, when P
2 is employed. We tum now to the shape of total- and unit-cost curves when there are
only a few processes available. The assumptions are that the prices of factors are
given and the technology gives rise to kinked isoquants.
[Link]-RUN ENGINEERING COSTS

It is assumed that there is a fixed factor of production which requires a minimum outlay, and
that there is some reserve capacity in the plant. The total-cost curve under these assumptions
will be as in figure 4.27.

For the range OX 1 the TC is formed from linear segments, with the slope of each segment
constant, but increasing for successive segments. The ends of linear segments correspond to
outputs at which one process is replaced by another.

(a) Along each linear segment the slope is the MC. Along the first segment (AB) the MC =
AVC. For each successive section (that is, for sections BC and CD) the MC > AVC. The
marginal cost increases step-
wise while the AVC increases
smoothly, at a decreasing rate.

(b) The AC falls continuously

over the range ABCD. We said
that the AC is the slope of the
rays from the origin to any
point on the TC curve. The
slope of such rays declines as
we move from A to B to C to
D (figure4.27).
 Over the range of reserve capacity the slope of total cost is constant.
Furthermore this segment of TC lies on a line through the origin, reflecting the
fact that only the TVC varies in proportion to output, while the fixed outlay
has already been paid at the installation of the plant. The reserve capacity built
into the plant allows the firm to operate by increasing only its variable costs
proportionally with output. Thus over the reserve capacity segment the A VC,
the MC and the ATC are equal and remain constant (between X 1 and X 2 in
figure 4.28).
* Once all reserve capacity is exhausted, output can be increased by
overworking of the plant and paying overtime labour. The total-cost curve
consists of linear segments, with each segment having a steeper slope than the
previous one. Along each linear segment marginal cost is constant, but the
level of marginal cost increases step-wise. The AVC increases continuously,
but is lower than the MC. The average total cost increases continuously and
lies below the MC but above the AVC. The short-run engineering-cost curves
are shown in figure 4.28.
B. LONG-RUN ENGINEERING COSTS

We said that the engineering costs include generally only the technical cost of production.
Thus diseconomies of large scale, which are associated with administration costs, are not
encountered here. There is a minimum optimal size of plant for each production process. The
TC, AC and MC are shown in figures 4.29 and 4.30.
 If we assume that there is a very large number of processes, the total and unit cost curves
become continuous (smooth) but retain broadly the above shapes, provided that there is a
minimum fixed outlay and some reserve capacity in the short run (figures 4.31 and 4.32). In
the long run the LAC will not turn upwards if we are considering only production costs; but if
we add the administrative costs and if there are strong managerial diseconomies, the LAC will
rise at very large scales of output (figures 4.33 and 4.34).

THE PRODUCTION FUNCTION OF A MULTIPRODUCT FIRM

We simplify the exposition by assuming that the firm produces two products, X and Y. The analysis
can easily be extended to any number of products.
 A. THE PRODUCTION-POSSIBILITY CURVE OF THE FIRM
Each product is assumed to be produced by two factors, Land K. For each product we
have a production function.

Each production function may be presented by a set of isoquants with the usual
properties. We may now obtain the production-possibility curve of the firm by using
the device of the Edge worth box. We assume that the firm has total quantities of
factors OL and OK (figure 3.45) measured along the sides of the Edge worth box.
Any point of the Edge worth box shows a certain combination of quantities of x and y
produced by the available factors of production. The production function for
commodity x is represented by the set of isoquants denoted by A which are convex to
the origin Ox. The production function for commodity y is represented by the set of
isoquants denoted by B which are convex to the origin 07 . The further down an
isoquant B lies, the higher the quantity of y it represents. The two sets of isoquants
have points of tangency, which form the contract curve. Only points lying on the
contract curve are efficient, in the sense that any other point shows the use of all
resources for producing a combination of outputs which includes less quantity of at
least one commodity. For example, assume that initially the firm produces at point Z,
at which the quantity of x is A3 and the quantity of y is B6. The production of the
level A3 of x absorbs OxL1 of labour and OxK 1 of capital. The remaining resources,
L 1 Land K 1 K, are used in the production of commodity y.

It can be shown that the firm can produce more of either x or y or of both
commodities by reallocating its resources so as to move to any point between V and
Won the contract curve.

If the firm moves to W it will be producing the same level of y (B6), but a higher level of x
(A4). If the firm chooses to produce at V, it will produce the same quantity of x (A3), but
more of y (B7). Finally, if the firm produces at any intermediate point between V and W, for
example at point C, it will attain higher levels of production of both x and y. Thus points on
the contract curve are efficient in that any other point off this curve implies a smaller level of
output of at least one product.

The choice of the actual point on the contract curve depends on the ratio of the prices of the
two commodities (see below).

To determine the choice of levels of x and y we need to derive the production-possibility

curve (or product-transformation curve) of the firm. This shows the locus of points of levels
of x and y which use up all the available resources of the firm. The production possibility
curve is derived from the contract curve. Each point of tangency between isoquants, that is,
any one point of the contract curve, defines a combination of x and y levels of output which
lies on the production-possibility curve. For example, point V, representing the output pair
A3 from x and B7 from y, is point V' on figure 3.46. Similarly point W of the contract curve
is point W' on the production-possibility curve.
Formal derivation of the production-possibility curve

The slope of isoquant A is

B. THE ISOREVENUE CURVE OF THE MULTIPRODUCT FIRM

An iso-revenue curve is the locus of points of various combinations of quantities of y and

x whose sale yields the same revenue to the firm (figure 3.47). The slope of the iso-
revenue curve is equal to the ratio of the prices of the commodities:
DYNAMIC CHANGES IN COSTS – THE LEARNING CURVE.
Why a large firm may have a lower long-run average cost than a small firm: increasing
returns to scale in production. It is tempting to conclude that firms that enjoy lower average
cost over time are growing firms with increasing returns to scale. But this need not be true. In
some firms, long-run average cost may decline over time because workers and managers
absorb new technological information as they become more experienced at their jobs.

As management and labour gain experience with production, the firm’s marginal and average
costs of producing a given level of output fall for four reasons:

1) Workers often take longer to accomplish a given task the first few times they do it. As
they become more adept, their speed increases.
2) Managers learn to schedule the production process more effectively, from the flow of
materials to the organization of the manufacturing itself.
3) Engineers who are initially cautious in their product designs may gain enough
experience to be able to allow for tolerances in design that save costs without
increasing defects. Better and more specialized tools and plant organization may also
lower cost.
4) Suppliers may learn how to process required materials more effectively and pass on
some of this advantage in the form of lower costs.

As a consequence, a firm “learns” over time as cumulative output increases. Managers can
use this learning process to help plan production and forecast future costs. Figure 7.12
illustrates this process in the form of a learning curve— a curve that describes the
relationship between a firm’s cumulative output and the amount of inputs needed to produce
each unit of output.
GRAPHING THE LEARNING CURVE:
Figure 7.13 shows a learning curve for the production of machine tools. The horizontal axis
measures the cumulative number of lots of machine tools (groups of approximately 40) that
the firm has produced.

The vertical axis shows the number of hours of labour needed to produce each lot. Labour
input per unit of output directly affects the production cost because the fewer the hours of
labour needed, the lower the marginal and average cost of production.

The learning curve in Figure 7.13 is based on the relationship

Where N is the cumulative units of output produced and L the labour input per unit of output.
A, B, and b are constants, with A and B positive, and b between 0 and 1. When N is equal to
1, L is equal to A + B, so that A + B measures the labour input required to produce the first
unit of output. When b equals 0, labour input per unit of output remains the same as the
cumulative level of output increases; there is no learning. When b is positive and N gets
larger and larger, L becomes arbitrarily close to A. A, therefore, represents the minimum
labour input per unit of output after all learning has taken place. The larger b is, the more
important the learning effect. With b equal to 0.5, for example, the labour input per unit of
output falls proportionately to the square root of the cumulative output. This degree of
learning can substantially reduce production costs as a firm becomes more experienced.

In this machine tool example, the value of b is 0.31. For this particular learning curve, every
doubling in cumulative output causes the input requirement (less the minimum attainable
input requirement) to fall by about 20 percent. As Figure 7.13 shows, the learning curve
drops sharply as the cumulative number of lots increases to about 20. Beyond an output of 20
lots, the cost savings are relatively small.