CHAPTER FIVE

Theory of Production
 Theory of Production
• Production is a process that create/adds
value or utility
• It is the process in which the inputs are
converted in to outputs.
 Production Function
• Production function means the functional
relationship between inputs and outputs in the
process of production.

• It is a technical relation which connects factors

inputs used in the production function and the
level of outputs

Q = f (Land, Labour, Capital, Organization,

Technology, etc)
Factors of Production
 Inputs : Fixed inputs and
Variable inputs
The factors of production that is carry
out the production is called inputs.
Land, Labour, Capital, Organizer,
Technology, are the example of inputs

Inputs Factors

Variable inputs Fixed Inputs

 Inputs : Fixed inputs and Variable
inputs

Fixed inputs Variable inputs

 In the long run all

 Remain the same in the short
period . factors of production
are varies according
 At any level of out put, the to the volume of
amount is remain the same. outputs.
 The cost of these inputs are  The cost of variable
called Fixed Cost inputs is called
 Examples:- Building, Land etc Variable Cost
 Example:- Raw
 ( In the long run fixed inputs
are become varies)
materials, labour, etc
 Various concept of production

Total Product

Average Product- Ratio of Total Product and

one variable
inputs

Marginal Product – The rate of change of out

put as a

result changes in one variable input

 Short run Production Function with Labour as Variable factor

Labour Capital Total Average Marginal Product

(L) (K) Output Product (AP)
(TP) (MP)

0 10 0

1 10 10

2 10 30

3 10 60
Production with One Variable Input
4 10 80

5 10 95

6 10 108

7 10 112

8 10 112

9 10 108

10 10 100
 Short run Production Function with Labour as Variable factor

Labour Capital Total Average Marginal Product

(L) (K) Output Product
(TP) (MP)
(AP)
0 10 0 -
1 10 10 10 10

2 10 30 15 20

3 10 30
Production60 20Input
with One Variable
4 10 80 20 20

5 10 95 19 15

6 10 108 18 13

7 10 112 16 4

8 10 112 14 0

9 10 108 12 -4

10 10 100 10 -8
 D
112
Output per
month Total Product
C

60 B

Labor per month

3 4 8
30

E
20

Average product
10

3 4 Labor per month

8
Marginal product
 Law of Production
Function

1) Laws of Variable proportion- Law of

Diminishing Return ( Short run
production function with at least one
input is variable)
2) Laws of Return scales – Long run
production function with all inputs
factors are variable.
 1. Law of variable proportion:
Short run Production
Function

• Explain short run production function

• Production function with at least one variable
factor keeping the quantities of others inputs as
a Fixed.
• Show the input-out put relation when one inputs
is variable
“If one of the variable factor of production used more and
more unit, keeping other inputs fixed, the total
product(TP) will increase at an increase rate in the first
stage, and in the second stage TP continuously increase
but at diminishing rate and eventually TP decrease.”
 Short run Production Function with Labour as Variable factor

Labour Land Capital Total Average Marginal Product

(L) (K) Output Product
(TP) (MP)
(AP)
0 10 10 0 -
1 10 10 10 10 10
First Stage
2 10 10 30 15 20

3 10 10 30
Production60 20Input
with One Variable
4 10 10 80 20 20

5 10 10 95 19 15
Second Stage
6 10 10 108 18 13

7 10 10 112 16 4

8 10 10 112 14 0

9 10 10 108 12 -4
Third Stage
10 10 10 100 10 -8
 D
112
Output per
month Total Product
C

60 B

Labor per month

3 4 8
30 Second Stage
Third Stage
E
20

First Stage Average product

10

8 Labor per month

3 4
Marginal product
 Stages in Law of variable
proportion
First Stage: Increasing return
 TP increase at increasing rate till the end of the stage.
 AP also increase and reaches at highest point at the end of the stage.
 MP also increase at it become equal to AP at the end of the stage.
 MP>AP

Second Stage: Diminishing return

 TP increase but at diminishing rate and it reach at
highest at the end of the stage.
 AP and MP are decreasing but both are positive.
 MP become zero when TP is at Maximum, at the end of
the stage
Third
MP<AP. Stage: Negative return
 TP decrease and TP Curve slopes downward
 As TP is decrease MP is negative. AP is decreasing but
positive.
Where should rational
firm produce?
 Where should rational firm produce?

• Stage I: MP is above AP implies an increase in input

increases output in greater proportion.

• The firm is not making the best possible use of the fixed
factor.

• So, the firm has an incentive to increase input until it

crosses over to stage II.

• Stage III: MP is negative implies contribution of

additional labor is negative so the total output decreases .
• In this case it will be unwise to employ an additional labor.
• Stage II: MP is below AP implies increase in input
increases output in lesser proportion.

• A rational producer/firm should produce in stage II.

• But where exactly the firm will operate within stage

II cannot be determined only on the basis of the
product curves.

• We need information about input costs and price of

output.
 2. Law of return to scales:
Long run Production
Function
• Explain long run production function when
the inputs are changed in the same
proportion.
• Production function with all factors of
productions are variable..
• Show the input-out put relation in the long
run with all inputs are variable.
“Return to scale refers to the relationship between
changes of outputs and proportionate changes in the in
all factors of production ”
 Law of return to scales: Long run
Production Function
Labou Capital TP MP
r
2 1 8 8
4 2 18 10 Increasing returns to scale

6 3 30 12
8 4 40 10
10 5 50 10 Constant returns to scale
12 6 60 10
14 7 68 8
16 8 74 6 Decreasing returns to scale

18 9 78 4
 1. Law of return to scales: Long run
Production Function

Inputs 10% increase – Outputs 15% increase Increasing returns to scale

Inputs 10% increase – Outputs 10% increase Constant returns to scale

Inputs 10% increase – Outputs 5% increase Decreasing returns to scale

 Homogeneous production function

In the long run all inputs are variable. The production

function is homogeneous if all inputs factors are
increased in the same proportions in order to change
the outputs.

A Production function Q = f (L, K )

An increase in Q> Q^ = f (L+L.10%, K+K.10% )-
Inputs increased same proportion

Increasing returns to scale Inputs increased 10% => output increased 15%

Constant returns to scale Inputs increased 10% => output increased 10%

Decreasing returns to scale Inputs increased 10% => output increased 8%

 Homogeneous production function

In the long run all inputs are variable. The production

function is homogeneous if all inputs factors are
increased in the same proportions in order to change
the outputs.

A Production function Q = f (L, K )

An increase in Q> Q^ = f (L+L.10%, K+K.10% )-
Inputs increased same proportion

Increasing returns to scale Inputs increased 10% => output increased 15%

Constant returns to scale Inputs increased 10% => output increased 10%

Decreasing returns to scale Inputs increased 10% => output increased 8%

 Linearly Homogeneous production
function
In the long run all inputs are variable. The
production function is Linearly homogeneous if all
inputs factors are increased in the same
proportions and the output is increased in the
same proportion.
Constant returns to scale Homogeneous production function

Inputs increased 10% => output increased 10%

A Linearly homogeneous Production function Q = f (L, K )

if labour and capital increased 10% then output increased the same
10%
 Linearly Homogeneous
production function
A Linearly homogeneous Production function Q = f (L, K )
if labour and capital increased 10% then output increased the
same 10%

400 unit output

%changes in factor
Capital 300 unit output

200 unit output

100 unit output

%changes in factor Labour

 Iosquants

Combinatio
Labour Capital Output level
n

A 20 1 100 unit
B 18 2 100 unit
C 12 3 100 unit
D 9 4 100 unit
E 6 5 100 unit
F 4 6 100 unit

An isoquants represent all those possible combination of two

inputs (labour and capital), which is capable to produce an equal
level of output .
 Iosquants

Isoquants or equal product curve

Capital

100 unit output

Labour

An isoquants represent all those possible

combination of two inputs (Labour and Capital),
which is capable to produce an equal level of output.
 Marginal Rate Technical Substitute(MRTS)

Isoquants or equal product curve

Capital

100 unit output

Labour

The slop of isoquant is known as Marginal Rate of Technical Substitution (MRTS). It is

the rate at which one factors of production is substitute with other factor so that the
level of the out put remain the same.
MRTS = Changes in Labour / changes in capital