Production Theory

Production
▪ The process of transformation of resources (like land, labour, capital
and entrepreneurship) into goods and services of utility to consumers
and/or producers.
▪ The process of creation of value or wealth through the production of
goods and services that have economic value.

▪ Goods includes all tangible items such as furniture, house, machine,

food, car, television etc
▪ Services include all intangible items, like banking, education,
management, consultancy, transportation.
 Types of Inputs
Technology
▪ determines the type, quantity and proportion of inputs.
▪ Fixed and Variable Inputs
▪ Production analysis of a firm uses two distinct time frames:
▪ short run
▪ long run
▪ Variable input : that can be made to vary in the short run, e.g. raw
material, unskilled/semi skilled labour, etc.
▪ Fixed input: that cannot be varied in the short run, e.g. land,
machine, technology, skill set, etc.
 Factors of Production
5 factors of production
▪ Land(l)
▪ gift of nature
▪ Reward is called as rent
▪ Labour(L)
▪ Skilled as well as unskilled.
▪ Reward is called as wages
▪ Capital(K)
▪ Wealth which is used for further production as machine/ equipment/intermediary
good
▪ Reward is called as interest
▪ Enterprise(E)
▪ The ability and action to take risk of collecting, coordinating, and utilizing all the
factors of production for the purpose of uncertain economic gains
▪ Reward is called as profit
▪ Organization(O)
▪ Combination of highly skilled labour and specialized human capital/managerial
aspect of business.
▪ Reward is called as salary
 Production Function
▪ A technological relationship between physical inputs and physical
outputs over a given period of time.
▪ production function is:
▪ Always related to a given time period
▪ Always related to a certain level of technology
▪ Depends upon relation between inputs.
▪ Normally a production function is written as:
▪ Q = f (L,K,I,R,E)
▪ where Q is the maximum quantity of output of a good being
produced, and L=labour; K=capital; l=land; R=raw material; E=
efficiency parameter.
▪ Technical efficiency is defined as a situation when using more of one
input with either the same amount or more of the other input must
increase output.
Production Function with One Variable Input
▪ short term production function
▪ Shows the maximum output a firm can produce when only
one of its inputs can be varied, other inputs remaining
fixed:
▪ Q = f ( L, K )
▪ where Q = output, L = labour and K = fixed amount of
capital
▪ Total product is a function of labour: TPL = f ( K ,L)
TP
▪ Average Product (AP)= APL =
L
TP
▪ Marginal product of labour (MPL) = MPL =
L
Labour Total Product MP AP Stages
(’00 (’000 tonnes)
units)
1 20 - 20 Increasing
2 50 30 25 returns
3 90 40 30
4 120 30 30 Diminishing
5 140 20 28 returns
6 150 10 25
7 150 0 21.5
8 130 -20 16.3 Negative
9 100 -30 11.1 returns
 200

150
Total Product
(’000 tonnes)
100
Output

Marginal
Product
50
Average
Product
0
1 2 3 4 5 6 7 8 9
-50
Labour
 Law of Variable Proportions

Total C ▪ First stage

Output
▪ Increasing Returns to the
B TPL Variable Factor
▪ MP>0 and MP>AP
A ▪ Second stage
▪ Diminishing Returns to a
Variable Factor
O
Labour
▪ MP>0 and MP<AP
Total ▪ Third Stage
Output ▪ Negative Returns
Stage III
Stage I Stage II ▪ MP<0 while AP is falling
A*
B but positive
* ▪ Technically inefficient
stage of production
APL
C ▪ A rational firm will never
O * operate in this stage
MPL Labour
 Production Function with Two Variable Inputs

▪ All inputs are variable in long Capital Labour

run and only two inputs are (Rs. crore) (’00 units)
used 40 6
▪ Firm has the opportunity to 28 7
select that combination of 18 8
inputs which maximizes returns 12 9
▪ Curves showing such 8 10
production function are called 45
isoquants or iso-product curves. 40

Capital (Rs. Crore)

35
▪ An isoquant is the locus of all 30
25
technically efficient 20
combinations of two inputs 15
10
for producing a given level of 5

output 0
6 7 8 9 10

▪ Represented as: Q = f ( L, K ) Labour ('00 units)

 Characteristics of Isoquants

▪ Downward sloping
▪ Convex to the origin
▪ A higher isoquant represents a higher output
▪ Two isoquants can not intersect each other
Capital Capital

C A

B A Q1
B C
Q2
Q1
Q0 Q2
O
O Labour Labour
 Marginal Rate of Technical Substitution

▪ Measures the reduction in one input, due to unit increase

in the other input that is just sufficient to maintain the
same level of output.
K
MRTSLK =−
L
▪ MRTS of labour for capital is equal to the slope of the
isoquant.
▪ It is also equal to the ratio of the marginal product of one
input to the marginal product of other input
Q = MPL  L + MPK  K
0 = MPL  L + MPK  K
MP K
MRTSLK = L
=−
MPK L
Capital

Q1 Q2 Q3
O
Labour

Linear isoquants
Q = f ( L, K ) = αK + βL
• Perfect substitutability
between two factors
• Isoquants are downward
sloping straight lines
• Constant MRTS
 Elasticity of Substitution

▪ Measures the percentage change in factor proportions due

to a change in marginal rate of technical substitution
d ( K / L)
σ= d ( MRTS)
K/L

MRTS
▪ σ is effectively a measure of the curvature of an isoquant
▪ More curved or convex is the isoquant, the lower is σ
▪ In Leontief (zero substitution) technology, with L shaped
isoquants, there is no substitutability between the inputs
▪ σ=0
▪ In perfect substitution or linear production technology, the
MRTS does not change at all along the isoquant.
σ is infinite
 Isocost Lines

Total Cost is sum of Labour cost (wL) and Capital cost (rK) where
wage (w) and interest (r)
C = wL + rK
Capital •The isocost line represents
A2 the locus of points of all the
A
different combinations of two
inputs that a firm can procure,
A1
given the total cost and
prices of the inputs.
O B1 B B2 Labour
C
K w
The (absolute) slope of this line is Slope = − = r =
equal to the ratio of the input prices. L C r
w
 Producer’s Equilibrium
Capital ▪ AB is the isocost line
▪ Any point below AB is feasible but not
A
desirable
C ▪ E is the point of tangency of Q2 with
isocost line AB
E
K*
▪ Corresponds to the highest level of
Q output with given cost function.
Q2 3
D Q1 ▪ Firm would employ L* and K* units of
Q0
O labour and capital
L B Labour
* ▪ Q3 is beyond reach of the firm
▪ Points C and D are also on the same
Maximization of output subject to isocost line, but they are on isoquant
cost constraint Q1, which is lower to Q2. Hence show
lower output.
Necessary condition for equilibrium
Slope of isoquant = Slope of ▪ E is preferred to C and D, which is on
isocost line the highest feasible isoquant.
 Producer’s Equilibrium
Capital ▪ Firm has decided the level output to be
produced shown by the isoquant Q
A2
▪ Will be indifferent between output
R combinations shown by R, S, E on
A isquant Q.
A1 ▪ Has to ascertain that combination of
E inputs Labour and Capital which
K
minimizes the cost of production
S
▪ Hence a map of isocost lines will be
Q prepared
O
B1 B B2 Labour ▪ The isocost lines are parallel to each
L
other because price of the inputs is
given.
Minimization of cost for a given ▪ A1B1 line is not feasible
level of output ▪ It will use OK and OL of capital and
labour respectively, at point E which is
Necessary condition for equilibrium also on AB, the lowest possible isocost
Slope of isoquant = Slope of line.
isocost line ▪ R, S are not desirable because they are
on higher cost line A2 B2.
 Expansion Path
Capital
Expansion Path

E2
E1

O
Labour

▪ 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 Scale
▪ 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.
Panel a Panel b Panel c
Capital Capital Capital
C2
C
B2 C1
B 400Q B1
A 200Q A2 A1 125Q
100Q 150Q
50Q 90Q
50Q 50Q
O O O
Labour Labour Labour

▪ Constant Returns to Scale : When a proportional increase in all inputs

yields an equal proportional increase in output (Panel a)
▪ Increasing Returns to Scale : When a proportional increase in all inputs
yields a more than proportional increase in output (Panel b).
▪ Decreasing Returns to Scale : When a proportional increase in all
inputs yields a less than proportional increase in output (Panel c).
 Cobb-Douglas Production Function
▪ Proposed by Wicksell and tested against statistical evidence by
Charles W. Cobb and Paul H. Douglas in 1928
 
▪ Q = AK L where α, β are constants. A is the technological
parameter, α is the elasticity of output with respect to capital, and β is
the elasticity of output with respect to labour.
▪ Properties
▪ Homogeneous of degree (+)
▪ The returns to scale is immediately revealed by the sum of the two
parameters  and 
▪ Constant Returns to Scale: ( +) = 1
▪ Increasing Returns to Scale: ( +) > 1
▪ Decreasing Returns to Scale: ( +) < 1
▪ Isoquants are negatively sloped and convex to the origin
▪ MRTSLK is a function of input ratio
▪ Elasticity of substitution is equal to 1