Theory of Production

Production is a process of combining various inputs to

produce an output for consumption. It is the act of
creating output in the form of a commodity or a service
which contributes to the utility of individuals.
In other words, it is a process in which the inputs are
converted into outputs.
 Factors of Production
The 4 Factors of
Production
• There are four factors
of production—land,
labor, capital, and
entrepreneurship.
 Production Function
The Production function signifies a technical relationship between the
physical inputs and physical outputs of the firm, for a given state of the
technology.
Q = f (a, b, c, . . . . . . z)
Where a,b,c ....z are various inputs such as land, labor ,capital etc. Q is
the level of the output for a firm.
If labor (L) and capital (K) are only the input factors, the production
function reduces to −
Q = f (L, K)
Production Function describes the technological relationship between
inputs and outputs. It is a tool that analysis the qualitative input output
relationship and also represents the technology of a firm or the
economy as a whole.
 The Production Function
• Total product is the total output produced.
• Average product equals total output divided by the total
quantity of inputs.
• We can calculate the marginal product of a factor as the
extra output added for each additional unit of input while
holding all other inputs constant.

• Inputs those change or are variable in the short run or

long run are variable inputs.
• Inputs that remain constant in the short term are fixed
inputs.
 The Law of Diminishing Returns
Assumptions
The law of diminishing marginal returns has the following
assumptions:
1.The time period is short run.
2. Labor is a variable factor of production.
3.Land and capital are constant production factors.
4.All units of variable factor production (all workers) are equally
skilled and motivated.
The Law of Diminishing Returns
Under the law of diminishing returns, a firm will get
less and less extra output when it adds additional units
of an input while holding other inputs fixed.

In other words, the marginal product of each unit

of input will decline as the amount of that input
increases, holding all other inputs constant.

Increase in rate of returns < Inputs increase

The Law of Diminishing Returns
The law of diminishing returns expresses a very
basic relationship. As more of an input such as labor is
added to a fixed amount of land, machinery, and
other inputs, the labor has less and less of the other
factors to work with.
The land gets more crowded, the machinery is
overworked, and the marginal product of labor declines.
 The Law of Diminishing Returns
Assuming a constant level of other production factors, every
additional unit of a production factor leads to a greater increase in
total output (marginal output) initially. After reaching a certain
optimal production level, every additional unit of the production
factor will result in a smaller increase in total output with a
diminishing marginal output, as the efficiency is limited by the other
production factors.
Assuming the production factor considered in the diagram above is
labor, the labor force increases from L1 to L2 by the same units as
from L2 to L3. Yet, the increase in total output units from Y1 to Y2 is
much higher than the increase from Y2 to Y3. Without increasing
other production factors, the marginal return will eventually decrease
to zero, which means the total output cannot be increased anymore by
merely putting extra laborers into the production line.
 The Law of Diminishing Returns
Increasing Returns
The graph of marginal product (MP) is initially upward sloping up
to the third unit of labor, which shows increasing marginal product
with an increase in the units of labor. This is called increasing
returns.
Reasons of Increasing Returns
Initially, when a variable factor of production (labor) is added to
the fixed factors of production (land and capital), the marginal
product (MP) starts increasing because of the division of labor and
better utilization of the fixed factors of production.
Diminishing Returns
The graph of marginal product (MP) eventually becomes
downward sloping after the third unit of labor, which shows
decreasing marginal product with an increase in the units of labor.
This is called diminishing returns.
Reasons of Diminishing Returns
Eventually, when more of a variable factor of production (labor) or
more employees are added to the fixed factors of production (land
and capital), the marginal product (MP) starts decreasing. This
decrease is because of applying too much variable input as
compared to fixed inputs and because of less utilization of fixed
factors of production by each worker.
Relationship between Marginal Product (MP) and Total
Product (TP)
1.When the marginal product is positive, the total product
increases.
2.When the marginal product is zero, the total product is the
maximum. This happens at the sixth unit of labor.
3.When the marginal product is negative (negative productivity),
the total product or total output decreases.
4.When the marginal product is positive and increasing, the total
product increases at an increasing rate.
5.When the marginal product is positive and decreasing, the total
product increases at a decreasing rate.
Relationship between Marginal Product (MP) and Average
Product (AP)
1.When the marginal product is greater than the average product,
the average product increases.
2.When the marginal product is equal to the average product, the
average product is the maximum.
3.When the marginal product is less than the average product, the
average product decreases.
 Law of return to Scale

The law of returns operates in the short period. It explains the

production behavior of the firm with one-factor variable while
other factors are kept constant.
Whereas the law of returns to scale operates in the long period.
It explains the production behavior of the firm with all variable
factors.
The law of returns to scale analysis the effects of scale on the
level of output. Here we find out in what proportions the output
changes when there is a proportionate change in the quantities of
all inputs. The answer to this question helps a firm to determine
its scale or size in the long run. It has been observed that when
there is a proportionate change in the amounts of inputs, the
behavior of output varies.
Three ways in which output can be increased.

1. Output may increase more than proportionately to an increase in

inputs (economies of scale)

2. Output may increase proportionately to an increase in inputs

(Constant returns to scale)
3. Output may increase less than proportionately to an increase in
inputs (diseconomies of scale)

Correspondingly, there are three types of returns to scale.

1. Increasing Returns to Scale:1. Output may increase more than
proportionately to an increase in inputs (economies of scale)
Rate of increase in outputs > Rate of increase in input
Example:

Inputs (Units) Output Percentage Increase Percentage Increase

(K = Capital, L = (Units) in Inputs in Outputs
Labor)

2K + 4L 200 - -

4K + 8L 450 100% 160%

6K + 12L 600 100% 120%

1) When Output increases
more than proportionately to
an increase in inputs, then it
is known as increasing
returns to scale. For example,
if labor and capital both
increase by 50% and
correspondingly the output
increases by more than 50%,
then it is known as the
increasing returns to scale.
• Technical and managerial indivisibility: Since it is difficult to
divide any machine or technique in fractions, therefore there is
always a minimum amount of employment, machine and technique
which are required for the production and which are indivisible in
nature. When these inputs are increased, then they increase the
production exponentially and hence increasing returns to scale take
place.
● Higher degree of specialization: When the labor is specialized
for a particular production technique/ process, then its
productivity increases, leading to an increase in the output per
labor. This leads to increasing returns to scale.

● Dimensional relations: For example, when the size of a room

(15’ × 10’ = 150 sq. ft.) is doubled to 30’ × 20’, the area of the
room is more than doubled, i.e., 30’ × 20’ = 600 sq. ft. When the
diameter of a pipe is doubled, the flow of water is more than
doubled. Following this dimensional relationship, when the labor
and capital are doubled, the output is more than doubled over
some level of output.
2. Output may increase proportionately to an increase in inputs
(Constant returns to scale)
Percentage Increase in Inputs = Percentage Increase
in Outputs
Inputs (Units) Output Percentage Percentage
(K = Capital, L = (Units) Increase Increase
Labor) in Inputs in Outputs

6K + 12L 600 - -

8K + 16L 1000 100% 100%

10K + 20L 2300 100% 100%

2. When Output increases
proportionately to an
increase in inputs, then it is
known as constant returns to
scale. For example, if labor
and capital both increase by
50% and correspondingly,
the output also increases by
50%, then it is known as
constant returns to scale.
The constant returns to scale happen because there is a limit on
economies of scale. When economies of scale disappear, and
diseconomies are yet to begin, the returns to scale become
constant. The diseconomies arise mainly because of decreasing
efficiency of management and scarcity of certain inputs. Moreover,
constant returns of scale appear when the factors of production are
perfectly homogeneous, like the Cobb- Douglas production
function.
3.Output may increase less than proportionately to an increase in
inputs (diseconomies of scale)
Percentage Increase in Inputs < Percentage Increase
in Outputs
Inputs (Units) Output Percentage Percentage
(K = Capital, L = (Units) Increase Increase
Labor) in Inputs in Outputs
10K + 20L 2300 - -
12K + 24L 4600 100 80
14K + 28L 6000 100 70
3). When Output increases less than
proportionately to an increase in inputs, then it
is known as decreasing returns to scale. For
example, if labor and capital both increase by
50% and correspondingly the output increases
by 30%, then it is known as decreasing returns
to scale.
As has been shown in the above diagram, 10
units of output (depicted by IQ1) are produced
using one unit of labor and capital, but when
the labor and capital were doubled, i.e. to 2
units each, then the output (depicted by IQ2)
did not double, i.e. it increases to 18 units
instead of 20 units and so on.
Decreasing returns to scale happens because of diseconomies of scale. Mainly,
when there are managerial diseconomies and the size of the firm expands,
managerial efficiency decreases, causing a decrease in the rate of increase in
output.

Moreover, when the natural resources exhaust nature, then also decreasing returns
of scale appear. For instance, if the coal mines are doubled, then it may be possible
that the coal production would not be doubled; rather, it just increases by less than
double because of the limitedness of the coal deposits or difficult accessibility to
coal deposits.
 Economies of scale
Economies of scale: factors which cause average cost to decline
in the long run as output increases.

The effect of economies of scale is to shift the whole cost structure

downwards and to the right on a graph showing costs and output.
A long run average cost curve (LRAC) can be drawn as the
'envelope' of all the short run average cost curves (SRAC) of firms
producing on different scales of output.
Each SRAC shows a different scale of production and, once
diminishing returns start to occur, the firm varies its factors of
production – thereby shifting the SRAC to a new position. The
LRAC is tangential to each of the SRAC curves. Figure 3 shows the
shape of such a long run average cost curve if there are increasing
returns to scale – economies of scale – up to a certain output
volume and then constant returns to scale thereafter.
Diseconomies of scale
It may be that the flat part of the LRAC curve is
never reached, or it may be that diseconomies of scale
are
encountered. Diseconomies of scale might arise when
a firm gets so large that it cannot operate
efficiently or it is too large to manage efficiently,
such that average costs begin to rise.
Reasons for economies of
scale
The economies of scale attainable from large scale
production fall into two categories.
• (a) Internal economies: economies arising within
the firm from the organisation of production
• (b) External economies: economies attainable by
the firm because of the growth of the industry as a
whole
(a) Internal economies of
scale
• 1. Technical economies
Technical economies arise in the production process. They
are also called plant economies of scale because they
depend on the size of the factory or piece of equipment.
Large undertakings can make use of larger and more
specialised machinery. If smaller undertakings tried to use
similar machinery, the costs would be excessive because the
machines would become obsolete before their physical life
ends (that is their economic life would be shorter than their
physical life). Obsolescence is caused by falling demand for
the product made on the machine, or by the development of
newer and better machines.
• 2. Commercial or marketing economies
Buying economies may be available, reducing the cost of material
purchases through bulk purchase discounts. Similarly, inventory holding
becomes more efficient. The most economic quantities of inventory to
hold increase with the scale of operations, but at a lower proportionate
rate of increase. Also, bulk selling will enable a large firm to make
relative savings in distribution costs, and advertising costs.
• 3. Organisational economies
When the firm is large, centralisation of functions such as
dministration, R&D and marketing may reduce the burden of overheads
(ie the indirect costs of production) on individual operating locations. The
need for management and supervisory staff does not increase at the same
rate as output.
• 4. Financial economies
Large firms may find it easier to borrow money than smaller firms and
they may also obtain loan finance at more attractive rates of interest, due
to their reputation and asset base. Quoted public limited companies can
also raise finance by selling shares to the public via a stock exchange.
(b) External economies of
scale
Whereas internal economies of scale accrue to an individual
firm, it is also possible for general advantages to be enjoyed
by all of the firms in an industry. These are known as external
economies of scale.
External economies of scale occur as an industry grows in size.
Here are two examples.
(a) A large skilled labour force is created and educational
services can be geared towards training new entrants.
(b) Specialised ancillary industries will develop to provide
components, transport finished goods, trade in by-products,
provide special services and so on. For instance, law firms may
be set up to specialise in the affairs of the industry.
SHORT RUN AND LONG
RUN
• Because decisions take time to implement, and because
capital and other factors are often very long-lived, the
reaction of production may change over different time
periods.
• The short run is a period in which variable
factors, such as labor or material inputs, can be easily
changed but fixed factors cannot.
• In the long run, the capital stock (a firm’s machinery
and factories) can depreciate and be replaced. In the
long run, all inputs, fixed and variable, can be adjusted.
 Iso-quant and Iso-cost Analysis

“An isoquant is a curve showing all possible combinations of inputs

physically capable of producing a given level of output.”

Ferguson
 A technical relation that shows how inputs are converted into output is
depicted by an isoquant curve.
 An isoquant curve is a curve that shows various combinations of two
factors of production that a firm can use in order to get the same total
output.
 The term ISO implies equal and quant means quantity or output.

 For example, for producing 100 calendars, 90 units of capital and 10

units of labor are used.
 Isoquant curves are also called as equal product curves or production
Assumptions
The following assumptions are made while drawing the isoquant
curves.
 The time period is long run.
 Technology remains constant.
 A firm uses two factors of production, i.e., labor and capital.
 Both factors of production are variable.
 Capital and labor are able to substitute each other up to a certain
limit.
 The shape of the Iso-quant depends on the level of substitutability
between the factors of production.
 All units of each factor of production are of equal quality.
 The law of diminishing marginal returns is applicable for each
factor of production.
 Iso-quant Schedule

Combination Labor (unit) Capital (Unit) Output

(Number)
A 1 10 100

B 2 9 100

C 3 8 100

D 4 7 100
Iso-quant Curve
Iso-quant MapAn iso-quant map shows the different iso-qua
curves representing the different combinations of factors of productio
yielding the different levels of output. Thus, higher the iso-quant curv
the higher is the level of output.
 Properties of Iso-Quant Curve
1. An isoquant lying above and to the right of another isoquant represents a higher level of output.
2. Two isoquants cannot cut each other.
3. Isoquants are convex to the origin.
4. No isoquant can touch either axis.
5. Isoquants are negatively sloped.
 Iso-cost line
An iso-cost line/function represents all possible
combinations of two inputs (e.g., labor and capital) that
a firm can afford within a given budget. It functions
similarly to a budget constraint in consumer theory but
applies specifically to production costs.
The mathematical equation for the iso-cost line is:

C = wL + rK
C = Total cost
w = Wage rate (cost per unit of labor)
L = Quantity of labor employed
r = Rental rate of capital (cost per unit of capital)
K = Quantity of capital employed
An iso-cost line is also called outlay line or price line or factor cost
line.
The iso-cost line is an important component when analyzing
producer’s behavior.
The iso-cost line illustrates all the possible combinations of two
factors that can be used at given costs and for a given
producer’s budget.

Example
Suppose a producer has a total budget of Tk. 120 and for
producing a certain level of output, he has to spend this amount on
2 factors A and B. Price of factors A and B are Tk. 15 and Tk.10
respectively.
Combinations Units of Units of Labor Total expenditure
Capital
Price =Tk 150 Price = Tk.100 ( in Taka)
A 8 0 120
B 6 3 120
C 4 6 120
D 2 9 120
E 0 12 120
 Profit maximization

To maximize profits, a firm will wish to produce at the point of

the highest possible isoquant and minimum possible iso-cost

In this example, we have one iso-cost and three isoquants. With

the iso-cost of £400,000 the maximum output a firm can manage
would be a TPP of 4,000. If it produced at say 13 K and 48 Labor,
it would only be able to produce a TPP of 3,500.
A total TPP of 4,500 is currently not possible without increasing
costs beyond £400,000
 Importance of the Iso-cost Line
1. Efficient Resource Allocation
Businesses use the iso-cost line to determine the best mix of
inputs to minimize costs while maximizing output.
2. Strategic Decision-Making in Production
Companies apply iso-cost analysis to assess whether a labor-
intensive or capital-intensive approach is more beneficial.
3. Cost Control and Profit Maximization
By optimizing input costs, businesses can enhance
profitability and competitiveness in the market.
4. Intersection with Isoquants
The intersection of an iso-cost line and an isoquant (a curve
representing equal output levels) helps businesses determine
the optimal input combination for cost efficiency.