Theory of Production

Production Function:
Production function states the functional relationship between inputs and output i.e., the maximum
amount of output that can be produced with given quantities of inputs under a given state of technical
knowledge. It can also be defined as the minimum quantities of various inputs that are required to yield a
given quantity of output. The output takes the form of volume of goods or services and the inputs are the
different factors of production i.e., land, labor, capital and enterprise.
The production function can be algebraically expressed in an equation in which the output is the
dependent variable and inputs are the independent variables. It can be expressed as:

Q = f (Labor, Capital, Land, technology, . . . )

To simplify the world, we will use two inputs Labor (L) and Capital (K), so,
Q = f (L, K, technology, ...)
Fixed Input and Variable Input:
Economists often talk about two types of inputs in the production process: fixed and variable.

A fixed input is an input whose quantity cannot be changed as output changes. To illustrate, suppose the
McMahon and McGee Bookshelf Company has rented a factory under a six-month lease: McMahon and
McGee, the owners of the company, have contracted to pay the $2,500 monthly rent for six months—no
matter what. Whether McMahon and McGee produce one bookshelf or 7,000, the $2,500 rent for the
factory must be paid. The factory is a fixed input in the production process of bookshelves.

A variable input is an input whose quantity can be changed as output changes. Examples of variable
inputs for the McMahon and McGee Bookshelf Company include wood, paint, nails, and so on. These
inputs can (and most likely will) change as the production of bookshelves changes. As they produce more
bookshelves, McMahon and McGee purchase more of these inputs; as they produce fewer bookshelves,
they purchase fewer of these inputs. Labor might also be a variable input for McMahon and McGee. As
they produce more bookshelves, they might hire more employees; as they produce fewer bookshelves,
they might lay off some.
Short Run and Long Run:
The production function of a firm can be studied in the context of short period or long period. Short
period or short run is that period of time which is too short for a firm to install a new capital equipment
to increase production. It implies that capital is a fixed factor in the short run and the production function
is studied by holding the quantities of capital fixed, while varying the amount of other factors (labor, raw
material etc.). The short-run production function will take the form
Q = f (L)
K and technology are fixed or held constant.

The long run is a period of time (or planning horizon) in which all the factors of production are variable.
It is a time period when the firm will be able to install new machines and capital equipments apart from
increasing the units of labor. The behavior of production when all factors are varied is the subject matter
of the law of returns to scale.

Relationship among Total Product, Marginal Product and Marginal Product:

In the short run, the relationship between the inputs and output can be describes from several perspectives.
The relationship can be described as the total product, the output per unit of input (the average product,
AP) or the change in output that is attributable to a change in the variable input (the marginal product,
MP).
Average Product (APL) is the output per unit of input. AP = Q/L (in this case the output per worker).
APL is the average product of labor.
Output Q
APL = =
Input L

Marginal Product (MPL) is the change in output ‘caused’ by a change in the variable input (L),
ΔQ
MPL =
ΔL
(a) Total and Marginal Product
Over the range of inputs there are four possible relationships between Q (or TP) and L.
1. Q or TP can increase at an increasing rate. MP will increase.
(In Figure 1 this range is from O to LA.)
2. Q or TP may pass through an inflection point, in which case MP will be a maximum.
(In Figure 1, this is point A at LA amount of input.)
3. Q might increase at a decreasing rate. This will cause MP to fall. This is referred to as ‘diminishing
marginal product’. (In Figure 1, this is shown in the range from LA to LB).
4. If "too many" units of the variable input are added to the fixed input, Q or TP can decrease, in which
case MP will be negative. Any addition of L beyond LB will reduce output; the MP of the input will be
negative. It would be foolish to continue adding an input (even if it were ‘free’) when the MP is negative.
The relationship between the total product (Q or TP) and the marginal product (MP) can be shown
through drawing tangent at different points on TP curve.

In Figure 2, note that from O to LA, the slope of the tangent is positive and slope increases as level of
input increases, which means MP is increasing and TP is increasing at a increasing rate. At the inflection
point (A) in the TP function, the slope of TP curve or MP is maximum.

Figure 1: Total Product Curve

From LA to LB, the slope of the tangent is positive, but slope decreases as level of input increases, which
means MP is decreasing and TP is increasing at a decreasing rate. At LB, slope of MP is zero, and if we
use further input, MP will be negative and TP will decrease. So at LB, TP is maximum.

(b) Average, Marginal and Total Product

The average product (AP) is related to both the TP and MP which can be shown through constructing rays
from origin to different points on the TP curve. As the rays rotate with the increase in input, if these rays
get steeper, then AP also increases whereas if these rays get flatter, then AP decreases. We see that the ray
OR (in Figure 2) started from the origin and touches as tangent on the TP curve at point H and this ray has
highest steepness at that point. So, this point will locate the level of input (LH) where the AP is a
maximum. Note that at LH level of input, APL is a maximum and is equal to the MPL. When the MP is
greater than the AP, then MP ‘pulls’ AP up. When MP is less than AP, then it ‘pulls’ AP down. So, MP
will always intersect the AP at the maximum of the AP.
 Figure 2: Marginal Product (MP) and Average Product (Ap)

(c) Production Decision:

The behavior of these total, average and marginal products can be used to explain the production decision
of a rational producer. Based on above analysis, whole production situation can be divided into three
stages (laws) which are explained below.
 Figure 2: Stages of Production

Stage 1: The Law of Increasing Returns: In this stage, total product increases at an increasing rate upto
a point (in figure upto point A), marginal product also rises and is maximum at the point corresponding to
A (which is A/) and average product goes on rising. From point A onwards during the stage one, the total
product goes on rising but at a diminishing rate. Marginal product falls but is positive. The stage 1 ends
where the AP curve reaches its highest point.

Thus in the first stage the AP curve rises throughout whereas the marginal product curve first rises
and then starts falling after reaching its maximum. It is to be noted that the marginal product although
starts declining, remains greater than the average product throughout the stage so that average product
continues to rise.
Explanation of the law: The law of increasing returns operates because; in the beginning the quantity of
fixed factors (like capital) is abundant relative to the quantity of the variable factor (like labor). As more
units of variable factor are added to the constant quantity of the fixed factors then the fixed factors are
more intensively and effectively utilized i.e., the efficiency of the fixed factors increases as additional
units of the variable factors are added to them. This causes the production to increase at a rapid rate.

For example, if a machine can be efficiently operated when four persons are working on it and if in the
beginning we are operating it only with three persons, production is bound to increase if the fourth person
is also put to work on the machine since the machine will be effectively utilized to its optimum. This
happens because, in the beginning some amount of fixed factor remained unutilized and, therefore, when
the variable factor is increased, fuller utilization of the fixed factor becomes possible and it results in
increasing returns.

A question arises as to why the fixed factor is not initially taken in a quantity which suits the available
quantity of the variable factor.

The answer is that, generally those factors are taken as fixed which are indivisible. Indivisibility of a
factor means that due to technological requirements, a minimum amount of that factor must be employed
whatever the level of output. Thus, as more units of the variable factor are employed to work with an
indivisible fixed factor, output greatly increases due to fuller utilization of the latter.

The second reason why we get increasing returns at the initial stage is that as more units of the variable
factors are employed, the efficiency of the variable factors itself increases. This is because with sufficient
quantity of the variable factor introduction of division of labor and specialization becomes possible which
results in higher productivity.

Stage 2: Law of diminishing returns: In stage 2, the total product continues to increase at a diminishing
rate until it reaches its maximum point B, where the second stage ends. In this stage, both marginal
product and average product of the variable factor are diminishing but are positive. At the end of this
stage i.e., at point LB (corresponding to the highest point B of the total product curve), the marginal
product of the variable factor is zero. Stage 2, is known as the stage of diminishing returns because
both the average and marginal products of the variable factors continuously fall during this stage.
This stage is very important because the firm will seek to produce in its range.
Explanation of the law: The question arises as to why do we get diminishing returns after a certain
amount of the variable factor has been added to the fixed quantity of that factor. As explained above,
increasing returns occur primarily because of the more efficient use of fixed factors as more units of
the variable factor are combined to work with it. Once the point is reached at which the amount of
variable factor is sufficient to ensure efficient utilization of the fixed factor, any further increases in the
variable factor will cause marginal and average product to decline because the fixed factor then
becomes inadequate relative to the quantity of the variable factor.

Continuing the above example, when four men were put to work on one machine, the optimum
combination was achieved. Now, if the fifth person is put on the machine, his contribution will be nil. In
other words, the marginal productivity will start diminishing.

The phenomenon of diminishing returns, like that of increasing returns, rests upon the indivisibility of the
fixed factor. Just as the average product of the variable factor increases in the first stage when better
utilization of the fixed indivisible factor is being made, so the average product of the variable factor
diminishes in the second stage when the fixed indivisible factor is being worked too hard. Another reason
offered for the operation of the law of diminishing returns is the imperfect substitutability of one factor
for another. Had the perfect substitute of the scarce fixed factor been available, then the paucity of the
scarce fixed factor during the second stage would have been made up by increasing the supply of its
perfect substitute with the result that output could be expanded without diminishing returns.

Stage 3: Law of negative returns: In Stage 3, total product declines, MP is negative, average product is
diminishing. This stage is called the stage of negative returns since the marginal product of the variable
factor is negative during this stage.

Explanation the law: As the amount of the variable factor continues to be increased to a constant
quantity of the other, a stage is reached when the total product declines and marginal product becomes
negative. This is due to the fact that the quantity of the variable factor becomes too excessive relative to
the fixed factor so that they get in each other’s ways with the result that the total output falls instead of
rising. In such a situation, a reduction in the units of the variable factor will increase the total output.

Stage of Operation: An important question is in which stage a rational producer will seek to produce. A
rational producer will never produce in stage 3 where marginal product of the variable factor is negative.
This being so a producer can always increase his output by reducing the amount of variable factor. Even
if the variable factor is free of cost, a rational producer stops before the beginning of the third stage.
A rational producer will also not produce in stage 1 as he will not be making the best use of the fixed
factors and he will not be utilizing fully the opportunities of increasing production by increasing, the
quantity of the variable factor whose average product continues to rise throughout stage 1. Even if the
fixed factor is free of cost in this stage, a rational entrepreneur will continue adding more variable factors.
It is thus clear that a rational producer will never produce in stage 1 and stage 3. These stages are called
stages of economic absurdity or economic non-sense.

A rational producer will always produce in stage 2 where both the marginal product and average product
of the variable factors are diminishing. At which particular point in this stage, the producer will decide to
produce depends upon the prices of factors.

Optimality Rule:
Profit maximizing amount of labor is known as the optimum employment of labor. It is determined
through the equality between wage rate (w) and the value of marginal product of labor (VMPL). If w <
VMPL, then the hiring labor would be profitable and the employer will do so. Such move will lower the
marginal product. The value of marginal product will decline. Once VMPL will become equal to the wage,
optimality will be attained.
Mathematically, Profit (π) = Total Revenue (TR) – Total Cost (TC)
=> π = (P x Q) – (Fixed Cost + Variable Cost)
= (P x Q) – (Fixed Cost + wL) [w=wage rate, L=Labor]
𝑑𝜋 𝑑𝑄
=> 𝑑𝐿 = P 𝑑𝐿 - w

= (P x MPPL) - w
= VMPL - w
𝑑𝜋
First order condition for profit maximization, = 0, this follows that
𝑑𝐿

VMPL = w
Which is the optimality rule of factor employment in short run.

Isoquant:
Isoquant shows different combinations of capital (K) and labor (L) that generate equal amount of output.
Thus, there is no change in output along an isoquant, i.e., dQ=0. It follows –
(ΔK x MPPk) + (ΔL x MPPL) = 0
=> ΔK x MPPk = - ΔL x MPPL
=> ΔK/ΔL= - MPPL/MPPK
 Figure 3: Isoquant
The negative slope of isoquant follows from the fact that an increase in one factor should be accompanied
by a decrease in another factor so that total output remains unchanged. This slope is also known as
marginal rate of technical substitution (MRTS).

Isocost Line:
Isocost embodies different combinations of capital and labor that involve equal cost. Suppose two factors
of production capital (K) and labor (L) are hired, whose prices are PK and PL respectively. So the equation
for isocost would be –
C= K PK + L PL

Figure 4: Isocost Line

At each point of isocost line total cost is same, thus dC=0;
K PK = C - L PL
=> K = C - L PL / PK
=> ΔK/ΔL = - PL/PK

Optimal Factor Combination:

Producer optimality is defined as the situation where a given amount of output can be produced at a
minimum cost. The combination of capital and labor that can produce output at a minimum cost is called
least cost factor combination.

Figure 5: Optimal Factor Combination

Figure 5 describes how Q0 output could be produced at a minimum cost. Three isocost lines C 1, C2 and C3
are presented assuming PK and PL as the prices of capital and labor respectively. Among the isocost lines
C1, cost is lowest but the producer cannot produce desired output Q 0 by spending this amount. Producer
should stay at point D or E or F if it desires to produce Q0 output. A rational producer would produce at E
because this point represents lowest cost than D or F since E is on lower isocost line. Distinguishing
feature of point E is tangent to isoquant, i.e., slope of isoquant and slope of isocost line are equal, which is
termed as the necessary condition or first order condition of producer equilibrium.

Producer’s equilibrium:
 Slope of isoquant = Slope of isocost line
=> - MPPL/MPPK = - PL/PK [=ΔK/ΔL]
=> MPPL/MPPK = PL/PK

So, the optimal combination of capital and labor is (K*, L*)