Managerial Economics

Production Function: Production function is a tool of analysis used to explain the input-
output relationship. A production function describes the technological relationship between
inputs and outputs in physical terms.

Assumption: A production function is based on the following assumption:

 Perfect divisibility of both inputs and outputs

 There are only two factors of production labour and capital
 Limited substitution of one factor to other
 A given technology and
 Inelastic supply of fixed factors in the short-run.

Production function as an equation: There are several ways of specifying the production
function. In a general mathematical form, a production function can be expressed as:
Q = f(X1, X2, X3,…… Xn) Where,

Q = quantity of output

X1, X2, X3,…… Xn = quantities of factor inputs

(such as capital, labour, land or raw materials)

This production function may be short -run or long-run. The short-run production function or
what may also term as single variable production function can be expressed as

X= f(L1,L2,L3,L4……..) Where,

X=Product

L1,L2,L3= factor of Production

In short-run only one factor is variable and other factors are fixed.

The Long-run production function can be expressed as:

X= f(L1,L2,L3,L4……..)

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Where,

X=Product

L1,L2,L3= factor of Production

In long-run all factors are variable.

Graphical Representation of Production Function:

Quadratic Production Function

A typical production function is shown in the following diagram under the assumption of a
single variable input. All points above the production function are unobtainable with current
technology, all points below are technically feasible, and all points on the function show the

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maximum quantity of output obtainable at the specified level of usage of the input. From the
origin, through points A, B, and C, the production function is rising, indicating that as additional
units of inputs are used, the quantity of outputs also increases. Beyond point C, the employment
of additional units of inputs produces no additional outputs (in fact, total output starts to decline);
the variable input is being used too intensively. With too much variable input use relative to the
available fixed inputs, the company is experiencing negative returns to variable inputs, and
diminishing total returns. In the diagram this is illustrated by the negative marginal physical
product curve (MPP) beyond point Z, and the declining production function beyond point C.

From the origin to point A, the firm is experiencing increasing returns to variable inputs. As
additional inputs are employed, output increases at an increasing rate. Both marginal physical
product (MPP, the derivative of the production function) and average physical product (APP, the
ratio of output to the variable input) are rising. The inflection point A defines the points beyond
which there are diminishing marginal returns, as can be seen from the declining MPP curve
beyond point X. From point A to point C, the firm is experiencing positive but decreasing
marginal returns to the variable input. As additional units of the input are employed, output
increases but at a decreasing rate. Point B is the point beyond which there are diminishing
average returns, as shown by the declining slope of the average physical product curve (APP)
beyond point Y. Point B is just tangent to the steepest ray from the origin hence the average
physical product is at a maximum. Beyond point B, mathematical necessity requires that the
marginal curve must be below the average curve.

SHORT-RUN PRODUCTION ANALYSIS:

An analysis of the production decision made by a firm in the short run, with the ultimate goal of
explaining the law of supply and the upward-sloping supply curve. The central feature of this
short-run production analysis is the law of diminishing marginal returns, which results in the
short run when larger amounts of a variable input, like labor, are added to a fixed input, like
capital. The analysis of short-run production sets the stage to better understand the supply-side of
the market. How producers respond to price depends, in part, on their ability to combine inputs
to produce output. This ability is guided by the law of diminishing marginal returns, which states
that the productivity of a variable input declines as more is added to a fixed input.

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If productivity declines, then more of the variable input is needed as the quantity produced
increases. This results in an increase in production cost, which means producers need to receive a
higher price. The connection between higher price and more production is essence of the law of
supply.

The analysis of short-run production assumes that at least one input in the production process is
fixed and at least one is variable. As already noted, the fixed and variable inputs are intertwined
with the notion of short run and long run.

 Fixed Input: A fixed input is an input used in production and under the control of the
producer that does not change during the time period of analysis (the short run).
 Variable Input: A variable input is an input used in production and under the control of
the producer that does change during the time period of analysis (the short run).

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Hypothetical Short -run Production Function:

Unites of Inputs Total product(TP) Marginal Product Average product (AP)

(000 kgs) (MP) (000 kgs)
(000 kgs)
1 10 10 10
2 24 14 12
3 39 15 13
4 56 17 14
5 65 9 13
6 72 7 12
7 77 5 11
8 80 3 10
9 72 -8 8

Above table is a numerical illustration of the short-run production function, Column 2 shows the
total product, resulting from combining each level of a variable input in column 1 with a fixed
amount of output.

Column 3 shows the marginal product (MP), the change in total product associated with each
additional unit of labour. The first 4 units of reflect increasing marginal returns, with marginal
products of 10, 12,13and 14 units, respectively. But beginning with the fifth unit, marginal
product diminishes continuously, becoming negative with the nine units.

Average product, per unit, is shown in column 4. It is calculated by dividing total product
(column 2) by the number of labor units needed to produce it (column 1).At 5 units of labor, for
example , AP is 13 (=65/5).

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Diagrammatic Representation of short-run Production Function:

Short-run production exhibits three distinct stages reflected by the shapes and slopes of the three
product curves--total product, marginal product, and average product.

The curve labeled TP is the total Product curve. Marginal product is the change in total product
associated with each new unit of labor. Average product is simply output per labor unit. Note
that marginal product intersects average product at the maximum average product.

 Stage I: The first stage is increasing marginal returns and is characterized by the
increasingly steeper positive slope of the total product curve, the positive slope of the

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marginal product curve, and the positive slope of the average product curve. Moreover,
the marginal product curve reaches a peak at the end of Stage I.

 Stage II: The second stage is decreasing marginal returns and is reflected in the positive
but flattening slope of the total product curve and the negative slope of the marginal
product curve. Moreover, the average product reaches a peak and is equal to marginal
product in this stage. The marginal product curve intersects the horizontal quantity axis at
the end of Stage II.

 Stage III: The third and last stage is negative marginal returns illustrated by the negative
value of marginal product and the negative slope of the total product curve. Average
product is positive, but the average product curve has a negative slope.

The Law of Returns to a variable input: the Law of Diminishing Returns

The inevitability of decreasing marginal returns is captured by the most important economic
principle in short-run production analysis--the law of diminishing marginal returns.

The Law of diminishing returns states that when more and more units of a variable input are
applied to a given quantity of fixed inputs, the total output may initially increase at a constant
rate but it will eventually increase at diminishing rates.

Assumptions: The law of diminishing returns is based on the following assumption:

 The state of technology is given.

 Labour is homogeneous.
 Input prices are given.

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LONG-RUN PRODUCTION ANALYSIS: The analysis of long-run production

indicates how a business pursues the production of output given that all inputs under its control
are variable. In particular, a firm is able to alter not only the quantity of labor and materials, but
also the amount of capital. In the long run, a firm is not constrained by a given factory, building,
or plant size.

Long-run production analysis provides the foundation for understanding long-run cost. In
particular, increasing and decreasing returns to scale are behind two important long-run cost
concepts--economies of scale and diseconomies of scale.

 Economies of Scale: These occur if a firm experiences a decrease in the long-run average
cost due to proportional increases in all inputs. Economies of scale result, in part, from
increasing returns to scale. If production increases more than inputs increase, then the
average cost of production declines.

 Diseconomies of Scale: These occur if a firm experiences an increase in the long-run

average cost due to proportional increases in all inputs. Diseconomies of scale result, in
part, from decreasing returns to scale. If production increases less than inputs increase,
then the average cost of production increases.

The Laws of Returns to scale:

The laws of returns to scale explain the behavior of output in response to a proportional and
simultaneous change in inputs. Increasing inputs proportionately and simultaneously is, in fact,
an expansion of scale of production.

When a firm expands its scale, i.e., it increases both the inputs proportionately then there are
three technical possibilities:

1. total output may increase more than proportionately;

2. total output may increase proportionately ; and

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3. total output may increase less than proportionately;

Accordingly, there are three kinds of returns to scale:

 Increasing returns to scale: Increasing returns to scale arise when an increase in all
inputs leads to a more than proportionate increase in the level of output.
 Constant returns to scale: Constant returns to scale denotes a case where a change in all
inputs leads to a proportionate change in output.
 Diminishing returns to scale: Decreasing returns to scale occur where a balanced
increased in all input leads to a less than proportionate increase in total output.

Long-run production function is graphically represented by a curve of equal total output - an isoquant.

Isoquants

An isoquant represents those combinations of inputs, which will be capable of producing an

equal quantity of output; the producer would be indifferent between them. The isoquants are thus
contour lines, which trace the loci of equal outputs. As the production remains the same on any
point of this line, it is also called equal product curve. Let, Q0 = f(L,K) is a production factor.
Where, Q0 = A fixed level of production.

L = Labour K = Capital

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Fig: Isoquant Curve

Here we see that vertical axis represents the labour(L) and horizontal axis represents the capital
(K).Q is the isoquant Curve.

Cost of production:
When we planned to produce any commodity we have to incurred some cost of production. This
cost may be classified in the following manner:

Total cost: Total cost represents the lowest total $ (money) expenses needed to produce a given
level of output. Total cost consists of 2 costs:
 Fixed cost: Fixed cost represents the total $ (money) expense that is paid out even when
no output is produced that is FC dependent output of 1. FC is unaffected by any variation
in the quantity of output. Concept of FC is only for short- run.FC is independent of
output.

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 Variable cost: Variable cost represents expenses that vary with the level of output, such
as raw materials, wages and fuel includes all cost that is not fixed. Concept of VC is only
for long-run. IN long run all cost are VC. VC is varies with the variation of production.

Always by definition,

TC = FC + VC

Marginal Cost: Marginal Cost denotes the extra or additional cost of producing 1 (one) extra
unit of output .Or Mc is the addition to TC incurred by producing one extra unit of output or
additional unit Output.
Average cost: Average cost is the per unit cost of production or we can say average cost is the
total cost divided by the total number of unit produc

Graphical Representation

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C TC VC

O Q

Q0

Fig: TC, VC, & FC Lines

Vertical axis represents the total cost of production (C) and horizontal axis represents the
unit of output (Q).FC is the fixed cost line. TC is the total cost line and VC is variable cost line.

So, at last we can say that Production refers to the economic process of converting of inputs into
outputs. Production uses resources to create a good or service that is suitable for exchange. This can
include manufacturing, storing, shipping, and packaging

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