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CHAPTER 3
THEORY OF PRODUCTION
AND COST
UNIT -1: THEORY OF PRODUCTION
LEARNING OUTCOMES
After studying this unit, you would be able to:

 Define Production and Describe Production Function.
 Describe the Characteristics of various Factors of Production.
 Distinguish between Short run and Long run Production Functions.
 Illustrate the Law of Diminishing Returns and Returns to Scale.
 Describe Production Optimisation using Isoquants and Iso-cost
curves.
© The Institute of Chartered Accountants of India

3.2 BUSINESS ECONOMICS
CHAPTER OVERVIEW
1.0 MEANING OF PRODUCTION

Production is a very important economic activity. As we are aware, the survival of any firm in
a competitive market depends upon its ability to produce goods and services at a
competitive cost. One of the principal concerns of business managers is the achi evement of
optimum efficiency in production by minimising the cost of production. The performance of
an economy is judged by the level of its production. The amount of goods and services an
economy is able to produce determines the richness or poverty of that economy. In fact, the
standard of living of people depends on the volume and variety of goods and services
produced in a country. Thus, the U.S.A. is a rich country just because its level of production
is high.

THEORY OF PRODUCTION AND COST 3.3
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In common parlance, the term ‘production’ is used to indicate an activity of making

something material. The growing of wheat, rice or any other agricultural crop by farmers and
manufacturing of cement, radio-sets, wool, machinery or any other industrial product is
often referred to as production. What exactly do we mean by production in Economics? In
Economics the word ‘production’ is used in a wider sense to denote the process by which
man utilises resources such as men, material, capital, time etc, working upon them to
transform them into commodities and services so as to make them satisfy human wants. In
other words, production is any economic activity which converts inputs into outputs which
are capable of satisfying human wants. Whether it is making of material goods or providing
a service, it is included in production provided it satisfies the wants of some people.
Therefore, in Economics, activities such as making of cloth by an industrial worker, the
services of the retailer who delivers it to consumers, the work of doctors, lawyers, teacher s,
actors, dancers, etc. are production.
According to James Bates and J.R. Parkinson “Production is the organized activity of
transforming resources into finished products in the form of goods and services; and
the objective of production is to satisfy the demand of such transformed resources”.
It should be noted that production should not be taken to mean as creation of matter
because, according to the fundamental law of science, man cannot create matter. What a
man can do is only to create or add utility to things that already exist in nature. Production
can also be defined as creation or addition of utility. For example, when a carpenter
produces a table, he does not create the matter of which the wood is composed of; he only
transforms wood into a table. By doing so, he adds utility to wood which did not have utility
before.
Production consists of various processes to add utility to natural resources for gaining
greater satisfaction from them by:
(i) Changing the form of natural resources. Most manufacturing processes consist of use
of physical inputs such as raw materials and transforming them into physical
products possessing utility, e.g., changing the form of a log of wood into a table or
changing the form of iron into a machine. This may be called conferring utility of
form.
(ii) Changing the place of the resources from a place where they are of little or no use to
another place where they are of greater use. This utility of place can be obtained by:
(a) Extraction from earth e.g., removal of coal, minerals, gold and other metal
ores from mines and supplying them to markets.
(b) Transferring goods from where they give little or no satisfaction, to places
where their utility is more, e.g., tin in Malaya is of little use until it is brought

to the industrialised centres where necessary machinery and technology are

available to produce metal boxes for packing. Another example is: apples in
Kashmir orchards have a little utility to farmers. But when the apples are
transported to markets where human settlements are thick and crowded like
the city centres, they afford more satisfaction to greater number of people.
These examples emphasise the additional utility conferred on goods, by all
forms of transportation systems, by transport workers and by the agents who
assist in the movement and marketing of goods.
(iii) Making available materials at times when they are not normally available e.g.,
harvested food grains are stored for use till next harvest. Canning of seasonal fruits is
undertaken to make them available during off-season. This may be called conferring
of utility of time.
(iv) Making use of personal skills in the form of services, e.g., those of organisers,
merchants, transport workers etc.
The fundamental purpose of all these activities is the same, namely to create utility in some
manner. Thus, production is nothing but creation of utilities in the form of goods and
services. For example, in the production of a woollen suit, utility is created in some form or
the other. Firstly wool is changed into woollen cloth at the spinning and weaving mill (utility
created by changing the form). Then, it is taken to a place where it is to be sold (utility
added by transporting it). Since woollen clothes are used only in winter, they will be retained
until such time when they are required by purchasers (time utility). In the whole process, the
services of various groups of people are utilised (as that of mill workers, shopkeepers,
agents etc.) to contribute to the enhancement of utility. Thus, the entire process of
production is nothing but creation of form utility, place utility, time utility and/or personal
utility.
It should be noted that the production process need not necessarily involve conversion of
physical inputs into physical output. For example, production of services such as those of
lawyers, doctors, musicians, consultants etc. involves intangible inputs to produce intangible
output. But, production does not include work done within a household by anyone out of
love and affection, voluntary services and goods produced for self-consumption. Intention
to exchange in the market is an essential component of production.
The money expenses incurred in the process of production, i.e., for transforming resources
into finished products constitute the cost of production. Although cost of production is not
taken into account for a pure production analysis, it is an extremely vital matter for any
business decision-making. Nevertheless, in the theory of production, we would confine
ourselves to laws of production, production function and methods of production
optimisation. However, it is necessary to remember that a production decision cannot

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depend merely on physical productivity based on operating efficiency alone. The

profitability of a productive activity would depend upon the revenue realised from the
output and the costs incurred in raising that output. Aspects of cost and revenue will be
discussed in the following units.
1.1 FACTORS OF PRODUCTION

Factors of production refer to inputs. An input is a good or service which a firm buys for use
in its production process. Production process requires a wide variety of inputs, depending
on the nature of output. The process of producing goods in a modern economy is very
complex. A good has to pass through many stages and many hands until it reaches the
consumers’ hands in a finished form. Land, labour, capital and entrepreneurial ability are the
four factors or resources which make it possible to produce goods and services. Even a small
piece of bread cannot be produced without the active participation of these factors of
production. While land is a free gift of nature and refers to natural resources, the human
endeavour is classified functionally and qualitatively into three main components namely,
labour, capital and entrepreneurial skills.
We may discuss these factors of production briefly in the following paragraphs.

1.1.0 Land
The term ‘land’ is used in a special sense in Economics. It does not mean soil or earth’s
surface alone, but refers to all free gifts of nature which would include besides land in
common parlance, natural resources, fertility of soil, water, air, light, heat natural vegetation
etc. It becomes difficult at times to state precisely as to what part of a given factor is due
solely to gift of nature and what part belongs to human effort made on it in the past.
Therefore, as a theoretical concept, we may list the following characteristics which would
qualify a given factor to be called land:
(i) Land is a free gift of nature: No human effort is required for making land available
for production. It has no supply price in the sense that no payment has been made to
mother nature for obtaining land
(ii) Supply of land is fixed: Land is strictly limited in quantity. It is different from other
factors of production in that, no change in demand can affect the amount of land in
existence. In other words, the total supply of land is perfectly inelastic from the point
of view of the economy. However, it is relatively elastic from the point of view of a
firm.
(iii) Land is permanent and has indestructible powers: Land is permanent in nature
and cannot be destroyed. According to Ricardo, land has certain original and
indestructible powers and these properties of land cannot be destroyed.
(iv) Land is a passive factor: Land is not an active factor. Unless human effort is
exercised on land, it does not produce anything on its own.
(v) Land is immobile: in the geographical sense. Land cannot be shifted physically from
one place to another. The natural factors typical to a given place cannot be shifted to
other places.
(vi) Land has multiple uses: and can be used for varied purposes, though its suitability
in all the uses is not the same.
(vii) Land is heterogeneous: No two pieces of land are alike. They differ in fertility and
situation.
1.1.1 Labour
The term ‘labour’, means any mental or physical exertion directed to produce goods or
services. All human efforts of body or of mind undergone partly or wholly with a view to
secure an income apart from the pleasure derived directly from the work is termed as
labour. In other words, it refers to various types of human efforts which require the use of
physical exertion, skill and intellect. It is, however, difficult to say that in any human effort all

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the three are not required; the proportion of each might vary. Labour, to have an economic
significance, must be one which is done with the motive of some economic reward. Anything
done out of love and affection, although very useful in increasing human well-being, is not
labour in the economic sense of the term. It implies that any work done for the sake of
pleasure or love does not represent labour in Economics. It is for this reason that the
services of a house-wife are not treated as labour, while those of a maid servant are treated
as labour. If a person sings just for the sake of pleasure, it is not considered as labour
despite the exertion involved in it. On the other hand, if a person sings against payment of
some fee, then this activity signifies labour.
Characteristics of labour:
 Human Effort: Labour, as compared with other factors is different. It is connected
with human efforts whereas others are not directly connected with human efforts. As
a result, there are certain human and psychological considerations which may come
up unlike in the case of other factors. Therefore, leisure, fair treatment, favourable
work environment etc. are essential for labourers.
 Labour is perishable: Labour is highly ‘perishable’ in the sense that a day’s labour
lost cannot be completely recovered by extra work on any other day. In other words,
a labourer cannot store his labour.
 Labour is an active factor: Without the active participation of labour, land and
capital may not produce anything.
 Labour is inseparable from the labourer: A labourer is the source of his own labour
power. When a labourer sells his service, he has to be physically present where they
are delivered. The labourer sells his labour against wages, but retains the capacity to
work.
 Labour power differs from labourer to labourer: Labour is heterogeneous in the
sense that labour power differs from person to person. Labour power or efficiency of
labour depends upon the labourers’ inherent and acquired qualities, characteristics of
work environment, and incentive to work.
 All labour may not be productive: (i.e.) all efforts are not sure to produce
resources.
 Labour has poor bargaining power: Labour has a weak bargaining power. Labour
has no reserve price. Since labour cannot be stored, the labourer is compelled to
work at the wages offered by the employers. For this reason, when compared to
employers, labourers have poor bargaining power and can be exploited and forced
to accept lower wages. The labourer is economically weak while the employer is

economically powerful although things have changed a lot in favour of labour during
20th and 21st centuries.
 Labour is mobile: Labour is a mobile factor. Apparently, workers can move from one
job to another or from one place to another. However, in reality there are many
obstacles in the way of free movement of labour from job to job or from place to
place.
 There is no rapid adjustment of supply of labour to the demand for it: The total
supply of labour cannot be increased or decreased instantly.
 Choice between hours of labour and hours of leisure: A labourer can make a
choice between the hours of labour and the hours of leisure. This feature gives rise to
a peculiar backward bending shape to the supply curve of labour. The supply of
labour and wage rate is directly related. It implies that, as the wage rate increases the
labourer tends to increase the supply of labour by reducing the hours of leisure.
However, beyond a desired level of income, the labourer reduces the supply of
labour and increases the hours of leisure in response to further rise in the wage rate.
That is, he prefers to have more of rest and leisure than earning more money.
1.1.2 Capital
We may define capital as that part of wealth of an individual or community which is used for
further production of wealth. In fact, capital is a stock concept which yields a periodical
income which is a flow concept. It is necessary to understand the difference between capital
and wealth. Whereas wealth refers to all those goods and human qualities which are useful
in production and which can be passed on for value, only a part of these goods and services
can be characterised as capital because if these resources are lying idle they will constitute
wealth but not capital.
Capital has been rightly defined as ‘produced means of production’ or ‘man-made
instruments of production’. In other words, capital refers to all man made goods that are
used for further production of wealth. This definition distinguishes capital from both land
and labour because both land and labour are not produced factors. They are primary or
original factors of production, but capital is not a primary or original factor; it is a produced
factor of production. It has been produced by man by working with nature. Machine tools
and instruments, factories, dams, canals, transport equipment etc., are some of the examples
of capital. All of them are produced by man to help in the production of further goods.
Types of Capital:
Fixed capital is that which exists in a durable shape and renders a series of services over a
period of time. For example tools, machines, etc.

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Circulating capital is another form of capital which performs its function in production in a
single use and is not available for further use. For example, seeds, fuel, raw materials, etc.
Real capital refers to physical goods such as building, plant, machines, etc.
Human capital refers to human skill and ability. This is called human capital because a good
deal of investment goes into creation of these abilities in humans.
Tangible capital can be perceived by senses whereas intangible capital is in the form of
certain rights and benefits which cannot be perceived by senses. For example, copyrights,
goodwill, patent rights, etc.
Individual capital is personal property owned by an individual or a group of individuals.

Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc.
Capital Formation: Capital formation means a sustained increase in the stock of real capital
in a country. In other words, capital formation involves production of more capital goods
like, machines, tools, factories, transport equipments, electricity etc. which are used for
further production of goods. Capital formation is also known as investment.
The need for capital formation or investment is realised not merely for replacement and
renovation but for creating additional productive capacity. In order to accumulate capital
goods, some current consumption has to be sacrificed and savings of current income are to
be made. Savings are also to be channelised into productive investment. The greater the
extent that people are willing to abstain from present consumption, the greater the extent
of savings and investment that society will devote to new capital formation. If a society
consumes all what it produces and saves nothing, the future productive capacity of the
economy will fall when the present capital equipment wears out. In other words, if the whole
of the current present capacity is used to produce consumer goods and no new capital
goods are made, production of consumer goods in the future will greatly decline. It is
prudent to cut down some of the present consumption and direct part of it to the making of
capital goods such as, tools and instruments, machines and transport facilities, plant and
equipment etc. Higher rate of capital formation will enhance production and productive
capacity, increase the efficacy of production efforts, accelerate economic growth and add to
opportunities for employment.
Stages of capital formation: There are mainly three stages of capital formation which are
as follows:
1. Savings: The basic factor on which formation of capital depends is the ability to save.
The ability to save depends upon the income of an individual. Higher incomes are
generally followed by higher savings. This is because, with an increase in income, the
propensity to consume comes down and the propensity to save increases. This is true

not only for an individual but also for the economy as a whole. A rich country has
greater ability to save and thereby can get richer quickly compared to a poor country
which has no ability to save and therefore has limited capacity for growth in national
income, given the capital output ratio.
It is not only the ability to save, but the willingness to save also counts a great deal.
Willingness to save depends upon the individual’s concern about his future as well as
upon the social set-up in which he lives. If an individual is far sighted and wants to
make his future secure, he will save more. Moreover, the government can enforce
compulsory savings on employed people by making insurance and provident fund
compulsory. Government can also encourage saving by allowing tax deductions on
income saved. In recent years, business community’s savings and government’s
savings are also becoming important.
2. Mobilisation of savings: It is not enough that people save money; the saved money
should enter into circulation and facilitate the process of capital formation.
Availability of appropriate financial products and institutions is a necessary
precondition for mobilisation of savings. There should be a wide spread network of
banking and other financial institutions to collect public savings and to take them to
prospective investors. In this process, the state has a very important and positive role
to play both in generating savings through various fiscal and monetary incentives
and in channelising the savings towards priority needs of the community so that
there is not only capital generation but also socially beneficial type of capital
formation.
3. Investment: The process of capital formation gets completed only when the real
savings get converted into real capital assets. An economy should have an
entrepreneurial class which is prepared to bear the risk of business and invest savings
in productive avenues so as to create new capital assets.
1.1.3 Entrepreneur
Having explained the three factors namely land, labour and capital, we now turn to the
description of the fourth factor of production, namely, the entrepreneur. It is not enough to
say that production is a function of land, capital and labour. There must be some factor
which mobilises these factors, combines them in the right proportion, initiates the process
of production and bears the risks involved in it. This factor is known as the entrepreneur. He
has also been called the organiser, the manager or the risk taker. But, in these days of
specialisation and separation of ownership and management, the tasks performed by a
manager or organiser have become different from that of the entrepreneur. While
organisation and management involve decision-making of routine and non-routine types,

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the task of the entrepreneur is to initiate production work and to bear the risks involved in
it.
Functions of an entrepreneur: In general, an entrepreneur performs the following
functions:
(i) Initiating business enterprise and resource co-ordination: An entrepreneur senses
business opportunities, conceives project ideas, decides on scale of operation,
products and processes and builds up, owns and manages his own enterprise. The
first and the foremost function of an entrepreneur is to initiate a business enterprise.
An entrepreneur perceives opportunity, organizes resources needed for exploiting
that opportunity and exploits it. He undertakes the dynamic process of obtaining
different factors of production such as land, labour and capital, bringing about co-
ordination among them and using these economic resources to secure higher
productivity and greater yield. An entrepreneur hires the services of various other
factors of production and pays them fixed contractual rewards: labour is hired at
predetermined rate of wages, land or factory building at a fixed rent for its use and
capital at a fixed rate of interest. The surplus, if any, after paying for all factors of
production hired by him, accrues to the entrepreneur as his reward for his efforts and
risk-taking. Thus, the reward for an entrepreneur, that is a profit, is not certain or
fixed. He may earn profits, or incur losses. Other factors get the payments agreed
upon, irrespective of whether the entrepreneur makes profits or losses.
(ii) Risk bearing or uncertainty bearing: The ultimate responsibility for the success and
survival of business lies with the entrepreneur. What is planned and anticipated by
the entrepreneur may not come true and the actual course of events may differ from
what was anticipated and planned. The economy is dynamic and changes occur every
day. The demand for a commodity, the cost structure, fashions and tastes of the
people and government’s policy regarding taxation, credit, interest rate etc. may
change. All these changes bring about changes in the cost and/or demand conditions
of a business firm. It may happen that as a result of certain broad changes which
were not anticipated by the entrepreneur, the firm has to incur losses. Thus, the
entrepreneur has to bear these financial risks. Apart from financial risks, the
entrepreneur also faces technological risks which arise due to the inventions and
improvement in techniques of production, making the existing techniques and
machines obsolete. The entrepreneur has to assess and bear the risks. However,
Frank Knight is of the opinion that profit is the reward for bearing uncertainties. An
entrepreneur need not bear the foreseeable risks such as of fire, theft, burglary etc.
as these can be insured against. Uncertainties are different from risks in the sense
that these cannot be insured against and therefore, the entrepreneur has to bear
them. For example genuine business uncertainties such as change in tastes,

emergence of competition etc. cannot be foreseen or insured against. Thus, an

entrepreneur earns profits because he bears uncertainty in a dynamic economy
where changes occur every day. While nearly all functions of an entrepreneur can be
delegated or entrusted with paid managers, risk bearing cannot be delegated to
anyone. Therefore, risk bearing is the most important function of an entrepreneur
(iii) Innovations: According to Schumpeter, the true function of an entrepreneur is to
introduce innovations. Innovation refers to commercial application of a new idea or
invention to better fulfilment of business requirements. Innovations, in a very broad
sense, include the introduction of new or improved products, devices and production
processes, utilisation of new or improved source of raw-materials, adoption of new or
improved technology, novel business models, extending sales to unexplored markets
etc. According to Schumpeter, the task of the entrepreneur is to continuously
introduce new innovations. These innovations may bring in greater efficiency and
competitiveness in business and bring in profits to the innovator. A successful
innovation will be imitated by others in due course of time. Therefore, an innovation
may yield profits for the entrepreneur for a short time but when it is widely adopted
by others, the profits tend to disappear. The entrepreneurs promote economic
growth of the country by introducing new innovations from time to time and
contributing to technological progress. But innovations involve risks and only a few
individuals in the society are capable of introducing new innovations. The greater the
innovating ability, the greater the supply of entrepreneurs in the economy, and
greater will be the rate of technological progress.
Enterprise’s objectives and constraints
The standard assumption about an enterprise is that its business activity is carried out with
the sole objective of earning profits. However, in the real world, enterprises do not make
decisions based exclusively on profit maximisation objective alone. Since an enterprise
functions in the economic, social, political and cultural environment, its objectives will have
to be set up in relation to its survival and growth in such environments.
Thus, the objectives of an enterprise may be broadly categorised under the following heads:
(1) Organic objectives
(2) Economic objectives
(3) Social objectives
(4) Human objectives
(5) National objectives

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1. Organic objectives: The basic minimum objective of all kinds of enterprises is to

survive or to stay alive. An enterprise can survive only if it is able to produce and
distribute products or services at a price which enables it to recover its costs. If an
enterprise does not recover its costs of staying in business, it will not be in a position
to meet its obligations to its creditors, suppliers and employees with the result that it
will be forced into bankruptcy. Therefore, survival of an enterprise is essential for the
continuance of its business activity. Once the enterprise is assured of its survival, it
will aim at growth and expansion.
Growth as an objective has assumed importance with the rise of professional
managers. R.L. Marris’s theory of firm assumes that the goal that managers of a
corporate firm set for themselves is to maximise the firm’s balanced growth rate
subject to managerial and financial constraints. In corporate firms, the structural
division of ownership and management, yields opportunity for mangers to set goals
which may not conform to the utility function of owner shareholders. It is po inted out
that ability or success of the managers is judged by their performance in promoting
the growth or expansion of the firm and rewards obtained by them are reflection of
their success is achieving growth of the firms managed by them. While owners want
to maximise their utility function which relate to profit, capital, market share and
public reputation, the managers want to maximise their utility function which
includes variables such as salary, power, and status and job security. Although there
is divergence and some degree of conflict between these utility functions, Marris
argues that most of the variables incorporated in both of them are positively related
to size of the firm and therefore, the two utility functions converge into a single
variable, namely, a steady growth in the size of the firm. The managers do not aim at
optimising profits; rather they aim at optimisation of the balanced rate of growth of
the firm which involves optimisation of the rate of increase of demand for the
commodities of the firm and the rate of increase of capital supply.
2. Economic objectives: The profit maximising behaviour of the firm has been the most
basic assumption made by economists over the last more than two hundred years
and is still at the heart of neo classical micro economic theory. This assumption is
simple, rational and quantitative and is amenable to equilibrium analysis. Under this
assumption, the firm determines the price and output policy in such a way as to
maximize profits within the constraints imposed upon it such as technology, finance
etc. The investors expect that their company will earn sufficient profits in order to
ensure fair dividends to them and to improve the prices of their stocks. Not only
investors but creditors and employees are also interested in a profitable enterprise.
Creditors will be reluctant to lend money to an enterprise which is not making

profits. Similarly, any increase in salaries, wages and perquisite of employees can
come only out of profits.
The definition of profits in Economics is different from the accountants’ definition of
profits. Profit, in the accounting sense, is the difference between total revenue and
total costs of the firm. Economic profit is the difference between total revenue and
total costs, but total costs here costs include both explicit and implicit costs.
Accounting profit considers only explicit costs while economic profit reflects explicit
and implicit costs i.e. the cost of self-owned factors used by the entrepreneur in his
own business. Since economic profit includes these opportunity costs associated with
self-owned factors, it is generally lower than the accounting profit. When the
economist speaks of profits, s/he means profits after taking into account the capital
and labour provided by the owners i.e. s/he differentiates between normal profits
and super normal profits. Normal profits include normal rate of return on capital
invested by the entrepreneur, remuneration for the labour and the reward for risk
bearing function of the entrepreneur.
Normal profit (zero economic profit) is a component of costs and therefore what a
business owner considers as the minimum necessary to continue in the business.
Supernormal profit, also called economic profit or abnormal profit is over and above
normal profits. It is earned when total revenue is greater than the total costs. Total
costs in this case include a reward to all the factors, including normal profit.
The profit maximisation objective has been subject to severe criticism in recent years.
Many economists have pointed out that all firms do not aim to maximise profits.
Some firms try to achieve security, subject to reasonable level of profits. H A Simon
argues that firms have ‘satisfying’ behaviour and strive for profits that are
satisfactory. Baumol’s theory of sales maximisation holds that sales revenue
maximisation rather than profit maximisation is the ultimate goal of the business
firms. He cites empirical evidence for his hypothesis that sales rank ahead of profits
as the main objective of the enterprise. He asserts that it is quite a common
experience that when an executive is asked about his business, he will answer that his
sales have been increasing (or decreasing) and talks about profits only as an
afterthought. He, however, points out that in their attempt to maximise sales,
businessmen do not completely ignore costs incurred on output and profits to be
made.
In 1932, A. A. Berle and G.C. Means pointed out that in large business corporations,
management is separated from ownership and therefore the managers enjoy
discretionary powers to set goals of the firm they manage. Williamson’s model of
maximisation of managerial utility function is an important contribution to

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managerial theory of firms’ behaviour. The owners (shareholders) of joint stock

companies prefer profit maximisation; but managers maximise their own utility
function subject to a minimum profit, rather than maximising profit.
The objective of utility maximization has been discussed in the context of two types
of firms: First in case of firms owned and managed by the entrepreneur himself,
utility maximisation implies that in choosing an output level, the entrepreneur owner
considers not only the money profits which he will make, but also the sacrifice of
leisure which he would have to make in doing the necessary activity for producing
that level of output. Second, in case of large joint stock companies, the utility
function of managers or executives of these companies includes not only the profits
which they earn for the shareholders but also the promotion of sales, maintaining
lavish offices, seeking to have a larger member of staff under their supervision etc. In
this case, the manager will maximise his utility by attaining a best combination of
profits and the above mentioned other objectives. Cyert and March suggests four
possible functional goals in addition to profit goal namely, production goal,
inventory goal, sales goal and market share goal.
3. Social objectives: Since an enterprise lives in a society, it cannot grow unless it
meets the needs of the society. Some of the important social objectives of business
are:
 To maintain a continuous and sufficient supply of unadulterated goods and
articles of standard quality.
 To avoid profiteering and anti-social practices.
 To create opportunities for gainful employment for the people in the society.
 To ensure that the enterprise’s output does not cause any type of pollution -
air, water or noise.
An enterprise should consistently endeavour to contribute to the quality of life of its
community in particular and the society in general. If it fails to do so, it may not
survive for long.
4. Human objectives: Human beings are the most precious resources of an
organisation. If they are ignored, it will be difficult for an enterprise to achieve any of
its other objectives. Therefore, the comprehensive development of its human
resource or employees’ should be one of the major objectives of an organisation.
Some of the important human objectives are:
 To provide fair deal to the employees at different levels

 To develop new skills and abilities and provide a work climate in which they
will grow as mature and productive individuals.
 To provide the employees an opportunity to participate in decision-making in
matters affecting them.
 To make the job contents interesting and challenging.
If the enterprise is conscious of its duties towards its employees, it will be able to
secure their loyalty and support.
5. National objectives: An enterprise should endeavour for fulfilment of national needs
and aspirations and work towards implementation of national plans and policies.
Some of the national objectives are:
 To remove inequality of opportunities and provide fair opportunity to all to
work and to progress.
 To produce according to national priorities.
 To help the country become self-reliant and avoid dependence on other
nations.
 To train young men as apprentices and thus contribute in skill formation for
economic growth and development.
Since all the enterprises have multiple goals, they need to set priorities. This requires
appropriate balancing of the objectives in order to determine the relative importance of
each.
Various objectives of an enterprise may conflict with one another. For example, the profit
maximisation objective may not be wholly consistent with the marketing objective of
increasing its market share which may involve improvement in quality, slashing down of
product prices, improved customer service, etc. Similarly, its social responsibility objective
may run into conflict with the introduction of technological changes which may cause
unemployment or environmental pollution. In such situations, the manager has to strike a
balance between the two so that both can be achieved with reasonable success.
In the above paragraphs, we have discussed the different objectives of an enterprise.

However, no comprehensive economic theory explaining the multitudes of behaviour of
firms under various market conditions (perfect competition, monopoly, etc.) has been
developed so far. Therefore, in rest of this book, we shall continue to assume that firms aim
at maximising profits until and unless otherwise mentioned.

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In the pursuit of this objective, an enterprise’s actions may get constrained by many factors.
Important among them are:
 Lack of knowledge and information: The enterprise functions in an uncertain world
where due to lack of accurate information, many variables that affect the
performance of the firm cannot be correctly predicted for the current month or the
current year, let alone for the future years. Similarly, the firms may not know about
the prices of all inputs and the characteristics of all relevant technologies. Under such
circumstances, it is very difficult to determine what the profit maximising price is.
 There may be other constraints such as restrictions imposed in the public interest by
the state on the production, price and movement of factors. In practice, there are
several hindrances for free mobility of labour and capital. For example, trade unions
may place several restrictions on the mobility of labour or specialised training may be
required to enable workers to change occupation. These contingencies may make
attainment of maximum profits a difficult task.
 There may be infrastructural inadequacies and consequent supply chain bottlenecks
resulting in shortages and unanticipated emergencies. For example, there could be
frequent power cuts, irregular supply of raw-materials or non-availability of proper
transport. This could put limitations on the power of enterprises to maximise profits.
 Changes in business and economic conditions which become contagious due to the
highly connected nature of economies, place constraints by causing demand
fluctuations and instability in firms’ sales and revenues. Besides, external factors such
as sudden change in government policies with regard to location, prices, taxes,
production, etc. or natural calamities like fire, flood etc. may place additional burdens
on the business firms and defeat their plans. When firms are forced to implement
policies in response to fiscal limitations, legal, regulatory, or contractual
requirements, these have adverse consequences on the firms’ profitability and
growth plans.
 Events such as inflation, rising interest rates, unfavourable exchange rate fluctuations
cause increased raw material, capital and labour costs and affect the budgets and
financial plans of firms. Significant constraints are also imposed by the inability of
firms to find skilled workforce at competitive wages as well as due to the recurring
need for personnel training.
Enterprise’s Problems
An enterprise faces a number of problems from its inception, through its life time and till its
closure. We shall try to get a few insights about them from the following discussion.

Problems relating to objectives: As mentioned earlier, an enterprise functions in the

economic, social, political and cultural environment. Therefore, it has to set its objectives in
relation to its environment. The problem is that these objectives are multifarious and very
often conflict with one another. For example, the objective of maximising profits is in
conflict with the objective of increasing the market share which generally involves improving
the quality, slashing the prices etc. Thus the enterprise faces the problem of not only
choosing its objectives but also striking a balance among them.
Problems relating to location and size of the plant: An enterprise has to decide about the
location of its plant. It has to decide whether the plant should be located near the source of
raw material or near the market. It has to consider costs such as cost of labour, facilities and
cost of transportation. Of course, the entrepreneur will have to weigh the relevant factors
against one another in order to choose the right location which is most economical.
Another problem relates to the size of the firm. It has to decide whether it is to be a small
scale unit or large scale unit. Due consideration will have to be given to technical,
managerial, marketing and financial aspects of the proposed business before deciding on
the scale of operations. It goes without saying that the management must make a realistic
evaluation of its strengths and limitations while choosing a particular size for a new unit.
Problems relating to selecting and organising physical facilities: A firm has to make
decision on the nature of production process to be employed and the type of equipments to
be installed. The choice of the process and equipments will depend upon the design chosen
and the required volume of production. As a rule, production on a large scale involves the
use of elaborate, specialized and complicated machinery and processes. Quite often, the
entrepreneur has to choose from among different types of equipments and processes of
production. Such a choice will be based on the evaluation of their relative cost and
efficiency. Having determined the equipment to be used and the processes to be employed,
the entrepreneur will prepare a layout illustrating the arrangement of equipments and
buildings and the allocation for each activity.
Problems relating to Finance: An enterprise has to undertake not only physical planning
but also expert financial planning. Financial planning involves (i) determination of the
amount of funds required for the enterprise with reference to the physical plans already
prepared (ii) assessment of demand and cost of its products (iii) estimation of profits on
investment and comparison with the profits of comparable existing concerns to find out
whether the proposed investment will be profitable enough and (iv) determining capital
structure and the appropriate time for financing the enterprise etc.
Problems relating to organisation structure: An enterprise also faces problems relating to
the organisational structure. It has to divide the total work of the enterprise into major
specialised functions and then constitute proper departments for each of its specialized

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functions. Not only this, the functions of all the positions and levels would have to be clearly
laid down and their inter-relationship (in terms of span of control, authority, responsibility,
etc) should be properly defined. In the absence of clearly defined roles and relationships, the
enterprise may not be able to function efficiently.
Problems relating to marketing: Proper marketing of its products and services is essential
for the survival and growth of an enterprise. For this, the enterprise has to discov er its target
market by identifying its actual and potential customers, and determine tactical marketing
tools it can use to produce desired responses from its target market. After identifying the
market, the enterprise has to make decision regarding 4 P’s namely,
 Product: variety, quality, design, features, brand name, packaging, associated
services, utility etc.
 Promotion: Methods of communicating with consumers through personal selling,
social contacts, advertising, publicity etc.
 Price: Policies regarding pricing, discounts, allowance, credit terms, concessions, etc.
 Place: Policy regarding coverage, outlets for sales, channels of distribution, location
and layout of stores, inventory, logistics etc.
Problems relating to legal formalities: A number of legal formalities have to be carried
out during the time of launching of the enterprise as well as during its life time and its
closure. These formalities relate to assessing and paying different types of taxes (corporate
tax, excise duty, sales tax, custom duty, etc.), maintenance of records, submission of various
types of information to the relevant authorities from to time, adhering to various rules and
laws formulated by government (for example, laws relating to location, environmental
protection and control of pollution, size, wages and bonus, corporate management
licensing, prices) etc.
Problems relating to industrial relations: With the emergence of the present day factory
system of production, the management has to devise special measures to win the co -
operation of a large number of workers employed in industry. Misunderstanding and conflict
of interests have assumed enormous dimensions that these cannot be easily and promptly
dealt with. Industrial relations at present are much more involved and complicated. Various
problems which an enterprise faces with regard to industrial relations are - the problem of
winning workers’ cooperation, the problem of enforcing proper discipline among workers,
the problem of dealing with organised labour and the problem of establishing a state of
democracy in the industry by associating workers with the management of industry.

1.2 PRODUCTION FUNCTION

The production function is a statement of the relationship between a firm’s scarce resources
(i.e. its inputs) and the output that results from the use of these resources. More specifically,
it states technological relationship between inputs and output. The production function can
be algebraically expressed in the form of an equation in which the output is the dependent
variable and inputs are the independent variables. The equation can be expressed as:
Q = f (a, b, c, d …….n)
Where ‘Q’ stands for the rate of output of given commodity and a, b, c, d…….n, are the
different factors (inputs) and services used per unit of time.
Assumptions of Production Function: There are three main assumptions underlying any
production function.
First we assume that the relationship between inputs and outputs exists for a specific period
of time. In other words, Q is not a measure of accumulated output over time.
Second, it is assumed that there is a given “state-of-the-art” in the production technology.
Any innovation would cause change in the relationship between the given inputs and their
output. For example, use of robotics in manufacturing or a more efficient software package
for financial analysis would change the input-output relationship.
Third assumption is that whatever input combinations are included in a particular function,
the output resulting from their utilization is at the maximum level.
The production function can be defined as:
The relationship between the maximum amount of output that can be produced and
the input required to make that output. It is defined for a given state of technology
i.e., the maximum amount of output that can be produced with given quantities of
inputs under a given state of technical knowledge. (Samuelson)
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, labour, capital and enterprise. To illustrate, for a company
which produces beverages, the inputs could be fixed assets such as plant and machinery;
raw materials such as carbonated water, sweeteners and flavourings and labour such as
assembly line workers, support-staff and supervisory personnel.
For the purpose of analysis, the whole array of inputs in the production function can be
reduced to two; L and K. Restating the equation given above, we get:

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Q = f (L, K). Where Q = Output

L= Labour
K= Capital
Short-Run Vs Long-Run Production Function
The production function of a firm can be studied in the context of short period or long
period. It is to be noted that in economic analysis, the distinction between short-run and
long-run is not related to any particular measurement of time (e.g. days, months, or years).
In fact, it refers to the extent to which a firm can vary the amounts of the inputs in the
production process. A period will be considered short-run period if the amount of at least
one of the inputs used remains unchanged during that period. Thus, short-run production
function shows the maximum amount of a good or service that can be produced by a set of
inputs, assuming that the amount of at least one of the inputs used remains fixed (or
unchanged). Generally, it has been observed that during the short period or in the short run,
a firm cannot install a new capital equipment to increase production. It implies that capital is
a fixed factor in the short run. Thus, in the short-run, the production function is studied by
holding the quantities of capital fixed, while varying the amount of other factors (labour, raw
material etc.) This is done when the law of variable proportion is studied.
The production function can also be studied in the long run. The long run is a period of time
(or planning horizon) in which all 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 variable factors of production. A long-run production function shows the maximum
quantity of a good or service that can be produced by a set of inputs, assuming that the firm
is free to vary the amount of all the inputs being used. The behaviour of production when all
factors are varied is the subject matter of the law of returns to scale.
1.2.0 Cobb-Douglas Production Function

A famous statistical production function is Cobb-Douglas production function. Paul H.
Douglas and C.W. Cobb of the U.S.A. studied the production function of the American
manufacturing industries. In its original form, this production function applies not to an
individual firm but to the whole of manufacturing in the United States. In this case, output is
manufacturing production and inputs used are labour and capital.
Cobb-Douglas production function is stated as:
Q = KLa C (1-a)
where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital. ‘K’ and ‘a’ are
positive constants.

The conclusion drawn from this famous statistical study is that labour contributed about
3/4th and capital about 1/4th of the increase in the manufacturing production. Although,
the Cobb-Douglas production function suffers from many shortcomings, it is extensively
used in Economics as an approximation.
1.2.1 The Law of Variable Proportions or The Law of Diminishing

Returns
In the short run, the input output relations are studied with one variable input (labour) with
all other inputs held constant. The laws of production under these conditions are known
under various names as the law of variable proportions (as the behaviour of output is
studied by changing the proportion in which inputs are combined) the law of returns to a
variable input (as any change in output is taken as resulting from the additional variable
input) or the law of diminishing returns (as returns eventually diminish).
The law states that as we increase the quantity of one input which is combined with other
fixed inputs, the marginal physical productivity of the variable input must eventually decline.
In other words, an increase in some inputs relative to other fixed inputs will, in a given state
of technology, cause output to increase; but after a point, the extra output resulting from
the same addition of extra input will become less and less.
Before discussing this law, if would be appropriate to understand the meaning of total
product, average product and marginal product.
Total Product (TP): Total product is the total output resulting from the efforts of all the
factors of production combined together at any time. If the inputs of all but one factor are
held constant, the total product will vary with the quantity used of the variable factor.
Column (1) of Table 1 presents the quantity of variable factor (labour) used along with the
factors whose quantity is held constant and column (2) represent the total product at
various levels of use of the variable input.
Table 1: Product Schedule
Quantity of labour Total Product (TP) Average Product Marginal Product

(AP) (MP)
(1) (2) (3) (4)
1 100 100.0 100
2 210 105.0 110
3 330 110.0 120
4 440 110.0 110
5 520 104.0 80

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6 600 100.0 80
7 670 95.7 70
8 720 90.0 50
9 750 83.3 30
10 750 75.0 0
11 740 67.3 –10
We find that when one unit of labour is employed along with other factors of production,
the total product is 100 units. When two units of labour are employed, the total product
rises to 210 units. The total product goes on rising as more and more units of labour are
employed. With 9 or 10 units of labour, the total product rises to maximum level of 750
units. When 11 units of labour are employed, total product falls to 740 units due to negative
returns from the 11 th unit of labour.
Average Product (AP): Average product is the total product per unit of the variable factor.
Total Product
AP=
No. of units of Variable Factors
It is shown as a schedule in column (3) of Table 1. When one unit of labour is employed,
average product is 100, when two units of labour are employed, average product rises to
105. This goes on, as shown in Table 1.
Marginal Product (MP): Marginal product is the change in total product per unit change in
the quantity of variable factor. In other words, it is the addition made to the total production
by an additional unit of input. Symbolically,
MPn = TP n – TPn-1
The computed value of the marginal product appears in the last column of Table 1. For
example, the MP corresponding to 4 units is given as 110 units. This reflects the fact that an
increase in labour from 3 to 4 units, has increased output from 330 to 440 units.
Relationship between Average Product and Marginal Product: Both average product and
marginal product are derived from the total product. Average product is obtained by
dividing total product by the number of units of the variable factor and marginal pro duct is
the change in total product resulting from a unit increase in the quantity of variable factor.
The relationship between average product and marginal product can be summed up as
follows:
(i) when average product rises as a result of an increase in the quantity of variable input,
marginal product is more than the average product.

(ii) when average product is maximum, marginal product is equal to average product. In
other words, the marginal product curve cuts the average product curve at its
maximum.
(iii) when average product falls, marginal product is less than the average product.
Table 1 and Figure 1 confirm the above relationship.
The Law of Variable Proportions or the Law of Diminishing Returns examines the production
function with one factor variable, keeping quantities of other factors fixed. In other words, it
refers to input-output relationship, when the output is increased by varying the quantity of
one input. This law operates in the short run ‘when all factors of production cannot be
increased or decreased simultaneously (for example, we cannot build a plant or dismantle a
plant in the short run).
The law operates under certain assumptions which are as follows:
1. The state of technology is assumed to be given and unchanged. If there is any
improvement in technology, then marginal product and average product may rise
instead of falling.
2. There must be some inputs whose quantity is kept fixed. This law does not apply to
cases when all factors are proportionately varied. When all the factors are
proportionately varied, laws of returns to scale are applicable.
3. The law does not apply to those cases where the factors must be used in fixed
proportions to yield output. When the various factors are required to be used in fixed
proportions, an increase in one factor would not lead to any increase in output i.e.,
marginal product of the variable factor will then be zero and not diminishing.
4. We consider only physical inputs and outputs and not economic profitability in
monetary terms.
The behaviour of output when the varying quantity of one factor is combined with a fixed
quantity of the others can be divided into three distinct stages or laws. In order to
understand these three stages or laws, we may graphically illustrate the production function
with one variable factor. This is done in Figure 1.
In this figure, the quantity of variable factor is depicted on the X axis and the Total Product
(TP), Average Product (AP) and Marginal Product (MP) are shown on the Y-axis. As the figure
shows, the TP curve goes on increasing upto to a point and after that it starts declining. AP
and MP curves first rise and then decline; MP curve starts declining earlier than the AP curve.

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The behaviour of these Total, Average and Marginal Products of the variable facto r
consequent on the increase in its amount is generally divided into three stages (laws) which
are explained below.
Fig. 1: Law of Variable Proportions

Stage 1: The Stage of Increasing Returns: In this stage, the total product increases at an
increasing rate upto a point (in figure upto point F), marginal product also rises and is
maximum at the point corresponding to the point of inflexion and average product goes on
rising. From point F 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 law of increasing returns: The law of increasing returns operates because
in the beginning, the quantity of fixed factors is abundant relative to the quantity of the
variable factor. As more units of the variable factor are added to the constant quantity of the
fixed factors, the fixed factors are more intensively and effectively utilised 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 utilised to its optimum.
This happens because, in the beginning some amount of fixed factor remained unutilised
and, therefore, when the variable factor is increased, fuller utilisation 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 which are indivisible are taken as fixed.
Indivisibility of a factor means that due to technological requirements, a minimum amount
of that factor must be employed whatever be 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 utilisation of the latter. The second reason why we get increasing returns at the
initial stage is that as more units of the variable factor are employed, the efficiency of the
variable factor increases. This is because introduction of division of labour and specialisation
becomes possible with sufficient quantity of the variable factor and these results in higher
productivity.
Stage 2: Stage of Diminishing Returns: In stage 2, the total product continues to increase
at a diminishing rate until it reaches its maximum at point H, 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 M (corresponding to the
highest point H 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 within its range.
Explanation of law of diminishing returns: The question arises as to why 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
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 utilisation 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 wo rds, 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 utilisation 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 t he
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

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its perfect substitute with the result that output could be expanded without diminishing
returns.
Stage 3: Stage 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 of negative returns: 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 utilising 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 ration al
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. The optimum
level of employment of the variable factor (here labour) will be determined by applying the
principle of marginalism in such a way that the marginal revenue product of labour is equal
to the marginal wages. (The principle of marginalism is explained in detail in the chapter
discussing equilibrium in different types of markets.)
1.2.2 Returns to Scale

We shall now study about changes in output when all factors of production in a particular
production function are increased together. In other words, we shall study the behaviour of
output in response to a change in the scale. A change in scale means that all factors of
production are increased or decreased in the same proportion. Change in scale is different

from changes in factor proportions. Changes in output as a result of the variation in factor
proportions, as seen before, form the subject matter of the law of variable proportions. On
the other hand, the study of changes in output as a consequence of changes in scale forms
the subject matter of returns to scale which is discussed below.It should be kept in mind
that the returns to scale faced by a firm are solely technologically determined and are not
influenced by economic decisions taken by the firm or by market conditions.
Returns to scale may be constant, increasing or decreasing. If we increase all factors i.e.,
scale in a given proportion and output increases in the same proportion, returns to scale are
said to be constant. Thus, if doubling or trebling of all factors causes a doubling or trebling
of output, then returns to scale are constant. But, if the increase in all factors leads to more
than proportionate increase in output, returns to scale are said to be increasing. Thus, if all
factors are doubled and output increases more than double, then the returns to scale are
said to be increasing. On the other hand, if the increase in all factors leads to less than
proportionate increase in output, returns to scale are decreasing. It is needless to say that
this law operates in the long run when all the factors can be changed in the same proportion
simultaneously.
It should be remembered that increasing returns to scale is not the same as increasing
marginal returns. Increasing returns to scale applies to ‘long run’ in which all inputs can be
changed. Increasing marginal returns refers to the short run in which at least one input is
fixed. The existence of fixed inputs in the short run gives rise to increasing and later to
diminishing marginal returns.
Constant Returns to Scale: As stated above, constant returns to scale means that with the
increase in the scale in some proportion, output increases in the same proportion. Constant
returns to scale, otherwise called as “Linear Homogeneous Production Function”, may be
expressed as follows:
kQx = f( kK, kL)
= k (K, L)
If all the inputs are increased by a certain amount (say k) output increases in the same
proportion (k). It has been found that an individual firm passes through a long phase of
constant returns to scale in its lifetime.
Increasing Returns to Scale: As stated earlier, increasing returns to scale means that output
increases in a greater proportion than the increase in inputs. When a firm expands,
increasing returns to scale are obtained in the beginning. For example, a wooden box of 3 ft.
cube contains 9 times greater wood than the wooden box of 1 foot-cube. But the capacity of
the 3 foot- cube box is 27 times greater than that of the one foot cube. Many such examples
are found in the real world. Another reason for increasing returns to scale is the indivisibility

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of factors. Some factors are available in large and lumpy units and can, therefore, be utilised
with utmost efficiency at a large output. If all the factors are perfectly divisible, increasing
returns may not occur. Returns to scale may also increase because of greater possibilities of
specialisation of land and machinery.
Decreasing Returns to Scale: When output increases in a smaller proportion relative to an
increase in all inputs, decreasing returns to scale are said to prevail. When a firm goes on
expanding by increasing all inputs, decreasing returns to scale set in. Decreasing returns to
scale eventually occur because of increasing difficulties of management, coordination and
control. When the firm has expanded to a very large size, it is difficult to manage it with the
same efficiency as earlier.
The Cobb-Douglas production function, explained earlier is used to explain “returns to scale”
in production. Originally, Cobb and Douglas assumed that returns to scale are constant. The
function was constructed in such a way that the exponents summed to a+1-a=1. However,
later they relaxed the requirement and rewrote the equation as follows:
Q = K La C b
Where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital, ‘K’ and ‘a’ and
‘b’ are positive constants.
If a + b > 1 Increasing returns to scale result i.e. increase in output is more than the
proportionate increase in the use of factors (labour and capital).
a+b=1 Constant returns to scale result i.e. the output increases in the same
proportion in which factors are increased.
a+b<1 decreasing returns to scale result i.e. the output increases less than the
proportionate increase in the labour and capital.
1.3 PRODUCTION OPTIMISATION

Normally, a profit maximising firm is interested to know what combination of factors of
production (or inputs) would minimise its cost of production for a given output. This can be
known by combining the firm’s production and cost functions, namely isoquants and iso-
cost lines respectively.
Isoquants: Isoquants are similar to indifference curves in the theory of consumer behaviour.
An isoquant represents all those combinations of inputs which are capable of producing the
same level of output. Since an isoquant curve represents all those combination of inputs
which yield an equal quantity of output, the producer is indifferent as to which comb ination
he chooses. Therefore, Isoquants are also called equal-product curves, production

indifference curves or iso-product curves. The concept of isoquant can be easily understood
with the help of the following schedule.
Table 2 : Various combinations of X and Y to produce a given level of output
Factor combination Factor X Factor Y MRTS

A 1 12
B 2 08 4
C 3 05 3
D 4 03 2
E 5 02 1
When we plot the various combinations of factor X and factor Y, we get a curve IQ as shown
in Figure 2.
Fig. 2 : Equal Product Curve or Isoquant

Isoquants have properties similar to indifference curves. Isoquants are negatively sloped,
convex to the origin due to diminishing marginal rate of technical substitution (MRTS) and
are non-intersecting. However, there is one important difference between the two: whereas
in an indifference curve it is not possible to quantify the level of satisfaction acquired by the
consumer, the level of production acquired by the producer is easily quantified. Thus, while
isoquant IQ1 represents 100 units, curves IQ2, IQ3 etc. representing higher levels of
production can be drawn. While a curve on the right represents a higher level of output that
on the left represents a lower level of output.
Isocost or Equal-cost Lines: Isocost line, also known as budget line or the budget constraint
line, shows the various alternative combinations of two factors which the firm can buy with

v
given outlay. Suppose a firm has ` 1,000 to spend on the two factors X and Y. If the price of
factor X is ` 10 and that of Y is ` 20, the firm can spend its outlay on X and Y in various
ways. It can spend the entire amount on X and thus buy 100 units of X and zero units of Y or
it can spend the entire outlay on Y and buy 50 units of it with zero units of X factor. In
between, it can have any combination of X and Y. Whatever be the combination of factors
the firm chooses, the total cost to the firm remains the same. In other words, all points on a
budget line would cost the firm the same amount.
We can show the iso-cost line diagrammatically also. The X-axis shows the units of factor X
and Y-axis the units of factor Y. When the entire ` 1,000 is spent on factor X, we get OB of
factor X and when the entire amount is spent on factor Y we get OA of f actor Y. The straight
line AB which joins points A and B will pass through all combinations of factors X and Y
which the firm can buy with outlay of ` 1,000. The line AB is called iso-cost line.
Fig. 3: Iso-cost lines

Figure 3 shows various iso-cost lines representing different combinations of factors with
different outlays. Isoquants, which represent the technical conditions of production for a
product and iso-cost lines which represent various ‘levels of cost or outlay’ (given the prices
of two factors) can help the firm to optimize its production. It may try to minimise its cost
for producing a given level of output or it may try to maximise the output for a given cost or
outlay. Suppose the firm has already decided about the level of output to be produced.
Then the question is with which factor combination the firm should try to produce the pre-
decided level of output. The firm will try to use the least-cost combination of factors. The
least cost combination of factors can be found by super-imposing the isoquant that
represents the pre decided level of output on the iso-cost lines. This is shown in Figure 4.

Fig. 4 : Least-cost Combination of Factors: Producer’s Equilibrium

Suppose the firm has decided to produce 1,000 units (represented by iso-quant P). These
units can be produced by any factor combination lying on P such as A, B, C, D, E, etc. The
cost of producing 1,000 units would be minimum at the factor combination represented by
point C where the iso-cost line MM1 is tangent to the given isoquant P. At all other points
such as A, B, D, E the cost is more as these points lie on higher iso-cost lines Compared to
MM1. Thus, the factor combination represented by point C is the optimum combination for
the producer. It represents the least-cost of producing 1,000 units of output. It is thus clear
that the tangency point of the given isoquant with an iso-cost line represents the least cost
combination of factors for producing a given output.
SUMMARY
 Production is the outcome of the combined activity of the four factors of production
viz, land, labour, capital and organization. In simple terms production, means
‘creation of utility’. i.e. Utility of form, utility of place, utility of time and personal
utility.
 Production does not include work done out of love and affection, voluntary services
and goods produced for self-consumption. Intention to exchange in the market is an
essential component of production.
 Land includes all those free natural resources whose supply for the economy as a
whole is fixed.

v
 Labour is all human efforts of body or of mind undergone partly or wholly with a
view to secure an income apart from the pleasure derived directly from the work.
 Capital is that part of wealth of an individual or community which is used for further
production of wealth. Capital, a stock concept, refers to produced means of
production and it comprises of man-made machines and materials which are used for
further production.
 Capital formation, also known as investment, means a sustained increase in the stock
of real capital in a country. There are mainly three stages of capital formation viz.
Savings which depends on ability to save and willingness to save; Mobilisation of
savings which depends on availability of financial institutions and products; and
Investment i.e. the process whereby the real savings get converted into real capital
assets.
 Entrepreneur is the person who organises business; initiates production, remunerates
other factors of production, introduces innovations and bears the risk and
uncertainties of business.
 The objectives of an enterprise may be broadly categorised under the following
heads. (i) Organic objectives (ii) Economic objectives (iii) Social objectives (iv) Human
objectives (v) National objectives.
 An enterprise faces a number of problems from its inception, through its life time
and till its closure. These may relate to objectives, location, size, physical facilities,
finance, organization structure, marketing, legal formalities and industrial relations.
 Factors of production can be divided into two categories – Fixed factors are those
factors whose quantity remains unchanged with changes in output within a capacity
and variable factors are those the quantity of which change with a change in the lev el
of output.
 Production function is the technical relationship between inputs and output.
Samuelson describes production function as the relationship between the maximum
amount of output that can be produced and the input required to make that output.
It is defined for a given state of technology.
 The law of variable proportion or the law of diminishing returns is relevant when
some factors are kept fixed and others are varied. It is applicable to the short-run.
 There are three stages of the law of variable proportion – where law of increasing
returns, law of diminishing returns and law of negative returns operate.
 Total product is the total output resulting from the efforts of all the factors of
production combined together at any time.

 Marginal product is the change in total product per unit change in the quantity of
variable factor.
 Average product is the total product per unit of the variable factor.
 The Law of returns to scale describes the relationship between inputs and output in
the long run when all inputs are changed in the same proportion. Returns to scale
may be constant, increasing and decreasing.
 Constant returns to scale occur when the inputs increase by some proportion and the
output also increases by the same proportion. It is also called linear homogeneous
production function.
 Increasing returns to scale occur when the inputs increase by some proportion and
the output increases more than proportionately.
 Decreasing returns to scale occur when the inputs increase by some proportion and
the output increases less than proportionately.
 Isoquants or product indifference curves show all those combinations of different
factors of production which give the same output to the producer.
 Iso-cost lines show various combinations of two factors which the firm can buy with
given expenditure or outlay.
 By combining Isoquants and iso-cost lines, a producer can find out the combination
of factors of production which is optimum i.e. the combination of factors of
production which would minimise his cost of production.
 For producing a given output, the tangency point of the relevant isoquant
(representing the output) with an iso-cost line represents the least cost combination
of factors.

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CHAPTER 3

UNIT -1: THEORY OF PRODUCTION

After studying this unit, you would be able to:

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1.0 MEANING OF PRODUCTION

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In common parlance, the term ‘production’ is used to indicate an activity of making

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to the industrialised centres where necessary machinery and technology are

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depend merely on physical productivity based on operating efficiency alone. The

1.1 FACTORS OF PRODUCTION

We may discuss these factors of production briefly in the following paragraphs.

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Individual capital is personal property owned by an individual or a group of individuals.

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emergence of competition etc. cannot be foreseen or insured against. Thus, an

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1. Organic objectives: The basic minimum objective of all kinds of enterprises is to

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managerial theory of firms’ behaviour. The owners (shareholders) of joint stock

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In the above paragraphs, we have discussed the different objectives of an enterprise.

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Problems relating to objectives: As mentioned earlier, an enterprise functions in the

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1.2 PRODUCTION FUNCTION

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Q = f (L, K). Where Q = Output

1.2.0 Cobb-Douglas Production Function

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1.2.1 The Law of Variable Proportions or The Law of Diminishing

Quantity of labour Total Product (TP) Average Product Marginal Product

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Fig. 1: Law of Variable Proportions

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1.2.2 Returns to Scale

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1.3 PRODUCTION OPTIMISATION

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Factor combination Factor X Factor Y MRTS

Fig. 2 : Equal Product Curve or Isoquant

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Fig. 3: Iso-cost lines

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Fig. 4 : Least-cost Combination of Factors: Producer’s Equilibrium