LESSON 6

Theory of Production

Structure of the Unit

6.1 Objectives of the Chapter
6.2 Introduction
6.3 Laws of Production
6.4 Equilibrium of the Firm: Optimal combination of Inputs
6.5 A Quick Revision
6.6 Keywords
6.7 Assess Your Performance
6.8 Suggested Readings

6.1 OBJECTIVES OF THE CHAPTER

The objective of this chapter is to apprise the readers about how the decisions regarding the
choice of inputs are taken by the producer. This is done through the explanation of the different
laws of production and through the determination of the equilibrium.

6.2 INTRODUCTION

The first five chapters explained how the

consumers decide the amount of a commodity to
be bought at different prices. While studying the
Production function
behavior of the consumers it was assumed that Production function shows the
the decisions of the producers were constant. functional relationship between factor
Now, in the theory of the production, the readers inputs and outputs.
are apprised about how the producers combine
the different factors of production to produce a particular level of output. While studying this we
assume that the decisions of the consumers are held constant.

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Production is the act of transforming inputs into outputs. Production is carried out by
transforming different inputs into outputs or the relationship between the factors of production
and output can be stated in a technical manner which is called as production function. The
production function can be classified into different types. These are discussed below:

1) Long run production function: Long run implies that during this time period output can
be increased by increasing both labour and capital i.e. the scale of the plant or its capacity
can be increased. Production is
done by combining various factors Types of Production function
of production. These are: land,
 Long run production function
labour, capital and raw material,
 Short run production function
etc. The long run production
 Homogeneous production
function can be written as,
function
X = f (La, L, K, R)  Non- homogeneous production
function
Where, X stands for output,
 Cobb – Douglas production
La stands for land, function

L stands for labour,

K stands for capital,

R stands for raw material.

Since land remains constant for any given economy, therefore, it is kept out of the
production function. Value of the raw materials is deducted from the total value of the
output; therefore, it is also kept out of the production function. Thus, the production
function can be rewritten as,

X = f (L, K)

This is the long run production where both labour and capital are variable.

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 2) Short run production function: In the short run, capital cannot be increased
immediately as a result it remains fixed. Then output can be increased by increasing only
labour. Then, production function can be written as,

X = f (L)K

i.e. output is a function of labour when capital is constant. Diagrammatically production

function can be explained in figure 6.2.1

Figure 6.2.1

y
Output

O l X

Labour

Thus, in the short run factors of production can be classified into two categories:

 Fixed factors of production: Fixed factors of production are those factors of

production which come into the production till the factory is ready for trial production.
Such as land, building, machinery etc. These are grouped under capital. These factors
cannot be increased or decreased
in the short run. Thus, these are Factors of Factors of
called as fixed factors of production in production in
production. short run long run
 Variable factors of
Fixed factors All factors are
production: Variable factors of variable
Variable factors
production are those factors of
production which come into the

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 production after the trial production. Usually labour, raw materials, running expenses of
the machinery falls in this category. These factors can be increased or decreased in the
short run. They do not remain fixed. Thus, these are called as variable factors of
production.

However, in long run all the factors of production can be increased or decreased. Thus, all the
factors of production are variable.

3) Homogeneous production function: Suppose, we have the following production

function, where output (X) is a function of labour (L) and capital (K),
X = f (L, K)
If now, we increase both labour and capital with the same proportion say ‘m’ then the
new level of output (X*) can be written as,
X* = f (m L, m K)
If it is possible to take out m as a common factor then the new level of output (X*) can
be expressed as a function of m raised to the power ‘n’ and the initial level of output, then
it is called as homogeneous production function. This can be explained as,
X* = mn f (L,K)
X* = mn X

So, a homogeneous production function is a function in which if each of the inputs are multiplied
by m, and it is possible to take m out of the production function as a common factor. The power
n of m is called as the degree of homogeneity and is a measure of returns to scale.

If n = 1 then we have constant returns to scale,

If n > 1 then we have increasing returns to scale,

If n < 1then we have decreasing returns to scale.

Homogeneous production function is divided into two categories:

 Linear homogeneous production function: Linear homogeneous production function is

that production function in which the degree of homogeneity is equal to 1. This implies
that n =1.

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 Non-linear homogeneous production function: Non homogeneous production function
is that production function in which the degree of homogeneity is not equal to 1.
4) Non Homogeneous production function: Suppose, we have the following production
function, where output (X) is a function of labour (L) and capital (K),
X = f (L, K)
If, now, we increase both labour and capital with the same proportion say ‘m’ then the
new level of output (X*) can be written as,
X* = f (m L, m K)
If it is not possible to take m out as a common factor then the production function is
called as non – homogeneous production function.
5) Cobb- Douglas production function: Various economists and mathematicians have
given empirical production functions based on actual data. Cobb and Douglas gave their
own production function based on empirical findings. The mathematical form of the
Cobb and Douglas production function is given below:
Q= A Lα Kβ
Where, Q stands for the level of output,
L stands for labour,
α and β are the constants,
K stands for capital,
A stands for technology and is a constant.
This production function shows that any change in labour will increase the level of output
by the exponent α and any change in capital will increase the level of output by the
exponent β. Cobb and Douglas gave this production function not for a firm but for the
whole of the manufacturing industry. So, the level of output Q represents the
manufacturing output or output of manufacturing industry. If we apply log on both sides
then the production function can be written as,
Log Q = Log A + α Log L+ β Log K
Cobb – Douglas production function is used to estimate returns to scale.
If α + β = 1 then we have constant returns to scale.
If α + β < 1 then we have decreasing returns to scale.
If α + β > 1 then we have increasing returns to scale.

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6.3 LAWS OF PRODUCTION

Since, there is difference in the long run and short run factors of production, therefore, the
decisions of the producers on how much of the factor inputs are to be combined in the short run
and in the long run are also different. Thus, the laws of production can be studied under two
heads:

LAWS OF PRODUCTION

Law of Variable Proportions Laws of Returns to Scale

6.3.1 Law of variable proportions

Since, in the short run one factor of production is fixed (capital) and the other factor of
production (labour) is variable, then any change in output will occur due to a change in the
variable factor of production. If we want to study that if we increase labour and capital then
whether the total output or product increases or decreases or remain constant then this is
explained by the law of variable proportions.

The law of variable proportions says that in the short run labour is variable and capital is fixed
then total output will increase initially but beyond a certain point it will decrease. This is called
as the law of variable proportions because the proportions of the variable factor (labour) are
increased to the fixed proportion of capital.

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6.3.1.1 Statement of the law
Law of Variable Proportions
According to Koutsoyiannis,
Applicable in the Short run
“In general if
one of the factors of production (usually
capital K) is fixed, the marginal product of the variable factor (labour), will diminish after a
certain range of production”1.

According to G.Stigler,

“As equal increments of one input are added; the inputs of other
productive services being held constant, beyond a certain point the resulting increments of
product will decrease, i.e. the marginal products will diminish”2.

According to Benham,

“As the proportion of one factor in a combination of factors is increased,

after a point, first the marginal and then the average product of that factor will diminish”3.

6.3.1.2 Assumptions

Following are the assumptions of the law:

1) State of technology is given

2) One factor capital is fixed.

6.3.1.3 Explanation of the law

For the explanation of the law of variable proportions some of the basic concepts used are
explained below:

1) Total Product:
Total product is the total amount of output produced.

1
Koutsoyiannis, A. (1979), Modern Microeconomics, Macmillan Press Limited.
2
Ahuja, H.L. (1980), Modern Economics, S.Chand and Company Limited, New Delhi.
3
Ibid

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 2) Average Product:
Average product is the total amount of output produced by total labour.
AP = x/l
Where, x = total output,
l = total labour,
AP = average product.
3) Marginal Product:
Marginal product of a factor is the addition made in total product due to a change in the
variable factor.
MP = ∆x / ∆l.
Where, ∆x = change in total output,
∆l = change in total labour,
MP = marginal product.

The law of variable proportions can be explained with the help of table 6.3.1.34 and figure
6.3.1.3. The table and the graph show that:

 As more and more of labour is employed, its marginal product increases up to the third
unit.
 The marginal product of labour becomes maximum at 3 unit and after that there is a
reduction in the same. This point is called as the point of inflexion after which the
marginal product curve starts to decrease.
 Since, marginal product is the slope of the total product curve, so till the 3 unit total
product is increasing at an increasing rate but after the 3 unit of labour the total product
curve is increasing at a decreasing rate.
 At the 9 unit, the marginal product of labour becomes zero.
 At the ninth unit of labour the total product curve becomes constant i.e. the total product
is maximum.
 At the employment of the 10 unit of labour the marginal product is negative and total
product is declining.

4
The table and the graph are from Satija, Kalpana (2009), Textbook on Economics for Law Students, Universal Law
Publishing Company, Delhi.

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  The average product is positive throughout. It is initially increasing reaching a maximum
at the 4 unit. After that it is declining.
 When the average and marginal products are increasing the marginal product is lying
above the average product curve. When the average product curve is at a maximum then
marginal product is equal to average product. When the average product is declining then
it is lying above the marginal product. When marginal product becomes zero average
product is still positive.

Table 6.3.1.3
Combination Fixed Units of Variable Total Marginal Average
Factor Factors Product Product Product
1 K 1 20 20 20
2 K 2 50 30 25
3 K 3 90 40 30
4 K 4 120 30 30
5 K 5 135 15 27
6 K 6 144 9 24
7 K 7 147 3 21
8 K 8 148 1 18.5
9 K 9 148 00 16.4
10 K 10 145 (-) 3 14.5

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 Figure 6.3.1.3

The law of variable proportions explains the different stages of production. As is explained in the
figure 6.3.1.3 there are three stages of production. These are discussed below:

Stage 1: In the first stage (from O to N) total product is first increasing at an increasing rate then
at a decreasing rate. Marginal product is increasing, reaches its maximum and cuts average
product from below at its maximum point. Average product is increasing in the first stage. Point
F is the point of inflexion where marginal product is maximum and beyond it the marginal
product of labour starts decreasing and average product of labour is increasing. In this stage
though marginal product starts to decline yet the total product curve is increasing. This is
because the efficiency of variable factor initially increases (i.e. marginal product of labour
increases) which pulls up the total product curve. However, when the marginal product starts to
decline then the efficiency of the fixed factor (i.e. average product is still increasing) pulls up the
total product curve.

Stage 2: In the second stage (from N to M) total product is increasing and it reaches a maximum
at point H. The marginal product cuts average product curve at its maximum at point N. Then it
reaches zero at the maximum point of total product curve. Though the average and marginal
products are falling yet these are positive. Thus, the efficiency of both the factors is falling yet
positive.

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Stage 3: In the third stage (M onwards) the marginal product curve is negative and total product
and average product curves are declining. Thus, the efficiency of the variable factor is negative
and the efficiency of the fixed factor is falling and it is not enough to pull up the total product
curve. Thus, the total product curve is declining.

6.3.1.4 The Economically Relevant Stage: Stage 2

Stage 2 is the most relevant stage of production. Producers will operate in stage 2. In stage 1 the
efficiency of variable factor is maximum and the efficiency of fixed factors has not reached its
maximum. The producers would like to maximize the use of both the factors as they are paying
for both the factors. Thus, they would not stop in stage 1. Rather they would move to stage 2. In
stage 2 both the factors attain their maximum efficiencies and the total product curve is also
maximum. However he will not operate in stage 3 as here marginal product of labour is negative
and average product is also decreasing. Thus, production will take place in stage 2.

6.3.1.5 Causes of increasing returns to variable factor

In stage 1 there are increasing returns to factor. This is because initially when labour is
increasing it is working with more of capital i.e. say 2 workers are working on 6 machineries. So,
the efficiency of both fixed and variable factors is increasing. Then as the labour is increased a
situation comes when 6 workers are working on 6 machineries.

6.3.1.6 Causes of decreasing returns to variable factor

As more and more of variable factor is hired then labour gets less and less of fixed factor to work
with. This implies a situation when 8 workers are working on 6 machineries or 9 workers are
working on 6 machineries. This leads to chaos and reduced efficiency.

6.3.2 Laws of returns to scale

For understanding the laws of returns to scale we need to know some basic concepts that are
used in the same. These are discussed below:

6.3.2.1 Basic concepts

1. Isoquants:

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Since in the long run both labour and capital are variable; therefore, a particular level of output
can be produced with the help of some labour and capital. The line which joins all the technically
efficient combinations of labour and capital for producing a given level of output is called as
isoquant. Isoquants can be of different shapes. These are discussed below:

 Linear Isoquant: Figure 6.3.2.1a shows the linear isoquant (ab). It is downward sloping
from left to right. With labour and capital this isoquant produces x level of output. This
type of isoquant exists in case of perfect substitutability between factors of production.

Y
Figure 6.3.2.1a
a

K
O b X

 Input-output isoquant: This type of isoquant assumes strict complementarity between

the different factors of production. This indicates zero substitution. There is only one
method of production of a commodity. This is called as ‘Leontif’s isoquant’.

Y
Figure 6.3.2.1b

a x
K

O b X

In figure 6.3.2.1b, x is the Leontif’s isoquant. There is only one method of producing x
i.e. oa amount of capital and ob amount of labour.

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  Kinked isoquant
Such an isoquant assumes limited substitution between labour and capital i.e. there are
only a few processes of producing a given commodity. Isoquant ac is shown in figure
6.3.2.1c. Substitution is only possible at the kinks (a, b, c). This is also called as activity
analysis or linear programming isoquant.

Y
Figure 6.3.2.1c

a
K

b c

O L X

 Convex isoquant

Convex isoquant assumes continuous substitutability of capital and labour over a certain range,
beyond which factors cannot be substituted. In this chapter we shall cover convex isoquant.
Figure 6.3.2.1d shows the convex isoquant (x). For producing x there are several combinations of
labour and capital like oa of capital and ob of labour and oc of capital and od of labour. The
curve which joins such combinations and is convex to the origin is called as convex isoquant.

The slope of the isoquant is called as marginal rate of technical substitution of labour for capital.
It is the rate at which labour can be substituted for capital so that the output remains constant. It
is diminishing in case of convex isoquant because the reduction in one factor is required to
increase the other factor so that the level of output remains the same.

MRTSLK = MPL / MPK

Y Figure 6.3.2.1d
Where,
a

MRTSLK stands for marginal rate c

of technical substitution of labour x

K

for capital.
O b d x

MPL stands for marginal L

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productivity of labour.

MPK stands for marginal productivity of capital.

2 Properties of isoquants

In this chapter we are concerned with the convex isoquant. Therefore, given below are the
properties of the convex isoquants:

 Negatively sloping: The isoquants are negatively sloping because if the additional labour
is to be hired then capital must decrease so that the level of output remains the same.
 Two isoquants do not intersect each other:
Two isoquants do not intersect as one point
Y Figure 6.3.2.1e
cannot represent two different levels of
10 20 30
outputs.
 Convex to the origin: The isoquants are
convex to the origin. It implies as we move
z
down from the isoquant, the amount of capital y
the producer is willing to give up for additional x
K

labour goes on decreasing. This means that the O L X

he is willing to give up less and less of capital

for more of labour.
 Higher isoquant represents
higher level of output: As we Properties of Isoquants
move from one isoquant to another Negatively sloping
isoquant the level of output that is
Do not intersect
represented by each isoquant goes
on increasing. Figure 6.3.2.1e Convex to the origin

shows the isoquant map. As we are Higher isoquant represents higher level
moving from isoquant x to isoquant of satisfaction

y to isoquant z, the level of output

represented by each isoquant goes on decreasing. Isoquant x represents 10 units of
output, isoquant y represent 20 units of y and isoquant z represents 30 units of output.

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6.3.2.2 Explanation of the Law

Laws of returns to scale tells us about the long run analysis of production. It tells us how the
contribution of labour and capital would change or how the level of output will change when we
increase both labour and capital in the long run. In the long run, output may be increased by
changing all the factors of production by the same proportion or by different proportions.
Traditional theory of production concentrates on the first case i.e. in law of returns to scale we
change both labour and capital in the same proportion.

Returns to scale refers to the changes in output as all factors of production change by the same
proportion in the long run.

Suppose we have,

X0 = f (L0, K0) i.e. initial output is a function of initial labour and initial capital.

Now, if we increase labour and capital by the same proportion say m then the new production
function will become,

X* = f (mL, mK),

Or, if it is possible to take out the common factor then,

X* = mn X0 i.e. new level of output will be a certain multiple of the original output.

If X* increases by the same proportion m as the inputs then it is called as constant returns to
scale. It can be written as,

Constant returns to scale - n =1.

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For explaining the constant returns to
scale we draw straight lines from the
Y Figure 6.3.2.2a
origin which passes through the various A
K3
isoquants. These lines are called as
K2
product lines. The distance between these B
lines (OA and OB in figure 6.3.2.2a) tells K1 3x

us about the returns to scale. Constant

K
2x

returns to scale implies that if we double x

O L1 L2 L3 X
the inputs then the output would also be
L
doubled. So if we are on isoquant x1 then
we are using OL1 of labour and OK1 of capital. If we double the labour and capital i.e. OL2 of
labour and OK2 of capital then we move to a higher isoquant i.e. from x to 2x which is
producing double the level of output. Constant returns to scale implies constant costs as factors
of production have same efficiency.

If X* increases by less than proportionately with the increase in factors then we have decreasing
returns to scale.

Decreasing returns to scale – n < 1.

Decreasing returns to scale are explained in figure 6.3.2.2b. Decreasing returns to scale implies
that if we want to double the level of output (2x) then we will need not to double the labour and
capital but we will have to increase labour and capital more than the double. This is because
there are decreasing returns to a factor. This can be shown in the figure. If we double the labour
and capital then we should have been at X’ but since we are experiencing decreasing returns so
we need to employ more than double the level of original labour and capital. Thus, in order to
attain 2x we will need more than the double of original labour and capital. Decreasing returns to
a scale implies increasing costs as the factors of production are not efficient.

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 K
Figure 6.3.2.2b K Figure 6.3.2.2c

K2 x

K1
2x X’
K

X’ 2x
x

O L1 L2 X O X

L L

If X* increases by more than proportionately with the increase in factors then we have increasing
returns to scale.

Increasing returns to scale – n > 1.

Figure 6.3.2.2c shows the increasing returns to a factor. In increasing returns to a scale the
factors of production are very efficient. For producing 2x we will just need less than double the
level of labour and capital. Thus, if we double the factors then we would reach X’ but since it is
increasing returns to a scale, therefore, 2x would be attained much earlier with less of labour and
capital. Increasing returns to scale implies decreasing costs as the factors of production are very
efficient.

6.4 EQUILIBRIUM OF THE FIRM: OPTIMAL COMBINATION OF INPUTS

By now, we have studied that in the long run the firm wants to be at the highest possible
isoquant. However, whether the firm can produce the output level assoiciated with the highest
possible isoquant or not will depend on certain factors. Therefore, in this section we will study
that how firm will take a decision to produce the level of output from all the available outputs
represented by the different isoquants. We will also study that how the firm will decide that how
much of labour and capital will go into the production of that commodity.

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6.4.1 Assumptions

The following assumptions are made:

1) The goal of the firm is profit maximization. This implies that the goal of the firm is to
maximize the difference between revenue and costs.
2) The price of the output is given and constant.
3) The prices of the factors of production i.e. labour and capital are given and constant.
4) The firm is producing one product.

6.4.2 Equilibrium

Since, the objective of the firm is profit maximization; therefore, profits can be maximized when
the difference between revenue and costs is maximized. Revenue can be maximized by
producing more output. Therefore, profits can be maximized in two ways:

 Maximizing output when cost is given / constant

 Minimizing costs when output is given

6.4.2.1 Maximizing output when cost is given / constant

In this case the firm has decided how much of costs are to be incurred and now, it has to decide
which level of output can be produced with this costs. For this purpose, we need a concept of
isocost line. Isocost line implies a line which shows same costs of capital and labour throughout.
Figure 6.4.2.1a shows the isocost line AB.

Koutsoyiannis, has defined isocost line as,

“The locus of all combinations of factors the firm can purchase with a given monetary
outlay”5

The slope of the isocost line is the ratio of the price of labour (w) over the price of capital (r).

Slope of isocost line = w /r.

3x

5
Koutsoyiannis, A. (1979), op.cit.

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 Figure 6.4.2.1a Figure 6.4.2.1b

Y A
Y

A x
K1
e

K1
K

2x
O L1 B X O L1 B X

L L

Figure 6.4.2.1a shows the isocost line. AB shows the different combinations of labour and capital
which can be purchased with the given budget of the producer. The figure 6.4.2.1b shows the
equilibrium of the firm. For this purpose the isoquant map has been superimposed over the
isocost line AB. The firm has the choice of three isoquants i.e. x, 2x and 3x. However, the
isoquant 3x is not within the reach of the producer. The producer given his cost constraint AB
can produce 2x level of output. However, the decision pertaining to the exact combination of
labour and capital depends on the tangency of the isoquant 2x on the isocost line. In figure
6.4.2.1b the isoquant is tangent to the isocost line AB at point e. Thus, the producer will produce
2x with OL1 of labour and OK1 of capital.

6.4.2.2 Minimizing costs when output is given

In this situation the firm has decided to produce a given level of output and now it has to find the
minimum cost of production required to produce such output. This is explained with the help of
figure 6.4.2.2a, 6.4.2.2b and 6.4.2.2c. In the first part of the figure i.e. in 6.4.2.2a the isoquant x
has been chosen by the firm and now the firm has to find the optimal combination of labour and
capital i.e. the minimum costs of production. Figure 6.4.2.2b shows the different isocost lines
which show the different costs of production. Now we superimpose the isoquant over the
isocosts lines. The point where the one of the isocost line is tangent to the isoquant is called as

126
the equilibrium point. The equilibrium point e shows that the firm will produce x level of output
with OL1units of labour and OK1 units of capital with CD isocost line.

Y’ Y’’
Y Figure 6.4.2.2a Figure 6.4.2.2b Figure 6.4.2.2c
E E
x
C C x

A A e
K

x
OBDF X
O L X OBDF X
L
L

6.5 A QUICK REVISION

Figure 6.5.1 quickly summarizes the whole chapter

127
Figure 6.5.1 A QUICK REVISION

Types of Production function

 Long run production function

Production Function  Short run production function
 Homogeneous production
function
 Non- homogeneous production
function
 Cobb – Douglas production
function

Laws of Production Function

 Law of Variable
Proportions
 Law of Returns to scale

Maximizing output
when cost is given

Equilibrium of the producers

Minimizing cost
when output is
given

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6.6 KEYWORDS

Production, production function, fixed factors, variable factors, total product, average product,
marginal product, variable proportions, returns to scale, isocost line, isoquants, isocline, marginal
rate of technical substitution.

6.7 ASSESS YOUR PERFORMANCE

Short Questions

1) What is production function?

 Production function shows the technical relationship between factor inputs and factor
outputs. It can be written as,

X = f (La, L, K, R)

Where, X stands for output,

La stands for land,

L stands for labour,

K stands for capital,

R stands for raw material.

2) What are fixed factors of production?

 Fixed factors of production are those factors of production which come into the
production till the factory is ready for trial production. Such as land, building,
machinery etc. These are grouped under capital. These factors cannot be increased or
decreased in the short run.
3) Explain the law of variable proportions.
 The law of variable proportions says that in the short run labour is variable and
capital is fixed then total output will increase initially but beyond a certain point it
will decrease. This is called as the law of variable proportions because the proportions
of the variable factor (labour) are increased to the fixed proportion of capital.
4) What are isoquants?

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  In the long run as both labour and capital are variable; therefore, a particular level of
output can be produced with the help of some labour and capital. The line which joins
all the technically efficient combinations of labour and capital for producing a given
level of output is called as isoquant.
5) What is average product?
 Average product is the total amount of output produced by total labour.
It can be written as,
AP = X/L, where AP is the average product, X stands for total output and L stands for
total labour employed.

Long Questions

Q.1 Explain the law of variable proportions.

Q.2 Discuss the laws of returns to scale.

Q.3 What is production function? Explain how equilibrium is determined when the producer is
producing one commodity.

Q.4 Explain the laws of production.

Q. 5 Explain the long run behavior of labour and capital in the theory of production. Also explain
the attainment of equilibrium when the producer aims at maximizing output given a cost
constraint.

6.8 Suggested Readings

Ahuja, H.L. (1980), Modern Economics, S.Chand and Company Limited, New Delhi.
Satija, Kalpana (2009), Textbook on Economics for Law Students, Universal Law Publishing
Company, Delhi.
Koutsoyiannis, A. (1979), Modern Microeconomics, Macmillan Press Limited.

130