UNIT IV

PRODUCTION CONCEPTS
Meaning of Production
Production has a broad meaning in economics. Production is an activity that creates utility or
value. It includes any process that transforms inputs into output to satisfy the demand for goods
and services of the community. In other words, production means presenting and readying goods
and services for sale.

Factors of Production
Production requires the use of various resources which are known as factors of production.
Factors of production are now termed as inputs. Inputs are broadly classified as land, labour,
capital and entrepreneurship (which relates to the managerial functions of risk taking planning,
organizing, controlling and directing).
Land refers to all kinds of natural resources available on the earth as a means of production
Labour refers to human efforts, physical as well as mental, used in the production activity
Capital is a man-made resource which includes physical capital assets or equipments, tools,
machines, factories, raw materials, etc.
Enterprise refers to entrepreneurial or organisational activity the process of production
undertaken by a class of people called entrepreneurs or organisers.
The owners or suppliers of these factors, land, labour, capital and enterprise, are called agents of
production.
The term output refers to the goods and services produced by various inputs.
Production function
Production is the transformation of physical inputs (resources) into physical outputs. In the
production process, a firm combines various inputs in different quantities and proportions to
produce different levels of outputs. Indeed, the rate of output of a commodity functionally
depends on the quantity of inputs used per unit of time. The technological-physical relationship
between inputs and outputs is referred to as the production function.
Definition: A production function refers to the functional relationship, under the given
technology, between physical rates of input and output of a firm, per unit of time.
In algebraic terms, the production function may be written as:
Q= f(a, b, c, d, ………,n, T )
Where Q represents the physical quantity of output per unit of time.
F denotes functional relationship,
a, b, c, d, n, represent the quantities of various inputs such as land, labour, capital, organisation
etc.
T refers to the prevailing state of technology or know-how. The bar is placed on T just to
indicate that technology assumed constant.
Often economists present a simple production function, assuming a two- factor model, as under.
Qx = f(K,L)
where, Qx is the rate of output of commodity X per unit of time, K refers to the units of capital
used per unit of time, and L is the labour units employed per unit of time.
The production function can be expressed in terms of a mathematical equation, a table, or
geometric curves specifying the maximum output that can be obtained for a given combination
of factor inputs.
Hence output becomes the dependent variable and inputs are the independent variables. It shows
that there is a constant relationship between applications of input and the amount of output
produced.
1. When inputs are specified in physical units, production function helps to estimate the
level of production.
2. It indicates the manner in which the firm can substitute on input for another without
altering the total output.
3. When price is taken into consideration, the production function helps to select the least
combination of inputs for the desired output.
4. It considers two types’ input-output relationships namely ‘law of variable proportions’
and ‘law of returns to scale’. Law of variable propositions explains the pattern of output
in the short-run as the units of variable inputs are increased to increase the output. On the
 other hand law of returns to scale explains the pattern of output in the long run as all the
units of inputs are increased.
5. The production function explains the maximum quantity of output, which can be
produced, from any chosen quantities of various inputs or the minimum quantities of
various inputs that are required to produce a given quantity of output.

Time Element and Production Functions

The functional relationship between changes in input and consequent changes in output
depends on the time element: short-run and long-run time periods. This time element
considered here is the functional or operational time period.

The Short-Run

The term "short run" is defined as a period of time over which the inputs of some factors of
production cannot be varied. Factors which cannot be in the short run are called fixed factors.
Thus, by definition, in the short period, some factors are fixed and some are variable,
Elements of capital such as plant, machinery and equipment are generally fixed in the short
run. But a fixed factor can also be land or the manager or administrative staff.

In the short period, thus, the output is produced with a given scale of production, ie, the size
of plant or firm remaining unchanged.

The Long-Run

The term "long run" is defined as a period of time long enough to permit variations in the
inputs of all factors of production employed by a firm. In other words, the long period is such
a time period over which all factors become variable. Thus, there is no distinction between
fixed and variable factors in the long run, as all factors become variable factors. The size of
plant which is usually fixed in the short period can be varied only in the long run; hence the
scale of production can be varied in the long run. Thus, in the long run, there is full scope for
adjustment between factors in the production process.

The duration of short run and long run varies from industry to industry or from product to
product. Thus, the long run and short run is a time concept and not a definite time period.

Law of variable proportions ((Short-run analysis of production):

Law of variable proportions occupies an important place in economic theory. This law examines
the production function with one factor variable, keeping the quantities of other factors fixed. In
other words, it refers to the input-output relation when output is increased by varying the
quantity of one input.

When the quantity of one factor is varied, keeping the quantity of other factors constant, the
proportion between the variable factor and the fixed factor is altered; the ratio of employment of
the variable factor to that of the fixed factor goes on increasing as the quantity of the variable
factor is increased.

I. The total product is generated from all the factors of production employed by the
firm. It is the quantity of output produced per time period given the inputs. The total
product can be easily determined. In the short run, the total produt increases with an
increase in the variable factor input. Thus TP = f (QVF). Where, TP denotestotal
product and QVF refers the quantity of variable factor.

II. The average product refers to the total product per unit of a given variable factor. It is
computed through the total output divided by the number of units of the variables of the factor of
production. For example, the 100 factory workers produce 1000 units of electronic components
of a computer, therefore the average product of labor is 10 units of electronic components per
worker. This example is generated by the output per worker employed in the factory.
Average Product= Total product/ QVF

III. The marginal product refers to the additional product obtained by employing an
additional unit of variable factor. All other factors being held constant, the addition
realized in the total product is referred to as the marginal product.
Thus, MPn = TPn – TPn-1. Where, MPn denotes marginal product at n units of
variable factors, TPn denotes total product at n units of variable factors.

For Ex:

No. of Total Product Marginal product:- 22-10=12, it means that if we add one
labourers more labour, the output has increased by 12 units.
1 10
2 22

Statement: Law of variable proportions states that when at least one factor of production is
varied and all other factors are fixed, the total output in the initial stages will increase at an
increasing rate and after reaching certain level of output, the output will increase at declining
rate. If variable factor inputs are added further to the fixed factor inputs, the total output may
decline.

The law of variable proportions is illustrated in the following Table and Fig. Assume that there is
a given fixed amount of land, with which more units of the variable factor labour, is used to
produce agricultural output.

Stages of Total Product Marginal product Average Product

Production
I Increases at an increasing Increases and reaches Increases and reaches
Stage of rate later increase at maximum and starts maximum
 increasing decreasing rate falling
returns
II Increases at a diminishing Continues to fall and Falls
Stage of rate and becomes maximum becomes zero
decreasing
returns
III Decreases Becomes negative Continues to fall
Stage of
negative
returns

(i) Stage of Increasing Returns. The first stage of the law of variable proportions is
generally called the stage of increasing returns. In this stage as a variable resource
(labor) is added to fixed inputs of other resources, the total product increases up to a
point at an increasing rate.
In the first stage, marginal product curve of a variable factor rises in a part and then
falls. The average product curve rises throughout .and remains below the MP curve.
Causes of Initial Increasing Returns:

The phase of increasing returns starts when the quantity of a fixed factor is abundant relative to
the quantity of the variable factor. As more and more units of the variable factor are added to the
constant quantity of the fixed factor, it is more intensively and effectively used. This causes the
production to increase at a rapid rate. Another reason of increasing returns is that the fixed factor
initially taken is indivisible. As more units of the variable factor are employed to work on it,
output increases greatly due to fuller and effective utilization of the variable factor.

(ii) Stage of Diminishing Returns. This is the most important stage in the production function.
In stage 2, the total production continues to increase at a diminishing rate until it reaches its
maximum point where the 2nd stage ends. In this stage both the marginal product (MP) and
average product of the variable factor are diminishing but are positive.

Causes of Diminishing Returns:

The 2nd phase of the law occurs when the fixed factor becomes inadequate relative to the
quantity of the variable factor. As more and more units of a variable factor are employed, the
marginal and average product decline. Another reason of diminishing returns in the production
function is that the fixed indivisible factor is being worked too hard. It is being used in non-
optimal proportion with the variable factor. The diminishing returns occur because the factors of
production are imperfect substitutes of one another.

(iii) Stage of Negative Returns. In the 3rd stage, the total production declines. The TP, curve
slopes downward. The MP curve falls to zero at point and then is negative. It goes below the X
axis with the increase in the use of variable factor (labor).
Causes of Negative Returns:

The 3rd phases of the law starts when the number of a variable, factor becomes, too excessive
relative, to the fixed factors, A producer cannot operate in this stage because total production
declines with the employment of additional labor.

A rational producer will always seek to produce in stage 2 where MP and AP of the variable
factor are diminishing. At which particular point, the producer will decide to produce depends
upon the price of the factor he has to pay. The producer will employ the variable factor (say
labor) up to the point where the marginal product of the labor equals the given wage rate in the
labor market.

Importance of Law of Variable Proportion:

The law of variable proportions has vast general applicability. Briefly:

(i) It is helpful in understanding clearly the process of production. It explains the input output
relations. We can find out by-how much the total product will increase as a result of an increase
in the inputs.

(ii) The law tells us that the tendency of diminishing returns is found in all sectors of the
economy which may be agriculture or industry.

(iii) The law tells us that any increase in the units of variable factor will lead to increase in the
total product at a diminishing rate. The elasticity of the substitution of the variable factor for the
fixed factor is not infinite.

From the law of variable proportions, it may not be understood that there is no hope for raising
the standard of living of mankind. The fact, however, is that we can suspend the operation of
diminishing returns by continually improving the technique of production through the progress in
science and technology.

Law of returns to scale ((Long-run analysis of production):

The period of production in the long run shows the production operation of a certain period
of time. Normally, the firm expansion on the average cost of production may result the increase
of production inputs. However, there are some conditions that:
a) If the firm increases or expand its production operation, is it always increases its production
output.
b) It is possible that the average cost of production may follow the same increase (to let say 50-
50%) in the production input and output.
c) If the firm increases by its production input, however, the production output decreases.
 The long run production for the expansion of the firm through the economies of scale
illustrates the importance of capital intensive ( more equipment per worker) in mass production;
increased specialization and division of labor .
Returns to scale refer to the returns enjoyed by the firm as a result of change in all the inputs. It
explains the behavior of the returns when the inputs are changed simultaneously. The returns to
scale are governed by laws of returns to scale.
1. Law of increasing returns to scale.
2. Law of decreasing returns to scale.
3. Laws of constant return to scale.
(i) Law of increasing returns to scale: This law states that the volume of output keeps
on increasing with every increase in the inputs. Where a given increase in inputs leads
to a more than proportionate increase in the output, the law of increasing returns to
scale is said to operate. We can introduce division of labour and other technologies
means to increase production. Hence, the total product increases at an increasing rate.

OA > AB > BC
Reasons to increasing returns to scale:
1.When a business unit expands, the returns to scale increase because the indivisible factors
are employed to their full capacity.
2. Increasing returns to scale also result from specialisation and division of labour. When
the scale of the firm expands, there is wide scope for specialisation and division of labour.

3. As the firm expands, it enjoys internal economies of production. It may be able to install
better machines, sell its products more easily, borrow money cheaply, procure the services
of more efficient manager and workers, etc.

4. A firm also enjoys increasing returns to scale due to external economies.

(ii) Law of constant returns to scale: When the scope for division of labour gets restricted, the
rate of increase in the total output remains constant, the law of constant returns to scale is said to
operate. This law states that the rate of increase/decrease in volume of output is same to that of
rate of increase/decrease in inputs.

OD = DE = EF
Reasons to constant returns to scale:
The returns to scale are constant when internal economies enjoyed by a firm are neutralized
by internal diseconomies so that output increases in the same proportion.

2. Another reason is the balancing of external economies and external diseconomies.

3. Constant returns to scale also result when factors of production are perfectly divisible,
substitutable, and homogeneous and their supplies are perfectly elastic at given prices.

That is why, in the case of constant returns to scale, the production function is homogeneous
of degree one.

(ii) Law of decreasing returns to scale: Where the proportionate increase in the inputs
does not lead to equivalent increase in output, the output increases at a decreasing
 rate, the law of decreasing returns to scale is said to operate. This results in higher
average cost per unit.

OG < GH < HK

Reasons to decreasing returns to scale:

1. Indivisible factors may become inefficient and less productive.

2. The firm experiences internal diseconomies. Business may become unwieldy and produce
problems of supervision and coordination. Large management creates difficulties of control
and rigidities.

3. To these internal diseconomies are added external diseconomies of scale. These arise
from higher factor prices or from diminishing productivities of the factors.

Capit % Increase In Outp % Increase

al Labour Inputs ut Outputs Laws Applicable

1 3 - 50 -

Law of increasing returns to

2 6 100 120 140
scale.

Law of decreasing returns

4 12 100 240 100
to scale

Law of constant return to

8 24 100 360 50
scale.

From the above table, it is clear that with 1 unit of capital and 12 units of labour, the firm
produces 50 units of output. When the inputs are doubled, two units of capital and six units of
labour, the output has gone up to 120 units. Thus, when inputs are increased by 100 percent, the
output has increased by 140 percent. That is, output has increased by more than double. This is
governed by law of increasing returns to scale.
When the inputs are further doubled that is to 4 units of capital and 12 units of labour, the output
has gone up to 240 units. (from 120 units to 240 units). Thus, when inputs are increased by 100
percent, the output has increased by 100 percent. This is governed by law of constant returns to
scale.
When the inputs are further doubled that is to 8 units of capital and 24 units of labour, the output
has gone up to 360 units. (from 240 units to 360 units). Thus, when inputs are increased by 100
percent, the output has increased by 50 percent. This is governed by law of decreasing returns to
scale.

ISOQUANTS

The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and ‘quant’
implies quantity. Isoquant therefore, means equal quantity. A family of iso-product curves or
Isoquants or production difference curves can represent a production function with two variable
inputs, which are substitutable for one another within limits.
Isoquants are the curves, which represent the different combinations of inputs producing a
particular quantity of output. Any combination on the Isoquants represents the same level of
output.
For a given output level firm’s production becomes,
Q= f (L, K)
Where ‘Q’, the quantity of output is a function of the quantity of two inputs ‘L’ land and ‘K’
capital.
Thus an isoquant shows all possible combinations of two inputs, which are capable of producing
equal or a given level of output. Since each combination yields same output, the producer
becomes indifferent towards these combinations.
Example: From the above table,

combinations capital Rs. In lakh number of labourers Output

A 1 10 50 qunitals

B 2 7 50 qunitals

C 3 4 50 qunitals

D 4 2 50 qunitals
 E 6 1 50 qunitals

Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’ quintals of a
product all other combinations in the table are assumed to yield the same given output of a
product say ‘50’ quintals by employing any one of the alternative combinations of the two factors
labour and capital. If we plot all these combinations on a paper and join them, we will get
continues and smooth curve called Iso-product curve as shown below.

Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which shows all
the alternative combinations A, B, C, D, E which can produce 50 quintals of a product.
Assumptions:
1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.
4. The technology is given over a period.

Types of Isoquants:
The production isoquant may assume various shapes depending on the degree of substitutability
of factors.
A. Linear isoquant: This type assumes perfect substitutability of factors of production. A
given commodity may be produced by using only capital, or only labour, or by an infinite
combination of K and L.
 B. Input-output isoquant: This assumes strict complementarity, that is, zero substitutability
of the factors of production. There is only one method of production for any one
commodity. The isoquant takes the shape of a right angle. This type of isoquant is called
“Leontief Isoquant” or “input-output isoquant”.

C. Kinked isoquant: This assumes limited substitutability of K and L. There are only a few
processes for producing any one commodity. Substitutability of factors is 66 Managerial
Economics Linear Isoquant Input Isoquant Linear Programming Isoquant Convex
Isoquant possible only at the kinks. It is also called “activity analysis-isoquant” or
“linear-programming isoquant”, because it is basically used in linear programming.

D. Smooth, convex isoquant: This form assumes continuous substitutability of K and L only
over a certain range, beyond which factors cannot substitute each other. This isoquant appears as
a smooth curve convex to the origin
PROPERTIES OF ISOQUANTS
The important properties of isoquants are the following:
1. Isoquants slope downwards to the right: It means that, in order to keep the output
constant; when the amount of one factor is increased the quantity of other factor must be
reduced. An upward sloping isoquant demonstrates that a given product can be produced
with less of both the factors of production. An entrepreneur, who is maximising profits,
would not use any combinations of factors shown on an upward sloping portion of an
isoquant. Therefore, the points on the upward sloping portion of an isoquant cannot
represent an equilibrium position. Thus, isoquants slope downwards to the right.

2. Isoquants are convex to the origin: Isoquants are convex to the origin due to the
concept of diminishing marginal rate of technical substitution (MRTS). A
declining MRTS refers to the falling marginal product of labour in relation to
capital. To put it differently, as more units of labour are used, and as certain units
of capital are given up, the marginal productivity of labour in relation to capital
will decline.

3. Isoquants do not intersect: By definition isoquants can never cut each other. If they cut
each other it would be a logical contradiction. Two Iso-product curves intersect each
other. Both curves IQ1 and IQ2 represent two levels of output. But they intersect
 each other at point A. Then combination A = B and combination A= C. Therefore B
must be equal to C. This is absurd. Therefore two curves which represent two levels
of output cannot intersect each other.

4. Isoquants cannot touch either axis: If an isoquant touches any axis, it would mean
that the output can be produced with the help of one factor. It is unrealistic because
output cannot be produced only by labour or capital alone.

5. Higher Iso-Product Curves Represent Higher Level of Output: A higher iso-product

curve represents a higher level of output as shown in the figure given below:
 6. Isoquants Need Not be Parallel to Each Other: It so happens because the rate of
substitution in different isoquant schedules need not be necessarily equal. Usually
they are found different and, therefore, isoquants may not be parallel.

MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS)

The marginal rate of technical substitution (MRTS) refers to the rate at which one input factor is
substituted with the other to attain a given level of output. In other words, the lesser units of one
input must be compensated by increasing amounts of another input to produce the same level of
output.
Marginal rate of technical substitution between L and K is defined as the quantity of K
which can be given up in exchange for an additional unit of L. It can also be defined as the
slope of an isoquant.

It can be expressed as:

MRTSLK = – ∆K/∆L = dK/ dL

Where ∆K is the change in capital and ∆L is the change in labour.

The following table presents the ratio of MRTS between the two input factors, say capital and
labour. 5 units of decrease in labour are compensated by an increase in 1 unit of capital, resulting
in a MRTS of 5:1.

Combinations Capital Rs. In lakh Number of Labourers Output MRTS

A 1 20- 20,000 UNITS -

B 2 15 20,000 UNITS 5:1

C 3 11 20,000 UNITS 4:1

D 4 8 20,000 UNITS 3:1

E 5 6 20,000 UNITS 2:1

 F 6 5 20,000 UNITS 1:1

From the above it can be observed that for an increase in the use of capital, fewer units of
labour will be used. In other words, a declining MRTS refers to the falling marginal product
of capital in relation to labour. To put it differently, as more units of capital are used, and as
certain units of laboour are given up, the marginal productivity of capital in relation to
labour will decline.

The Isocost

The isocost line is an important component when analysing producer’s behaviour. The isocost
line illustrates all the possible combinations of two factors that can be used at given costs and for
a given producer’s budget. In simple words, an isocost line represents a combination of inputs
which all cost the same amount.

Now suppose that a producer has a total budget of Rs 120 and for producing a certain level of
output, he has to spend this amount on 2 factors A and B. Price of factors A and B are Rs 15 and
Rs. 10 respectively.
Combinations Units of Capital Units of Labour Total expenditure

Price = 15Rs Price = 10 Rs ( in Rupees)

A 8 0 120

B 6 3 120

C 4 6 120

D 2 9 120

E 0 12 120
The isocost line shows all the possible combinations of two factors Labour and capital that result
in same cost.

LEAST COST COMBINATION OF INPUTS

The manufacturer has to produce at lower costs to attain higher profits. The isocosts and
isoquants can be used to determine the input usage that minimizes the cost of production. The
point where the slope of isoquant is equal to that of isocost, i.e. where iso cost curve becomes
tangent to isoquant is the lowest point of cost of production. This can be observed by super
imposing the isocosts on isoquant curves.