MODULE 3

PRODUCTION
In Economics the term production means process by which a commodity (or commodities) is
transformed in to a different usable commodity. In other words, production means transforming inputs
(labour, machines, raw materials etc.) into an output. This kind of production is called manufacturing.
The production process however does not necessarily involve physical conversion of raw materials
in to tangible goods. it also includes the conversion of intangible inputs to intangible outputs . For
example, production of legal, medical, social and consultancy services- where lawyers, doctors, social
workers consultants are all engaged in producing intangible goods.
An „input` is good or service that goes in to the process of production and “out put is any good or
service that comes out of production process.
Fixed and variable inputs.
In economic sense, a fixed input is one whose supply is inelastic in the short run Therefore, all of its
users cannot buy more of it in short run. Conceptually, all its users, cannot employ more of it in the
short run. If one user buys more of it, some other users will get less of it. A variable input is defined
as one whose supply in the short run is elastic, eg: Labour, raw materials etc. All the users of such
factors can employ larger quantity in the short run.
In technical sense, a fixed input remains fixed (constant) up to a certain level of output whereas a
variable input changes with change in output.
A firm has two types of production function:-
1. Shot run production function
2. Long run production function

Production function
Production function shows the technological relationship between quantity of output and the quantity
of various inputs used in production. Production function is economic sense states the maximum
output that can be produced during a period with a certain quantity of various inputs in the existing
state of technology. In other words, it is the tool of analysis which is used to explain the input - output
relationships. In general, it tells that production of a commodity depends on the specified inputs. in its
specific tem it presents the quantitative relationship between inputs and output. Inputs are classified
as:-
1. Fixed input or fixed factors.
2. Variable input or variable factors.
Short run and Long run
Shot run refers to a period of time in which the supply of certain inputs (E.g. :- plant,
building ,machines, etc) are fixed or inelastic. Thus an increases in production during this period is
possible only by increasing the variable input. In some Industries, short run may be a matter of few
weeks or a few months and in some others it may extent even up to three or more years.
The long run refers to a period of time in which “supply of all the input is elastic; but not enough to
permit a change in technology. In the long run, the availability of even fixed factor increases.
Thus in the long run, production of commodity can be increased by employing more of both, variable
and fixed inputs.
In the strict sense ,production function is defined as the transformation of physical input in to physical
output where output is a function input .It can be expressed algebraically as;
Q=f (K,L etc).
Where,
Q Is the quantity of output produced during a particular period
K, L etc are the factors of production
f -denotes the function of or depends on.
The production functions are based on certain assumptions;
1. Perfect divisibility of both inputs and output;
2. Limited substitution of one factor for the others
3. Constant technology; and
4. Inelastic supply of fixed factors in the short run
Cobb-Douglas Production Function.
One of the important tool of statistical analysis in production function that measures the relation
between change in physical input is cob-Douglas production function . The concept was originated in
USA. This is more peculiar to manufacturing concerns. The cob-Douglas formula says that labour
contributes about 75% increases in manufacturing production while capital contributes only 25%.The
formula is as follows:-
α (1-α)
Q=AL K
Where Q is output. L is the quantity of labour K is the quantity of capital employed A and α (α<1) are
positive constants. α and (1-α) measure percentage response of output to percentage change in labour
and capital respectively. The production function shows at One (1%)percentage change in labour,
capital remaining constant, is associated with 0.75% change in output . Similarly One percentage
change in capital, labour remaining constant, is associated with a 20%change in output. Returns to
scale are constant. That is if factors of production are increased, each by 10 percentage then the output
also increases by 10 percentage
The laws of production
Production function shows the relationship between a given quantity of input and its maximum
possible output. Given the production function, the relationship between additional quantities of
input and the additional output can be easily obtained. This kind of relationship yields the law of
production. The traditional theory of production studies the marginal input-output relationship under
(I) Short run; and (II) long run.
In the short run, input-output relations are studied with one variable input, while other inputs are held
constant. The Law of production under these assumptions are called “the Laws of variable
production”. In the long run input output relations are studied assuming all the input to be variable.
The long-run input output relations are studied under `Laws of Returns to Scale.
Law of Diminishing Returns (Law of Variable Proportions)
The Laws of returns states the relationship between the variable input and the output in the short term.
By definition certain factors of production (e.g.-Land, plant, machinery etc) are available in short
supply during the short run . Such factors which are available in unlimited supply even during the
short periods are known as variable factor. In short-run therefore ,the firms can employ a limited or
fixed quantity of fixed factors and an unlimited quantity of the variable factor . In other words, firms
can employ in the short run varying quantities of variable inputs against given quantity of fixed
factors. This kind of change in input combination leads to variation in factor proportions. The Law
which brings out the relationship between varying factor properties and output are therefore known as
the Law of variable proportions.
The variation in inputs lead to a disproportionate increase in output more and more units of variable
factor when applied cause an increase in output but after a point the extra output will grow less and
less. The law which brings out this tendency in production is known as‟ Law of Diminishing Returns.
The Law of Diminishing returns levels that any attempt to increase output by increasing only one
factor finally faces diminishing returns. The Law states that when some factor remain constant, more
and more units of a variable factor are introduced the production may increase initially at an
increasing rate; but after a point it increases only at diminishing rate. Land and capital remain fixed in
the short-term whereas labour shows a variable nature.
Thefollowingtableexplains theoperation ofthe Law ofDiminishingReturns.
No. of Workers Total Product (TP) Avg. Product (AP) Marginal Product
(Variable Input) (MP)
1 10 10 10
2 24 12 14
3 39 13 15
4 56 14 17
5 70 14 14
6 78 13 8
7 84 12 6
8 84 10.5 0
9 81 9 -3

The above table illustrates several important features of a typical production function .With
onevariableinput.- herebothAverageProduct(AP)andMarginal
Product(MP)firstrise,reachamaximum-
thendecline.Averageproductistheproductforoneunitoflabour.Itisarrivedatby
dividingtheTotal Product(TP)bynumberof workersMarginalproductistheadditionalproduct
resulting term additional labour.It is found out by dividing the change in totalproduct by
thechange in thenumber of workers. The total output increasesatanincreasingrate till the
employmentof the 4th worker.The rateofincrease inthe
marginalproductrevealsthis .Anyadditionallabouremployed beyondthe 4 thlabour
clearlyfaces theoperation of the Law ofDiminishing Returns.
Themaximummarginalproduct is16afterwhich itcontinues
tofall,ultimatelybecomingnegative. Thus whenmoreandmoreunitsof labourare
combinedwithotherfixedfactors thetotaloutputincreasefirstat an increasingratethen at a
diminishingratefinallyitbecomes negative.
Thegraphical representationtheabovetableisshown below
OX axis represents the units of labour and OY axis represents the unit of output. The total output(TP)
curve has a steep rise till the employment of the 4 th worker. This shows that the output increases at an
increasing rate till the employment of the 4th labour. TP curve still goes on increasing but only at a
diminishing rate. Finally TP curve shows a downward trend. The Law of Diminishing Returns
operation at three stages. At the first stage, total product increases at an increasing rate. The marginal
product at this stage increases at an increasing rate resulting in a greater increases in total product.
The average product also increases. This stage continues up to the point where average product is
equal to marginal product the law of increasing returns is in operation at this stage.
The Law of increasing Returns operates from the second stage on wards. At the second stage , the
total product continues to increase but at a diminishing rate . As the marginal product at this stage
starts falling ,the average product also declines. The second stage comes to an end where total product
become maximum and marginal product becomes zero. The marginal product becomes negative in the
third stage. So the total product also declines. The average product continues to decline in the third
stage.

Assumptions of Law Diminishing Returns

The Law of Diminishing Returns is based on the following assumptions;- Returns is based on the
following assumptions;-
1. The production technology remains unchanged
2. The variable factor is homogeneous.
3. Any one factor is constant
4. The fixed factor remains constant.

Law of Returns to scale

In the long –run all the factor of production are variable ,and an increase in output is possible by
increasing all the inputs. The Law of Returns to scale explains the technological relationship between
changing scale of input and output. The law of returns of scale explain how a simultaneous and
proportionate Increase in all the inputs affect the total output. The increase in output may be
proportionate, more than proportionate or less than proportionate. If the increase in output is
proportionate to the increase in input , it is constant Returns to scale .If It is less then proportionate
it is diminishing returns to scale . The increasing returns to the scale comes first ,then constant and
finally diminishing returns to scale happens.
Increasing Returns to scale
When proportionate increase in all factor of production results in a more than proportionate increase
in output and this results first stage of production which is known as increasing returns to scale.
Marginal output increases at this stage. Higher degree of specialization, falling cost etc will lead
higher efficiency which result increased returns in the very first stage of production.
Constant Returns to scale
Firms cannot maintain increasing returns to scale indefinitely after the first stage , firm enters a stage
when total output tends to increase at a rate which is equal to the rate of increase in inputs. This stage
comes in to operation when the economies of large scale production are neutralized by the
diseconomies of large scale operation.
Diminishing Returns to Scale
In this stage, a proportionate increase in all the input result only less than proportionate increase in
output. This is because of the diseconomies of large scale production. When the firm grows further,
the problem of management arise which result inefficiency and it will affect the position of output.
Economies of Scale
The factors which cause the operation of the laws of returns the scale are grouped under economies
and diseconomies of scale. Increasing returns to scale operates because of economies of scale and
decreasing returns to scale operates because of diseconomies of scale where economies and
diseconomies arise simultaneously. Increasing returns to scale operates when economies of scale are
greater then the diseconomies of scale and returns to scale decreases when diseconomies.
overweight the economies of scale. Similarly when economies and diseconomies are in balance,
returns to scale becomes constant. When a firm increases all the factor of production it enjoys the
same advantages of economies of production. The economies of scale are classified as;
 Internal economies.
 .External economies
Internal economies of scale
Internal economies are those which arise form the explanation of the plant-size of the firm .Internal
economies of scale may be classified;-
1. Economies in production.
2. Economies in marketing
3. Economies in economies
4. Economies in transport and storage
A. Economies in production :-it arises term
 Technological advantages
 Advantages of division of labour and specialization
B. Economies in marketing;-It facilitates through
 Large scale purchase of inputs.
 Advertisement economies ;
 Economies in large scale distribution
 Other large-scale economies
C. Managerial economies ;- It achieves through
 Specialization in management
 Mechanization of managerial function.
D. Economies in transport and storage
Economies in transportation and storage costs arise from fuller utilization of transport and storage
facilities.
External Economies of scale
External or pecuniary economies to large size firms arise from the discounts available to it due to;
1. Large scale purchase of raw materials
2. Large scale acquisition of external finance at low interest 3 . Lower advertising rate fun
advertising media.
3. Concessional transport charge on bulk transport.
4. Lower wage rates if a large scale firm is monopolistic employer of certain kind of specialized
labour
Thus External economies of scale are strictly based on experience of large –scale firms or well
managed small scale firms. Economies of scale will not continue forever. Expansion in the size of the
firms beyond a particular limit, too much specialization, inefficient supervision, Improper labour
relations etc will lead to diseconomies of scale .
Isoquant Curve.
The terms “Iso-quant” has been derived from the Greek word iso means `equal` and Latin word
quantus means `quantity`. The iso-quant curve is therefore also known as`` equal product curve ``or
production indifference curve. An iso- quant curve is locus of point representing the various
combination of two inputs –capital and labour –yielding the same output. It shows all possible
combination of two inputs, namely- capital and labour which can produce a particular quantity of
output or different combination of the two inputs that can give in the same output . An isoquant curve
all along its length represents a fixed quantity of output.
The following table illustrates combination of capital (K) and labour (L) which give the same output
say 20 units.
The combinations of A uses one unit of „K‟ and 12 units of „L‟ to produce is20 units. likewise the
combinations B,C,D and E give the same output 20 units.
Combination Capital Labour Output
A 1 12 20
B 2 8 20
C 3 5 20
D 4 3 20
E 5 2 20

The above curve shows the four different combinations of inputs. (capital and labour) which give the
same output namely 20units ,40units ,60units respectively. Thus it provides fixed level of output.
Further the shape of isoquants reveal the degree of substitutability of one factor for another to yield
the same level of output . It also implies the diminishing marginal rate of technical substitution.
Marginal rate of technical substitution refers to the rate at which one output can be substituted for
another in order to keep the output constant . The slope of an isoquant indicates the marginal rate of
technical substitution at the point.
Properties of Isoquants
1. Isoquants have a negative slope:-An isoquant has a negative slope in the economic region or
in the relevant range. Economic region means where substitution between input is technically
possible that keeps same output.
2. Isoquants are convex to origin:- Convex nature of Isoquant shows the substitutability of One
factor for another and the diminishing marginal rate of technical substitution.
3. Isoquant cannot Intersect or be tangent to each other
Marginal Rate of Technical substitution (MRTS)
MRTS is the rate at which marginal unit of an input can be substituted for the marginal units of the
other input so that the level of output remains the same. In other words it is the ratio of marginal unit
of labour substituted for the marginal units of capital without affecting the total output. This ratio
indicates the slop of Isoquants.
Isocost Curve
Isocost curve shows the different combination that a firm can buy with a certain an unit of money.

Usually, the management has to incur expenditure in buying inputs namely - labour , raw – materials,
machinery etc. Further, management is expected to know price of inputs what it costs to produce a
given output. Therefore, it is required to minimize the cost of output that it produces. Here
management is more helpful to draw isocost curve that represents the equal cost. An iso-cost line is so
called because it shows the all combinations of inputs having equal total cost. The isocost lines are
straight lines which represents the same cost with different input combinations. .Suppose a firm
decides to spend Rs.100 on output .If one unit of labour costs Rs.10 the firm can purchase 10units of
labour. Similarly, If a unit of capital cost Rs.25,the firm can spend the whole amount on buying 4
units of capital likewise the firm can spend partly on capital, say 2 units and party on labour ,say 5
units for this Rs.100.
The figure shows that the firm has the option to spend the total money either on capital or labour or on
both, from this Rs.100, the firm can buy either OL, units of labour or OK, units of capital or any
combination of those two between the extremes‟K1‟and L1. An isocost curve represents the same
cost for all the different combination of inputs. The upward isocost curve as represented by K2 L2 and
K3 L3shows higher amounts spent on larger quantities of both K and L
Optimum Combination of inputs
A profit maximizing firm seeks to minimize its cost for a given output or to maximize the output for a
given total cost. A certain quantity of output can be produced with different Input combinations.
Optimum input combination is that which bears least cost .Thus the input combination that results in
the minimum cost of production is to be found out .This is known as least - cost input combination.
This can be found out by combining Isoquant curves and Isocost curves. The production function is
represented by Isoquant curve and the cost function is represented by Isocost curve .The least cost
combination exists at a point where Isoquant is tangent to Isocost.

The figure shows the least –cost combination of capital end labour .The Isoquant Iq1, is tangent to the
Isocost curve K1,L1 at point `z` .At this point in the combination is OP of capital and OQ of labour .
The point `z` gives the ideal combination which minimizes cost of production per units, It is the point
at which the firm is in equilibrium. At the point `z` the isocost line K1,L1, representing Rs100 is
tangent to the isoquant curve Iq1, representing 20units of output .Any other point on Iq1, would mean
the same output ,but at high cost .The point A or B or Iq1, gives the same output but with a higher
cost combination of inputs K2 L2 representing Rs.200 . The point C` is the least cost point of
producing 40 units formed by the intersection of Iq2(40 units)and K2,L2(Rs.200)