Chapter 7

Production Theory
 Lecture Plan
• Objectives
• Production
• Types of inputs
• Factors of production
• Production function
– Production function with one variable input
– Production function with two variable inputs
– Isoquants
• Producer’s equilibrium
• Returns to scale
• Cobb Douglas and CES production functions
• Technical progress
• Summary
 Chapter Objectives
• To examine the economic analysis of a firm’s
technology, different types of inputs and the process of
production.
• To help develop an understanding of the distinction
between short run and long run production functions.
• To build up a critical appraisal of the law of variable
proportions and returns to scale.
• To introduce the concepts of isoquant, isocost line,
marginal rate of technical substitution, elasticity of
substitution and expansion path.
• To develop an understanding of technical progress and
its nuances.
 Production
• The process of transformation of resources (like land, labour, capital
and entrepreneurship) into goods and services of utility to
consumers and/or producers.
• The process of creation of value or wealth through the production of
goods and services that have economic value.
• process of adding value may occur
– by change in form (input to output, say steel into car), or
– by change in place (supply chain, say from factory to dealers/retailer), or
– by changing hands (exchange, say from retailer to consumer).
• Goods includes all tangible items such as furniture, house, machine,
food, car, television etc
• Services include all intangible items, like banking, education,
management, consultancy, transportation.
 Types of Inputs
Technology
• determines the type, quantity and proportion of inputs.
• also determines the maximum limit of total output from a given
combination of inputs.
• at any point of time, technology will be given; impact of technology
can be seen only over a period of time.
Fixed and Variable Inputs
• Production analysis of a firm uses two distinct time frames:
– the short run: refers to a period of time when the firm cannot vary some of
its inputs.
– the long run., refers to a time period sufficient to vary all of its inputs,
including technology.
• Variable input : that can be made to vary in the short run, e.g. raw
material, unskilled/semi skilled labour, etc.
• Fixed input: that cannot be varied in the short run, e.g. land, machine,
technology, skill set, etc.
 Factors of Production
5 factors of production
• Land
– Anything which is gift of nature and not the result of human effort, e.g. soil,
water, forests, minerals
– Reward is called as rent
• Labour
– Physical or mental effort of human beings that undertakes the production
process. Skilled as well as unskilled.
– Reward is called as wages
• Capital
– Wealth which is used for further production as machine /
equipment/intermediary good
– It is outcome of human efforts
– Reward is called as interest
• Enterprise
– The ability and action to take risk of collecting, coordinating, and utilizing all
the factors of production for the purpose of uncertain economic gains
– Reward is called as profit
• Organization
 Combination of highly skilled labour and specialized human
capital/managerial aspect of business.
 Reward is called as salary.
 Production Function
• A technological relationship between physical inputs and physical
outputs over a given period of time.
• shows the maximum quantity of the commodity that can be produced
per unit of time for each set of alternative inputs, and with a given
level of production technology.
Hence it can be said that production function is:
• Always related to a given time period
• Always related to a certain level of technology
• Depends upon relation between inputs.
• Normally a production function is written as:
Q = f (L,K,I,R,E)
where Q is the maximum quantity of output of a good being produced,
and L=labour; K=capital; l=land; R=raw material; E= efficiency
parameter.
• Technical efficiency is defined as a situation when using more of one
input with either the same amount or more of the other input must
increase output.
Production Function with One Variable
Input
• Also termed as variable proportion production function
• It is the short term production function
• Shows the maximum output a firm can produce when only
one of its inputs can be varied, other inputs remaining
fixed:
Q = f ( L, K )
where Q = output, L = labour and K = fixed amount of capital
• Total product is a function of labour: TPL = f ( K ,L)
– Average Product (AP) is total product per unit of variable
input TP
– Average product of labour (APL) is: APL = L
– Marginal Product (MP) is the addition in total output per unit
change in variable input ∆TP
MPL =
– Marginal product of labour (MPL) is: ∆L
 Law of Variable Proportions
Labour Total Product MP AP Stages
(’00 units) (’000 tonnes)
200
1 20 - 20 Increasing
2 50 30 25 returns 150
Tot a l P ro d u c t
(’00 0 to nn e s )
100
3 90 40 30 M a rg in a l

Output
P rod u c t
50
4 120 30 30 Diminishing A ve ra g e

5 140 20 28 returns 0
P rod u c t

1 2 3 4 5 6 7 8 9
6 150 10 25 -5 0
La bour
7 150 0 21.5
8 130 -20 16.3 Negative
returns
9 100 -30 11.1
•As the quantity of the variable factor is increased with other fixed factors,
MP and AP of the variable factor will eventually decline.
•Therefore law of variable proportions is also called as law of diminishing
marginal returns.
 Law of Variable Proportions

C •First stage
Total •Increasing Returns to
Outp the Variable Factor
ut B TP
L
•MP>0 and MP>AP
A •Second stage
•Diminishing Returns to
a Variable Factor
O •MP>0 and MP<AP
Labo
Total ur •Third Stage
Outp Stage I Stage II Stage •Negative Returns
ut III •MP<0 while AP is falling
A* B* but positive
•Technically inefficient
stage of production
APL
C*
•A rational firm will never
O operate in this stage
MP Labo
ur
 Production Function with Two Variable
Inputs
• All inputs are variable in long Capital (Rs. Labour (’00
crore) units)
run and only two inputs are
used 40 6
28 7
• Firm has the opportunity to
select that combination of inputs 18 8
which maximizes returns 12 9
• Curves showing such 8 10
production function are called 45

isoquants or iso-product curves. 40

35

• An isoquant is the locus of all

30

Capital (Rs. Crore)

25

technically efficient
20
15

combinations of two inputs for 10

5

producing a given level of 0

6 7 8 9 10

output L a b o u r ('0 0 u n i ts)

• Represented as: Q = f ( L, K )
 Characteristics of Isoquants

• Downward sloping
• Convex to the origin
• A higher isoquant represents a higher output
• Two Isoquants do not intersect

Capital Capital
A
C

B A
B Q1
C
Q2
Q1
Q0 Q2
O O
Labour Labour
Marginal Rate of Technical Substitution
• Measures the reduction in one input, due to unit increase
in the other input that is just sufficient to maintain the
same level of output.
∆K
MRTS LK =−
∆L
• MRTS of labour for capital is equal to the slope of the
isoquant.
• It is also equal to the ratio of the marginal product of one
input to the marginal product of other input
∆ Q = M PL × ∆ L + M PK × ∆ K
0 = MPL × ∆ L + MPK × ∆ K
MP ∆K
MRTS LK = L
=−
MPK ∆L
 Special Shapes of Isoquants
Capi Capi
tal tal

Q3
Q2
Q1
Q1 Q2 Q
O Lab O Lab
3
our our
Linear isoquants Right angled isoquants
L K
Q = f ( L, K ) = αK + βL Q = min( , )
α β
•Leontief production technology
•Perfect substitutability •Capital is a perfect complement
between two factors for labour
•Isoquants are downward •Non existence of any
sloping straight lines substitutability between the two
•Constant MRTS factors
 Elasticity of Substitution

• Measures the percentage change in factor proportions due

to a change in marginal rate of technical substitution
d ( K / L)
σ= K/L
d ( MRTS)
MRTS
• σ is effectively a measure of the curvature of an isoquant
• More curved or convex is the isoquant, the lower is σ
• In Leontief (zero substitution) technology, with L shaped
isoquants, there is no substitutability between the inputs
σ=0
• In perfect substitution or linear production technology, the
MRTS does not change at all along the isoquant.
σ is infinite
 Isocost Lines
Capit
al A2
Total Cost is sum of Labour cost
A (wL) and Capital cost (rK) where
A1 wage (w) and interest (r)
C = wL + rK
O B1 B B2 Labo
ur
The isocost line represents the locus of points of all the
different combinations of two inputs that a firm can procure,
given the total cost and prices of the inputs
C
∆K w
Slope = − = r =
∆L C r
w

The (absolute) slope of this line is equal to the ratio of the

input prices
 Producer’s Equilibrium
Capita
Capit
l al
A A2
R
C
A
E A1
K* E
K
Q3
D Q2
Q S
Q 0 Q
O 1
Labo O
L* B L B1 B B2 Labo
ur
ur
Maximization of output subject to Minimization of cost for a given
a cost constraint level of output

Necessary condition for equilibrium

Slope of isoquant = Slope of isocost line
 Expansion Path
Capital

Expansion
Path
E E2
E1

O
Labour

•Line formed by joining the tangency points between various

isocost lines and the corresponding highest attainable isoquants
is known as Expansion Path.
•For homogeneous production function and given factor
prices (and hence factor ratio):
expansion path is a straight line through the origin.
•For non- homogeneous production function:
optimal expansion path is non linear.
 Returns to Scale
• Returns to Scale show the degree by which the level of output changes in
response to a given change in all the inputs in a production system.
Pane
Pane lb Pane
Capit la Capit Capit lc
C2
al al al
C
B2 C1
B 400Q B
A 200 A2 A
Q 1 125Q
100Q 150Q
50Q
1
90Q
50Q 50Q
O O O
Labou Labou Labou
r r r
• Constant Returns to Scale : When a proportional increase in all inputs
yields an equal proportional increase in output (Panel a)
• Increasing Returns to Scale : When a proportional increase in all inputs
yields a more than proportional increase in output (Panel b).
• Decreasing Returns to Scale : When a proportional increase in all
inputs yields a less than proportional increase in output (Panel c).
 Cobb-Douglas Production Function
• Proposed by Wicksell and tested against statistical evidence by
Charles W. Cobb and Paul H. Douglas in 1928
• Q = AK α Lβ where α, β are constants. A is the technological
parameter, α is the elasticity of output with respect to capital, and β is
the elasticity of output with respect to labour.
Properties
• Homogeneous of degree (α +β )
• The returns to scale is immediately revealed by the sum of the two
parameters α and β
 Constant Returns to Scale: (α + β ) = 1
 Increasing Returns to Scale: (α +β ) > 1
 Decreasing Returns to Scale: (α +β ) < 1
• Isoquants are negatively sloped and convex to the origin
• MRTSLK is a function of input ratio
• Elasticity of substitution is equal to 1
 Leontief Production Function

• Represents the extreme case of perfect complements

• ‘L’ shaped or right angled isoquants.
• Also known as fixed coefficient production function
L K
Q = min( , )
α β
• Production technology always involves inputs labour (L) and
capital (K) in fixed proportions to produce a unit of output and α
and в are the fixed coefficients
• A certain amount of each input is required technologically to
produce one unit to output
• Demand for inputs is uniquely determined
 Inputs are required in exact quantities per unit of output
• Any change in MRTS will not lead to any change in the factor
proportions: б = 0
 CES Production Function
• Constant Elasticity of Substitution (CES) production
function
• Introduced by Arrow, Chenery, Minhas and Solow (also
known as ACMS)
• Q=A[αK -ρ +(1-α)L -ρ ] -r/ρ, where:
 A(>0) is the efficiency parameter which represents the "size" of
the production function
 α is the distribution parameter which will help us explain relative
factor shares (so 0<α<1);
 ρ is the substitution parameter, which will help us derive the
elasticity of substitution and
 r is the scale parameter which determines the degree of
homogeneity
• Homogeneous of degree r
 Technical Progress
• Refers to research and development and investments made
to manage technical know how
• Technical change may be
– Embodied or investment specific, where new capital is used in
the production apparatus, which requires investment to take
place; or
– Disembodied or investment neutral, where output increases
without any increase in investment but by an innovation
through research and knowledge.
• Types of Technical Progress (Hicks)
– Neutral Technical Progress: changes in the marginal product
of labour (MPL) and capital (MPK) are same
– Labour augmenting Technical Progress: MPL increases
faster than the MPK
– Capital augmenting Technical Progress : MPK increases
faster than MPL
 Technical Progress
• Panel ‘a’ shows Neutral technical Progress: MRTS is constant and
independent of time along the points on the expansion path; isoquants shift
parallel downwards.
• Panel ‘b’ shows Labour augmenting technical Progress: MRTS LK, being the
ratio of the marginal products, decreases.
• Panel ‘c’ shows Capital augmenting technical Progress: MRTS LK, , being the
ratio of the marginal products, increases.

Capi Pane Capita Q Pane Capita Q Pane

Q la Q lb lc
tal l l
L QK
K
Q
K
Q Q
1
Q1 Q
Q
O O O K
L L Labo Lab
L Lab
1 ur our our
 Summary
• A production function shows the relationship between inputs and
outputs given the state of technology.
• According to the law of variable proportions, as the quantity of the
variable factor is increased with other fixed factors, the marginal product
and the average product will eventually decline.
• Isoquants are locus of points of different combinations of labour and
capital inputs that produce the same level of output.
• MRTS is the absolute slope of an isoquant; it is equal to the ratio of the
marginal products of factor inputs.
• The isocost line represents the locus of points of all the different
combinations of labour and capital that a firm can purchase, given the
total cost and prices of the inputs.
• The (absolute) slope of the isocost line is equal to the ratio of the input
prices; i.e. the relative price of labour to capital.
• The optimum level of inputs needed for objective of either minimizing
cost of producing a given level of output, or maximizing output at a given
cost would be at the point of tangency of an isoquant and an isocost
line.
 Summary
• Expansion path is defined as the line formed by joining such tangency
points between the isocost lines and the highest attainable isoquants.
• In increasing returns to scale a proportional increase in all inputs yields
a more than proportional increase in output
• If a proportional increase in all inputs yields an equal proportional
increase in output, then there is constant returns to scale.
• If a proportional increase in all inputs yields a less than proportional
increase in output, then there is decreasing returns to scale.
• In a homogeneous function if each input is multiplied by λ , then λ is
factored out of the function. The power of λ is known as the degree of
homogeneity and is a measure of returns to scale.
• Technical progress refers to improvements made in research and
development and various investments made to manage technical know
how.
• Technical progress is neutral if changes in marginal products of labour
and capital are same; labour augmenting if MPL increases faster than
MPK and capital augmenting if MPK increases faster than MPL.