Chapter 5

PRODUCTION FUNCTION
Meaning of production:
• Refers to any process that converts a commodity or commodities into a different
commodity.
• It is the process which transforms the raw materials into a finished good.
• It is an economic activity of converting inputs into output.
Production Function:
• It is the functional relation between physical inputs and output of a good which is technical
in nature.
• It is the functional relation between change in output due to change in inputs.
• It defines the maximum output that can be produced with the given minimum quantity of
inputs and the given technology.
• It is always based on the given level technology.
Factors of Production: Producer makes use of various inputs for production of goods and
services known as factors of production. It can be classified into Variable and Fixed Factors.
 VARIABLE FACTORS FIXED FACTORS

1. Refers to those factors ,which can be changed in 1. Refers to those factors, which cannot be
the short run. changed in the short run.

2. They vary directly with the level of output, i.e. 2. They do not vary directly with the level of
as output increases, requirement for variable output, i.e. it remains same irrespective of
factors also increases and vice-versa. level of output in short run.

3. Raw material, casual labour, power, fuel, etc. 3. Building, plant and machinery, permanent
staff, etc.
 Types of Production Period:
I. Short Run:
• Refers to a period in which output can be changed by changing only variable factors.
• Under this factors are classified as variable and fixed factors.
• Here production can be increased by increasing variable factors, but till the extent of capacity of fixed factors.
• Demand is more active in price determination as supply cannot be increased immediately with increase in
demand.
• Raw material, casual labour, power, fuel, etc.
II. Long Run:
• Refers to a period in which output can be changed by changing all factors of production.
• All factors are variable in long run.
• Both demand and supply play equal role in price determination as both can be increased.
• Building, plant and machinery.
 Types of Production Function:

I. Short Run Production Function:

• Refers to a situation when output is increased by changing only one input while keeping other inputs
unchanged.
• There is change in variable input only, this leads to change in input at different levels of output.
• The law which operates under short run production function is Law of Variable Proportion.

II. Long Run Production Function:

• Refers to a situation when output is increased by increasing all the inputs simultaneously and in the same
proportion.
• Here all inputs are variable, the ratio between different inputs tends to remain the same at different
levels of output.
• The law which operates under long run production function is Law of Returns to Scale.
Concept of Product:
• Meaning : Refers to the volume of goods produced by a firm or an industry during a specified period of
time.
• Categories of product:
i. Total Product (TP): * Refers to total quantity of goods produced by a firm during a given period of
time with given number of inputs and given level of technology.
• TP can be expanded by increasing only the variable factors.
• It is also known as Total Physical Product (TPP)/ Total Return/Total Output.
• TP= ∑ MP TP = Units of variable factor x AP
ii. Average Product(AP): * Refers to output per unit of variable input.
* It is also known as Average Physical Product (APP)/ Average Return.
• Average Product = TP/ Units of variable factor

iii. Marginal Product (MP): * Refers to addition to total product, when one more unit of variable factor is
employed.
*It is also known Marginal Physical Product (MPP)/ Marginal Return.
• MP = Current TP – Previous TP or MP TPn – TPn-1 or MP = Change in TP/ Change in units of
variable factor
Law of Variable Proportion:
• Refers to the increase in the total product when only one factor is increased, keeping all other factors
constant.
• It shows the nature of rate of change in output due to a change in only one variable factor of production.
• It is also knows as Law of Returns or Law of Returns to Factor or Returns of Variable Factor.
Statement of Law of Variable Proportion: It states that as we increase quantity of only one input
keeping other inputs fixed, TP initially increases at an increasing rate, then at a decreasing rate and
finally at a negative rate.
Assumptions of Law of Variable Proportions:
1. It operates in short run
2. The variable factors can be combined with fixed factors.
3. The law applies to the field of production function only.
4. The effect of change in output due to change in variable factor can be easily determined.
5. Factors of production become imperfect substitutes of each other after a certain limit.
6. State of technology is constant.
7. All variable factors are equally efficient.
 According to Law of Variable proportion, the changes in TP and MP can be classified into 3 phases:

Phase I: TP increases at increasing rate, MP increases.

Phase II: TP increases at decreasing rate, MP decreases and is positive.
Phase II: TP falls, MP becomes negative.
 The relation between output and input is explained in three phases:
 Phase 1-TP increases at an increasing rate: In this phase every additional variable factor adds more and more to
the total output, i.e. TP increases at increasing rate and MP also rises till it reaches its maximum point. This
happens because of the following reasons:
1. Initially quantity of variable input is too small as compared to the fixed input. As production starts, there is
efficient use of the fixed input, which raises the productivity of variable input.
2. Fixed factor in this phase is too large and variable factors are too low, due to this the fixed factors are not fully
utilized. When variable factors are increased and combined with fixed factor, then fixed factor is better utilized
and variable factors are utilized in more efficient manner, by which output increases at increasing rate.
3. Fixed factors combined with variable factors are indivisible. When variable factors are increases more and
more it improves the utilisation of fixed factors.
4. This phase is also known as Increasing Returns to a factor.
 Phase II – TP increases at diminishing rate: In this phase every additional variable facto adds lesser and
lesser amount of output, i.e. TP increases at diminishing rate and becomes maximum while MP falls and is
zero. Every producer aims to produce in the second phase. This happens because of the following reasons:
1. After a level of output, pressure on fixed output leads to fall in the productivity of the variable factor.
2. After making the optimum use of fixed factor the marginal return of variable factor begins to diminish.
3. There is a limit to the extent of which one factor of production can be substituted for another, beyond the
optimum limit, they become imperfect substitutes of one another, which leads to diminishing returns.
4. This phase is also known as Diminishing Returns of a factor.
 Phase III – TP falls: In this phase the employment of additional variable factor causes decrease in TP and MP
becomes negative. This happens because of the following reasons:
1. Amount of variable factor becomes too large in comparison to the fixed input, it leads to poor coordination
between variable and fixed factor which leads to decline in TP.
2. With continuous increase in variable factor the advantages of specialization start diminishing.
3. It is also known as Negative Returns to a factor.
 .

• Three phases of returns to a variable factor

Phase I: Increasing returns to a factor
TP increases at an increasing rate. Point of Inflexion takes place at the end of this phase.
MP is increasing & maximum at the end of this phase.
Reasons – Better utilization of fixed factors, Increase in efficiency of variable factor, Indivisibility of fixed
factors.

Phase II: Diminishing returns to a factor

TP increasing at an decreasing rate.
MP falls but remains positive.
At the end of this phase MP is 0 & TP is maximum.
Crucial phase as a rational producer aims to produce in this phase.
Reasons – Optimum combination of factors, Imperfect substitutes.

Phase III: Negative returns to a factor

TPP falls.
MPP declines & becomes negative.
No firm will choose to operate in this phase.
Reasons – Limitation in fixed factor, Poor coordination between variable and fixed factors, Decrease in
efficiency of variable factors.
RELATIONSHIP BETWEEN APP AND MPP
•When MPP > APP, APP increases.
•When MPP = APP, APP is maximum and
constant.
•When MPP < APP, APP decreases.
•Both APP and MPP falls but MPP becomes
negative whereas APP remains positive because
MPP falls at a faster rate than APP.
Law of diminishing returns: It states that when more and more units of a variable factor are employed
with a fixed factor, then marginal product of the variable factor must fall.