THEORY OF PRO DU C TIO N

Production function: Laws of variable

proportions, Economies and
diseconomies of scale, Economies of
Scope, Isoquants and Isocost, optimum
combination of inputs. Risk and
Uncertainty.
 Production Inputs

Time Raw Material

Labou Capital
r
Output
Goods &
Services
Introduction
Production is an important topic in economics as it is
directly related to the well-being of societies.
We can understand the health of an economy from its
production values of it.
Production is not only important for survival but
prosperity is also brought to economies by it.
Productions include variable and fixed factors and by
differentiating the factors various observations can be
made.
Three Measures of Production and their
Relationship
Total Physical Product (TPP) :

TPP is the total amount of a commodity that is produced with a given level of factor
inputs and technology during a given period of time.

Average Physical Product (APP) : APP is the output produced per unit of input
employed. It can be obtained by dividing TPP by the number of units of variable input.

Formula,𝐴𝑃𝑃 = 𝑇𝑃𝑃 /𝐿

L = no. of Variable Unit

Marginal Physical Product (MPP) : MPP of an input is the additional output that can
be produced by employing one more unit of that input while keeping other inputs
constant

𝑀𝑃𝑃 = ∆𝑇𝑃𝑃 / ∆𝐿 Where, ∆𝑇𝑃𝑃 = Change in TPP And ∆𝐿 = Change in Unit of

Labour
 Fixed factors and variable factors : Fixed factors are
those factors of production whose quantity can not be
hanged with change in the level of output.
Variable factors are those factors of production whose
quantity can easily be changed with change in the level
of output.
Short run production function: A short run production
function that shows the changes in output when only
one factor is changed while other factor remains
constant is termed as a short run production function.
 The underlying theory to the short run production
function is the “Law of variable proportion or Returns
to a factor”.
Long run production function: A long run production
function studies the impact on output when all the
factors of production can be changed simultaneously
and in the same proportion.
 Production Function
Mathematical presentation of
Input Output relationship

Q = f(LB, L, K, M , T, t)

LB=land and building, L= Labour

K=Capital, M= Raw Material, T=
Technology and t= Time
 Cobb–Douglas
 The Cobb–Douglas form is developed and tested against
statistical evidence by Charles Cobb and Paul Douglas
 A Cobb-Douglas production function models the relationship
between production output and production inputs (factors).
 It is used to calculate ratios of inputs to one another for
efficient production and to estimate technological change in
production methods.
 Cobb and Douglas themselves acknowledged that their
production function does not rest on solid theoretical
foundations, nor should it be understood as a law of production;
it merely represents a statistical approximation of the observed
relationships between production inputs and output.
 Production Function

Q = total production (the real value of all goods produced

in a year or 365.25 days)
L =labour input (person-hours worked in a year or 365.25
days)
K = capital input (a measure of all machinery, equipment,
and buildings; the value of capital input divided by the
price of capital)
A = total factor productivity
a and b are the output elasticities of capital and labor,
respectively. These values are constants determined by
available technology.
 Cobb- Douglas Q = AK a L b (where b=1-a)
Long Terms Laws of Production :
Production with two variable
inputs
Law of Variable Proportion
It is referred to as the law which states that when the
quantity of one factor of production is increased, while
keeping all other factors constant, it will result in the
decline of the marginal product of that factor.
Law of variable proportion is also known as the Law of
Proportionality. When the variable factor becomes more, it
can lead to negative value of the marginal product.
When variable factor is increased while keeping all other
factors constant, the total product will increase initially at
an increasing rate, next it will be increasing at a
diminishing rate and eventually there will be decline in the
rate of production.
 The Law of variable proportion or law of diminishing
marginal utility states that when only one production
element is allowed to increase keeping all other elements
constant, the production firstly increases, then the output
will decrease and finally there will be a negative
production.
 This law is also known as the law of equality. According to
this law when the dynamic value goes up, it can lead to a
negative product value of a third-party product.
 When the dynamic factor increases while all other factors
remain constant, initially the price of the product will rise.
 However, in subsequent phases, there will be a decrease in
output. Finally, with additional input of dynamic factor, there
will be a negative output of production.
 Simple Way to State the Law of Diminishing
Marginal Utility

The law of diminishing marginal utility means that as

you use or consume more of something, you will get
less satisfaction from each additional unit of that thing.
It not only paves the path for controlled production but
also shows the producers why their productions may have
halted.
The law also offers insight into the optimal amount of
inputs that are required to control a given amount of
output.
The producers of goods and services can be benefited
from the use of this law.
Moreover, in the case of two variable productions,
producers can realize the points of increasing,
diminishing, and negative outputs.
Thereby they can limit the wastage of resources and
increase the output to the maximum level.
The law of diminishing marginal utility predicts how
consumers will react to a certain level of supply.
As they consume more units of a single type of good,
the utility of each unit will decrease until the consumer
doesn't want anymore.
Businesses can use the law of diminishing marginal
utility to understand consumer behavior, price their
goods and services, and diversify their offerings
Three Phases of the Law
Increasing, Diminishing, and Negative Returns
First Stage: Increasing Return to a Factor
In the first stage, the addition of every additional
variable factor adds more value to the output.
Therefore, the production of goods increases with an
increase in the additional variable input.
This means that total product (TP) increases at a
quicker rate and the marginal product (MP) of each
variable factor goes up.
More efficient use of fixed factors and an increase in
efficiency of variable factors due to specialization are
the main reasons for the increase in output.
Second Stage: Diminishing Returns to a Factor
In the following stage, additional inputs of every unit
result in a lesser and lesser amount of output.
The total product increases at a lower rate while the
marginal product falls with the increase in the variable
factors.
Third Stage: Negative Returns to a Factor
The addition of units of variable factors causes
negative returns.
The TP declines with the addition of each unit of the
additional variable factor.
As production declines in this phase, it is known to be
a phase of negative returns.
Poor coordination between fixed and variable factors
causes negative returns in the third stage.
 There are some assumptions that must be considered while
considering the law of variable proportions.
 Continuous technological improvement − It is assumed that
the technological infrastructure will remain the same and with
improvements in technology, production will improve.
 Flexible estimates of characters − The law assumes that
production characteristics will vary. The law is not applicable
when production features remain constant.
 Homogenous units of factors − The law indicates that all
output products are the same in nature. Their attributes, prices,
and other features are all the same.
 Short-run − The production is considered to be of a short
duration
Reasons for the Law of Variable Proportions
There are various reasons for the law of variable proportions
for all three phases
 Better use of the fixed factor − In the first phase of the production function,
the supply of fixed factors is huge. Therefore, the fixed factor remains
under-utilized. When variable factors are introduced to fixed factors, the
underutilized fixed factors are included in the production process which
increases the overall efficiency of production leading to increasing returns.
 Increased efficiency of variable factors − When variable factors are
increasingly combined with fixed factors, the variable factors are used in a
more efficient manner. Moreover, better cooperation and higher degrees of
specialization are observed in the case of variable factor which helps to
increase production.
 Indivisibility of fixed factor − The fixed factors that are combined with
variable factors are usually indivisible. When large and increasing amounts
of variable factors are added to indivisible fixed factors, production
increases until the optimum level of combination between variable and
fixed factors is reached.
Reasons for diminishing returns to a factor
Optimum combination − There is an optimum
combination of fixed and variable factors where the total
product (TP) value is maximum. After having the
maximum use of fixed factors, the marginal product return
of variable factors starts to diminish. This leads to a
diminishing return to a factor.
Imperfect substitution − The variable factors can be used
as a substitute for one another up to a certain limit. When
this limit is crossed, the availability of substitutes is no
more accessible. This reduces production and leads to
diminishing returns.
 Reasons for a negative return to a factor
 Limits of fixed factor − Some factors of production are always fixed
in nature. These factors cannot be increased with an increase in
variable factors which results in a negative return to a factor.
 Poor coordination between fixed and variable factors − Too
excessive amount of variable factors in comparison to fixed factors
obstructs production. Therefore, the addition of variable factors
beyond a limit leads to poor coordination between the two, leading
to negative returns to a factor. The outcome is a fall in the output
instead of an increase.
 Decrease in the efficiency of variable factors − The advantages
related to the specialization of a variable and its division of labor
start to go down with a continuous increment of variable factors.
This causes negative returns to take place.
Economies of Scale
Mass production involves several important factors of
production like labor, electricity, equipment usage, and
more.
Economies of scale show that a company can usually
increase their profit per unit of production when they
produce goods in mass quantities.
When these factors are adjusted, economies of scale still
allow a company to produce goods at a lower relative
per unit cost.
Economic theory suggests that the benefit obtained is
not constant per additional units produced but rather
diminishes.
Diseconomies of Scale
Diseconomies of scale happen when a company
or business grows so large that the costs per unit
increase.
 It takes place when economies of scale no longer
function for a firm.
 With this principle, rather than experiencing
continued decreasing costs and increasing output, a
firm sees an increase in costs when output is increased.
Diseconomies of scale occur when the expansion of
output comes with increasing average unit costs.
Diseconomies of scale can involve factors internal to
an operation or external conditions beyond a firm's
control.
Diseconomies of scale may result from technical issues
in a production process, organizational management
issues, or resource constraints on productive inputs.
 Types of Diseconomies of Scale
 Internal diseconomies of scale involve either technical constraints on
the production process that the firm uses or organizational issues that
increase costs or waste resources without any change to the physical
production process.
 Diseconomies of scale can occur for a variety of reasons, but the
cause often comes from the difficulty of managing an increasingly
large workforce.
 Technical Diseconomies of Scale :Technical diseconomies of scale
involve physical limits on handling and combining inputs and goods in
process. These can include overcrowding and mismatches between the
feasible scale or speed of different inputs and processes.
 An overcrowding effect within an organization is often the
leading cause of diseconomies of scale. This happens when a company
grows too quickly, thinking that it can achieve economies of scale in
perpetuity.
 Organizational Diseconomies of Scale
 Organizational diseconomies of scale can happen for many
reasons, but overall, they arise because of the difficulties of
managing a larger workforce. Several problems can be
identified with diseconomies of scale.
 First, communication becomes less effective. As a business
expands, communication between different departments
becomes more difficult. Employees may not have explicit
instructions or expectations from management. In some
instances, written communication becomes more prevalent
over face-to-face meetings, which can lead to less feedback.
 Another drawback to diseconomies of scale is motivation.
Larger businesses can isolate employees and make them feel
less appreciated, which can result in a drop in productivity.
External Diseconomies of Scale
External diseconomies of scale can result from
constraints of economic resources or other constraints
imposed on a firm or industry by the external
environment within which it operates.
 Typically, these include capacity constraints on
common resources and public goods or increasing
input costs due to price inelasticity of supply for
inputs.
Diminishing marginal productivity can also be
associated with diseconomies of scale.
 Diminishing marginal productivity can potentially
lead to a loss of profit after breaching a threshold.
If diseconomies of scale occur, companies don’t see a
cost improvement per unit at all with production
increases.
Instead, there is no return gained for units produced
and losses can mount as more units are produced.
Economies of scope
In an economy of scale, a company increases its production
volume to reduce per-unit costs and increase efficiency.
 In an economy of scope, a company diversifies its product
offerings to reduce per-unit costs and increase efficiency.
Economies of scope can be described as producing two or
more products simultaneously at a lower cost than
producing them individually.
For example, a company uses similar raw materials and
production units to produce various products instead of
going for one at a time.
Economies of scope business usually exist amongst
prominent multinationals with a massive product
portfolio.

The wider it becomes, the more it causes the fixed

cost to spread over each product amongst the variety
they offer.
 Types
 Adopting Flexible Production and Manufacturing Processes –
The easiest way is by sharing raw materials and production
facilities when producing different but related products.
Companies can quickly and effectively enhance manufacturing
processes by taking this route.
 Linking the Supply Chain – Integrating the vertical supply
chain assists in reducing costs and wastage.
 Acquisition of Companies with Similar
Products – Mergers with horizontal acquisitions or strategic
acquisitions will help achieve the economies of scope. The
company will benefit from synergies due to utilizing similar raw
materials, production, and assembly lines.
 Diversification – Companies producing products using similar
inputs and production processes will improve productivity.
 Isoquant Curves

An isoquant curve can be

defined as the locus of
points representing
various combinations of
two inputs-capital & labour
yeilding the same output

Assumptions:
Only two inputs:
Labour(L)
Capital (K)
Isoquants have Convex to
 L and K are perfectly a negative slope origin
divisible
 L and K are
substitutable Non
Upper
intersecting
at diminishing rate isoquants –
and non
 Technology is given Higher Output
tangential
Isoquant in Economics
 An isoquant in economics is a curve that, when
plotted on a graph, shows all the combinations of two
factors that produce a given output.
Often used in manufacturing, with capital and labor as
the two factors, isoquants can show the optimal
combination of inputs that will produce the maximum
output at minimum cost.
The term "isoquant," broken down in Latin, means
“equal quantity,” with “iso” meaning equal and
“quant” meaning quantity.
The isoquant is known, alternatively, as an equal
product curve or a production indifference curve. It
may also be called an iso-product curve.
An isocost show all combinations of factors that cost
the same amount.
What Is an Isoquant and Its Properties?
An isoquant is a concave-shaped curve on a graph that
measures output, and the trade-off between two factors
needed to keep that output constant.
Among the properties of isoquants:
An isoquant slopes downward from left to right
The higher and more to the right an isoquant is on a graph,
the higher the level of output it represents
Two isoquants can not intersect each other
An isoquant is convex to its origin point
An isoquant is oval-shaped
The isoquant curve assists companies and businesses in
making adjustments to their manufacturing operations, to
produce the most goods at the most minimal cost.
The isoquant curve demonstrates the principle of the
marginal rate of technical substitution, which shows the
rate at which you can substitute one input for another,
without changing the level of resulting output.
Isoquant curves all share seven basic properties, including
the fact that they cannot be tangent or intersect one
another, they tend to slope downward, and ones
representing higher output are placed higher and to the
right.
Isoquant and isocosts
An isoquant shows all combination of factors that
produce a certain output
An isocost show all combinations of factors that cost
the same amount.
Isocosts and isoquants can show the optimal
combination of factors of production to produce the
maximum output at minimum cost.
Risk and uncertainty in economics
In the case of risk, the outcome is unknown, but the
probability distribution governing that outcome is
known.
Uncertainty, on the other hand, is characterised by both
an unknown outcome and an unknown probability
distribution.
 Risk and uncertainity
 In common practice the two terms “Risk” and “Uncertainty” are used synonyms. A very thin
line of demarcation can be drawn between these two terms.
 Business decisions involve calculation of cost and revenue. It is not easy to predict the future
with accuracy.
 Future involves change.
 Changes may be known or unknown.
 The result of known changes may be definite or indefinite.
 The definite result related with known changes is known as certainty.
 The indefinite nature of outcome or result related with known changes involves risk. Such
risks can be estimated and insured.
 On other hand if changes are unknown their outcome is indefinite and risk element is
incalculable and immeasurable it is called uncertainty.
 For example changes in prices demand and supply are non-insurable risks involve
uncertainty. On other hand theft, loss by fire, death by accident are insurable. Such risks do
not involve profit. It is only non-insurable risk which have element of uncertainty and lead
to emergence of profits.
 This is the difference between risk and uncertainty.
DIFFERENCE BETWEEN RISK AND
UNCERTAINTY
 Prof. Knight stated in this regard that, “Uncertainty is a unknown risk and risk is a
measurable uncertainty.”
 1 Probability of Ouantitative Measurement. Risk is measurable and can be quantitatively
measured but uncertainty cannot be measured in any form.
 2. Insurability. The risk is measurable. There are certain risks which can be fully covered
by taking insurance policies such as-fire, flood, draught, theft, robbery etc. On the other
hand, insurance of uncertainties is not possible.
 3. Transferability. A risk can be transferred into another risk but an uncertainty cannot be
so transferred.
 4. Element of Cost. According to Prof. Knight, “Cost of production includes the cost of
risk bearing also. Enterpreneur does not get any profit for risk bearing. On the other hand,
uncertainty is not included in the cost of production. The reality is that the profit is the
reward of the enterpreneur for bearing uncertainty.”
 5. Subjective and Objective. Risk is objective while uncertainty is subjective because risk
can be measured while uncertainty is not.
 6. Knowledge of Alternatives. In case of risk, all the possible alternatives of a problem are
known to the economists in advance but in case of uncertainty, such previous knowledge is
not possible.
 7. Nature of Decisions. Decisions taken under the conditions of uncertainty are more
important than the decisions taken under the conditions of risk because in the case of
uncertainty, measurement of alternatives is not possible.