CCT Unit 5 Theory of production

Butwal

THEORY OF PRODUCTION

Meaning of Production

Adam Smith and other classical economists defined production as "the creation of material goods". But
it is narrow definition because matters neither can be created nor can be destroyed. Some economists
defined production as the "creation of utility" or "increase in utility". But according to modern
economists, production is the creation of utility along with exchange value. Hence production refers not
only to create utility but also to create values and economic utility.

Production Function and Laws of Production

Production is the transformation of physical input(i.e. factors of production) into physical outputs(i.e.
the quantity of goods produced). Thus the output is the function of inputs because if the quantity of the
inputs changes then the quantity of output also changes. This production function can be written as,

Q=f(L,K,N,T,......)

Where , Q=quantity of output produced

L=land K=capital N=labor T=technology

The production function refers to the maximum quantity of output that can be produced from given
quantity of inputs or it states that the minimum quantity of input(factors of production) that can
produce given quantity of output.

The law of production describes the technically efficient method to increase the level of production.
Output may be increased in various ways. In short run, output may be increased by using more of
variable factors(increasing variable factors) keeping some factors constant. But in long run, the output
can be increased by changing the quantity of all factors of production.

Concept of Total Product(TP),Average Product(AP),and Marginal Product(MP)

TP,AP and MP are the concept of short-run production function. Short-run refers to that time period
when the increase or decrease in output depends on variable factors of production. Thus in short-run
output can be increased or decreased by increasing or decreasing the quantity of variable factors
keeping the quantity of other factors fixed(constant).

Total Product(TP):

Total product is the amount of total output produced by a given amount of variable factors keeping the
quantity of other factors fixed. Thus if labor(N) is the variable factor of production then,

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TP=f(N)

where, TP=total product N=quantity of labor

The concept of TP can be clearly explained with the help of a numerical example. Suppose one unit of
labor is used in fixed quantity of land, the total product is 10 quintals and when two units of labor is
used with same quantity of land, the total product reaches to 24 quintals. Thus the total product refers
to the total amount of goods which can be produced by given quantity of variable factor keeping
quantity of other factors constant.

Average Product(AP):

Average product of variable factor , say, labor is the total product divided by quantity of labor employed
with given quantity of fixed factors such as land, capital etc.

Therefore, APL=TP/L

where, APL=average product of labor

TP=total product

L=quantity of labor employed

According to the numerical example above, TP is 24 quintals when quantity of labor used is 2 units.

∴ APL=TP/L =24/2 =12quintals.

Marginal Product(MP):

Marginal product of variable factor is the additional quantity of output produced by employing one extra
unit of variable factor such as employing one extra unit of labor keeping other factors constant.

Mathematically, MPL=∆ TP/∆ Q L

Where, MPL= marginal product of labor

∆ TP=change in total product

∆ Q L=change in quantity of labor

According to the numerical example above, ∆ TP=24-10 =14 and ∆ Q L=2-1 =1unit

∴ MPL=∆ TP/∆ Q L =14/1 =14

Concept of Total Product(TP),Average Product(AP),and Marginal Product(MP)

The table below shows, as the unit of labor increases, TP increases at increasing rate up to 3 rd unit of
labor, then increases at decreasing rate up to 7 th unit of labor and starts to decline. In other words, until

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Units of Total Product Marginal Product Average Product

labor used (TP) MP=TPn-TPn-1 APL=TP/L
1 20 20 20
2 50 50-20=30 25
3 90 90-50=40 30
4 120 120-90=30 30
5 140 140-120=20 28
6 150 150-140=10 25
7 150 150-150=00 21.4
8 140 140-150=-10 17.5
rd
TP increases at increasing rate, MP increases, after the 3 unit of labor TP increases at decreasing rate,
MP decreases and when TP becomes maximum, MP becomes zero and then TP starts to decline.

Similarly AP increases up to 4th unit of labor and then diminishes. This can be explained with the help of
following figure:

In the figure, output has been measured along vertical axis and quantity of labor along horizontal axis. It
is seen in the figure that in the beginning, as labor increases, TP increases at increasing rate and reaches
to maximum at P and starts to decrease. In other words TP is maximum when MP is zero. Similarly, MP
increases in the beginning and reaches to its maximum at point F then starts to decline and MP becomes
zero when TP is maximum. Hence MP curve is inverted ‘U’ shaped as shown in the figure by MP.
Similarly in the beginning AP increases and reaches to maximum then starts to decline. Hence AP curve
is also inverted ‘U’ as shown in the figure by AP.

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Relationship between TP, MP and AP:

Relationship between TP, MP and AP can be explained with the help of the above diagram.It is seen in
the figure that as quantity of labor increases initially,

AP, TP and MP all increases. TP increases at increasing rate up to point F,then increases at decreasing
rate and reaches to maximum at point P and starts to decrease. Point F is called point of inflation.

MP is maximum at the point of inflation and it is zero when TP is maximum and negative when TP
decreases.

So long as MP is greater than AP, AP increases. AP reaches to maximum at the point where MP is equal
to AP. After that when MP is less than AP, AP starts to decrease. In other words, AP rises when MP>AP
and AP falls when MP<AP. So the intersection point of AP and MP is the maximum point of AP. In short,
MP intersects AP at its maximum point from above.

Law of Variable Proportion:

The law of variable proportion is the new name of law of diminishing returns. The law of diminishing
returns states that, if we increase the quantity of variable factors of production keeping other factors
constant yields a less than proportionate increase in output. In other words, doubling the variable factor
of production to a given quantity of fixed factors, the output increases by less than double. But it is only
the one stage of the law of variable proportion.

The law of variable proportion explains the short run production phenomenon. This law states that,
when the amount of a variable factor of production is increased, keeping the quantity of other factors of
production constant, average and marginal product firstly increases and reaches to maximum and then
starts to decline. In short, this law says that, if the quantity of a variable factor of production is
increased, keeping constant the quantity of other factors, the average and marginal product eventually
declines. According to this law, the total product initially increases at increasing rate then increases at
decreasing rate and after its maximum level, it starts to decline.

Assumptions:

1 The state of technology is unchanged.

2 Production is possible with combination of factors of production in varying proportion.

3 There must be some inputs whose quantity is kept constant.

This law can be explained with the help of following table.

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Units of Total Product Marginal Product Average Product

labor used (TP) MP=TPn-TPn-1 APL=TP/L
1 10 10 10
2 30 20 15
3 60 30 20
4 100 40 25
5 130 30 26
6 150 20 25
7 160 10 22.8
8 160 0 20

Let Q= f (L, K) where, L=Labor, K= Capital and K is a fixed factor of production. How output Q increases
with the increase in labor keeping capital constant has been shown in the table. In the table TP has
increased at increasing rate up to employment of 4 th units of labor. It increases at decreasing rate up to
8th units of labor.TP is maximum at 8th units of labor after that TP has started to decline.

Marginal product has increased up to 4 th unit of labor then it starts to decrease. MP is zero at the level of
maximum output or at 8th unit of labor. AP also increases initially. It becomes maximum at 5 th unit of
labor and then it has started to decline. Maximum AP has came after the maximum MP. The law of
variable proportion has been illustrated by the following diagram:

In the figure above, output has been measured along vertical axis and labor along horizontal axis. It is
seen in the figure that TP increases at increasing rate up to F point. F point is called point of inflation.
From point F to P, TP has increased at decreasing rate. P is the peak point of TP. Beyond the point P, TP
has started to decline. The law of variable proportion has three stages of production as explained below:

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Stage-1 : First stage is demarcated by the point of intersection of AP and MP or peak point of AP. The
first stage is called the stage of increasing returns. In this stage;

1) Inintially TP increases at increasing rate up to F then increases at decreasing rate.

2) MP also increases initially, reaches to maximum at point F and starts to decline.

3) AP also increases and reaches to maximum when MP and AP are equal. The first stage ends when the
AP is maximum.

Causes of increasing returns:

In the beginning, the quantity of mixed factor is too much relative to the quantity of variable factor.
Therefore when more and more unit of variable factor are added to the fixed factor leads to efficient
use of fixed factor. In other words, due to indivisibility of fixed factor initially the quantity of fixed factor
cannot be taken to the quantity which suits the quantity of variable factor. Another reason is the more
use of variable factor makes the specialization and division of labor possible which causes to increase
the output in rapid rate.

Stage-2 : Second stage is demarcated by the point of intersection of MP and AP to left and peak point of
TP or zero MP to the right. In this stage;

TP increases at decreasing rate and reaches to maximum.

MP and AP both decline.

The second stage ends when TP is maximum or MP is zero and this stage is called the stage of
diminishing returns.

Causes of diminishing returns:

Scarcity of fixed factors:

In this stage the fixed factor is inadequate, relative to variable factor. In other words, in the stage of
increasing returns(stage 1st) fixed factor is utilized more efficiently. But once the point is reached at
which fixed factor is utilized most efficiently, further increase in variable factor will cause AP and MP to
decline because the fixed factor then becomes inadequate relative to the quantity of variable factors.

Imperfect substitute of the factors:

According to the John Robinson the diminishing return occurs due to the factors of production are
imperfect substitutes of one another. In the other words, the variable factor cannot substitute the fixed
factor.

Stage-3 : Third stage starts with the fall in TP, in this stage;

TP starts to decline

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AP continuously decline

MP becomes negative

This stage is called the stage of negative returns.

Causes of negative returns:

In this stage TP starts to decline and MP becomes negative because the amount of variable factor
becomes too much to the fixed factor. So that they disturb each other leads to fall in the total output
instead of rising. The proverb “too many cooks spoil the broth” come to be true.

It can be concluded that as we increase the quantity of one factor keeping the other factors of
production constant gives three types of return such as increasing, decreasing and negative. In short as
we increase more and more of one factor to fixed factor the production will eventually decline. The
production declines because of the indivisibility of fixed factor. According to Bober “ let divisibility enter
through the door, the law of variable proportion rushes out of the window.”

Choice of the Optimum Stage of Production:

Now the important question is that in which stage a rational producer will seek to produce.

A rational producer will not choose 3rd stage to produce because at this stage marginal product of
variable factor is negative. i.e. TP is declining.

The producer will not choose 1st stage to produce because at this stage AP and TP both are increasing
and there is more chance to increase TP by employing more variable factor.

Hence a rational producer will decide to produce in 2 nd stage because in this stage although AP and MP
are declining but they are not negative and TP is increasing

Applicability of the law of variable proportion:

According to Marshall and his followers, law of diminishing returns is applicable in agriculture and law of
increasing returns is applicable in manufacturing industries. But the law of diminishing returns is also
applicable in manufacturing industries if some factors are fixed and some are variable.

The law of diminishing returns is specially applicable in agriculture sector because in agriculture nature
is supreme. There are several reasons why agriculture is subjected to the law of diminishing returns such
are,

1 The agriculture operations are spread out over a wide area and consequently supervision cannot be
effective.

2 Scope of using specialized machinery is also very limited by which benefit of economics of large scale
of production cannot be obtained.

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3 Agriculture operations are affected rain and other climate change so the law of diminishing return
operates.

Limitations of the law of diminishing returns:

The law of diminishing returns doesn’t apply in all situations. There are several exceptions to the law as
it applies in agriculture;

1 Improved method of cultivation:

Scientific rotation of crops, improved seeds, modern equipments, better irrigation facility stop to hold
law of diminishing returns to agriculture.

2 New soil :

In case of new soil, this law doesn’t apply in the beginning because when a virgin land is brought under
cultivation, the additional return for each successive unit of labor and capital may increase for a time.

Isoquant
An isoquant is a curve whose every point represents the same level of output. In other words an
isoquant represents all those input combinations which are capable for producing the same level of
output. The concept of isoquant can be explained with the help of following table:

Process(factor combination) Labor(L) Capital(K) Output(Q)

A 1 12 20
B 2 08 20
C 3 05 20
D 4 03 20
E 5 02 20

The above table shows that 20 units of commodity can be produced by 5 processes. A producer can
produce 20 units of goods by using factor combination A (1L+12K) or B (2L+8K) or C (3L+5K) or D (4L+3K)
or E (5L+2K).It is seen in the table that the producer is capable for producing 20 units of commodity, no
matter which combination does he apply. If we plot the above combination in the graph, we get the
points A,B,C,D and E. And if we join all these points, we will get downward sloping curve called
isoquant, represented by QQ 1 .

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In the figure above the isoquant QQ 1 shows the 20 unit of production.

Laws of Returns to Scale

Laws of returns to scale explains the long run production phenomenon. In long run all factors of
production are variable. Hence in returns to scale, we study the change in output when all factors of
production are changed keeping the factor proportion constant. An increase in the scale means that all
inputs or factors of production are increased in same proportion. Returns to scale are of three kinds :
constant, increasing and decreasing returns to scale.

Increasing Returns to Scale (IRS):

Increasing returns to scale refers that output increases in greater proportion than the increase in inputs.
For example, if all inputs are increased by 2 folds the output increases by 3 folds then we say there is
increasing returns to scale. It can be explained with the help of following table and diagram;

Capital (K) Labor (L) Ratio (K/L) Output (Q)

2 3 2/3 10
4 6 2/3 22

The above table shows 2 units of capital and 3 unit of labor can produce 10 unit of output. If the factors
of production are increased by 2 folds means 4 units of capital and 6 units of labor is used in production

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then output will increase by more than 2 times like from 10 to 22. This is known as increasing return to
scale.

In the figure above, capital is measured along vertical axis and labor along horizontal axis. Q ‘s are the
isoquants showing the different levels of output. In the figure it is seen that when factors are increased
by 2 folds then output increases by more than 2 folds such as output level increases from 10 to 22. Q=22
is the output level which can be produced by input combination (4K,6L) is more than isoquant showing
20 unit of outputs.

Constant Returns to Scale (CRS):

If we increase all factors in a given proportion and output also increases in the same proportion then the
returns to scale is said to be constant. Hence if doubling or trebling all the factors causes a double or
treble of output, then returns to scale is constant. It can be explained with the help of following table
and diagram;

Capital (K) Labor (L) Ratio (K/L) Output (Q)

2 3 2/3 10
4 6 2/3 20

The above table shows factor combination of 2 units of capital and 3 unit of labor can produce 10 unit
of output. If the factors of production are increased by 2 folds means 4 units of capital and 6 units of
labor is used in production then output will also increase by 2 times like from 10 to 20. This is known as
constant return to scale.

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In the figure above, capital is measured along vertical axis and labor along horizontal axis. Q =10 and Q
=20 are the isoquants showing the different levels of output. In the figure it is seen that when factors
are increased by 2 folds then output also increases by 2 folds such as output level moves from 10 to 20.
Hence it shows that if inputs are increased in a given proportion output expands by the same
proportion.

Decreasing Returns to Scale (DRS):

Decreasing returns to scale refers that output increases in smaller proportion than the increase in
inputs. For example, if all input factors of production are increased by 10% then the output increases by
8% only then we say there is decreasing returns to scale. It can be explained with the help of following
table and diagram;

Capital (K) Labor (L) Ratio (K/L) Output (Q)

2 3 2/3 10
4 6 2/3 18

The above table shows 2 units of capital and 3 unit of labor can produce 10 unit of output. If the factors
of production are increased by 2 folds means 4 units of capital and 6 units of labor is used in production
then output will increase by less than 2 times like from 10 to 18. It is clear from the above table that
when inputs are increased by certain times, the output increases by less than given times. This is known
as increasing return to scale.

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In the figure above, capital is measured along vertical axis and labor along horizontal axis. Q =10 , Q =18
and Q =20 are the isoquants showing the different levels of output. In the figure it is seen that when
factors are increased by 2 folds then output increases by less than 2 folds such as output level increases
from 10 to 18 units. Q=18 is the output level which can be produced by input combination (4K,6L) is less
than isoquant showing 20 unit of outputs.

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