CHAPTER 3: PRODUCTION FUNCTION

INTRODUCTION
The production function expresses a functional relationship between physical inputs and
physical outputs of a firm at any particular time period. The output is thus a function of inputs.
Mathematically production function can be written as

Q= f (A, B, C, D)

Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as land,
labor, capital and organization. Here output is the function of inputs.

Hence output becomes the dependent variable and inputs are the independent variables.

The above function does not state by how much the output of “Q” changes as a
consequence of change of variable inputs. In order to express the quantitative relationship
between inputs and output, Production function has been expressed in a precise mathematical
equation i.e.
Y= a+b(x)

Which shows that there is a constant relationship between applications of input (the only factor
input ‘X’ in this case) and the amount of output (y) produced.

IMPORTANCE:
1. When inputs are specified in physical units, production function helps to estimate the level
of production.
2. It becomes is equates when different combinations of inputs yield the same level of output.
3. It indicates the manner in which the firm can substitute on input for another without altering
the total output.
4. When price is taken into consideration, the production function helps to select the least
combination of inputs for the desired output.
5. It considers two types’ input-output relationships namely ‘law of variable proportions’ and
‘law of returns to scale’. Law of variable propositions explains the pattern of output in the
short-run as the units of variable inputs are increased to increase the output. On the other
hand, law of returns to scale explains the pattern of output in the long run as all the units
of inputs are increased.
6. The production function explains the maximum quantity of output, which can be
produced, from any chosen quantities of various inputs or the minimum quantities of
various inputs that are required to produce a given quantity of output.

Production function can be fitted the particular firm or industry or for the economy as whole.
Production function will change with an improvement in technology.

ASSUMPTIONS:
1. Production function has the following assumptions.
2. The production function is related to a particular period of time.
3. There is no change in technology.
4. The producer is using the best techniques available.
5. The factors of production are divisible.
6. Production function can be fitted to a short run or to long run.

Cobb-Douglas Production Function:

Production function of the linear homogenous type is invested by Junt wicksell and first
tested by C. W. Cobb and P. H. Dougles in 1928. This famous statistical production function is known
as Cobb-Douglas Production Function. Originally the function is applied on the empirical study of
the American manufacturing industry.
Cabb–Douglas production function takes the following mathematical form.

Y= (AKX L1-x)

Where:
Y=output K=Capital L=Labor
A, ∞=positive constant

ASSUMPTIONS:
1. It has the following assumptions
2. The function assumes that output is the function of two factors viz. capital and labor.
3. It is a linear homogenous production function of the first degree
4. The function assumes that the logarithm of the total output of the economy is a linear
function of the logarithms of the labor force and capital stock.
 5. There are constant returns to scale
6. All inputs are homogenous
7. There is perfect competition
8. There is no change in technology

ISOQUANTS:
The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and
‘quant’ implies quantity. Isoquant therefore, means equal quantity. A family of iso-product curves
or isoquants or production difference curves can represent a production function with two
variable inputs, which are substitutable for one another within limits.

Isoquants are the curves, which represent the different combinations of inputs producing a
particular quantity of output. Any combination on the isoquant represents some level of output.
For a given output level firm’s production become,
Q= f (L, K)
Where ‘Q’, the units of output is a function of the quantity of two inputs ‘L’ and ‘K’.
Thus, an isoquant shows all possible combinations of two inputs, which are capable of producing
equal or a given level of output. Since each combination yields same output, the producer
becomes indifferent towards these combinations.

ASSUMPTIONS:
1. There are only two factors of production, namely, labor and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.
4. The technology is given over a period.

An isoquant may be explained with the help of an arithmetical example.

Combinations Labor (units) Capital (Units) Output (quintals)
A 1 10 50
B 2 7 50
C 3 4 50
D 4 4 50
E 5 1 50

Combination ‘A’ represent 1 unit of labor and 10 units of capital and produces ‘50’ quintals of a
product, all other combinations in the table are assumed to yield the same given output of a
product say ‘50’ quintals by employing any one of the alternative combinations of the two
factors labor and capital. If we plot all these combinations on a paper and join them, we will get
continues and smooth curve called ISOPRODUCT CURVE as shown below.

Factor K

Factor L

Labor is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which shows all the
alternative combinations A, B, C, D, E which can produce 50 quintals of a product.

Producer’s Equilibrium:
The term producer’s equilibrium is the counter part of consumer’s equilibrium. Just as the
consumer is in equilibrium when secures maximum satisfaction, in the same manner, the producer
is in equilibrium when he secures maximum output, with the least cost combination of factors of
production.

The optimum position of the producer can be found with the help of iso-product curve.
The Iso-product curve or equal product curve or production indifference curve shows different
combinations of two factors of production, which yield the same output.

LAW OF PRODUCTION:
Production analysis in economics theory considers two types of input-output relationships.
1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.

These two types of relationships have been explained in the form of laws.
i) Law of variable proportions
ii) Law of returns to scale

I. Law of variable proportions:

The law of variable proportions which is a new name given to old classical concept of
“Law of diminishing returns has played a vital role in the modern economics theory. Assume that
a firms production function consists of fixed quantities of all inputs (land, equipment, etc.) except
labor which is a variable input when the firm expands output by employing more and more labor,
it alters the proportion between fixed and the variable inputs. The law can be stated as follows:

“When total output or production of a commodity is increased by adding units of a

variable input while the quantities of other inputs are held constant, the increase in total
production becomes after some point, smaller and smaller”.

“If equal increments of one input are added, the inputs of other production services being
held constant, beyond a certain point the resulting increments of product will decrease i.e. the
marginal product will diminish”. (G. Stigler)

“As the proportion of one factor in a combination of factors is increased, after a point, first
the marginal and then the average product of that factor will diminish”. (F. Benham)

The law of variable proportions refers to the behavior of output as the quantity of one
Factor is increased Keeping the quantity of other factors fixed and further it states that the
marginal product and average product will eventually decline. This law states three types of
productivity an input factor – Total, average and marginal physical productivity.

Assumptions of the Law: The law is based upon the following assumptions:
1. The state of technology remains constant. If there is any improvement in technology, the
average and marginal output will not decrease but increase.
2. Only one factor of input is made variable and other factors are kept constant. This law
does not apply to those cases where the factors must be used in rigidly fixed proportions.
3. All units of the variable factors are homogenous.

Three stages of law:

The behaviors of the Output when the varying quantity of one factor is combines with a
fixed quantity of the other can be divided in to three district stages. The three stages can be
better understood by following the table.

Above table reveals that both average product and marginal product increase in the
beginning and then decline of the two marginal products drops of faster than average product.
Total product is maximum when the farmer employs 6 th worker, nothing is produced by the 7th
worker and its marginal productivity is zero, whereas marginal product of 8 th worker is ‘-10’, by just
creating credits 8th worker not only fails to make a positive contribution but leads to a fall in the
total output.

Production function with one variable input and the remaining fixed inputs is illustrated as below

From the above graph the law of variable proportions operates in three stages. In the first
stage, total product increases at an increasing rate. The marginal product in this stage increases
at an increasing rate resulting in a greater increase 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 diminishing returns
starts operating from the second stage awards. At the second stage total product increases only
at a diminishing rate. The average product also declines.
The second stage comes to an end where total product becomes 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.

We can sum up the above relationship thus when ‘A.P.’ is rising, “M. P.’ rises more than “A.
P; When ‘A. P.” is maximum and constant, ‘M. P.’ becomes equal to ‘A. P.’ when ‘A. P.’ starts
falling, ‘M. P.’ falls faster than ‘A. P.’.

Thus, the total product, marginal product and average product pass through three phases,
namely, increasing diminishing and negative returns stage. The law of variable proportion is
nothing but the combination of the law of increasing and diminishing returns.

II. Law of Returns of Scale:

The law of returns to scale explains the behavior of the total output in response to change
in the scale of the firm, i.e., in response to a simultaneous to changes in the scale of the firm, i.e.,
in response to a simultaneous and proportional increase in all the inputs. More precisely, the Law
of returns to scale explains how a simultaneous and proportionate increase in all the inputs affects
the total output at its various levels.

The concept of variable proportions is a short-run phenomenon as in these period fixed

factors cannot be changed and all factors cannot be changed. On the other hand, in the long-
term all factors can be changed as made variable. When we study the changes in output when
all factors or inputs are changed, we study returns to scale. An increase in the scale means that
all inputs or factors are increased in the same proportion. In variable proportions, the cooperating
factors may be increased or decreased and one faster (Ex. Land in agriculture (or) machinery in
industry) remains constant so that the changes in proportion among the factors result in certain
changes in output. In returns to scale all the necessary factors or production are increased or
decreased to the same extent so that whatever the scale of production, the proportion among
the factors remains the same.

When a firm expands, its scale increases all its inputs proportionally, then technically there are
three possibilities.
(i) The total output may increase proportionately
(ii) The total output may increase more than proportionately and
(iii) The total output may increase less than proportionately. If increase in the total output is
proportional to the increase in input, it means constant returns to scale. If increase in the
output is greater than the proportional increase in the inputs, it means increasing return to
scale. If increase in the output is less than proportional increase in the inputs, it means
diminishing returns to scale.
 Let us now explain the laws of returns to scale with the help of isoquants for a two-input and
single output production system.

ECONOMIES OF SCALE
Production may be carried on a small scale or o a large scale by a firm. When a firm
expands its size of production by increasing all the factors, it secures certain advantages known
as economies of production. Marshall has classified these economies of large-scale production
into internal economies and external economies.
Internal economies are those, which are opened to a single factory or a single firm
independently of the action of other firms. They result from an increase in the scale of output of a
firm and cannot be achieved unless output increases. Hence internal economies depend solely
upon the size of the firm and are different for different firms.
External economies are those benefits, which are shared in by a number of firms or
industries when the scale of production in an industry or groups of industries increases. Hence
external economies benefit all firms within the industry as the size of the industry expands.

Causes of internal economies:

Internal economies are generally caused by two factors
1. Indivisibilities
2. Specialization.

1. Indivisibilities
Many fixed factors of production are indivisible in the sense that they must be used in a
fixed minimum size. For instance, if a worker works half the time, he may be paid half the salary.
But he cannot be chopped into half and asked to produce half the current output. Thus, as output
increases the indivisible factors which were being used below capacity can be utilized to their full
capacity thereby reducing costs.
Such indivisibilities arise in the case of labor, machines, marketing, finance and research.

2. Specialization.
Division of labor, which leads to specialization, is another cause of internal economies.
Specialization refers to the limitation of activities within a particular field of production.
Specialization may be in labor, capital, machinery and place. For example, the production
process may be split into four departments relation to manufacturing, assembling, packing and
marketing under the charge of separate managers who may work under the overall charge of
the general manger and coordinate the activities of the for departments. Thus, specialization will
lead to greater productive efficiency and to reduction in costs.

Internal Economies:
Internal economies may be of the following types.
A) Technical Economies.
Technical economies arise to a firm from the use of better machines and superior
techniques of production. As a result, production increases and per unit cost of production falls.
A large firm, which employs costly and superior plant and equipment, enjoys a technical
superiority over a small firm. Another technical economy lies in the mechanical advantage of
using large machines. The cost of operating large machines is less than that of operating mall
machine.
B) Managerial Economies:
These economies arise due to better and more elaborate management, which only the
large size firms can afford. There may be a separate head for manufacturing, assembling,
packing, marketing, general administration etc. Each department is under the charge of an
expert. Hence the appointment of experts, division of administration into several departments,
functional specialization and scientific co-ordination of various works make the management of
the firm most efficient.
C) Marketing Economies:
The large firm reaps marketing or commercial economies in buying its requirements and in
selling its final products. The large firm generally has a separate marketing department. It can buy
and sell on behalf of the firm, when the market trends are more favorable. In the matter of buying,
they could enjoy advantages like preferential treatment, transport concessions, cheap credit,
prompt delivery and fine relation with dealers. Similarly, it sells its products more effectively for a
higher margin of profit.
D) Financial Economies:
The large firm is able to secure the necessary finances either for block capital purposes or
for working capital needs more easily and cheaply. It can barrow from the public, banks and
other financial institutions at relatively cheaper rates. It is in this way that a large firm reaps financial
economies.
E) Risk bearing Economies:
The large firm produces many commodities and serves wider areas. It is, therefore, able to
absorb any shock for its existence. For example, during business depression, the prices fall for every
firm. There is also a possibility for market fluctuations in a particular product of the firm. Under such
circumstances the risk-bearing economies or survival economies help the bigger firm to survive
business crisis.
F) Economies of Research:
A large firm possesses larger resources and can establish it’s own research laboratory and
employ trained research workers. The firm may even invent new production techniques for
increasing its output and reducing cost.
G) Economies of welfare:
A large firm can provide better working conditions in-and out-side the factory. Facilities
like subsidized canteens, crèches for the infants, recreation room, cheap houses, educational and
medical facilities tend to increase the productive efficiency of the workers, which helps in raising
production and reducing costs.

External Economies.
Business firm enjoys a number of external economies, which are discussed below:
A) Economies of Concentration:
When an industry is concentrated in a particular area, all the member firms reap some
common economies like skilled labor, improved means of transport and communications,
banking and financial services, supply of power and benefits from subsidiaries. All these facilities
tend to lower the unit cost of production of all the firms in the industry.
B) Economies of Information
The industry can set up an information center which may publish a journal and pass on
information regarding the availability of raw materials, modern machines, export potentialities
and provide other information needed by the firms. It will benefit all firms and reduction in their
costs.
C) Economies of Welfare:
An industry is in a better position to provide welfare facilities to the workers. It may get land
at concessional rates and procure special facilities from the local bodies for setting up housing
colonies for the workers. It may also establish public health care units, educational institutions both
general and technical so that a continuous supply of skilled labor is available to the industry. This
will help the efficiency of the workers.
D) Economies of Disintegration:
The firms in an industry may also reap the economies of specialization. When an industry
expands, it becomes possible to spilt up some of the processes which are taken over by specialist
firms. For example, in the cotton textile industry, some firms may specialize in manufacturing
thread, others in printing, still others in dyeing, some in long cloth, some in dhotis, some in shirting
etc. As a result, the efficiency of the firms specializing in different fields increases and the unit cost
of production falls.

Thus, internal economies depend upon the size of the firm and external economies depend
upon the size of the industry.