Lesson 3 ◼ Theory of Production, Costs and Revenue 69

Unit 4
Production Analysis

LESSON OUTLINE
LEARNING OBJECTIVES

Production Markets have two sides: consumers and

producers. Up until now we focused on the
Factors of Production consumer side of the market. We now focus on
Production Function the other one, the producer side of the market.

The traditional theory of any enterprise is to plan

Theory of Production
the prices and output in a manner that
TP, AP, MP maximizes profits in the short as well as long
run. It is of an emergent importance to learn
Law of Diminishing Returns or Law
how the firms can produce efficiently and how
of Variable Proportions
their costs of production change with the change
Law of Returns to Scale in the prices of inputs and level of output.

Cobb – Douglas Production Function In this section, you will learn how to use the
theory of production so as to maximize the profit.
Production Function with two variable
Inputs Profit of the firm may be maximized by
minimization of costs or/and maximizing revenue.
Optimum Factor Combination
The producers’ equilibrium would be derived with
the help of different theories of production.
You will also learn the concepts of returns to
scale, economies and diseconomies of scale.
70 FP-BE

PRODUCTION

Meaning

Production is another important economic activity. It directly or indirectly satisfies the wants and needs of the
people. Satisfaction of human wants is the objective of production.
Production is the conversion of input into output. The factors of production and all other things which the producer
buys to carry out production are called inputs. The final goods and services produced are known as output. In
economics, the term production is not the same as in common language where it is usually taken to mean
‘creation’ of something. In economics, the term production carries a wider connotation. It stands for creation of
‘value’, which can be of two varieties, namely ‘use value’ and ‘exchange value’. Thus, production is the activity
which creates or adds utility and value.
According to Edwood Buffa, “Production is a process by which goods and services are created”.

Factors of Production

The resources needed to produce a given product are called factors of production. Production of goods and
services needs various inputs which are known as ‘Factors of Production’, ‘Agents of Production’, ‘Productive
Resources’ or sometimes even ‘Productive Services’. According to Marshall, the four major factors of production
are:

– Land

– Labour

– Capital

– Entrepreneurship

The level of production depends upon both the quantity of inputs and the efficiency with which they are employed
in the process of production. It is also noteworthy that economic growth of a country, in a way, represents its
productive capacity which, in turn, depends upon the technology and amounts of productive resources.

1. Land: Land is not created by mankind but it is a gift of nature available to us free of cost. So, it is called as
natural factor of production. It is also called as original or primary factor of production. Normally, land means
surface of earth. But in economics, land has a wider meaning.

Land includes earth’s surface and resources above and below the surface of the earth. It includes following
natural resources: -

– On the surface (e.g. soil, agricultural land, etc.)

– Below the surface (e.g. mineral resources, rocks, ground water, etc.)

– Above the surface (e.g. climate, rain, etc.)

Land is the sum total of those productive resources which are provided ‘free of cost’ by nature to us that is to say those
resources on which no human effort has been expended to make them actually usable in a productive process

The salient features of land are highlighted below.

– Land is a free gift of nature to mankind. It is not a man-made factor but is a natural factor.

– Land is primary factor of production.

 Lesson 3 ◼ Theory of Production, Costs and Revenue 71

– Supply of land is perfectly inelastic i.e. fixed in quantity. Neither it can be increased nor decreased.

– Land is a passive factor in the sense that it cannot produce anything of its own. It needs help of Labor,
Capital, Entrepreneur, etc.

– There is no social cost of land since; it is a gift of nature to society. It is not created by society by putting
any efforts and paying any price. So, its supply price for society is zero. At the same time, the supply
price for individual is not zero.

– Land is a perfectly immobile factor.

– Economic reward for the use of land is rent.

2. Labour: The term labour is used to mean several things and can be a source of great deal of vagueness and
imprecise statements. The term labour refers to only human effort (or activity) which can be physical, mental or
a mixture of the two. It does not include the work performed by animals or machines or nature.

Labour lately is known as human resource. All companies need labor in order to carry out production. Everyone
from the manual workers, to the owner of the company falls under the classification of human resources. Without
this factor, there would be no production because nobody would be working.

The salient features of labour are highlighted below.

– Labour cannot be separated from laborers. Worker sells their service and doesn’t sell themselves.

– Labour cannot be stored. Once the labour is lost, it cannot be made up. Unemployed workers cannot
store their labour for future employment.

– Labour is an active factor of production unlike land.

– Labour is heterogeneous. No two persons possess the same quality of labour. Skills and efficiency differ
from person to person. So, some workers are more efficient and productive than others in the same job.

– Labour is an imperfectly mobile factor.

– Labour supply is inelastic in general. Supply of labour depends upon many factors like size of population,
age and sex composition, desire to work, quality of education, attitude towards work, etc. Thus, supply
cannot be changed easily according to changes in demand.

– The amount of labour is the product of (i) duration of time over which it is performed and (ii) the intensity
with which it is performed.

Supply of labour in a country refers to

– the total number of workers available for labour

– the intensity with which they can work

– the duration for which they work

– their efficiency (or productivity)

3. Capital: Capital is another important factor which plays a huge role in the production. Capital includes things
like tools, machines, and other things that a business uses in order to produce their goods or services. At some
level, all companies rely on their capital in order to run successfully. Without these things, the company would be
unable to carry out production.

The term capital may mean different in different disciplines; in economics, capital is that part of wealth which is
used for production. It is one of the factors of production/ input. The word capital in economics may mean either
of the three;
72 FP-BE

– assets

– money/ wealth

– income
The salient features of capital are highlighted below.
– Capital is not a gift of nature. It is man made, secondary as well as an artificial factor of production.
– Capital helps in increasing level of productivity and speed of production.
– Supply of capital is relatively elastic.
– Capital is not perishable like labour. It has a long life subject to periodical depreciation.
– Capital is a perfectly mobile factor.
– Capital has a social cost. Capital as a resource has alternative uses. It can be put to either of the uses.
The society in order to have one of them sacrifices another; accounting it as social cost.
4. Entrepreneurship: Factors of production viz. land, labour and capital are scattered at different places. These
cannot produce economic goods and services by themselves. They have to be brought together and, in a coordinated
way, made to pass through a productive process to create output. According to Kaldor, entrepreneurship consists
of three major functions, viz, coordination, management and supervision. All these factors have to be assembled
together. This work is done by enterprise through entrepreneur. This is the function of an entrepreneur; to bring the
required factors together and making them work harmoniously.
This final factor of production of entrepreneurship involves the activity right from start of the business to assembling of
other factors in order to carry out production smoothly. It is not possible for an entrepreneur to start production process
without other factors of production viz. land, labour, capital. Entrepreneurship is an independent factor of production.
The salient features of an entrepreneur as a factor of production are highlighted below.
– Entrepreneur should be able to plan, organize, manage and allocate other primary factors of production
efficiently.
– Entrepreneur should be able to define objective precisely.
– Entrepreneur should be able to deal with numerous risks involved in entrepreneurship.
– Entrepreneur should be able to incorporate innovation and adopt modern techniques of production.
– Entrepreneur should be able to take decisions promptly. Quick decisions are expected but hasty decisions
may be avoided.

I. THEORY OF PRODUCTION

Theory of production basically determines, how the producer, given the state of technology combines various
inputs economically to produce a definite amount of output in an efficient manner. In the production process, firm
converts combination of inputs/factors of production, into outputs/finished goods/products.
Production Function: The functional relationship between input and output is known as production function.
The production function states the maximum quantity of output which can be produced from any selected
combination of inputs. In other words, it states the minimum quantities of input that are necessary to produce a
given quantity of output.
The production function can be expressed in form of an equation in which the output is the dependent variable
and inputs are the independent variables. The equation is expressed as follows:
 Lesson 3 ◼ Theory of Production, Costs and Revenue 73

QX = f (L, K, T.................. n)
Where, QX = Output
L = Labour
K = Capital
T = Level of Technology
n = Other Inputs Employed in Production

Assumptions of Production Function

The production function is based on the following set of assumptions:
– The level of technology remains constant.
– The firm uses its inputs at maximum level of efficiency.
– It relates to a particular unit of time.
– A change in any of the variable factors produces a corresponding change in the level of output.
– The inputs are divisible into most viable units.
There are two types of production function - short run production function and long run production function.
Short run is defined as that time period over which a firm is unable to vary the quantities of all inputs. In contrast,
long run is defined as that time period over which a firm can vary quantities of all factors of production and
therefore, can switch between different scales. In the long run production function all inputs are variable. There
are two alternative theories to these production functions i.e.
– Law of Diminishing Returns or Laws of Variable Proportions (to analyze production in the short period)
– Law of Returns to Scale (to analyze production in the long period)

Attributes of Production Function

For a clear understanding of the concept of production function, its following attributes should be carefully noted:
Flow Concept. A production function is a flow concept. It relates to the flow of inputs and the resulting flows of
output of a commodity during a period of time. Here, time is taken to be functional or operational time period.
Physical Concept. A production function is a technical relationship between inputs and outputs expressed in
physical terms and not in terms of a monetary unit, such as rupee or dollar.
State of Technology and Inputs. It implies that the production of a firm depends on the state of technology
and inputs. Technology refers to the sum total of knowledge of the means and methods of producing goods and
services. It is the society’s knowledge concerning the industrial and agricultural arts. It includes methods of
organization and techniques of production. Input refers to anything that is used by the firm in the process of
production. Thus, inputs include every type of productive resource — land, labor, capital, etc., also time and
human energy as well as knowledge which are employed by the firm for producing a commodity. The set of
factor inputs in a production function has the following important characteristics.
Inputs (a, b, c, d, n..) are complementary in nature as their combined productive services are transformed into
production of a specific commodity.
Some inputs are substitutes to one another. Thus, for example, if a and b are substitutable factors, a may
be increased instead of b. The a is fixed while b is variable at a time. In practice, however, factors like labor and
capital, are not perfectly substitutable, but there may be sufficiently high degree of substitutability.
Some inputs may be specific. Particularly, highly specialized factors are of specific use, as they have least
degree of substitutability.
Factors Combination for the Maximum Output. The concept of a production function in economic analysis
is viewed to indicate something more than just a technical relationship. It is taken to be the technical relationship
showing the maximum output that can be produced by a specific set of combination of factor inputs. From the
economic point of view, the rational firm is interested not in all the numerous possible levels of output
corresponding to the different combinations of factor inputs, but only that combination which yields maximum
output.
 74 FP-BE

Short-run and Long-run Production Function. Fixity or variability of factors depends on the functional time
period under consideration. On functional criteria, there are short period and long period. Correspondingly, we
have a short-run and long-run production functions. Short-run production function pertains to the given scale of
production. Long-run production function pertains to the changing scale of production

LAW OF DIMINISHING RETURNS OR LAW OF VARIABLE PROPORTIONS

The law of variable proportions is the modern approach to the ‘Law of Diminishing Returns (or The Laws of
Returns). It is now usually called the Law of Variable Proportions. It can also be called the Law of Diminishing
Marginal Product or Diminishing Marginal Returns or simply as Diminishing Returns. The law of variable
proportions shows the production function with one input factor variable while keeping the other input factors
constant.
The law of variable proportions states, “as the proportion of variable factor is increased, the total production at
first increases more than proportionately, then proportionately and finally less than proportionately”. The classical
economists called it the Law of Diminishing Returns. They derived it by applying more and more labour to a
fixed acreage of land, and thought of it as associated particularly with agriculture. But, it is a general principle
that can be applied to any production operation.
According to K.E. Boulding, “As we increase the quantity of any one input which is combined with a fixed
quantity of the other inputs, the marginal physical productivity of the variable input must eventually decline”.
According to P. A. Samuelson, “An increase in some inputs relative to other fixed inputs will in a given state of
technology, cause output to increase but after a point the extra output resulting from the same additions of extra
inputs will become less and less”
Marshall defined the law by saying, “An increase in the capital and labor applied in the cultivation of land causes
in general a less proportionate increase in the amount of product raised until it happens to coincide with an
improvement in the art of agriculture.”
It should be noted that Marshall recognizes that this law is applicable only in the short run when the technology
can be assumed to be given and inputs can be combined only within a given range of combinations.
 Lesson 3 ◼ Theory of Production, Costs and Revenue 75

This law states the effect of variations in factor proportion on output. When one factor varies and the others
remain fixed; the proportion between the fixed factor and the variable factor will vary. That is why the law is
called the law of variable proportions.

Assumptions of the Law

The law of variable proportion is valid with the following assumptions:
– The technology remains constant. If there is an improvement in the technology, due to inventions, the
average and marginal product will increase instead of decreasing.
– There are two factors of production. One factor is variable and other factor is kept constant.
– All the units of the variable factor are identical in all respects. They are of the same size and quality.
– A particular product can be produced under varying proportions of the input combinations.
– The law operates in the short run.
In short-period, when the production of an output is sought to be increased; by increasing an additional unit of
variable factor to a given quantity of fixed factors, the law of variable proportions comes into operation. The law
of variable proportions provides the result to varying the proportions of the fixed and variable factors of production.
When the quantity of one factor is increased while all other factors remain constant, then the proportion between
the fixed and variable factors is altered.
Earlier, economists distinguished this law into three separate laws of returns; namely diminishing, increasing
and constant returns. Modern Economist, however, stated that these are three different aspects of the same
law, viz. ‘Law of Variable Proportions’. There are three stages to this law in the following sequence:
– Stage of Increasing Returns
– Stage of Diminishing Returns
– Stage of Negative Returns

Table 3.1: Stages of Law of Returns

Labour Capital Total Average Marginal Stage

Units Units Product Product Product

1 10 8 8 8
2 10 20 10 12 STAGE I
3 10 36 12 16
4 10 48 12 12
5 10 55 11 7
STAGE II
6 10 60 10 5
7 10 60 8.6 0
8 10 56 7 -4
9 10 51 5.7 -5 STAGE III
10 10 45 4.5 -6
11 10 38 3.6 -7

Total Product or Total Physical Product (TPP): is the total quantity of output a firm obtains from a given
quantity of inputs (L, K).
76 FP-BE

Average Product or Average Physical Product (APP): is the total physical product (TPP) divided by the
quantity of input.
APPL = TPP/L
APPK = TPP/K
Marginal Product or Marginal Physical Product (MPP): It is the increase in total output that results from a one
unit increase in the input, keeping all other inputs constant.
MPPL = TPP/ L
or
MPPL = TPPn-TPPn-1
In the above table, the total product initially increases at an increasing rate till the employment of the 4th unit of
labour. Beyond, the marginal product started diminishing. The marginal product declines faster than the average
product. At the 6th unit, the total product is at its maximum. For 7th unit, marginal product is zero and the marginal
product of 8th unit is negative. Thus, when more and more units labour are combined with other fixed factors, the
total product increases first at an increasing rate, and then at a diminishing rate and finally it declines in absolute
terms.
All the three stages taken together describe the Law of Variable Proportions.
– Stage I: Total product first increases at an increasing rate and then at a decreasing rate and this continues
till the end of this stage. Average product is continuously increasing. MP first increases, becomes maximum
and then starts falling. The stage I ends where average product reaches its highest point, so here, the
efficiency of variable factor (labour) is maximum. There are two important reasons for increasing returns:
– indivisibility
– specialization
– Stage II: Total product continues to increase at a diminishing rate until it reaches its maximum point at the
end of this stage. Both AP and MP diminish, but are positive. At the end of the second stage, MP becomes
zero. TP is maximum when MP is zero. AP shows a steady decline throughout this stage. As both AP and
MP decline, this stage is known as stage of diminishing returns. The main cause of the application of the
law of diminishing returns is the scarcity of one or the other factor of production. In other words, the
elasticity of substitution between the factor is not infinite.
– Stage III: In this stage, TP starts to decline. AP shows a steady decline, but never becomes zero. MP
becomes negative. The phenomenon of negative returns emerges as a result of application of excessive
units of variable factor in relation to fixed factor, so they get in each other’s way, with the result that TP starts
diminishing.
Fig. 3.1: Law of Variable Proportions

In Fig 3.1, X-axis shows labour levels and Y-axis shows TP, AP, and MP.
Stage I is till point A on TP curve where MP=AP.
Stage II is till point B on TP curve where TP reaches its maximum, AP steadily
falls and MP=0.
Stage III is beyond point B on TP curve where TP begins to fall and MP becomes
negative.
 Lesson 3 ◼ Theory of Production, Costs and Revenue 77

Where to operate?
A rational producer will not produce is Stage I where ‘AP’ is increasing. A rational producer will also not produce
in Stage III where MP is negative & TP is falling.
Thus, Stage II, presents the range of rational production decision; where both AP and MP falling but AP is
greater than MP through out this stage and TP is still increasing. At the end of this stage, MP of variable factor is
zero and TP is maximum. It is stage of operation suitable for rational producer.
Limitations of Law of Variable Proportions
The law of variable proportions is based on unrealistic set of assumptions.
– A homogeneous unit of variable input (especially labour) is an illogical assumption. Every unit of labour or
worker is different from each other.
– The assumption of constant input prices and technique of production also seems unrealistic in the present
dynamic world.

LAW OF RETURNS TO SCALE

Law of Returns to Scale is a long run concept. In the long run, all factors of production become variable as the
firm is able to alter its stock of inputs in long run which is not the case in short run. When all factors are changed
in some proportion, the behaviour of output is analyzed with the help of laws of returns to scale. Thus, this law
takes into consideration not the varying units of inputs but changing scale of production. The scale of production
of the firm is determined by those input factors which cannot be changed in the short period. If the firm increases
the units of both factors labour and capital, its scale of production increases.
A return to scale is the rate at which the output increases with the increase in all inputs proportionately. There are
three cases of returns to scale:
– Increasing Returns to Scale
– Constant Returns to Scale
– Diminishing Returns to Scale
Increasing Returns to Scale: When inputs are increased in a given proportion and output increases in a
greater proportion, the returns to scale are said to be increasing. In other words, proportionate increase in all
factors of production results in a more than proportionate increase in output is a case of increasing returns to
scale. Thus, if all inputs are doubled then total output is more than doubled.
For example, if the inputs are increased by 40% and output increases by 50%, return to scale are increasing. It
is the first stage of production. If the industry is enjoying increasing returns, then its marginal product increases.
As the output expands, marginal costs come down.
Constant Return to Scale: When inputs are increased in a given proportion and output increases in the same
proportion, the returns to scale are said to be constant. Thus, if all inputs are doubled then total output is also doubled.
For example, if inputs are increased by 40% and output also increases by 40%, the returns to scale are said to
be constant.
Decreasing Returns to Sale: If the firm continues to expand beyond the stage of constant returns, the stage of
diminishing returns to scale will start to operate. If a proportionate increase in all inputs results in less than
proportionate increase in output, the returns to scale are said to be decreasing. Thus, if all inputs are doubled
then total output is less than doubled.
For example, if inputs are increased by 40%, but output increases by only 30%, it is a case of decreasing returns
to scale. Decreasing return to scale implies increasing costs.
Increasing Returns: % change in output > % change in inputs
Constant Returns: % change in output = % change in inputs
Decreasing Returns: % change in output < % change in inputs
78 FP-BE

Table 3.3: Returns to Scale

Units of Units of Total % Change % Change Retruns to

Capital Labour Output in Inputs in Output Scale
20 150 3000 – –
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing

II. THEORY OF COSTS

In the process of its decision-making, in order to be able to decide the price of the product at which it would offer
the same in market; a firm needs to acquaint itself with the costs of producing the product. The cost of supplying
the product is determined by the productivity and the prices of the inputs used. The cost function of a firm shows
a relationship between output produced and the associated cost of producing it. Hence, costs are nothing but
input prices. There are four major inputs as discussed; land, labour, capital and entrepreneurship. The costs
attached with each are; rent, wages, interest and profits respectively.
Like production, costs of a firm may also be analyzed in the context of time period as follows:
– Short Run Costs
– Long Run Costs
Short Run Costs
There are two categories of costs in short run: Fixed cost and Variable cost. The firm needs to incur few fixed
costs initially in short period irrespective of the level of output. For ex., a firm would need land to build factory, an
electricity connection to run machines, machinery to produce output, some mangers or employees to manage
each & every function. All these expenditures are not related to the level of output and are required to incur
before production actually starts. A firm then needs to incur variable cost which is the expenditure on variable
factors i.e. factors which vary with the level of output, for example, raw material, labor etc. It is obvious that total
cost (TC) is the summation of total fixed costs (TFC) and total variable costs (TVC).

Fig. 3.2: Concepts of Total Cost of a Firm

In this Fig. 3.2, X axis shows levels of output and Y axis shows costs.
TC is Total Cost Curve
TVC is Total Variable Cost Curve
TFC is Total Fixed Cost Curve

Total Cost Curves: Graphically, if quantity of output is measured along X-axis and costs are measured along Y-
axis, then the Total Fixed Cost Curve (TFC) runs parallel to X-axis (See Fig. 3.4). In contrast, total variable cost
and total output are positively related. They move together. With zero output, the variable costs of the firm are
also zero. The total variable cost (TVC) curve, therefore, starts from the point of origin. If we add the two curves
 Lesson 3 ◼ Theory of Production, Costs and Revenue 79

vertically, we get a corresponding curve which represents total cost (TC). Its starting point on Y-axis coincides
with that of TFC curve.

Fig. 3.3: Average and Marginal Cost of a Firm

In this Fig. 3.3, X axis shows levels of output and Y axis shows
costs.
MC is Marginal Cost Curve
ATC is Average Total Cost Curve
AVC is Average Variable Cost Curve
AFC is Average Fixed Cost Curve

Average Fixed Cost (AFC) Curve: Since total fixed costs do not change with level of output, therefore, average
fixed cost (AFC) declines with increase in the level of output and tends to infinity when output reaches zero. For
first unit of output, AFC equals TFC. The AFC curve, therefore, is a rectangular hyperbola.
AFC= TFC/ Q
Average Variable Cost (AVC) Curve: As output increases total variable cost also increases. But the rate of
increase of TVC would depend on whether the law of eventual diminishing returns operates or not. When it is not
operating TVC increases (slowly) less than proportionately to product (Q). As a result, AVC decreases. However,
once the law starts to operate, TVC increases (steadily) more than proportionately to product implying increase
in AVC. Consequently, the shape of the average cost curve is U-shaped. It first falls then rises.
AVC= TVC/ Q
Average Total Cost, or Average Cost (ATC or AC) Curve:
AC= TC/Q
Since, TC= TFC + TVC
∴ AC = (TFC + TVC)/ Q
∴ AC = (TFC/Q) + (TVC/Q)
∴ (AC = AFC + AVC)
As output increases AFC is declining throughout. However, AVC is declining up to a point and later starts to rise.
Therefore, AC is declining rapidly when both AFC and AVC are declining; whereas it starts rising as AFC continues
to decline and AVC rises. Graphically, it is obtained by vertical addition of the AFC and AVC curves. AC curve lies
above AVC curve. At each point, its vertical distance from AVC curve is exactly equal to the distance of AFC
curve from X-axis. Therefore, AC curve is U-shaped and with increasing output, its vertical distance from AVC
keeps declining.
Marginal Cost (MC) Curve: Marginal cost is addition to total cost on account of the production of an additional
unit. It is ratio of change in total cost to change in total output.
80 FP-BE

In short run, TC= TFC + TVC

MC= d(TC)/ dQ

MC= d(TFC + TVC)/ dQ

= (dTFC/dQ) + (dTVC/dQ)

Since, TFC does not change in short run, MC depends upon only TVC

⇒ dTFC/dQ = 0

∴ MC = d(TVC)/dQ

For this reason, MC curve is related to only AVC curve. Therefore, MC curve is also a U shaped curve. When
AVC is decreasing, MC is less than it and MC curve lies below AVC curve. However, when the rate of fall of AVC
slows down, MC curve reaches its lowest value and starts increasing and cuts AVC from below at its lowest
point. In other words, when AVC is minimum, MC is equal to it. In the next phase, when AVC curve slopes
upwards, MC curve rises faster than the former and lies above it.

Long Run Costs

The term long run is defined as that length of time over which the firm gets an opportunity to vary if need be the
quantities of all its inputs. In other words, there are no fixed factors in the long run and therefore there are no
fixed costs. All factors are variable and as a result all costs are variable.

If a firm closes down, its total cost (TC) also falls to zero. Similarly, TC increases with an increase in output, but
its rate of increase may not be proportionate to the increase in output.

In classical reasoning, where production efficiency is determined by proportion of inputs rather than their
absolute quantities, total cost of production changes in direct proportion to output. Therefore, TC curve is a
straight line with a fixed slope and starts from the origin. Further, in this case, both average cost and marginal
cost are throughout equal to each other and remain constant. Their numerical value is equal to the slope of
the TC curve.

Fig. 3.4: Long Run Total, Average and Marginal Costs

In this Fig. 3.4, X axis shows levels of output and Y axis shows
costs.
In Fig 3.4, TC curve represents total cost of output of a firm for
corresponding quantities of output. Thus, when the output of the
firm is OM, total cost is PM, average cost is PM/OM. Marginal cost
is also equal to the constant slope of TC curve, that is, PM/OM.
 Lesson 3 ◼ Theory of Production, Costs and Revenue 81

Fig. 3.5: TC, AC and MC with Varying Returns to Scale

In Fig. 3.5 TC curve starts from point O, rises at a decreasing rate

till point P (corresponding to output scale OB). At this output, there
are constant returns to scale. When scale of production exceeds
OB, diminishing returns set in and total cost curve starts rising at
an increasing rate.

Modern economic theory contends that in the long run, a firm experiences varying returns to scale. With an
expansion in the scale, it starts with the benefit of increasing returns. This is followed by constant returns which,
in turn, are replaced by diminishing returns. If we take a point, say K, on TC curve, then the slope of the line
joining it with origin O (that is, the slope of OK) measures AC and the slope of the tangent to the curve at this
point measures MC.

COBB-DOUGLAS PRODUCTION FUNCTION

C.W. Cobb, and P.H. Douglas made a statistical inquiry into some manufacturing industries in America and other
countries to trace the empirical relations between changes in physical inputs and the resulting output. From their
studies, a generalised form of production function with two variable inputs, viz., labour and capital, has been
evolved which is as follows:
Q = a [LbK 1–b]

where, Q is the quantity of output, L and K stand for the quantities of labour and capital, respectively while a and b
are positive constants.
The above stated production function is a linear and homogeneous function of degree, one which establishes
constant returns to the scale.

The above stated forms of production functions considered only a single variable factor at a time. To be more
realistic in approach, Cobb-Douglas production function considers twovariable factor inputs. Thus:

Q = f (L, K, F)

Where,

L = Labour
K = Capital
F = Refers to fixed factor component of input.
For empirical measurement, the Cobb-Douglas production function is presented with power terms as:
Q = aLb Kc
Q = Total output
L = Labour units-input
K = Capital units-input
Stated in double log form it is transformed into a linear function: Log Q = log a +
b log L + c log K
It is widely used in empirical research on production. In estimating regression of a Cobb- Douglas
production, it showed transformed into a linear form by using double-log terms.
82 FP-BE

Data to estimate production function can be obtained from relevant sources such as company records and
accounts on employment, purchases, output, etc. For using regression methods, time series or cross-sectional
data may be collected.

PRODUCTION FUNCTION THROUGH ISO-QUANT CURVE

In the long-run, as all factors are variable, the firm has a wider choice of adopting productive techniques
and factor proportions, in relation to employed technology. Again, the basic characteristic of productive resources is
that they are substitutable, though imperfectly, by another one to a certain extent. Thus, in a given production
function, the variability of different factor inputs also implies their substitutability. In fact, one factor can be
substituted for another in a particular manner; so that a constant level of output may be maintained. To elucidate
the point, let us assume a production function with two variable inputs, say, labour (L), and capital (K); thus: Q
= F (L, K).
Now, the firm can combine labour and capital in different proportions and can maintain specified level of
output; say, 10 units of output of a product X, under the prevailing state of technology and given
organisational ability of the entrepreneur units of labour (L) and capital (K) may combine alternatively, as
follows:
2L + 9K
3L + 6K
4L + 4K
5L + 3K
The first combination implies greater use of capital and less of labour to have a given level of output (say
10 units of X as we assumed). In this factor combination, we have relative capital intensity, while even by the last
combination, by using more labour and less capital we can produce the same level of output. We have illustrated
only four alternative combinations of labour and capital. However, there can be innumerable such combinations
for producing the same quantity of output. If we plot all these combinations graphically and join the loci of their
points, we derive a curve, as shown in Figure 11.5.

Equal Product Curve (Iso-Quant)

The equal product curve is also called production iso-quant. (Iso-quant means equal quantity). The
concept of production iso-quant is, thus, similar to the concept of indifference curve. It represents all these
combinations of two-factor inputs which produce a given quantity of product. Unlike an indifference curve, the
equal product curve, however, signifies a definite measurable quantity of output, so the units of output can be
labelled to the given iso- quant. In Figure 11.5 (A) thus, we have labelled IQ curve as X 10, as it represents 10
units of commodity X.
Iso-quant measures a quantum of production resulting from alternative combination of two variable inputs.
Iso-quant map represents a set of iso-quants describing production function of a firm. A higher iso-quant
represents a larger quantity of output than the lower one.
Like an indifference map, we can have an iso-quant map or production map showing a set of iso-quants,
each iso-quant representing a specified volume of output. See Figure 11.5 (B).
 Lesson 3 ◼ Theory of Production, Costs and Revenue 83

Difference Between Equal Product Curve and Indifference Curve

Equal product curves, however, may be distinguished from indifference curves as follows:
• Indifference curves indicate level of satisfaction. Equal product curves indicate quantity of output.
⚫ Indifference curves relate to combinations between two commodities. Equal product curves relate
to combinations between two factors of production.
⚫ Indifference curves cannot be easily labelled as there is no numerical measurement of the
satisfaction involved. Equal product curves can be easily labelled as physical units of output
represented by it are measurable.
⚫ On indifference map, between higher and lower indifference curve, the extent of difference in
the satisfaction is not quantifiable. On equal product map, we can measure the exact difference
between the output represented by one iso-quant and the other iso-quant. Thus, unlike indifference
maps and their levels of satisfaction, the size of physical output at various points on equal product
maps are quantifiableand comparable.

PROPERTIES OF ISO-QUANT
Following are the important properties (characteristic features) of iso-quants:
⚫ Iso-quants have a negative slope. This means that in order to maintain a given level of output,
when the amount of one factor input is increased that of the other must be decreased. At each
point on a iso-quant term, we get factor combination whichproduces the same level of output.
⚫ Iso-quants are convex to origin. The slope of the iso-quant measures, the marginal rate of
technical substitution of one factor input (say labour) for the other factorinput (say, capital).
Symbolically,
MRTSLK = DK/DL
where, AIRTSLK = the marginal rate of technical substitution of factor L (labour) for factor K
(capital)
DK = Change in capital, and DL = Change in
labour
The marginal rate of technical substitution measures the rate of reduction in one factor for an additional
unit of another factor in the combination. This is just sufficient to produce the same quantity of output.
The convexity of iso-quant suggests that MRTS is diminishing which means that as quantities of one
factor labour is increased, the less of another factor capital will be given up, if output level is to be
kept constant.

⚫ Iso-quants do not intersect. This is necessary because by definition each iso-quant represents a
specific quantum of output. Therefore, if two iso-quants intersect each other it would involve logical
contradiction as a particular iso-quant at a time may be representing a small as well as a large
quantity of output. To avoid such logical contradiction, care is taken that no two or more iso-quants
(equal product curves) should cut each other.
Iso-quants do not intercept either axis. If an iso-quant is touching the x-axis, it means output is possible
even by using a factor (e.g., labour alone without using capital). But, this is unrealistic from the
production function point of view. Both (labour and capital) are essential in some proportion to
produce a commodity. Similarly, if an iso-quant touches y-axis, that is only capital, can produce output.
This is unrealistic.
⚫ The iso-quant is an ovaL shape curve. It must be noted that one iso-quant may have a positive
upward slope at its ends, when with relatively small amount of a factor, relatively large amount
of another factor is combined, in such a manner that the marginal productivity of this abundant
factor tends to be negative and as such resulting in a decline in a total output. In such cases, the
end portions of the curvesare regarded as uneconomical.
84 FP-BE

ECONOMIC REGION
The economic region of the iso-quant is determined by drawing tangents to the curves parallel to the
two axes, and the points of tangency indicate zero marginal productivity of the abundant factor.
See Figure 11.6.

a1 and b1 are tangency points on 1Q1. Similarly, a2 and b2 points are on 1Q2. Thus, points a1, a2, a3,
etc., represent zero marginal productivities of capital. While, b1, b2, b3, etc., represent zero marginal
productivities of labour. Joining these points, we derive ‘ridge lines.’ The economic region is constrained by
these ridge lines.

Isocost Line
The concept of isocost line is similar to budget line discussed in the theory of consumerdemand in
chapter 4 section 4.8.
Isocost line is a graphical device — a line showing all of the combinations of the two factors (say, labour
and capital) that can be purchased for a given expenditure outlay by the firm.
To draw an isocost line, we require the information about unit prices of the two factorsand total outlay.
Suppose total outlay is Rs. 100. Labour cost is Rs. 10 per unit. Capital costis Rs. 30 per unit. Some
alternative factor combinations are assumed as follows:
Combination Capital (K) Labour (L)
A 3 1
B 2 4
C 1 7

Plotting these values on a graph, joining the loci of points a, b, and c we have to draw the isocost line as
shown in Fig. 11.7.
Lesson 3 ◼ Theory of Production, Costs and Revenue 85
86 FP-BE

RETURNS TO SCALE EXPLAINED THROUGH ISQ-QUANTS

Laws of returns to scale can be explained with the help of equal product curves or iso-quants.
Assuming that a rational firm tries to produce each quantum of output at the least possible costs, we
may draw various alternatives.
OZ is the scale line. It shows different quantities of output at minimum costs.
Equilibrium points at which different cost lines or firm’s budget lines are tangent to different equal
product curves as shown in Figure 11.11.
 Lesson 3 ◼ Theory of Production, Costs and Revenue 87

Figure 11.12 shows that initially there are increasing returns with an increase in outlay on factors as there
is a narrowing distance between successive iso-quants in the beginning: AB> BC> CD. After point D, the
distance between successive iso-quants remains the same.Thus:
CD = DE, which means constant returns to scale. Finally, after point B there is operation of the law of
decreasing return. The distance between successive iso-quants tend to get widened. Thus,
EF < FG.
The narrowing distance between successive IQs suggests increasing returns to scale. The widening
distance suggests decreasing returns.