Production

Function

Tanu Kathuria 1
Tanu Kathuria 2
Production Function

Tanu Kathuria 3
Production Function
 States the relationship between inputs and outputs
 Inputs – the factors of production classified as:
 Land – all natural resources of the earth – not just
‘terra firma’!
 Price paid to acquire land = Rent

 Labour – all physical and mental human effort

involved in production
 Price paid to labour = Wages

 Capital – buildings, machinery and equipment

not used for its own sake but for the contribution
it makes to production
 Price paid for capital = Interest

Tanu Kathuria 4
Production Function

Inputs Process Output

Land
Product or
Labour service
generated
– value added
Capital

Tanu Kathuria 5
Production Function
 Mathematical representation
of the relationship:
 Q = f (K, L, La)
 Output (Q) is dependent upon the amount
of capital (K), Land (L) and Labour (La)
used

Tanu Kathuria 6
 Analysis of Production Function:
Short Run
 In the short run at least one factor fixed in supply but all other
factors capable of being changed
 Reflects ways in which firms respond to changes
in output (demand)
 Can increase or decrease output using more or less of some
factors but some likely to be easier
to change than others
 Increase in total capacity only possible
in the long run

Tanu Kathuria 7
Analysis of Production Function:
Short Run
In times of rising
sales (demand)
firms can increase
labour and capital
but only up to a
certain level –
they will be limited
by the amount of
space. In this
example, land is
the fixed factor
which cannot be
altered in the
short run.

Tanu Kathuria 8
Analysis of Production Function:
Short Run
If demand slows
down, the firm can
reduce its variable
factors – in this
example it reduces
its labour and
capital but again,
land is the factor
which stays fixed.

Tanu Kathuria 9
Analysis of Production Function:
Short Run
If demand slows
down, the firm can
reduce its variable
factors – in this
example, it
reduces its labour
and capital but
again, land is the
factor which stays
fixed.

Tanu Kathuria 10
Short-Run Changes in Production
Factor Productivity
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed

How much does the quantity of Q

change, when the quantity of L is
11
increased? Tanu Kathuria
 The Marginal Product of Labour
 The marginal product of labour is the
increase in output obtained by adding 1 unit
of labor but holding constant the inputs of all
other factors

Marginal Product of L:
MPL= ∆Q/∆L (holding K constant)
= δQ/δL

Average Product of L:
APL= Q/L (holding K constant)
Tanu Kathuria 12
Relationship Between Total,
Average, and Marginal Product:
Short-Run Analysis
 Total Product (TP) = total quantity of
output

 Average Product (AP) = total product per

total input

 Marginal Product (MP) = change in

quantity when one additional unit of input
used Tanu Kathuria 13
Short-Run Analysis of Total,
Average, and Marginal Product
 If MP > AP then
AP is rising
 If MP < AP then
AP is falling
 MP = AP when
AP is
maximized
 TP maximized
when MP = 0 14
Tanu Kathuria
Three Stages of Production in Short
Run
AP,MP
Stage I Stage II Stage III

APX

MPX X
Fixed input grossly Specialization and
underutilized; teamwork continue to
specialization and result in greater output Fixed input capacity
teamwork cause AP to when additional X is is reached;
increase when additional used; fixed input being additional X causes
X is used properly utilized output to fall

Tanu Kathuria 15
Law of Diminishing Returns
(Diminishing Marginal Product)
Holding all factors constant except one, the
law of diminishing returns says that:
 As additional units of a variable input are
combined with a fixed input, at some point
the additional output (i.e., marginal product)
starts to diminish
 e.g. trying to increase labor input without also
increasing capital will bring diminishing returns
 Nothing says when diminishing returns will start
to take effect, only that it will happen at some
point
 All inputs added to the production process are
exactly the same in individual productivity
Tanu Kathuria 16
Analysing the Production
Function: Long Run
 The long run is defined as the period of time taken to vary all factors of
production
 By doing this, the firm is able to increase its total capacity – not
just short term capacity
 Associated with a change in the scale of production
 The period of time varies according to the firm
and the industry
 In electricity supply, the time taken to build new capacity could be
many years; for a market stall holder, the ‘long run’ could be as little
as a few weeks or months!

Tanu Kathuria 17
 Analysis of Production Function:
Long Run

In the long run, the firm can change all its factors of production thus
increasing its total capacity. In this example it has doubled its capacity.

Tanu Kathuria 18
Long-Run Changes in Production
Returns to Scale
Units of K
Employed Output Quantity (Q)
8 37 60 83 96 107 117 127 128
7 42 64 78 90 101 110 119 120
6 37 52 64 73 82 90 97 104
5 31 47 58 67 75 82 89 95
4 24 39 52 60 67 73 79 85
3 17 29 41 52 58 64 69 73
2 8 18 29 39 47 52 56 52
1 4 8 14 20 27 24 21 17
1 2 3 4 5 6 7 8
Units of L Employed

How much does the quantity of Q change,

when the quantity of both L and K is
increased? Tanu Kathuria 19
Optimal Combination of Inputs
 Now we are ready to answer the question
stated earlier, namely, how to determine the
optimal combination of inputs
 As was said this optimal combination
depends on the relative prices of inputs and
on the degree to which they can be
substituted for one another
 This relationship can be stated as follows:
MPL/MPK = PL/PK
(or MPL/PL= MPK/PK)
Tanu Kathuria 20
An Isoquant
Graph of Isoquant

Y
7

0
1 2 3 4 5 6 7 X

Tanu Kathuria 21
Law of Diminishing Marginal Rate
of Technical Substitution:
Table 7.8 Input Combinations
for Isoquant Q = 52
Combination L K ∆L ∆K MRTS
A 6 2
-2 1 2
B 4 3
C 3 4 -1 1 1
D 2 6 -1 2 1/2
E 2 8 0 2

Tanu Kathuria 22
Law of Diminishing Marginal Rate of
Technical Substitution continued
Y 7
A
6

5
∆Y =- 2
B
4
∆X = 1 C
3 ∆Y = -1
D
∆X = 1 E
2
∆Y = -1
∆X = 2
1

0
2 3 4 6 8 X

Tanu Kathuria 23
Isocost Curves

Assume PL =$100
Input Combinations and PK =$200
Rs.1000 Budge
Combination L K
A 0 5
B 2 4
C 4 3
D 6 2
E 8 1
G 10 0

Tanu Kathuria 24
Isocost Curve and Optimal
Combination of L and K
K

100L + 200K = 1000

5

“Q52”

10 L

Isocost andTanu
isoquant
Kathuria
curve for inputs L and
25
Expansion Path: the locus of points which presents
the optimal input combinations for different isocost
curves
The long-run situation:
both factors variable
Expansion path
Units of capital (K)

300
TC =
£60 000
TC =
TC = £40 000 200
£20 000
100
O Tanu Kathuria 26
Units of labor (L)
 Returns to Scale

 Let us now consider the effect of

proportional increase in all inputs on the
level of output produced

 To explain how much the output will

increase we will use the concept of returns
to scale

Tanu Kathuria 27
 Returns to Scale continued
 If all inputs into the production process
are doubled, three things can happen:
 output can more than double
 increasing returns to scale (IRTS)
 output can exactly double
 constant returns to scale (CRTS)
 output can less than double
 decreasing returns to scale (DRTS)

Tanu Kathuria 28
Graphically, the returns to scale concept can be
illustrated using the following graphs

IRTS CRTS DRTS

Q Q Q

X,Y X,Y X,Y

Tanu Kathuria 29