Production Function

1
Dr Monika Jain
 Fixed factor and variable factors
Fixed factors Variable factors
Definition Its employment Its employment
remains constant when increases
_______________ ________ as output
output increases. increases.
Examples factory buildings, land, raw materials, labour,
capital tools and fuel and electricity
entrepreneurial skills

The Law of DMP 2

 Short run and long run

Short run Long run

A period when there are bot A period when all factors

fixed factors
h ___________ and _____ variable
are ________.
variable
________.factors

A firm can expand output A firm can expand output

by employing more by increasing the use of
variable factors only.
______________ __________.
all factors

The Law of DMP 3

 SHORT RUN AND LONG RUN

SHORT RUN LONG RUN

PERIOD IN WHICH PERIOD IN WHICH

Supply of certain inputs Supply of inputs is elastic

are fixed ( Plant, Building
Machines)
Production can be
Production can be
increased by employing
increased by the use of
more of both variable and
variable inputs (labour, The Law of DMP
fixed inputs 4
raw materials)
 The Technology of Production
• The Production Process
– Combining inputs or factors of production to ac
hieve an output
• Categories of Inputs (factors of production)
– Labor
– Materials
– Capital

The Law of DMP 5

 INPUT AND OUTPUT

INPUT OUTPUT

An input is a good or
service that goes into
the process of PRODUCT
production

1. LABOUR
2. CAPITAL
3. LAND
4. RAW MATERIALS
5. TIMES
6. SPACE
The Law of DMP 6
 The Technology of Production
• Production Function:
– Indicates the highest output that a firm can prod
uce for every specified combination of inputs gi
ven the state of technology.
– Shows what is technically feasible when the fir
m operates efficiently.

The Law of DMP 7

 THE LAWS OF PRODUCTION

LAWS OF VARIABLE LAWS OF RETURNS

PROPORTIONS TO SCALE

Relates to the study of Relates to the study of

input output input output
relationship in the relationship in the long
short run with one run assuming all
variable input while inputs to be variable
other inputs are held
constant
The Law of DMP 8
 SHORT RUN

Firms employ limited

quantity of fixed factors
LAW OF VARIABLE
PROPORTIONS
Unlimited quantity of
variable factors
OR
Leads to variation in
factor proportions
LAW OF
The laws which bring out DIMINISHING
the relationship between RETURNS
varying factor
proportions and output The Law of DMP 9
are called
ASSUMPTIONS OF THE LAW OF VARI
ABLE PROPORTION
• Short Run
• Constant Technology

Basic Concepts of the Law

 Total Product (TP)

 Marginal Product (MP)
 Average Product (AP)
The Law of DMP 10
Short-Run Production Relationships

• Total Product (TP): It means total quantit

y or total output of a particular good produc
ed in a given period.
• Marginal Product (MP): it is extra output
associated with adding an unit of variable re
source (in this case, labor) to production pro
cess while all other inputs remaining the sa
me. Change in Total Product
Marginal Product =
Change in Labor Input
Q
MPX 
X 11
Short-Run Production Relationships

• Average Product (AP): It is called labor pr

oductivity. The output of per unit of resourc
e (in this case per unit labor output).
Total Product
Average Product =
Units of Labor
Q
AP X 
X

12
 Law of variable proportions
• The production function for two inputs:

Q = F(K,L)
Q = Output, K = Capital, L = Labor
• For a given technology

The Law of DMP 13

 Input-output relationship in the short run
Assume there are two factors only: capital (fixed) and la
bour (variable). Technology is constant.
Total product
Labour
(units)
The total product of labour is the
1 4
labour
total output produced by ______
2 10 given period of time holding
in a _________________,
3 20 capital and technology constant.
__________________
4 28
5 34
6 38
7 40
TP ________
increases initially and
8 40 decreases
________ eventually with
9 39 increasing amount of workers.
10 37
The Law of DMP 14
 THE LAW OF DIMINISHING RETURNS

The law states that if more and more units of

variable input are applied to a given quantity of
fixed inputs, the total output may initially increase
at an increasing rate , but beyond a certain level of
output, the rate of increase in the total output
diminishes.

The Law of DMP 15

The Law of DMP 16
 REASON

Given the quantity of fixed factor, (say, capital)

with increasing inputs of variable input, (say,
labour), capital-labour ratio goes on decreasing .
Each additional worker has less and less
equipments and tools to work . As a result , the
total output increase but at a decreasing rate

The Law of DMP 17

 LAW OF VARIABLE PROPORTION
Average Marginal Total Product No. of Workers
Product Product
- - 0 0
10 10 10
Increasing 1
Marginal
12.50 15 25Return 2
15 20 45 3
15 15 60 4
Diminishing
14 10 70
Marginal 5
Return
12.5 5 75 6
10.71 0 75
Negative 7
The Law of DMP Marginal 18
8.75 -5 70
Return
8
The Law of DMP 19
The Law of DMP 20
 LAW OF VARIABLE PROPORTION

Stage TP
2
Output Stage Stage
1 3

AP
0
MP
The Law of DMP 21
No of Workers
 Production Function
With One Variable Input

The Law of DMP 22

 LAW OF VARIABLE PROPORTION

• Stage 1: Stage of Increasing Returns:

• In this stage, total product increases at an increasing rate up to a p
oint. This is because the efficiency of the fixed factors increases a
s additional units of the variable factors are added to it.
• The point of inflection is where marginal product of labour is ma
ximum, after which it diminishes.
• This stage is called the stage of increasing returns because the ave
rage product of the variable factor increases throughout this stage.
This stage ends at the point where the average product curve reac
hes its highest point.

The Law of DMP 23

 LAW OF VARIABLE PROPORTION

Stage 2: Stage of Diminishing Returns: 

• In this stage, total product continues to increase but at a diminishi
ng rate until it reaches its maximum point where the second stage
ends.
• In this stage both the marginal product and average product of lab
our are diminishing but are positive. This is because the fixed fact
or becomes inadequate relative to the quantity of the variable fact
or.
• At the end of the second stage, i.e., at point marginal product of l
abour is zero which corresponds to the maximum point of the tot
al product curve TP. This stage is important because the firm will
seek to produce in this range. than MP.
The Law of DMP 24
 LAW OF VARIABLE PROPORTION

• Stage 3: Stage of Negative Returns: In stage 3, total product d

eclines and therefore the TP curve slopes downward. As a result,
marginal product of labour is negative and the MP curve falls bel
ow the X-axis. In this stage the variable factor (labour) is too muc
h relative to the fixed factor.
• This stage is called the stage of negative returns, since the margin
al product of the variable factor is negative during this stage.

The Law of DMP 25

 The Stage of Operation
• A rational producer will never choose to produce in stage 3 where
marginal product of the variable factor is negative. A producer ca
n always increase his output by reducing the amount of the variab
le factor.
• The rational producer will stop at the end of the second stage whe
re the marginal product of the variable factor is zero.
• At the end point M of the second stage where the marginal produc
t of the variable factor is zero, the producer will be maximising th
e total product and will thus be making maximum use of the varia
ble factor.

The Law of DMP 26

 The Stage of Operation
• A producer producing in stage 1 means that he will not be
making the best use of the fixed factor and further that he
will not be utilizing fully the opportunities of increasing pr
oduction by increasing quantity of the variable factor whos
e average product continues to rise throughout the stage 1.
Thus, a rational entrepreneur will not stop in stage 1 but wi
ll expand further.

The Law of DMP 27

 FACTORS BEHIND THE LAWS OF RETURNS
STAGE I STAGE II
1. Underutilization of fixed
factor 1. Addition of further
2. Addition of workers workers upsets optimum
increases better utilization capital-labour combination
of fixed factor 2. Additional labour cannot
3. Productivity of workers substitute capital
increases 3. Marginal productivity of
4. Optimum capital-ratio is workers decreases
reached
5. Marginal productivity of
workers increases

LAW OF INCREASING LAW OF DECREASING28

The Law of DMP
RETURNS RETURNS
 Why do diminishing marginal returns occur ?
When more workers are added to a given amount of fixed
factors, the fixed factors are ________________;
more fully utilised so MP
rises initially.

Later, when more and more workers are added, there are
workers relative to the amount of
eventually too many _______
fixed factors.
The Law of DMP 29
 The Effect of
Technological Improvement
Output
per Labor productivity
time C can increase if there
period are improvements in
technology, even though
100 any given production
B O3 process exhibits
diminishing returns to
labor.

A
50 O2

O1

Labor per
time period
0 1 2 3 4 5 6 7 8 9 10
The Law of DMP 30
THE LAW OF RETURNS TO SCALE

EXPLAINED BY

ISOQUANT
PRODUCTION
CURVE
FUNCTION
TECHNIQUE

The Law of DMP 31

 ISOQUANT CURVE
An ISOQUANT CURVE is a locus of points
representing the various combinations of two
inputs…. Capital and labour yielding the same
output.
The isoquants emphasize how different input
combinations can be used to produce the same output.

This information allows the producer to respond

efficiently to changes in the markets for inputs

The Law of DMP 32

 ISOQUANTS

COMBINATION CAPITAL LABOUR OUTPUT

A 24 2 100 UNITS
B 16 4 100 UNITS
C 10 6 100 UNITS
D 6 2 100 UNITS

The Law of DMP 33

The Marginal Rate of Technical S
ubstitution
• Similar to indifference curves, isoquants ma
y tell us how firms are willing to substitute
one input for another.

• At the extreme cases, inputs may be perfect

substitutes or perfect complements.

The Law of DMP 34

The Marginal Rate of Technical S
ubstitution
• MRTS is the rate at which one input can be
exchanged for another without altering outp
ut.

• MRTS is the absolute value of the slope of t

he isoquant : |ΔK/ΔL|

The Law of DMP 35

The Marginal Rate of Technical S
ubstitution
• Holding output constant, the less we have o
f one input, the more we must add of the oth
er input to compensate from a one-unit redu
ction in the first input.

The Law of DMP 36

Figure 9-9: The Marginal Rate
of Technical Substitution

The Law of DMP 37

 PROPERTIES OF ISO-PRODUCT CURVES

• Slopes Downward from left to right

• The higher Isoquant show higher output

• Non-intersecting

• Convex to the origin because of the Marginal Rate of T

echnical Substitution

MRTSxy = Change in X =
Change in YThe Law of DMP 38
 ISOQUANTS OR EQUAL PRODUCT CURVE
S
• It means equal quantity produced. It shows various com
binations of two inputs say Labor and Capital giving the
same level of output.

DMRTS xy Total Factor Y Factor X Combinatio

Output ns
100 units 12 1 A
4:1 100 units 8 2 B
3:1 100 units 5 3 C
2:1 100 units 3 4 D
1:1 100 units 2
The Law of DMP 5 E 39
Units of K

K4 A
K3 B

K2 C

K1 D
Iq1 = 100
0
L1 L2 L3 L4
The Law of DMP 40
Units of L
Units of K

K4 A
Iq4 = 250
K3 B
Iq3 = 200
K2 C
Iq2 = 150
K1 D
Iq1 = 100
0
L1 L2 L3 L4
The Law of DMP 41
Units of L
 Isoquants of perfect substitutes
• When two factors are perfect substitutes of
each other, then each of them can be used in
place of another. Therefore MRTS remains
constant and hence isoquants are straight lin
es.

The Law of DMP 42

Isoquants When Inputs are Perfectly Subst
itutable

Capital
per A
month

C
Q1 Q2 Q3
Labor
per month
The Law of DMP 43
 Isoquants of Complements
• When two factors complimentary to each o
ther, then the isoquants are right angled. Th
e perfect complementary factors are those w
hich are jointly used in fixed proportions. A
n increase in one factor without the required
proportional increase in the other factor will
yield no additional output. That's why isoqu
ant is right angled .
The Law of DMP 44
 Fixed-Proportions
production Function

Capital
per
month

Q3
C
Q2
B

K1 Q1
A

Labor
per month
L1
The Law of DMP 45
LONG TERM PRODUCTION WITH TWO VAR
IABLE INPUTS

1. BOTH CAPITAL AND LABOUR ARE VARIABLE

FACTORS
2. SUPPLY OF BOTH INPUTS ARE ELASTIC
3. FIRMS CAN HIRE LARGE QUANTITIES OF BOTH
4. WITH LARGE EMPLOYMENT OF BOTH INPUTS
SCALE OF PRODUCTION CHANGES
5. THE TECHNOLOGICAL RELATIONSHIP BETWEEN
CHANGING SCALE OF INPUTS AND OUTPUT IS
EXPLAINED UNDER “THE LAW OF RETURNS TO
SCALE”
The Law of DMP 46
 Increasing returns to scale
1) A production function for which any give
n proportional change in all inputs leads to
a more than proportional change in output.
Output more than doubles when all inputs
are doubled
• Larger output associated with lower cost
• One firm is more efficient than many
• The isoquants get closer together

The Law of DMP 47

 Increasing Returns:

Capital
Returns to Scale
The isoquants move closer together

(machine A
hours)

30
2 20
10
Labor (hours)
0 5 10
The Law of DMP 48
 Constant returns to scale
A production function for which a proporti
onal change in all inputs causes output to
change by the same proportion. output dou
bles when all inputs are doubled
• Size does not affect productivity
» May have a large number of producers
» Isoquants are equidistant apart

The Law of DMP 49

 Capital
Returns to Scale
(machine
hours) A
6
30

4 Constant Returns:
Isoquants are
20 equally
spaced
2
10

0 5 10 15
The Law of DMP 50
Labor (hours)
 Decreasing returns to scale
• A production function for which a proporti
onal change in all inputs causes a less than
proportional change in output output less t
han doubles when all inputs are doubled
• Decreasing efficiency with large size
• Reduction of entrepreneurial abilities
• Isoquants become farther apart

The Law of DMP 51

 Capital
Returns to Scale
(machine
hours) A

Decreasing Returns:
Isoquants get further
4 apart

30
2
20
10

0 5 10
The Law of DMP 52
Labor (hours)
 ISOCOST CURVES
• They are also called as Outlay Lines, Price Lines or Fac
tor Cost Lines.

• Each Iso-cost shows different combinations of two inpu

ts that a firm can buy for a given sum of money at the gi
ven prices.

The Law of DMP 53

 ISOCOST CURVES
• Suppose a firm has Rs.400 to spend on the combination of two fac
tors for producing a level of output. So it will have the following I
socost curve.
A
10
B
8
C
Factor Y 6
Rs.40 per unit
D
4
E
2
F
0
1 2 3 4 5
The Law of DMPFactor X 54
Rs.80 per unit
Isoquant analysis

The least-cost
method of production

fig
 PRODUCER’S EQUILIBRIUM

• It is achieved when the Producer produce goods at lowe

st possible rates.

• The Least Cost Factors Combination method is used to

determine the Producer’s Equilibrium.

• The Least Cost Factors Combination refers to the combi

nation of factors with which a firm can produce a specif
ic quantity of output at the lowest possible cost.

• We take the Isoproduct curve and Isocost Line to deter

mine the producer’s equilibrium under Least Cost Facto
rs Combination method.The Law of DMP 56
 35
Finding the least-cost method
Assumptions
of
30
production P = £20 K
W = £10
25
Units of capital (K)

TC = £200
20
TC = £300
15
TC = £400
10 TC = £500

0
0 10 20 fig 30 40 50
Units of labour (L)
 35
Finding the least-cost method of
30
production
25
s
Units of capital (K)

TC = £500
20

15
TC = £400
r
10

t
5 TPP1

0
0 10 20 fig 30 40 50
Units of labour (L)
 Expansion path
Units of capital (K)

100 200
TC TC
O
1 2 fig
Units of labour (L)
 Expansion Path
• The line joining the minimum cost combina
tions is called the expansion path

The Law of DMP 60

 Expansion Path
Units of capital (K)

700

600
500
400
300
100 200
TC TC TC TC TC TC TC
O
1 2 3 4 5 6 7
fig
Units of labour (L)
 Expansion Path
Units of capital (K)

Expansion path

700

600
500
400
300
100 200
TC TC TC TC TC TC TC
O
1 2 3 4 5 6 7
fig
Units of labour (L)
 What is economies of scale?
• Economies of scale are the cost advantages that
a business obtains due to expansion. When
economists are talking about economies of
scale, they are usually talking about internal
economies of scale. These are the advantages
gained by an individual firm by increasing its
size i.e having larger or more plants.
 What is diseconomies of scale?
• Diseconomies of scale are the disadvantages
of being too large. A firm that increases its
scale of operation to a point where it
encounters rising long run average costs is
said to be experiencing internal
diseconomies of scale.
 Internal and External economies of
scale.
• Internal economies of scale :- lower long run
average costs resulting from a firm growing
in size.
• External economies of scale :- lower long
run average costs resulting from an
industry growing in size.
 Internal and external diseconomies o
f scale.
• Internal diseconomies of scale :-higher long
run average cost arising from a firm
growing too large.
• External diseconomies of scale:- higher
long run average costs resulting from an
industry growing too large
 Types of Internal economies of scal
e.
• Buying economies
• Selling economies
• Managerial economies
• Financial economies
• Technical economies
• Research and development
economies
• Risk-bearing economies.
 Buying Economies.
• Economies of Bargain - Large firms that buy
raw materials in bulk and place large orders
for capital equipment usually receive a
discount. This means that they have paid less
for each item purchased. They may receive a
better treatment because the suppliers will
be anxious to keep such large customers.
 Selling Economies.
• Every part of marketing has a cost – particularly
promotional methods such as advertising and
running a sales force.
• Many of these marketing costs are fixed costs
and so as a business gets larger, it is able to
spread the cost of marketing over a wider range
of products and sales – cutting the average
marketing cost per unit.
 Managerial Economies.
• As a firm grows, there is
greater potential for managers
to specialize in particular
tasks (e.g. marketing, human
resource management,
finance).
• Specialist managers are likely
to be more efficient as they
possess a high level of
expertise, experience and
qualifications compared to
one person in a smaller firm
trying to perform all of these
roles.
 Financial economies
• Many small businesses find it hard
to obtain finance and when they do
obtain it, the cost of the finance is
often quite high.
• This is because small businesses are
perceived as being riskier than
larger businesses that have
developed a good track record.
• Larger firms therefore find it easier
to find potential lenders and to
raise money at lower interest rates.
 Technical Economies.
• Businesses with large-scale production can
use more advanced machinery (or use
existing machinery more efficiently). This
may include using mass production
techniques, which are a more efficient form
of production. A larger firm can also afford
to invest more in research and development.
 Research and development eco
nomies.
• A large firm can have a research and
development department, since running
such a department can reduce average costs
by developing more efficient methods of
production and raise total revenue by
developing new products.
 Risk-bearing economies.
• Larger firms produce a range of products.
This enables them to spread the risks of
trading. If the profitability of one of the
products it produces falls, it can shift its
resources to the production of more
profitable products.
 Internal Diseconomies of scale.
• Growing beyond a certain output can cause
a firms average costs to rise. This is because
the firm may encounter a number of
problems including difficulties :-
• controlling the firm.
• communication problems.
• poor industrial relations.
 Difficulty controlling the firm.
 It can be hard for those
managing a large firm to
supervise everything that
is happening in the
business.
 Management becomes
more complex and
meetings are necessary
quite often.
 This can increase administrative
costs and make the firm slower
in responding to changes in
 Communication problems.
• Difficult to ensure that everyone is aware
about their duties in a large firm and
available opportunities like training etc.
• The may not get a chance to exchange
their views and innovative ideas to the
management team.
 Poor industrial relations.
• Higher risk for larger firms as there will
be more conflicts and diverse opinions.
• Lack of motivation of workers, strikes will be
seen at certain situations in larger firms due
to poor industrial relations.
 External economies of scale.
• A skilled labour workforce – A firm can recruit
workers who have been trained by other firms
in the industry.
• A good reputation – An area can gain a
reputation for high quality production.
• Specialist suppliers of raw materials and
capital goods – When an industry becomes
large enough, it can become worthwhile for
other industries, called subsidiary industries to
set up for providing for the needs of the
industry.
 External economies of scale.
• Specialist services – Universities and colleges ma run courses
for workers in large industries and banks and transport firms
may provide services, specially designed to meet the particular
needs of firms in the industry.
• Specialist markets – Some large industries have specialist
selling places and arrangements such as corn exchanges and
insurance markets.
• Improved infrastructure – The growth of an industry may
encourage a govt and private sector firms to provide better
road links, electricity supplies, build new airports and develop
dock facilities.
 External Diseconomies of scale.
• Just as a firm can grow too large, so can an
industry.
• Larger firms -> transportation increase ->
congestion -> increased journey time -> high
transport cost -> reduced workers productivity.
• Growth of industry may increase competition
for resources, pushing up the price of key sites,
capital equipment and labour.