Theory Of

Production
Dr. Bijit Debbarma
 The Firm & Production
• Major portion of goods and services consumed in a modern
economy are produced by firms.
• The firm is an organisation that combines and organises
resources for the purpose of producing goods and services for
sale at a profit.
• The firm also has to identify the technically efficient production
processes for avoiding any wastage of resources.
• The most important reason for a firm or business enterprises
exist is that firms are specialised organisation devoted to
manage the process of production.
Definition of Production Function
• A production function defines the relationship between inputs
and the maximum amount that can be produced within a
given period of time with a given level of technology.
• Two special features of a production function are given below:
• 1. Labour and capital are both unavoidable inputs to
produce any quantity of a good, and
• 2. Labour and capital are substitutes to each other in
production
Production Function and
Managerial Decision
• Production process involves the transformation of inputs into
output.
• The inputs could be land, labour, capital, entrepreneurship
etc. and the output could be goods or services.
• In a production process managers take four types of
decisions:
a) whether to produce or not,
b) how much output to produce,
c) what input combination to use, and
d) what type of technology to use
 Production Function
• Suppose we want to produce apples.
• We need land, seedlings, fertilizer, water, labour, and some machinery.
• These are called inputs or factors of production.
• The output is apples.
• A production function is the functional relationship between inputs and
output.
• Algebraically, it may be expressed in the form of an equation as
• Q = f (L,M,N,K,T)
• Where Q stands for the output of a good per unit of time, L for labour, M
for management (or organization), N for land (or natural resources), K for
capital and T for given technology, and f refers to the functional
relationship.
 Production Function-2
• it may be expressed in the form of an equation as:
• Q = f (L,M,N,K,T)
• Where:
• Q stands for the output of a good per unit of time,
• L for labour,
• M for management (or organization),
• N for land (or natural resources),
• K for capital and
• T for given technology, and
• f refers to the functional relationship
 Production Function-3
• Economists, use a two input production function.
• If we take two inputs, labour and capital, the production function
assumes the form:
• Q = f(L, K)
The Objective of Production Function
• The primary purpose of the production function is to address
allocative efficiency in the use of factor inputs in production and
the resulting distribution of income to those factors.
• Production function is a function that specifies the output of a firm
for all combinations of inputs.
• The relationship of output to inputs is non-monetary; that is, a
production function relates physical inputs to physical outputs, and
prices and costs are reflected in the function.
• Influences economic decision-making
Economic Efficiency and Technical
Efficiency
• We say that a firm is technically efficient when it obtains
maximum level of output from any given combination of inputs.
• When economists use production functions, they assume that
the maximum output is obtained from any given combination of
inputs.
• On the other hand, we say a firm is economically efficient, when
it produces a given amount of output at the lowest possible cost
for a combination of inputs provided that the prices of inputs are
given.
Example of Economic Efficiency and
Technical Efficiency
• An ABC company is producing ready made garments using
cotton fabric in a certain production process. It is found that 10
percent of fabric is wasted in that process. An engineer
suggested that the wastage of fabric can be eliminated by
modifying the present production process. To this suggestion,
an economist reacted differently saying that if the cost of
wasted fabric is less than that of modifying production process
then it may not be economically efficient to modify the
production process.
 Short Run and Long Run
Production Function
• All inputs can be divided into two categories: i) fixed inputs and ii)
variable inputs.
• Fixed Inputs are those that cannot be quickly changed during the time
period under consideration except, perhaps at a very great expense, (e.g.,
a firms’ plant).
• Variable Inputs are those that can be changed easily and on very short
notice (e.g., most raw materials and unskilled labour).
• In the short run, the technical conditions of production are rigid so
that the various inputs used to produce a given outputs are in fixed
proportions.
• In the long run all inputs are variable. Production can be increased by
changing one or more of the inputs.
The Law of Diminishing Returns
• The law of variable proportions is also known as the law of
diminishing returns states that as the quantity of a variable
input is increased by equal doses keeping the quantities of
other inputs constant, total product will increase, but after
a point at a diminishing rate.
Returns to Scale
• Returns to scale describes the relationship between outputs
and scale of inputs in the long run when all the inputs are
increased in the same proportion.
• To meet a long run change in demand, the firm increases its
scale of production by using more space, more machines
and laborers in the factory.
Economies of Scale
• Economies of scale, in microeconomics, refers to the cost
advantages that a business obtains due to expansion.
• There are factors that cause a producer's average cost per
unit to fall as the scale of output is increased.
• "Economies of scale" is a long run concept and refers to
reductions in unit cost as the size of a facility and the
usage levels of other inputs increase.
 Summing Up
• Production Function: A production function is a function that specifies the
output of a firm, an industry, or an entire economy for all combinations of
inputs.
• Law of variable proportions: In economics, diminishing returns (also
called diminishing marginal returns) refer to how the marginal production of
a factor of production starts to progressively decrease as the factor is in
creased, in contrast to the increase that would otherwise be normally
expected.
• The law of returns to scale: An economic concept referring to a situation
in which economies of scale no longer function for a firm. Rather than
experiencing continued decreasing costs per increase in output, firms see
an increase in marginal cost when output is increased.
• Economies of Scale : Economies of scale, in microeconomics, are the
cost advantages that a business obtains due to expansion. They are
factors that cause a producer's average cost per unit to fall as scale is
increased.