Whatever be the objective of business firms,
achieving optimum efficiency in production or
minimizing the cost of production is one of the
prime concerns of managers today. Infact, the
very survival of the firms in a competitive market
depend on their ability to produce at a competitive
cost.
Production
The process of transformation of resources
(like land, labour, capital and
entrepreneurship) into goods and services
that have utility to consumers and producers.
Goods includes all tangible items such as
furniture, house, machine, food, car, television
etc
Services include all intangible items, like
banking, education, management,
consultancy, transportation.
Production theory can be divided into
short run theory or long run theory.
Long run and short run:
The Long Run is distinguished from the
short run by being a period of time long
enough for all inputs, or factors of
production, to be variable as far as an
individual firm is concerned
The Short Run, on the other hand, is a
period so brief that the amount of at least
one input is fixed
The length of time necessary for all inputs
to be variable may differ according to the
nature of the industry and the structure of a
firm
Types of Inputs
Technology
determines the type, quantity and proportion of
inputs.
also determines the maximum limit of total output
from a given combination of inputs.
at any point of time, technology will be given;
impact of technology can be seen only over a
period of time.
Fixed and Variable Inputs
Variable input : that can be made to vary in the short run,
e.g. raw material, unskilled/semi skilled labour, etc.
Fixed input: that cannot be varied in the short run, e.g.
land, machine, technology, skill set, etc.
Production Function
A technical relationship between physical inputs
and physical outputs over a given period of time.
shows the maximum quantity of the commodity
that can be produced for each set of alternative
inputs, and with a given level of production
technology.
Normally a production function is written as:
Q = f (L,N,K,R,E)
where Q is the maximum quantity of output of a
good being produced, and N=labour; K=capital;
L=land; R=raw material;E=Enterprenuer.
Production Function continued
Q = f(X1, X2, …, Xk)
where
Q = output
X1, …, Xk = inputs
For our current analysis, let’s reduce the
inputs to two, capital (K) and labor (L):
Q = f(L, K)
Thus production function is :
Always related to a given time period
Always related to certain level of
technology
Depends on relation between inputs
Cost (economic aspect) is taken to be
constant.
Eg. Production of say cloth
Categories Of Production
Function
With one Variable Input/The law of
variable proportions.
With two variable inputs/Returns to
Scale
The Production Process
production technology The quantitative
relationship between inputs and outputs.
labor-intensive technology Technology that relies
heavily on human labor instead of capital.
capital-intensive technology Technology that relies
heavily on capital instead of human labor.
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The Production Process
How Fast Should a Truck
Driver Go?
Modern technology, in the form of
on-board computers, allows a
modern trucking firm to monitor
driving speed and instructs
drivers.
12 of 28
Choice of Technology
Two things determine the cost of production: (1)
technologies that are available and (2) input prices.
Profit-maximizing firms will choose the technology
that minimizes the cost of production given current
market input prices.
UPS Technology Speeds
Global Shipping
New UPS Technologies Aim to
Speed Worldwide Package
Delivery
Information Week
13 of 28
Production Function with One Variable Input
Also termed as variable proportion production function
It is the short term production function
Shows the maximum output a firm can produce when only
one of its inputs can be varied, other inputs remaining
fixed:
Q = f (L,K constant)
where Q = output, L = labour and K = fixed amount of capital
Total product is a function of labour:
TPL = f (K constant, L)
Average Product (AP) is total product per unit of variable
input
AP L = TPL / K
Marginal Product (MP) is the addition in total output per unit
change in variable input
MPL ▲TP / ▲L
==
Total Product(TP): Amount of total
output produced by a given amount of
variable factor, keeping the quantity of
other factors (L,K) to be fixed
Average Product(AP):It is the total
product divided by the amount of labor
employed with a fixed K used to produce
a commodity
Marginal Product (MP):It is the rate of
change of TP or it is the addition to TP
by the employment of a extra unit of
factor.
Short Run Production Function: The Law of Variable
Proportions
Statement of the law:
As per F.Benham “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”
The law of variable proportions states that when more
and more units of the variable factor are added to a
given quantity of fixed factors, the total product may
initially increase at an increasing rate reach the
maximum and then decline but first the marginal and
then average product of that factor will diminish
Labour (’00 Total Product (’000 MP AP Stages
units) tonnes)
1 20 - Increasing returns
20
2 50 3 0
25
3 90 40
3 0
4 120 3 0 Diminishing
3 0 returns
5 140 20
28
6 150 10
25
7 150 0
21.5
8 130 -20 Negative returns
16.3
9 100 -30
11.1
200
150
Total Product
(’000 tonnes)
Output
100
Marginal
Product
50
Average
Product
0
1 2 3 4 5 6 7 8 9
-50
Labour
As the quantity of the variable factor is increased with other fixed factors, MP and
AP of the variable factor will eventually decline.
Therefore law of variable proportions is also called as law of diminishing
marginal returns.
Graphical Representation of Three Stages of Law of
Variable Proportions
H 3RD STAGE
1st STAGE 2 STAGE
ND
Negative
Increasing Returns Decreasing Returns Returns
TOTAL PRODUCT
F
PRODUCT
AVERAGE PRODUCT
MARGINAL PRODUCT
WORKER
agrammatical Presentation of Law of Variable Proportions
First stage
Increasing Returns
to the Variable Factor
MP>0 and
MP>AP
Second stage
Diminishing
Returns to a Variable
Factor
AP MP>0 and MP<AP
Third Stage
Negative Returns
MP AP MP<0 while AP is
falling but positive
Technically
inefficient stage of
MP production
A rational firm will
never operate in this
AP,MP
Stage I Stage II Stage III
APX
MPX X
Law of Diminishing Returns and Business Decisions
A Rational producer will never choose to produce in stage III where
Marginal Productivity of variable factor is negative. It will stop at the
end of the second stage where Marginal Productivity of the variable
factor is Zero. At this point the producer is maximizing the total output
and will thus be making the maximum use of the available variable
factors.
A producer will also not choose to produce in Stage I where he will not
be making full use of the available resources as the average product of
the variable factor continues to increase in this stage.
A producer will like to produce in the second stage. At this stage
Marginal and Average Product of the variable factor falls but the Total
Product of the variable factor is maximum at the end of this stage.
Thus stage II represents the stage of rational producer decision.
Important Results and Relationships
Relation between Marginal and Total Quantity
Marginal quantity shows the rate of change of total quantity
When marginal quantity increases it means the total quantity
increases at increasing rate, while if marginal quantity is
decreasing, (but positive) total quantity increases at
decreasing rate
When total quantity increases, marginal quantity is positive
When total quantity is maximum, marginal quantity is zero
When total quantity falls, marginal quantity is negative
Important Results and Relationships
Relation between Average and Marginal Quantity
When average quantity is increasing, marginal quantity is
greater than average quantity.
When average quantity is decreasing, marginal quantity is
less than average quantity.
When average quantity is neither increasing nor decreasing,
marginal quantity is equal to average quantity
Important Results and Relationships
Relation between Total and Average Quantity
Average quantity is equal to the total quantity divided by the
number of units of a factor employed
Average = Total / Units
When average is zero, total quantity is zero
In economics, an isoquant (derived from
quantity and the Greek word iso, meaning
equal) is a contour line drawn through the
set of points at which the same quantity of
output is produced while changing the
quantities of two or more inputs.[1][2] While an
indifference curve mapping helps to solve
the utility-maximizing problem of consumers,
the isoquant mapping deals with the cost-
minimization problem of producers.
Isoquants are typically drawn along with isocost
curves in capital-labor graphs, showing the
technological tradeoff between capital and labor in
the production function, and the decreasing
marginal returns of both inputs. Adding one input
while holding the other constant eventually leads
to decreasing marginal output, and this is reflected
in the shape of the isoquant. A family of isoquants
can be represented by an isoquant map, a graph
combining a number of isoquants, each
representing a different quantity of output.
Isoquants are also called equal product curves.
An isoquant shows the extent to which the firm in
question has the ability to substitute between the
two different inputs at will in order to produce the
same level of output. An isoquant map can also
indicate decreasing or increasing returns to scale
based on increasing or decreasing distances
between the isoquant pairs of fixed output
increment, as output increases. If the distance
between those isoquants increases as output
increases, the firm's production function is
exhibiting decreasing returns to scale; doubling
both inputs will result in placement on an isoquant
with less than double the output of the previous
isoquant
An isoquant map where Q3 > Q2 > Q1. Typically inputs X and Y would refer
to labor and capital respectively. More of input X, input Y, or both is required
to move from isoquant Q1 to Q2, or from Q2 to Q3.
A) Example of an isoquant map with two inputs that are perfect substitutes.
B) Example of an isoquant map with two inputs that are perfect complements.
Returns to Scale(Long -Run Phenomenon)
Returns to scale is the rate at which
output increases in response to
proportional increases in all inputs.
It refers to the degree by which the level
of output changes in response to a given
change in all the inputs in a production
system.
Constant Returns to Scale
If a proportional increase in all inputs
yields an equal proportional increase in
output,then there would be constant
returns to scale
A production function is said to exhibit
constant returns to scale if a doubling of
all inputs results in a precise doubling of
output.
Decreasing Returns to Scale
If a proportional increase in all inputs
yields a less than proportional increase
in output,then there would be
decreasing returns to scale.
If doubling all inputs yields less than a
doubling of output, the production
function is said to exhibit decreasing
returns to scale.
Increasing Returns to Scale
If a proportional increase in all inputs
yields a more than proportional
increase in output,the phenomenon is
known as increasing returns to scale.
If doubling all inputs results in more than
a doubling of output, the production
function exhibits increasing returns to
scale.
ECONOMIES OF SCALE
Economies of scale are reductions in average costs attributable
to production volume increases.
SPECIALIZATION
Mass production allows the use of specialized equipment and
automation to perform repetitive tasks. The larger the output of
a product, plant, or firm, the greater will be the opportunities for
specialization of labor and capital equipment.
VOLUME DISCOUNTS
Oftentimes, the suppliers of raw materials, machinery, and other
inputs will charge a lower price per unit for these items if a firm
buys in large quantities. When a firm produces at high output
levels, it needs a large volume of inputs and can take advantage
of the associated price discounts to reduce its per-unit costs; if
the company is large enough it may have strong negotiating
power on this point.
ECONOMIES OF SCALE
ECONOMIC USE OF BY-PRODUCTS
The production of many types of goods gives rise to
economically valuable by-products. Large-scale
firms are often able to recycle "waste" by-products
that smaller size firms simply have to throw away
because it is not economical to do anything else with
them.
Technical economies of scale
Large-scale businesses can afford to invest in
expensive and specialist capital machinery.
Marketing economies of scale
A large firm can spread its advertising and marketing
budget over a large output.
ECONOMIES OF SCALE
Financial economies of scale
Larger firms are usually rated by the financial
markets to be more ‘credit worthy’ and have access
to credit facilities, with favourable rates of borrowing.
In contrast, smaller firms often face higher rates of
interest on overdrafts and loans.
Businesses quoted on the stock market can
normally raise fresh money (i.e. extra financial
capital) more cheaply through the issue of shares.
They are also likely to pay a lower rate of interest on
new company bonds issued through the capital
market
DISECONOMIES OF SCALE
When a firm grows beyond the scale of
production that maximizes long-run cost,
diseconomies of scale may result. When
diseconomies of scale occur the firm
sees an increase in marginal cost when
output is increased. This can happen if
processes become "out of balance," or
when one process cannot produce the
same output quantity as a related
process.
DISECONOMIES OF
SCALE
Diseconomies of scale also can occur when a firm becomes
so large that :
Transportation costs increase enough to offset the
economies of scale
Monitoring worker productivity becomes too imperfect or
costly
Coordinating the production process becomes too difficult
Frequent breakdowns result
Maintaining efficient flows of information becomes too
expensive
Workers feel alienated and become less productive
The focus of the firm is reduced, leading to inefficiencies
and loss of strategic position
