PRODUCTION FUNCTION

NOVEL MOTORS Automobile Manufacturing

Plant

AN ENTREPREUNER Setting up his own soft drink

bottling plant

A STEEL Has to decide on the plant

MANUFACTURER size
AUTOMOBILE SOFT DRINK STEEL
FACTORY FACTORY MANUFACTURER

INPUTS Plant Plant size

specifications Blast furnace
Steel
Labourers Lime stone
Power Coke
Other raw materials
Electricity

Paint
Copper wires
HOW DOES PRODUCTION FUNCTION DO THIS ?
 PRODUCTION DECISIONS

Technically feasible combination of inputs

Specification that the plant has to conform to
Expansion of capacity Vs Stretching existing
production facilities
Achieving a given level of output

DECISION VARIABLES INVOLVED IN THE PRODUCTION

DECISIONS

INPUTS Combination OUTPUT

PROVIDED BY PRODUCTION FUNCTION

 QUESTIONS FACED BY MANAGERS

1. HOW CAN THE PRODUCTION COSTS BE REDUCED ?

2. TO WHAT EXTENT CAN ONE FACTOR SUBSTITUTE
ANOTHER SO AS TO REDUCE COST ?
3. WHAT COMBINATION OF INPUTS (LABOUR AND CAPITAL)
WOULD GIVE MINIMUM COSTS ?
4. HOW CAN LEAST-COST COMBINATION OF INPUTS BE
ACHIEVED ?
5. WHAT WILL BE THE RATE OF RETURN WHEN MORE
PLANTS ARE ADDED TO EXPAND PRODUCTION?
6. WHAT ARE THE FACTORS THAT CREATE ECONOMIES AND
DISECONOMIES FOR THE FIRM?
 THEORY OF PRODUCTION

1 2 3
Basic Production Laws of Returns
Concepts Function, To Scale Through
The Production Function
Laws of
Production

4 5
Optimal Input Economies
Combination of Scale
PRODUCTION DEFINED: Process by which a commodity is
transformed into a different usable commodity.
PRODUCTION: Means transforming inputs (labour,
machines, raw materials) into an output

Production process takes various forms

TRANSPORTATION LEGAL MEDICAL

MINING SOCIAL
FISHING
STORAGE
WHOLESALING
RETAILING
PACKAGING
 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
 SHORT RUN AND LONG RUN

SHORT RUN LONG RUN

PERIOD IN WHICH PERIOD IN WHICH

Supply of certain inputs are Supply of inputs is elastic

fixed ( Plant, Building
Machines)
Production can be increased
Production can be
by employing more of both
increased by the use of
variable and fixed inputs
variable inputs (labour,
raw materials)
 FIXED AND VARIABLE INPUTS

FIXED INPUTS VARIABLE INPUTS

Whose supply is inelastic in Whose supply is elastic in

the short run the short run

All of its user cannot buy All users can employ more
more of it in the short run of it in the short run

All users cannot employ

more of it in the short run
 PRODUCTION FUNCTION

1. The tool of analysis used to explain the input-output

relationship
2. Describes the technological relationship between inputs
and outputs in physical terms
3. It tells that the production of a commodity depends on
specific inputs
4. It represents quantitative relationship between inputs and
output
5. It represents the technology of a firm, of an industry, or of
the economy as a whole
 PRODUCTION FUNCTION FORMS

A production function may take the form of:

A SCHEDULE OF TABLE
A GRAPHED LINE OR CURVE
AN ALGEBRAIC EQUATION
A MATHEMATICAL MODEL
 ALGEBRAIC FORM
A Production Function may be algebraically expressed as

Q = ƒ ( K , L)
WHERE

Q = The Quantity Produced

K = Capital

L = Labour
SHORT RUN K IS INELASTIC

So the short run production function is

Q = ƒ (L)
In the long run both capital and labour are included and the
production function takes the form

Q = ƒ ( K , L)
 ASSUMPTIONS
THE PRODUCTION FUNCTIONS ARE BASED ON CERTAIN
ASSUMPTIONS

1. Perfect divisibility of both inputs and outputs

2. Limited substitution of one factor for another
3. Constant technology
4. Inelastic supply of fixed factors in the short run
 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 relationship input output relationship
in the short run with one in the long run assuming
variable input while all inputs to be variable
other inputs are held
constant
 SHORT RUN LAWS OF PRODUCTION

Short run

Certain factors of LAND Known

CAPITAL
production are as fixed
PLANT
available in short factors
MACHINERY
supply

Factors available in
plenty are known as
variable factors
 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 are called
 1 2 3 4 5
No. of workers Total Product Marginal Product Average Product
Stages of
(N) (TP) MT (MPL) MT (APL) MT
production
(based on MPL)

1 24 24 24
2 72 48 36
I
3 138 66 46
Increasing
4 216 78 54 returns
5 300 84 60
6 384 84 64

7 462 78 66
II
8 528 66 66
Diminishing
9 576 48 64 returns
10 600 24 60

III
11 594 -6 54 Negative
12 552 -42 46 returns
 300

250

200
. .
Total Product (Tonnes)

150

100

50

0
1 2 3 4 5 6 7 8 9 10 11 12
50 No. of workers
 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. That is the
marginal increase in the total output eventually
decreases when additional units of variable are
applied to a given quantity of fixed factors
 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 . Consequently the productivity of the
marginal worker eventually decreases. As a result ,
the total output increase but at a decreasing rate
 FACTORS BEHIND THE LAWS OF RETURNS
STAGE I STAGE II

1. Underutilization of fixed
factor
Addition of workers
increases better utilization of
fixed factor
3. Productivity of workers
increases
4. Optimum capital-ratio is
reached
Marginal productivity of
workers increases
2. 1. Addition of further workers
upsets optimum capital-labour
combination 2. Additional
labour cannot substitute capital
3. Marginal
productivity of workers
decreases
5.

LAW OF INCREASING LAW OF DECREASING

RETURNS RETURNS
 ASSUMPTIONS

The application of law of Diminishing Returns is subject to

certain assumptions

1. THE STATE OF
TECHNOLOGY REMAINS
UNCHANGED
2. INPUT PRICES REMAIN
UNCHANGED
3. THE VARIABLE FACTORS
ARE HOMOGENOUS
 THE LAW OF DIMINISHING RETURNS AND
BUSINESS
STAGE III STAGE II STAGE I

1.High labour- 1. Meaningful 1. Capital-labour

capital ratio and rational ratio is high
2. Additional stage 2. Capital is
workers in 2. Optimum unproductive
fructuous 3. combination of
Causes decline capital and
in TP labour

REDUCE INCREASE
LABOUR LABOUR
HOW MANY WORKERS WILL THE FIRM EMPLOY

MARGINAL REVENUE PRODUCTIVITY AND

LOBOUR EMPLOYMENT

MRP = MPP × P

Equi-Marginal Principle

MARGINAL MAR GINAL

REVENUE
PRODUCTIVITY
= WAGE RATE
OF LABOUR
No. of Marginal Price per Marginal Wage
workers Physical unit of Revenue per
Productivity- product-P Productivity worker
MPP MRP(MPP ×P)
1 29 10 290 390
2 43 10 430 390
3 41 10 410 390
4 63 10 630 390
5 49 10 490 390
6 39 10 390 390
7 23 10 230 390
8 1 10 10 390
 P´ P
MRP and MW

W AW = MW

O N
MRP
LABOUR
 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 relationship input output relationship
in the short run with one in the long run assuming
variable input while all inputs to be variable
other inputs are held
constant
LONG TERM LAWS OF PRODUCTION
 LONG TERM PRODUCTION WITH TWO
VARIABLE 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 RETURNS TO SCALE

EXPLAINED BY

ISOQUANT
PRODUCTION
CURVE
FUNCTION
TECHNIQUE
 ISOQUANT CURVE
An ISOQUANT CURVE is a locus of points representing the
various combinations of two inputs…. Capital and labour
yielding the same output.

ASSUMPTIONS
1. THERE ARE ONLY TWO FACTORS OF
PRODUCTION…CAPITAL (K) AND LABOUR (L) TO
PRODUCE A COMMODITY X
2. THE TWO FACTORS CAN SUBSTITUTE EACH
OTHER UP TO A CERTAIN LIMIT
3. THE TECHNOLOGY IS GIVEN OVER A PERIOD
 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
Units of K

K4 A

K3 B
K2 C

K1 D
Iq1 = 100

0
L1 L2 L3 L4

Units of L
Units of K

K4 A
Iq4 = 250
K3 B
Iq3 = 200
K2 C
Iq2 = 150
D
K1
Iq1 = 100
0
L1 L2 L3 L4
Units of L
 Reduction in costs when the scale of
production increases is called

ECONOMIES
OF SCALE

INTERNAL EXTERNAL
ECONOMIES ECONOMIES
ADVANTAGES AND DISADVANTAGES OF LARGE SCALE
PRODUCTION

Specialization Rent

Economy of Overhead
labour charges

Economics of
buying and
selling
 INTERNAL ECONOMIES

Technological Large scale production provides

opportunities for technological advances
Advantages
Economies in
Production
Large scale production workers of
Advantages of varying skills & qualifications are
divisions employed which facilitates division of
of labour labour as per specialization
&
Specialization
.. Large scale selling of
firms own products

.. Large scale purchase of

raw materials & other Improves the overall
Economies in performance of the firm
inputs
Marketing
.. Advertising cost
.. Large
scale distribution
 .. Specialization in
managerial activities

Managerial .. Improves managerial

Economies efficiency
.. Mechanization of
managerial functions

.. Efficient management
of the transport function

.. Helps in reducing
Transport
transportation and
& Storage
storage costs
Economies

.. Proper utilization of
storage facilities
 CAUSES OF INTERNAL ECONOMIES

Bigger capacity
SIZE Big lower Energy
Machine less labour

LIMITING Spreading of
Mergers costs
PROCESS

Superior Shorter period of

TECHNIQUE Technique time

SPECIALI - Division of Increase in

ZATION Labour efficiency
MANAGERIAL Managerial
Aggregation economies
ECONOMICS

Financial Credit facilities

economies
COMMERCIAL
ECONOMIES
Wide Market Encourages
investment

RISK BEARING
Diversification Spreading
ECONOMIES Risks
 CAUSES OF EXTERNAL ECONOMIES
Common Pool of
Knowledge
Advantages
CONCENTRATION of locality
of Reduced transportation cost
locality

The benefits which

companies derive from
trade publications and
Knowledge technical journals
INFORMATION
sharing By virtue of location,
common pool of research
can be created and benefits
can be shared

Breaking up of processes
Breaking up which can be handled by
DISINTEGRATION
specialist firms
processes
No. of workers Total Product Marginal Product Average Product Stages
(N) (TP) MT (MPL) MT (APL) MT