Production

Production in economics is generally understood as the transformation of inputs into

outputs. The inputs are what a firm buys (i.e, productive resources) and outputs (i.e,
goods and services produced) what it sells. Apart from physical changes of the matter,
production also includes services like buying and selling, transporting and financing. But
in economic analysis, we restrict the use of term production to the production of goods
only because in the production of goods we can precisely specify the inputs and also
identify the quantity and quality of outputs.
Production is sometimes defined as creation of utility or the creation of want-satisfying
goods. It is said that just as man cannot destroy matter, he cannot create matter, what he
can do is to give it utility. Consumption means extracting utility from the matter,
production means putting utility into it. But this is not a scientifically correct definition.
To produce a thing which has utility but not value is not production in economic sense.
Production, therefore, should be defined, not as creation of utility but creation or addition
of value. The utility and value can be created by changing: (i) the form of matter, (ii)
place of matter, (iii) and the time of matter.
Production Function
Production function may be defined as the functional relationship between physical
inputs and physical outputs. It describes technology, not economic behavior. It refers to a
flow of inputs resulting into a flow of outputs over a period of time, leaving prices aside.
The production function shows the maximum quantity of output that can be produced
from a given set of inputs in the existing state of technology. A production function for a
good y can be shown in the general form as:
y = (x1, x2, ..., xm)
Which relates a single output y to a series of factors of production x 1, x2, ..., xm. Note that
in writing production functions in this form, we are excluding joint production, i.e. that a
particular process of production yields more than one output (e.g. the production of wheat
grain often yields a co-product, straw.
For understanding the nature of production function, the following points may be
considered:
1. The production function represents purely a technical relationship between
physical quantities of inputs and outputs.
2. The output is the result of a joint use of factors of production. It is obvious that
the physical production of one factor can be measured only in context of this
factor being used in conjunction with other factors.
3. The nature or the quantity of the various factors and the manner in which they are
combined will depend upon the state of technological knowledge. For example,

labour productivity will depend on the quantity of labour as determined by their

education and training. Similarly, the productivity of machines will be determined
by the technical advances embodied in them. Thus, the state of technology is
treated as given for specifying the production function. A change in technology
will mean a shift to another production function. Improvement in technology will
result in a larger output from a given combination of factors of production.
4. In specifying the production function of a firm, we have to take into account the
variability of the factors and also whether they are divisible or indivisible. These
features of the factors determine their physical productivities and hence the nature
of
the
production.
5. The production function may be short run and long run according to the time
period. In the short run, all the factors cannot be raised in the same proportion
because in the short run, some of inputs may be fixed in supply. Their supply
cannot be enhanced. So when, we study the short run production function, we
have to keep some of the inputs constant and some variable. Hence, when
quantity of a factor of production is augmented, keeping the quantity of other
factors constant, we get the laws of returns. In the long run, quantity of all the
factors of production can be increased in the same proportion or in a different
proportion. In the long run, study laws of returns to scale.
Law of Variable Proportions
There are three laws of returns known to economists, the law of increasing,
constant and decreasing returns. There is said to be increasing, decreasing or constant
returns according as the marginal return rises, falls or remains unchanged as the quantity
of a factor of production is increased. In terms of cost, an industry is subject to
increasing, decreasing or constant returns according as the marginal cost of production
falls, rises or remains the same with the increase in the quantity of a variable factor.
Modern economists consider these three laws only the three stages of one law,
i.e., law of variable proportion.
The law of variable proportion occupies a very important place in economic
theory. It describes the production function with one variable factor while quantities
of other factors are held constant. It describes the input-output relation in a
situation when output is increased by increasing the quantity of one factor, keeping
the quantity of other inputs constant. When the quantity of one factor is increased,
keeping the quantities of other factors constant, naturally the proportion between
the variable factor and fixed factors altered, i.e., the ratio of the variable factor to
that of fixed factors goes on increasing with the successive increase in the quantity of
variable factor.
According to Stigler, As equal increments of one input are added, the inputs of other
productive services being held constant, beyond a certain point the result in increment of
product will decrease, i.e., the marginal product will diminish.

According to Benham, As the proportion of one factor in the combination of factors is

increased, after a point, first the marginal and then the average product of that factor will
diminish.
Assumptions of the Law
1. State of technology is assumed to be constant.
2. Some inputs are held constant.
3. Proportion of inputs is assumed changeable.
In order to study the law, three terms must be properly understood. They are:
Total Product: The total quantity produced during some period of time by all the factors
of production that the firm uses. If the inputs of all but one factor are held constant, the
total output (TP) will change as more or less of the variable factor is used. This variation
is shown in the table.
Average Product: It is merely the total product per unit of variable factor, which is
labour in the present case.
APL = TP / L
Marginal Product: It is the change in total product resulting from the use of one more
(or one less) unit of the variable factor. MP refers to the rate at which output is tending to
vary as input varies at a particular output. It is the partial derivative of the TP with respect
to variable factor.
MPL = TP /L (in case of discrete variable) and MPL = TP/L (In case of continuous
variable).
Statement of Law
The law can be explained with the help of following table
Labour
Unit

TP (Unit)

APL (Unit)

MPL (Unit)

14

14

14

52

26

38

108

36

56

176

44

68

250

50

74

324

54

74

392

56

68

448

56

56

486

54

68

10

500

50

14

11

484

44

-16

12

432

36

-52

13

338

26

-94

14

196

14

-142

First stage is up to 8th unit of labour; second stage starts from the point where average
product is equal to marginal products and ends when marginal products becomes zero (810 unit of labour); and third stage is the stage of negative marginal product (after 10th unit
of labour).

Figure 1 Law of variable proportion

This graph shows three stages of productionincreasing AP; decreasing AP while MP is
positive; and negative MP. Stage first is inefficient because the addition of an extra unit
of labour results in an increase in the AP of all labour units employed. A DMU should
never produce where APL is rising since this implies that it could increase APL by
employing more labour. It should produce somewhere in the second stage.

Uses of the Law

Besides agriculture, the law also applies to other fields of economic activities such as
manufacturing.

Reasons for application of the Law

1. Wrong combinations
2. Scarcity of factors
3. Imperfect substitutes of factors

RETURNS TO SCALE (RTS)

The law of variable proportion states that as more and more of the variable input is added
to the fixed factor base, the increment to the total output after some point will decline
progressively with each additional unit of variable factor. This law is applicable in the
short run. Under returns to scale, the behaviour of output is studied when all factors of
production are changed in the same direction and in the same proportion. RTS is a long
run concept. In the long run, output may be increased by changing all the factors by the
same proportion or by different proportion. Traditional theory of production concentrates
on the first case and assumes the homogeneity of production function.
Suppose we start from an initial level of inputs and output
Q0 = f (L, K) and we increase both the inputs by the same proportion , we will
obtain a new level of output Q1 higher than the original level Q0 .
Q1 = f (L, K)
If Q1 increases by the same proportion as the inputs, we say that there are constant
returns to scale (CRTS). If Q1 increases less than proportionally with the increase in the
inputs, we have decreasing returns to scale (DRTS). If Q1 increases more than
proportionally with the increase in the inputs, we have increasing returns to scale (IRTS).
RTS are measured mathematically by the coefficients of the production function. For
example, above simple function can be converted into mathematical as:
Q0 = a Lb1 K b2
Let L and K be increased time. The new level of output is
Q1 = a (L)b1 (K) b2
Q1 = (a Lb1 K b2) b1+b2
Q1 =b1+b2Q0
If b1+b2 = v, then
Q1 =v Q0

If v = 1, Constant RTS, v 1, Increasing RTS; and v 1, Decreasing RTS.

Here v is total elasticity of production, indicating how much output is responsive to
change in the total inputs.

From Q = a Lb1 K b2 , Isoquants (Equal product curve) can be drawn. If Q = a Lb1

K is written in terms of L with Q held constant, combinations of L and K producing
that level of Q can be derived.
b2

L = (a-1QK-b2)1/b1
Thus, given level of Q can be produced by using different combination of L and
K. A family of isoquants can be derived by specifying alternative, constant levels of Q
and solving for the value of L, consistent with each value of K. These isoquants are
shown in the figure below.
A map of isoquants

Figure-2
The slope at each point on an isoquant represents the rate at which L must be
substituted for K to maintain output at the constant level. The slope of isoquant is known
as the marginal rate of technical substitution (MRTS). It reflects the rate at which labour
can be substituted for capital, while holding output constant. It is equal to the ratio of
marginal product of labour to the marginal product of capital. MRTS LK declines as more
labour is substituted for capital.
MRTSLK = (Q/L) / (Q/K) = (b1/b2). (K/L)

Where Q/L is the marginal product of labour and Q/K is the marginal product of
capital.
Level of Optimum Input-use
Optimum combination of labour and capital to produce a given level of output
will be at the point where the isoquant is tangent to the factor price line. It means that the
slope of isoquant should be equal to the slope of factor price line. That is:
MRTSLK = (Q/L) / (Q/K = PL / P K
Point a, b and c in the graph below show the optimum combination of L and K under
different investment constraints. Line from the origin going through these equilibrium
points is known as expansion path or scale line or production line. This line is a straight
line, indicating that production function is homogeneous. The product lines describe the
technically possible alternative paths of expanding output. What path will be chosen by a
firm, will depend on the prices of labour and capital.
Optimum combinations of Labour and Capital

The above stated

scale
can
be
isoquants
and
lines.

returns
to
described by
factor price

Increasing returns to scale

If the output more than doubles when inputs are doubled, there are increasing returns to
scale. The prospect of increasing returns to scale is an important issue from a public
policy perspective. If there are IRTS, then it is economically advantageous to have one
large firm producing (at relatively low cost) rather than to have many small firms (at

relatively high cost). Because this large firm can control price that it sets, it may need to
be regulated.

Capital

labour
Increasing Returns to Scale

Constant returns to scale

A second possibility with respect to scale of production is that output may double when
inputs are doubled. In this case we say there are CRTS. With CRTS, the size of the firms

operation does not affect the productivity of its factorsone plant using a particular

production process can easily be replicated, so that two plants produce twice as much
output.

Constant Returns to Scale

Decreasing returns to scale

Finally output may less than doubles when all inputs double. The case of DRTS applies to
some firms with large-scale operations. Eventually, difficulties in organizing and running
at large-scale operations may lead to decreased productivity of both labour and capital.
Thus, the DRTS case is likely to be associated with the problems of coordinating tasks
and maintain a useful line of communication between management and workers.

Decreasing returns to
Scale
Causes of increasing returns to scale
The IRTS are due to technical and/ or managerial indivisibilities. Usually most processes
can be duplicated but it may not be possible to halve them. One of the basic
characteristics of advanced industrial technology is the existence of mass production
methods over large sections of manufacturing industry. Mass Production methods, such
as the assembly line in the car industry, are processes are available only when the level of
output is large. They are more efficient than the best available process for producing
small levels of output. Assume that we have three processes:
Labour (L)

capital (K)

output

A. Small Scale process

01

01

01

B. Medium Scale Process

50

50

100

(Q)

C. Large Scale Process

100

100

400

The K/L ratio is the same for all the processes and each process can be duplicated (but
not halve). The large scale processes are technically more productive than small scale
process. The indivisibility will tend to lead to IRTS.
Thus, specialization, division of labour, and some physical laws are the major factors in
explaining the IRTS.
Causes of decreasing returns to scale
The most common causes are diminishing returns to management. As size of operation
increased, top management eventually becomes overburdened and less efficient in its role
as coordinator and ultimate decision-maker. Another cause for DRTS may be found in
exhaustible natural resources. For example, doubling the fishing fleet may not lead to a
doubling of the catch of fishes as fishes may exhaust in the sea or pond area.