In economics, a production function relates physical output of a production process to

physical inputs or factors of production. It is a mathematical function that relates the maximum
amount of output that can be obtained from a given number of inputs – generally capital and
labor. The production function, therefore, describes a boundary or frontier representing the limit
of output obtainable from each feasible combination of inputs.
In microeconomics, the long run is the conceptual time period in which there are
no fixed factors of production, so that there are no constraints preventing changing the output
level by changing the capital stock or by entering or leaving an industry. The long run contrasts
with the short run, in which some factors are variable and others are fixed, constraining entry or
exit from an industry. In macroeconomics, the long run is the period when the general price
level, contractual wage rates, and expectations adjust fully to the state of the economy, in
contrast to the short run when these variables may not fully adjust
In short-run period production function is described by total product, average product and
marginal product.
1. Total Product:
Total product of a factor is the amount of total output produced by a given amount of the factor,
other factors held constant. As the amount of a factor increases, the total output increases. It will
be seen from Table 16.1 that when with a fixed quantity of capital (K), more units of labour are
employed total product is increasing in the beginning.
Table 16.1:

Thus, when one unit of labor is used with a given quantity of capital 80 units of output
are produced. With two units of labor 170 units of output are produced, and with three units of
labor total product of labor increases to 270 units and so on.
 Firms use the production function to determine how much output they should produce
given the price of a good, and what combination of inputs they should use to produce given the
price of capital and labor. When firms are deciding how much to produce they typically find that
at high levels of production, their marginal costs begin increasing. This is also known as
diminishing returns to scale – increasing the quantity of inputs creates a less-than-proportional
increase in the quantity of output. If it weren’t for diminishing returns to scale, supply could
expand without limits without increasing the price of a good.
Long-run period
Isoquant is also called as equal product curve or production indifference curve or constant
product curve. Isoquant indicates various combinations of two factors of production which give
the same level of output per unit of time. The significance of factors of productive resources is
that, any two factors are substitutable e.g. labour is substitutable for capital and vice versa. No
two factors are perfect substitutes. This indicates that one factor can be used a little more and
other factor a little less, without changing the level of output.
It is a graphical representation of various combinations of inputs say Labour(L) and
capital (K) which give an equal level of output per unit of time. Output produced by different
combinations of L and K is say, Q, then Q=f (L, K). Just as we demonstrate the MRSxy in
respect of indifference curves through hypothetical data, we demonstrate the Marginal Rate of
Technical Substitution of factor L for K (MRTS L,K )
1. There are two factor inputs labour and capital
2. The proportions of factor are variable.
3. Physical production conditions are given
4. The Scale of operation is variable
5. The state of technology remains constant
The shape of Isoquant
We can see that the shape of isoquant plays an important a role in the production theory as the
shape of indifference curve in the consumption theory. Isoquant map shows all the possible
combinations of labour and capital that can produce different levels of output. The iso quant
closer to the origin indicates a lower level of output. The slope of iso quant is indicated as
KLKL
=MRSLk=
MPLMPkMPLMPk
Table indicating various combinations of Labour and Capital to produce 1500 Units of Output
 UNITS OF UNITS OF TOTAL
COMBINATIONS
CAPITAL LABOUR OUTPUT

A 50(OK) 1 (OL1) 1500(IQ1)

B 45(OK2) 2(OL2) 1500(IQ1)

C 41(OK3) 3(OL3) 1500(IQ1)

D 38(OK4) 4(OL4) 1500(IQ1)

Properties/Characteristics of Isoquants
Isoquants, abbreviated as IQs, possess the same properties as those of the indifference curves.
For the convenience of the students, we can state them as follows.
1. Two isoquants do not intersect each other:
1. No isoquant can touch either axis

1. Isoquant is oval in shape

1. A higher IQ implies a higher level of output

 1. IQs are never parallel to each other. Interspacing between them is least at the ends and
maximum in the middle.
2. IQs are convex to the origin: convex isoquants possess continuous substitutability of K
and L over a stretch. Beyond this stretch, K and L are not substitutable foe each other.
3. IQs may be linear when labour and capital are perfect substitute. A linear isoquant
implies that either factor can be used in proportion. If isoquant has several linear
segments separated by kinks, the isoquant is called kinked isoquant or activity analysis
isoquant or linear programming isoquant. Such isoquants are used in linear
programming.
4. If Land K are prefect complements to each other, the IQ is L-shaped. Such isoquant
is known a input-output isoquant or Leontief isoquant. There is only one combination of
L and K available for production. It is the corner point of L-shaped isoquant.
5. If marginal product of one of the two factors is zero, IQ is parallel to the axis on which
the factor with zero marginal products is represented.
6. If one of the two factors has negative marginal product the IQ slopes upwards from left to
right.
7. If both the factors have negative marginal products, the IQ is concave to the origin.
8. If the producer has a preference for a factor of production, the IQ is quasi linear.
9. If the factors to be employed in whole numbers units only. The IQ is discontinuous.
Isocost curves:
Isocost curve is the locus traced out by various combinations of L and K, each of which costs the
producer the same amount of money (C ) Differentiating equation with respect to L, we
have dK/dL = -w/r This gives the slope of the producer’s budget line (isocost curve). Iso cost
line shows various combinations of labour and capital that the firm can buy for a given factor
prices. The slope of iso cost line = PL/Pk. In this equation , PL is the price of labour and Pk is
the price of capital. The slope of iso cost line indicates the ratio of the factor prices. A set of
isocost lines can be drawn for different levels of factor prices, or different sums of money. The
iso cost line will shift to the right when money spent on factors increases or firm could buy more
as the factor prices are given.
Slope of iso cost line
With the change in the factor prices the slope of iso cost lien will change. If the price of labour
falls the firm could buy more of labour and the line will shift away from the origin. The slope
depends on the prices of factors of production and the amount of money which the firm spends
on the factors. When the amount of money spent by the firm changes, the isocost line may shift
but its slope remains the same. A change in factor price makes changes in the slope of isocost
lines as shown in the figure.

Least Cost Factor Combination or Producer’s Equilibrium or Optimal Combination of Inputs

The firm can achieve maximum profits by choosing that combination of factors which will cost it
the least. The choice is based on the prices of factors of production at a particular time. The firm
can maximize its profits either by maximizing the level of output for a given cost or by
minimizing the cost of producing a given output. In both cases the factors will have to be
employed in optimal combination at which the cost of production will be minimum. The least
cost factor combination can be determined by imposing the isoquant map on isocost line. The
point of tangency between the isocost and an isoquant is an important but not a necessary
condition for producer’s equilibrium. The essential condition is that the slope of the isocost line
must equal the slope of the isoquant. Thus at a point of equilibrium marginal physical
productivities of the two factors must be equal the ratio of their prices. The marginal physical
product per rupee of one factor must be equal to tht of the other factor. And isoquant must be
convex to the origin. The marginal rate of technical substitution of labour for capital must be
diminishing at the point of equilibrium.

What is 'Economies Of Scale'

Economies of scale is the cost advantage that arises with increased output of a
product. Economies of scale arise because of the inverse relationship between the quantity
produced and per-unit fixed costs; i.e. the greater the quantity of a good produced, the lower the
per-unit fixed cost because these costs are spread out over a larger number of goods. Economies
of scale may also reduce variable costs per unit because of operational efficiencies and synergies.
Economies of scale can be classified into two main types: Internal – arising from within the
company; and External – arising from extraneous factors such as industry size.
“Economies of scale” is a simple concept that can be demonstrated through an example. Assume
you are a small business owner and are considering printing a marketing brochure. The printer
quotes a price of $5,000 for 500 brochures, and $10,000 for 2,500 copies. While 500 brochures
will cost you $10 per brochure, 2,500 will only cost you $4 per brochure. In this case, the printer
is passing on part of the cost advantage of printing a larger number of brochures to you. This cost
advantage arises because the printer has the same initial set-up cost regardless of whether the
number of brochures printed is 500 or 2,500. Once these costs are covered, there is only a
marginal extra cost for printing each additional brochure.
Economies of scale can arise in several areas within a large enterprise. While the benefits of this
concept in areas such as production and purchasing are obvious, economies of scale can also
impact areas like finance. For example, the largest companies often have a lower cost of
capital than small firms because they can borrow at lower interest rates. As a result, economies
of scale are often cited as a major rationale when two companies announce a merger or takeover.
However, there is a finite upper limit to how large an organization can grow to achieve
economies of scale. After reaching a certain size, it becomes increasingly expensive to manage a
gigantic organization for a number of reasons, including its complexity, bureaucratic nature and
operating inefficiencies. This undesirable phenomenon is referred to as "diseconomies of scale".
Diseconomies Of Scale
Diseconomies of scale is an economic concept referring to a situation in which economies of
scale no longer functions for a firm. With this principle, rather than experiencing continued
decreasing costs and increasing output, a firm sees an increase in marginal costs when output is
increased. Diseconomies of scale can occur for various of reasons, but the root cause usually
comes from the difficulty of managing an increasingly large workforce.

BREAKING DOWN 'Diseconomies Of Scale'

Diseconomies of scale specifically come about due to three reasons. The first is a situation of
overcrowding, where employees and machines get in each other's way, lowering operational
efficiencies. The second situation arises when there is a greater level of operational waste, due to
a lack of proper coordination. The third and final reason for diseconomies of scale happens when
there is a mismatch between the optimum level of outputs between different operations.
Essentially, diseconomies of scale is the result of the growing pains of a company after it's
already realized the cost-reducing benefits of economies of scale.
Examples of Diseconomies of Scale
An overcrowding effect within an organization is often the leading cause of diseconomies of
scale. This happens when a company grows too quickly, thinking that it can achieve economies
of scale in perpetuity. If, for example, a company is able to reduce the per unit cost of its product
each time it adds a machine to its warehouse, it might think that maxing out the number of
machines is a great way to reduce costs. However, if it takes one person to operate a machine,
and 50 machines are added to the warehouse, there is a good chance that these 50 additional
employees will get in each other's way and make it harder to produce the same level of output
per hour. This increases costs and decreases output.
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COSTS OF PRODUCTION

Fixed and variable costs

Fixed costs are those that do not vary with output and typically include rents, insurance,
depreciation, set-up costs, and normal profit. They are also called overheads.

Variable costs are costs that do vary with output, and they are also called direct costs. Examples
of typical variable costs include fuel, raw materials, and some labour costs.

An example

Consider the following hypothetical example of a boat building firm. The total fixed costs, TFC,
include premises, machinery and equipment needed to construct boats, and are £100,000,
irrespective of how many boats are produced. Total variable costs (TVC) will increase as output
increases.

TOTAL TOTAL
TOTAL
OUTPUT FIXED VARIABLE
COST
COST COST
1 100 50 150
2 100 80 180
3 100 100 200
4 100 110 210
5 100 150 250
6 100 220 320
7 100 350 450
8 100 640 740
Plotting this gives us Total Cost, Total Variable Cost, and Total Fixed Cost.

Total fixed costs

Given that total fixed costs (TFC) are constant as output increases, the curve is a horizontal line
on the cost graph.

Total variable costs

The total variable cost (TVC) curve slopes up at an accelerating rate, reflecting the law of
diminishing marginal returns.

Total costs

The total cost (TC) curve is found by adding total fixed and total variable costs. Its position
reflects the amount of fixed costs, and its gradient reflects variable costs.

Average fixed costs

Average fixed costs are found by dividing total fixed costs by output. As fixed cost is divided by
an increasing output, average fixed costs will continue to fall.

TOTAL AVERAGE
OUTPUT FIXED COST FIXED COST
(£000) (£000)
1 100 100
2 100 50
3 100 33.3
4 100 25
5 100 20
6 100 16.6
7 100 14.3
 8 100 12.5

The average fixed cost (AFC) curve will slope down continuously, from left to right.

Average variable costs

Average variable costs are found by dividing total fixed variable costs by output.

TOTAL AVERAGE
OUTPUT VARIABLE VARIABLE
COST (£000) COST (£000)
1 50 50
2 80 40
3 100 33.3
4 110 27.5
5 150 30
6 220 36.7
7 350 50
8 640 80
The average variable cost (AVC) curve will at first slope down from left to right, then reach a
minimum point, and rise again.

AVC is ‘U’ shaped because of the principle of variable Proportions, which explains the three
phases of the curve:

1. Increasing returns to the variable factors, which cause average costs to fall, followed by:
2. Constant returns, followed by:
3. Diminishing returns, which cause costs to rise.

Average total cost

Average total cost (ATC) is also called average cost or unit cost. Average total costs are a key
cost in the theory of the firm because they indicate how efficiently scarce resources are being
used. Average variable costs are found by dividing total fixed variable costs by output.

AVERAGE AVERAGE AVERAGE

FIXED VARIABLE TOTAL
OUTPUT
COST COST COSTS
(£000) (£000) (£000)
1 100 50 150
2 50 40 90
3 33.3 33.3 67
4 25 27.5 52.5
5 20 30 50
6 16.6 36.7 53.3
7 14.3 50 64.3
8 12.5 80 92.5
Average total cost (ATC) can be found by adding average fixed costs (AFC) and average
variable costs (AVC). The ATC curve is also ‘U’ shaped because it takes its shape from the
AVC curve, with the upturn reflecting the onset of diminishing returns to the variable factor.

Areas for total costs

Total Fixed costs and Total Variable costs are the respective areas under the Average Fixed and
Average Variable cost curves.

Marginal costs

Marginal cost is the cost of producing one extra unit of output. It can be found by calculating
the change in total cost when output is increased by one unit.

TOTAL MARGINAL
OUTPUT
COST COST
1 150
 2 180 30
3 200 20
4 210 10
5 250 40
6 320 70
7 450 130
8 740 290

It is important to note that marginal cost is derived solely from variable costs, and not fixed
costs.

The marginal cost curve falls briefly at first, then rises. Marginal costs are derived from variable
costs and are subject to the principle of variable proportions.

The significance of marginal cost

The marginal cost curve is significant in the theory of the firm for two reasons:

1. It is the leading cost curve, because changes in total and average costs are derived from
changes in marginal cost.
2. The lowest price a firm is prepared to supply at is the price that just covers marginal cost.

ATC and MC

Average total cost and marginal cost are connected because they are derived from the same basic
numerical cost data. The general rules governing the relationship are:

1. Marginal cost will always cut average total cost from below.
2. When marginal cost is below average total cost, average total cost will be falling, and
when marginal cost is above average total cost, average total cost will be rising.
3. A firm is most productively efficient at the lowest average total cost, which is also
where average total cost (ATC) = marginal cost (MC).
Total costs and marginal costs

Marginal costs are derived exclusively from variable costs, and are unaffected by changes in
fixed costs. The MC curve is the gradient of the TC curve, and the positive gradient of the total
cost curve only exists because of a positive variable cost. This is shown below:

In the long run, all the factors of production used by an organization vary. The existing size of
the plant or building can be increased in case of long run.
There are no fixed inputs or costs in the long run. Long run is a period in which all the costs
change as all the factors of production are variable.
There is no distinction between the Long run Total Costs (LTC) and long run variable cost as
there are no fixed costs. It should be noted that the ability of an organization of changing inputs
enables it to produce at lower cost in the long run.
1. Long Run Total Cost:
Long run Total Cost (LTC) refers to the minimum cost at which given level of output can be
produced. According to Leibhafasky, “the long run total cost of production is the least possible
cost of producing any given level of output when all inputs are variable.” LTC represents the
least cost of different quantities of output. LTC is always less than or equal to short run total
cost, but it is never more than short run cost.

The LTC curve is shown in Figure-10:

As shown in Figure-10, short run total costs curves; STC1, STC2, and STC3 are shown depicting
different plant sizes. The LTC curve is made by joining the minimum points of short run total
cost curves. Therefore, LTC envelopes the STC curves.
2. Long Run Average Cost:
Long run Average Cost (LAC) is equal to long run total costs divided by the level of output. The
derivation of long run average costs is done from the short run average cost curves. In the short
run, plant is fixed and each short run curve corresponds to a particular plant. The long run
average costs curve is also called planning curve or envelope curve as it helps in making
organizational plans for expanding production and achieving minimum cost.
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Figure-11 shows the derivation of LAC curve:

Suppose there are three sizes of the plant and no other size of the plant can be built. In short run,
the plant sizes are fixed thus, organization increase or decrease the variable factors. However, in
the long run, the organization can select among the plants which help in achieving minimum
possible cost at a given level of output.
From Figure-11, it can be noted that till OB amount of production, it is beneficial for the
organization to operate on the plant SAC2 as it entails lower costs than SAC1. If the plant
SAC2 is used for producing OA, then cost incurred would be more. Thus, in the long run, it is
clear that the producer would produce till OB on plant SAC2. On SAC2, the producer would
produce till OC amount of output. If an organization wants to exceed output from OC, it will be
beneficial to produce at SAC3 than SAC2.
Thus, in the long run, an organization has a choice to use the plant incurring minimum costs at a
given output. LAC depicts the lowest possible average cost for producing different levels of
output. The LAC curve is derived from joining the lowest minimum costs of the short run
average cost curves.
It first falls and then rises, thus it is U- shaped curve. The returns to scale also affect the LTC and
LAC. Returns to scale implies a change in output of an organization with a change in inputs. In
the long run, the output changes with respect to change in all inputs of production.
In case of increasing returns to scale (IRS), organizations can double the output by using less
than twice of inputs. LTC increases less than the increase in the output, thus, LAC falls. In case
of constant returns to scale (CRS), organizations can double the output by using inputs twice.
LTC increases proportionately to the output; therefore, LAC becomes constant. On the other
hand, in case of decreasing returns to scale (DRS), organizations can double the output by using
inputs more than twice. Thus, LTC increases more than the increase in output. As a result, LAC
increases.
Figure-12 shows the effect on LAC because of returns to scale:

As shown in Figure-12, up to M, LAC slopes downward. This is because at this stage IRS is
applied. On the other hand, at M, LAC becomes constant. After M, LAC slopes upwards
implying DRS.
3. Long Run Marginal Cost:
Long run Marginal Cost (LMC) is defined as added cost of producing an additional unit of a
commodity when all inputs are variable. This cost is derived from short run marginal cost. On
the graph, the LMC is derived from the points of tangency between LAC and SAC.
LMC curve can be learned through Figure-13:
If perpendiculars are drawn from point A, B, and C, respectively; then they would intersect SMC
curves at P, Q, and R respectively. By joining P, Q, and R, the LMC curve would be drawn. It
should be noted that LMC equals to SMC, when LMC is tangent to the LAC.
In Figure-13, OB is the output at which:
SAC2 = SMC2 = LAC = LMC
We can also draw the relation between LMC and LAC as follows:
When LMC < LAC, LAC falls
When LMC = LAC, LAC is constant
When LMC > LAC, LAC rises