What is the Production Function?

The functional relationship between physical inputs (or factors of production) and output is called
production function. It assumed inputs as the explanatory or independent variable and output as the
dependent variable. Mathematically, we may write this as follows:

Q = f (L, K)

Here, ‘Q’ represents the output, whereas ‘L’ and ‘K’ are the inputs, representing labor and capital (such
as machinery) respectively. Note that there may be many other factors as well but we have assumed two-
factor inputs here.
Time Period and Production Functions
The production function is differently defined in the short run and in the long run. This distinction is
extremely relevant in microeconomics. The distinction is based on the nature of factor inputs.
Those inputs that vary directly with the output are called variable factors. These are the factors that can be
changed. Variable factors exist in both, the short run and the long run. Examples of variable factors
include daily-wage labor, raw materials, etc.
On the other hand, those factors that cannot be varied or changed as the output changes are called fixed
factors. These factors are normally characteristic of the short run or short period of time only. Fixed
factors do not exist in the long run.
Consequently, we can define two production functions: short-run and long-run. The short-run production
function defines the relationship between one variable factor (keeping all other factors fixed) and the
output. The law of returns to a factor explains such a production function.
[For example, consider that a firm has 20 units of labour and 6 acres of land and it initially uses one unit
of labour only (variable factor) on its land (fixed factor). So, the land-labour ratio is 6:1. Now, if the firm
chooses to employ 2 units of labour, then the land-labour ratio becomes 3:1 (6:2).]
The long-run production function is different in concept from the short run production function. Here, all
factors are varied in the same proportion. The law that is used to explain this is called the law of returns to
scale. It measures by how much proportion the output changes when inputs are changed proportionately.
In the long run, supply of both the inputs is supposed to be elastic and firms can hire larger quantities of
both labour and capital. With large employment of capital and labour, the scale of production increases.
The length of time required for the long run varies from sector to sector. [In the nuclear power industry
for example, it can take many years to commission new nuclear power plant and capacity.]
 Diminishing Returns
In the short run, the law of diminishing returns states that as more units of a variable input are added to
fixed amounts of land and capital, the change in total output will first rise and then fall.
The law of diminishing returns, also referred to as the law of diminishing marginal returns, states that in a
production process, as one input variable is increased, there will be a point at which the marginal per unit
output will start to decrease, holding all other factors constant. In other words, keeping all other factors
constant, the additional output gained by another one unit increase of the input variable will eventually be
smaller than the additional output gained by the previous increase in input variable. At that point, the
diminishing marginal returns take effect.
We use three measures of production and productivity:

 Total product (total output). In manufacturing industries such as motor vehicles, it is

straightforward to measure how much output is being produced. In service or knowledge
industries, where output is less “tangible" it is harder to measure productivity.
 Marginal product is the change in output from increasing the number of workers used by one
person, or by adding one more machine to the production process in the short run.
 Average product measures output per-worker-employed or output-per-unit of capital.

TP, AP & MP Graphical

Points to Note:
• When AP is rising it is always less than MP and when it is
falling it is always greater than MP. MP = AP when AP is
at its max.
• MP = 0 when TP reaches its max and AP = 0 when TP = 0

• The Total Product Curve shows the maximum output

attainable from a given amount of a fixed input
(capital) as the amount of the variable input (labor) is
changed
• The Average Product of an input is the Total Product
divided by the total amount of the variable input used
to produce it.
• The Marginal Product of an input shows the increase
in total output from a one unit increase in the amount
of the variable input
Example:
Consider a corn farmer with one acre of land. In addition to land, other factors include quantity of seeds,
fertilizer, water, and labor. Assume the farmer has already decided how much seed, water, and labor he
will be using this season. He is still deciding on how much fertilizer to use. As he increases the amount of
fertilizer, the output of corn will increase. It may also reach a point where the output actually begins to
decrease since too much fertilizer can become poisonous.
The law of diminishing returns states that there will be a point where the additional output of corn gained
from one additional unit of fertilizer will be smaller than the additional output of corn from the previous
increase in fertilizer. This table shows the output of corn per unit of fertilizer.
Farmer Output
As the farmer increases from one to two units of fertilizer, total
output increases from 100 to 250 ears of corn. Therefore the
marginal, or additional, ears of corn gained from one more unit
of fertilizer is 150 (250 - 100). From two to three units of
fertilizer, the total output increases from 250 to 425 ears of corn,
a 175 marginal increase.
Output of corn per unit fertilizer

At what point does the law of diminishing returns set in? Look for the point at which the marginal
increase is at the highest point and the next marginal increase is less. In this example, that occurs after the
farmer adds the third unit of fertilizer. At three units, the marginal output in ears of corn is 175, but when
the fourth unit is added, the marginal output drops to 125.
Again, this does not mean the total production starts to decrease. In fact, the total production is still
increasing, as shown in the total ears of corn column. Also note that at the sixth unit of fertilizer, the
farmer starts to experience negative returns, where the increase in fertilizer actually decreases the total
output and the marginal output becomes negative.
Law of Diminishing Returns
• The law of diminishing returns states that as a firm uses more of a variable input without changing the
quantity of fixed inputs, the MP of the variable input will eventually decline.
• Why? Because the productivity of additional units of the variable input (Labor) is limited by the lack of
the fixed input (machines). This is the reason for the shapes of the TP, AP & MP curves.
Law of Diminishing MP
• For example: Consider a factory with 10 jean machines. Suppose one machine can be used by one
worker. The first ten workers can each have a machine. The next few can carry raw materials for those on
the machines. However eventually you get to a point where additional workers are just standing around
getting in each other’s way. Eventually the MP of each additional hour worked will decline due to the
bottleneck in the number of machines.
• The law of diminishing MP is the reason why TP, AP and MP curves rise reach a max and then fall.
What is a 'Marginal Revenue Product - MRP'
Marginal revenue product (MRP), also known as the marginal value product, is the market value of one
additional unit of output. The marginal revenue product is calculated by multiplying the marginal physical
product (MPP) by the marginal revenue (MR). The MRP assumes that the expenditures on other factors
remain unchanged.
[Business owners frequently use MRP analysis to make critical production decisions. For example, a
farmer wants to know whether to purchase another specialized tractor to seed and harvest wheat. If the
extra tractor can eventually produce 3,000 additional bushels of wheat (the MPP), and each additional
bushel sells at market for $5 (price of product or marginal revenue), the MRP of the tractor is $15,000.
Holding other considerations constant, the farmer is only willing to pay less than or equal to $15,000 for
the tractor. Otherwise, he will take a loss. Estimating costs and revenues is difficult, but businesses that
can estimate MRP accurately tend to survive and profit more than their competitors.]
Marginalism
MRP is predicated on marginal analysis, or how individuals make decisions on the margin. [ If a
consumer purchases a bottle of water for $1.50, that does not mean the consumer values all bottles of
water at $1.50; instead, it means the consumer subjectively values one additional bottle of water more
than $1.50 at the time of the sale only. Marginal analysis looks at costs and benefits incrementally, not as
an objective whole.]
Marginal Product of Labor
In economics, the marginal product of labor (MPL) is the change in output that results from employing an
added unit of labor. This is not always equivalent to the output directly produced by that added unit of
labor; for example, employing an additional cook at a restaurant may make the other cooks more efficient
by allowing more specialization of tasks, creating a marginal product that is greater than that produced
directly by the new employee. Conversely, hiring an additional worker onto an already crowded factory
floor may make the other employees less productive, leading to a marginal product that is lower than the
work done by the additional employee.
When production is discrete, we can define the marginal product of labor as ΔY/ΔL where Y is output. If
a factory that is initially producing 100 widgets hires another employee and is then able to produce 106
widgets, the MPL is simply six. When production is continuous, the MPL is the first derivative of the
production function in terms of L. Graphically, the MPL is the slope of the production function.
Gives another example of marginal product of labor. The second column shows total production with
different quantities of labor, while the third column shows the increase (or decrease) as labor is added to
the production process.

Marginal Product of Labor: This table

shows hypothetical returns and marginal
product of labor. Note that in reality this
firm would never hire more than seven
employees, since a negative marginal
product is bad for the firm regardless of
the wage rate.
Optimal employment of labor in the short run
The marginal revenue product of labor (MRPL) is the change in revenue that results from employing an
additional unit of labor, holding all other inputs constant. The marginal revenue product of a worker is
equal to the product of the marginal product of labor (MPL) and the marginal revenue (MR) of output,
given by MR×MP: = MRPL. This can be used to determine the optimal number of workers to employ at
an exogenously determined market wage rate. Theory states that a profit maximizing firm will hire
workers up to the point where the marginal revenue product is equal to the wage rate, because it is not
efficient for a firm to pay its workers more than it will earn in revenues from their labor.
[For example, if a firm can sell t-shirts for $10 each and the wage rate is $20/hour, the firm will continue
to hire workers until the marginal product of an additional hour of work is two t-shirts. If the MPL is three
t-shirts the first will hire more workers until the MPL reaches two; if the MPL is one t-shirt then the firm
will remove workers until the MPL reaches two.]
Let TR=Total Revenue; L=Labor; Q=Quantity. Mathematically:
MRPL= ∆TR/∆L
MR = ∆TR/∆Q
MPL = ∆Q/∆L
MR x MPL = (∆TR/∆Q) x (∆Q/∆L) = ∆TR/∆L
Note that the change in output is not limited to that directly attributable to the additional worker.
Assuming that the firm is operating with diminishing marginal returns then the addition of an extra
worker reduces the average productivity of every other worker (and every other worker affects the
marginal productivity of the additional worker) – in other words, everybody is getting in each other’s
way.
Because the MRPL is equal to the marginal product of labor times the price of output, any variable that
affects either MPL or price will affect the MRPL. For example, changes in technology or the quantity of
other inputs will change the marginal product of labor, and changes in the product demand or changes in
the price of complements or substitutes will affect the price of output. These will all cause shifts in the
MRPL.
An isoquant describes the possible combinations of labour and capital that produce the same level of
output (the curve“ISOlates the QUANTity of output). Isoquants…
- must be downward sloping
- do not intersect
- that are higher indicate more output
- are convex to the origin
- have a slope that is the negative of the ratio of the marginal products of labour and capital. The absolute
value of this is called the marginal rate of technical substitution.

Production Isoquants:
The long-run production function involving the usage of two factors (say, capital and labour) is
represented by isoquants or equal product curves (or production indifference curves).

Definition:

An isoquant is a curve or locus of points showing all possible combinations of inputs physically capable
of producing a certain fixed level of output. An isoquant which lies above another shows a higher level of
output.

Fig. 1 shows two typical isoquants — capital use is measured on the vertical axis and labour use on the
horizontal. Isoquant Q1 shows the locus of combinations of capital and labour yielding 100 units of
output. The producer can produce 100 units of output by using 10 units of capital and 75 of labour or 50
units of capital and 15 of labour, or by using any other combination of inputs on Q1 = 100. Similarly,
isoquant Q2 shows the various combinations of capital and labour that can produce 200 units of output.

We can draw any number of isoquants in Fig. 1 because there are an infinite number of possible
production levels between 100 and 200 units (as also below 100 units or above 200 units).

Properties:

Isoquants have four important properties. These are the following:

1. Firstly, an isoquant which lies above and to the right of another shows a higher level of output. So, any
point on a higher isoquant is always better than any point on a lower isoquant.

2. Secondly, isoquants cannot meet or intersect one another. If they did, then one combination of K and L
would yield two different levels of output. The producer’s technology is inconsistent. We rule out such
events.

3. Thirdly, as shown in Fig. 1, isoquants slope downward over the relevant range of production. This
negative slope indicates that, if the producer decreases the amount of capital employed, more labour must
be added in order to keep the rate of output constant. Or, if labour use is decreased, capital use must be
increased to keep output constant. Thus, the two inputs can be substituted for one another to maintain a
constant level of output.
The marginal rate of technical substitution (MRTS):

The rate at which one input can be substituted for another along an isoquant is called the marginal
rate of technical substitution (MRTS), defined as:
MRTSL for K = – ∆K/∆L

where K is capital, L is labour and ∆ denotes any change. The minus sign is added in order to make
MRTS a positive number, since ∆K/∆L, the slope of the isoquant, is negative.
For any movement along an isoquant, the MRTS equals the ratio of the marginal products of the two
inputs.

To prove this, suppose the use of L increases by 3 units and K by 5. If, in this stage, the MPL is 4 units of
Q per unit of L and that of K is 2 units of Q per unit of K, the resulting change in output (Q) is:

∆Q = (4 x 3) + (2 x 5) = 22

This means that when L and K are allowed to vary slightly, the change in Q resulting from the change in
the two inputs is the marginal product of L times the amount of change in L plus the marginal product of
K times its change.

As a general rule:
∆Q = MPL. ∆L + MPK. ∆K.

Along an isoquant, Q is constant; therefore ∆Q equals zero. Setting ∆Q in the above equation equal to
zero and solving for the slope of the isoquant, ∆K/∆L, we have:

∆K/∆L = MPL/MPK = MRTSL for K

Since along an isoquant K and L must vary inversely, ∆K/∆L is negative.

4. Fourthly, over the relevant stage, the MRTS diminishes. This means that isoquants are convex to the
origin. This point is illustrated in Fig. 1. If capital is decreased by 10 units, from 50 to 40, labour must be
increased by only 5 units, from 15 to 20, in order to keep the level of output at 100 units. If capital is
decreased by 10 units, from 20 to 10, labour must be increased by 35 units, from 40 to 75, to keep output
at 100 units.

Return to Scale
Returns to scale refers to a relationship which shows the degree of change in output caused by
change in quantities of all inputs in a fixed proportion. The concept of returns to scale is a long-run
concept, because it refers to a case where all inputs are variable.

There are Three Types of Returns to Scale:

(a) Increasing Returns to Scale:

When all inputs are increased by a given proportion and the output increases by more than that
proportion, it is called increasing returns to scale. For instance, if all inputs are doubled and output
increases by three times, then that kind of input-output relationship is referred to as increasing returns to
scale.

Figure 8.12 shows the case of increasing returns to scale. Suppose, in a particular production
process, 10 units of capital and 20 units of labour make 15 units of output. When capital is increased to 20
units and labour is increased to 40 units, output is also expected to get doubled i.e., from 15 units to 30
units. But in this case, since a return to scale is increasing, output increases to 35 units, which is more
than double.

(b) Decreasing Returns to Scale:

When all inputs are increased by a given proportion and
the output increases by less than that proportion, it is called
decreasing returns to scale. For example, if all inputs are
increased by three times and yet output gets only doubled, then
that kind of input-output relationship is referred to as decreasing
returns to scale.
Figure 8.13 explains decreasing returns to scale.
Suppose, in a particular production process 10 units of capital
and 20 units of labour make 15 units of output. When quantity of
both the inputs are doubled, i.e., capital increases to 20 units and labour increases to 40 units, output is
also expected to get doubled i.e., from 15 units to 30 units. But in case of decreasing returns to scale,
output increases by 10 units, which is less than double.
(c) Constant Returns to Scale:
When all inputs are increase by a given proportion and the
output increases by the same proportion, it is called constant
returns to scale. For example, if all inputs are doubled and output
also gets doubled, then that kind of input- output relationship is
referred to as constant returns to scale.
Figure 8.14 provides the diagrammatic description of
constant returns to scale. Suppose, in a particular production
process 10 units of capital and 20 units of labour make 15 units of
output. When both the inputs are doubled, i.e., capital is increased
to 20 units and labour is increased to 40 units, output also gets
doubled i.e., it increases from 15 units to 30 units.
Isocost Line
The combination of factor-inputs with which a firm produces output depends upon the quantity of output
that the firm wants to produce. Besides, the combination of factor-inputs also depends upon the amount of
money that the firm wants to spend and prices of the factor-inputs.
An isocost line is a graphical representation of various combinations of two factors (labor and capital)
which the firm can afford or purchase with a given amount of money or total outlay. It is an important
tool for determining what combination of factor-inputs the firm will choose for production process.
Suppose a producer has Rs. 200 and he wants to spend his entire outlay on two factors – labor and capital.
Further suppose that the price of Labor is Rs. 4 per unit and the price of capital is Rs 5 per unit. If the firm
spends its whole outlay of Rs 200 on labor only, he can buy 50 units of labor. And, if the firm spends its
entire outlay on capital only, then he can buy 40 units of capital.
Mathematically, an isocost line can be expressed as
C=wL+rK
Where,
C = cost of production
w = price of labor or wages
L = units of labor
r = price of capital or interest rate
K =units of capital
A firm can purchase only such combinations of factor-inputs which satisfy the given equation.
For example, a producer can purchase combinations like ’25 units labor + 20 units capital’, ‘30 units labor
+ 16 units capital’ or ’12.5 units labor + 30 units capital’ because all of them fulfill the equation at given
prices and outlay.
In the given diagram, x-axis represents units of labor and y-axis represents units of capital.
Therefore, OB in the figure represents 50 units of labor and OA represents 40 units of capital.
If we join points A and B, we get isocost line for Rs. 200. And, the straight line which joins
points A and B will pass through all combinations of labor and capital which the firm can buy with the
outlay of Rs 200, if it spends the entire sum on them at the given prices.
This way, an isocost line is also known as price line or outlay line. It is a counterpart of budget
line of indifference curve analysis.
The slope of the isocost line is equal to the ratio of price
of factor-inputs. Mathematically, slope of an isocost line is
expressed as

And this slope remains the same throughout the isocost line.
Optimal Combination of Resources:
A rational producer has the goal of either maximising output given a fixed budget (say, Rs. 300 per day)
or minimising cost given a required output to produce (say, 150 units). Each goal is a problem of
constrained optimisation.
Our task here is to determine the specific combinations of inputs a firm should select when it is
constrained. Here we will observe that a firm attains the highest possible level of output for any given
level of cost or the lowest possible cost for producing any level of output when the MRTS for any two
inputs equals the ratio of their prices.
Meaning of Expansion Path:
We know that the production function of the firm: q = f(x,y) gives us the isoquant map of the firm,
one isoquant (IQ) for each particular level of output, and the cost equation of the firm: C = rXx + rYy  
gives us the family of parallel iso-cost lines (ICLs), given the prices of the inputs rX and rY, one ICL for
one particular level of cost.
The expansion path is so called because if the firm decides to expand its operations, it would have to
move along this path. Let us note that the firm may expand in two ways.
First, it may want to expand by successively increasing its level of cost or its expenditure on the inputs X
and Y, i.e., by using more and more of inputs, and, consequently, by producing more of its output.
Second, the firm may decide to expand by increasing its level of output per period. This the firm may do
by increasing the expenditure on the inputs, i.e., by using more and more of them.
The two approaches to expansion apparently appear to be the
same, for both involve an increase in expenditure. However,
there is a fundamental difference. In the first case, decision is
taken initially at the point of cost. Cost levels are made
higher and higher and then efforts are made to maximise the
level of output subject to the cost constraint.
On the other hand, in the second case, decision-making
occurs initially and directly at the point of output. Here the
firm first decides to produce more of output and then efforts
are made to produce the output at the minimum possible cost.

Types of Expansion Path:

(a) Expansion by Means of Increasing the Level of Expenditure on the Inputs:
In Fig. 8.14, let us suppose that, initially, the firm’s level of cost is such that its ICL is L1M1 and
output-maximisation subject to cost constraint occurs at the point of tangency, E1, between the ICL,
L1M1, and an IQ which is IQ1. At E1 the firm uses X1 of the first input and y1 of the second input to
produce the maximum possible output, say, q1, which is represented by IQ1.
Now, if the firm decides to expand by increasing the cost level from the level of L1M1 to that of
L2M2, then the firm would be in output-maximising equilibrium at the point of tangency E2 (x2, y2), on
IQ2, using more of the inputs, x2 > x1 and y2 > y1, and producing an output level, say, q2, q2 > q1, since
IQ2 is a higher isoquant than IQ1.
In the same way, if the firm decides to expand further, it would increase its cost level from that of L2M2
to that of L3M3 and it would produce the maximum output subject to the cost constraint at the point of
tangency E3 (x3, y3) on IQ3 using more of the inputs, x3 > x2 and y3 > y2, and producing a higher level
of output, say, q3, q3 > q2, since IQ3 is a higher IQ than IQ2.
The process of expansion of firm’s operations through increases in the level of cost may go on in this say
so long as the firm decides in its favour. If we now join the point of origin O and the points E1, E2, E3,
etc. by a path, then we would obtain the firm’s expansion path OK in Fig. 8.14.
That is, if the firm expands by increasing its level of cost, it would have to move successively from one
equilibrium point to another along this expansion path.
We have joined the path through the equilibrium points E1, E2, etc. with the point of origin O, because if
the firm moves backward along the expansion path by decreasing the cost level then it would be moving
from the initial equilibrium point, say, E3 to E2, then from E2 to E) and would approach the point O
which would be the limiting point in this process.
As the firm’s cost level decreases and tends to zero, the input quantities and the output quantity would all
decrease and tend to zero, and thus the point of origin O would be the limiting point.
(b) Expansion by Means of Increasing the Level of Output:
In Fig. 8.14, let us suppose that initially the firm decides to produce q1 of output which can be
produced at any point on the isoquant, IQ1. The firm would be in cost-minimising equilibrium at the point
E1 which is the point of tangency between IQ1 and an iso-cost line say, ICL1. At the point E1, the firm
would use Xi and y] quantities of the two inputs and its cost amounts to, say, C1, which is the minimum
possible.
The firm may now decide to expand by increasing its level of output from q1 to q2 on IQ2. If the firm
makes this decision, its cost-minimising equilibrium will be obtained at the point of tangency E2 (x2, y2)
on L2M2 using more of the inputs, x2 > x1 and y2 > y1 and incurring a cost level C2 on L2M2, which is
the minimum possible required to produce the output of q2. However, C2 > C1 since L2M2 is a higher
ICL than L2M2.
In the same way, the firm may decide to increase again its level of output from q2 to q3 on IQ3. In this
case, the firm’s equilibrium point would be the point of tangency E3 (x3, y3) on the ICL, L3M3. At E3,
the firm would use still more of the inputs, x3 > x2 and y3 > y2, incurring a cost level C3 on L3M3,
which is the minimum required for producing q3 of output. However, C3 > C2 since L3M3 is a higher
ICL than L2M2.
The firm’s process of expansion may go on like this as long as it decides to expand. The expansion path
again would be OK that would start from the point of origin O and pass through the points E1, E2, E3,
etc.
If the firm decides to contract and produce less of output, then the limiting point of the process of
contraction would be the point of origin O, where the firm’s use of the inputs, its cost level and output
would all tend to zero.
The Equation of the Expansion Path:
 Each point on the expansion path like OK in Fig. 8.14, is a point of tangency between an isoquant
and an iso-cost line. Therefore, at each point on the expansion path, we have numerical slope of the IQ =
numerical slope of the ICL
⇒ MRTSX,Y = rX/rY
⇒ fX/fY= rX/rY = constant [... rX and rY are given and constant] (8.64)
Therefore, (8.64) gives us the equation of the expansion path.