Economics

Theory of Production
Production Function

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 Agenda
Production Function

Law of Returns – Short Term and Long Term

Short Run Analysis

Long Run Analysis

Isoquants and Isocost Lines

MRTS

Optimum Factor Combination

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 What is Production Function
inputs are called factors of production

A production function shows the relationship between the

amounts of factors used and the amount of output
generated per period of time.

Rational producer is always interested that he should get the maximum output from the set of resources
or inputs available to him
What is Production Function

Short Run Long Run

Some factors All factors are
variable variable

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 Agenda
Production Function

Law of Returns – Short Term and Long Term

Short Run Analysis

Long Run Analysis

Isoquants and Isocost Lines

MRTS

Optimum Factor Combination

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 Law of Returns – Short Term
Law of Variable Proportions or Law of Diminishing Returns

"As equal increments of one input are added, the inputs of other productive services being held constant,
beyond a certain point, the resulting increments of produce will decrease i.e., the marginal product will
diminish".

Law of Increasing Returns or Law of Diminishing Costs

The law of increasing returns is also called the law of diminishing costs. The law of increasing return states that when
more and more units of a variable factor is employed, while other factor remain fixed, there is an increase of production
at a higher rate

Law of Constant Returns

The law of constant returns also called law of constant cost. It is said to operate when with the addition of successive
units of one factor to fixed amount of other factors, there arises a proportionate increase in total output.
 Law of Returns – Short Term
Law of Variable Proportions or Law of Diminishing Returns

"As equal increments of one input are added, the inputs of other productive services being held constant,
beyond a certain point, the resulting increments of produce will decrease i.e., the marginal product will
diminish".

Law of Increasing Returns or Law of Diminishing Costs

The law of increasing returns is also called the law of diminishing costs. The law of increasing return states that when
more and more units of a variable factor is employed, while other factor remain fixed, there is an increase of production
at a higher rate

Law of Constant Returns

The law of constant returns also called law of constant cost. It is said to operate when with the addition of successive
units of one factor to fixed amount of other factors, there arises a proportionate increase in total output.
 Law of Returns To Scale – Long Term
Increasing Returns to Scale
Leads to lower average cost per unit produced as
the firm enjoys economies of scale

Constant Returns to Scale

The constant scale of production has no effect

on average cost per unit produced.

Diminishing Returns to Scale

The firm's scale of production leads to higher

average cost per unit produced.
 Agenda
Production Function

Law of Returns – Short Term and Long Term

Short Run Analysis

Long Run Analysis

Isoquants and Isocost Lines

MRTS

Optimum Factor Combination

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 Short Run – Some Factor Variable
The short run is a period of time in which only some inputs (say labor) is allowed to vary while other inputs land
and capital are held fixed. In the short run, therefore, production can be increased with one variable factor and
other factors remaining constant. In the short run, the law of variable proportion governs the production behavior
of a firm

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Short Run - Law of Variable Proportions

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Short Run - Law of Variable Proportions

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Short Run - Law of Variable Proportions

Stage 1:
Total Output Increase
AP keeps on increasing
Marginal Product reaches peak and then starts decreasing but
remains above AP

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Short Run - Law of Variable Proportions

Stage 2:
Total Output Increase
AP starts decreasing but remains positive
Marginal Product keep on decreasing and comes below AP but
still remains positive
MP cuts AP at its highest point

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Short Run - Law of Variable Proportions

Stage 3:
Total Output decrease
AP keeps decreasing but remains positive
Marginal Product keep on decreasing and remains below AP
and turns negative

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 Agenda
Production Function

Law of Returns – Short Term and Long Term

Short Run Analysis

Long Run Analysis

Isoquants and Isocost Lines

MRTS

Optimum Factor Combination

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 Long Run
The long run is the lengthy period of time during with all inputs can be varied. There are no fixed output in the
long run. All factors of production are variable inputs.

The curve isoquant which represents 150 units of output

illustrate that the same level of output (150 units) can be
produced with different combinations of labor and capital.
Combination of labor and capital represented by A, can
employ OL1 quantity of labor and OC1 units of capital to
produce 150 units of output

Thus, if a country has surplus labor and less capital, it

may use the combination of labor and capital represented
by point A. In case the country has abundant capital and
less labor, it might produce at point B. The isoquants
through points A and B shows all the different
combinations of labor and capita that can be used to
produce 150 units of output.

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 Long Run
The long run is the lengthy period of time during with all inputs can be varied. There are no fixed output in the
long run. All factors of production are variable inputs.

In this figure each curve (called an isoquant) represents a

different level of output. The curves which lie higher and to the
right represent greater output levels than curves which are
lower and to the left.

For example, point D represents a higher output level of 250

units than point A or B which shows output level of 150 units.

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 Agenda
Production Function

Law of Returns – Short Term and Long Term

Short Run Analysis

Long Run Analysis

Isoquants and Isocost Lines

MRTS

Optimum Factor Combination

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Isoquant
The concept of isoquant or
equal product curve can be
better explained with the help
of schedule given below:
Isoquant Map
 Isocost Lines
A firm can produce a given level of output using efficiently different combinations of two inputs.

For choosing efficient combination of the inputs, the producer selects that combination of factors which has the lower cost of
production.

The information about the cost can be obtained from the isocost lines.
 Agenda
Production Function

Law of Returns – Short Term and Long Term

Short Run Analysis

Long Run Analysis

Isoquants and Isocost Lines

MRTS

Optimum Factor Combination

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 Marginal Rate of Substitution
Marginal rate of technical substitution (MRTS) is:

"The rate at which one factor can be substituted for another while holding the level of output constant".
 Marginal Rate of Substitution
Marginal rate of technical substitution (MRTS) is:

"The rate at which one factor can be substituted for another while holding the level of output constant".
Diminishing Marginal Rate of Technical Substitution.

The decline in MRTS along an isoquant for producing the same level of output is named as diminishing marginal
rates of technical education. As we have seen when a firm moves down from point (a) to point (b) and it hires
one more labor, the firm gives up 4 units of capital (K) and yet remains on the same isoquant at point (b). So the
MRTS is 4.

If the firm hires another labor and moves from point (b) to (c), the firm can reduce its capital (K) to 3 units and
yet remain on the same isoquant. So the MRTS is 3.

If the firm moves from point (C) to (D), the MRTS is 2 and from point D to e, the MRTS is 1. The decline in
MRTS along an isoquant as the firm increases labor for capital is called Diminishing Marginal Rate of
Technical Substitution.
 Agenda
Production Function

Law of Returns – Short Term and Long Term

Short Run Analysis

Long Run Analysis

Isoquants and Isocost Lines

MRTS

Optimum Factor Combination

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Optimum Factor Combination
Here the isocost line CD is tangent to the iso-product
curve 400 units at point Q.

The firm employs OC units of factor Y and OD units of

factor X to produce 400 units of output. This is the
optimum output which the firm can get from the cost
outlay of Q.

In this figure any point below Q on the price line AB is

desirable as it shows lower cost, but it is not attainable for
producing 400 units of output. As regards points RS above
Q on isocost lines GH, EF, they show higher cost.
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