CHAPTER

PRODUCTION FUNCTION -
WHAT AND WHY

3.1 C o n c e p t o f P ro d u ctio n Function 77

3.2 N eo-classical P roduction Function 80

3.3 Various Forms o f P ro d u ctio n Function 82

3.4 P roduction Function in A g ricu ltu re 91

 CHAPTER 3
PRODUCTION FUNCTION - WHAT AND WHY

3.1 Concept o f Production Function:

Economists are directly interested in physical relationship between products and inputs. Based
on this relationship, economists have developed further functional relationships to measure the
response o f the supply of products to changes in costs and returns. A simple measure o f the
relationship between output and inputs can be the average product. The yield per acre which is
the most widely used indicator o f resource productivity is an instance o f measuring the
production relationship in terms o f average product. Though used extensively, yield per acre has
serious limitations. To achieve optimum allocation o f resources it is necessary to know the
marginal and not average product. Marginal products can be. known only if full technical
relationship between output and inputs is known.

Production is an activity, the net result o f which is to increase the degree o f compliance between
the quantity, form and distribution o f commodities and a given preference pattern. Production
function expresses the relationship between the inputs and output o f a production process and
helps to study the effects o f technology, productivity o f each input and to measure the overall
growth o f the industrial sector. Very useful information can be obtained from the relationship
between the production function and factor rewards. Such a relationship can be established
through the specification and estimation o f production function and it is to that we now turn.

There are three principal groups into which an act o f production can be classified : (1) Changing
the quantify o f a good; (2) Changing the form o f a good; (3) Distribution o f the goods.

Each o f these constitutes an act of production in so far as the new quantity form or distribution
is "preferred” to the old. Conversely, consumption is said to occur when the old state was
preferred to new.

Increasing the quantity o f goods available is a fairly obvious example o f what is meant by
production if the number of carrots grown this year is twice the number grown last year then the
production o f carrots has doubled.

Changing the form o f a good may not be quite so obviously an act o f production for example,
while changing Iron ore into steel or raw eggs into an omelet the latter form with material takes
is "preferred”to its original form, then production has occurred.

The distributive kind o f production may be spatial or temporal. The spatial aspect o f
distribution involves transporting goods to those consumers who require to consume those
goods at a place distant from the point o f production. But this 1ms been ignored by economists
until the development o f "space" or "location". The temporal aspect o f distribution involves
storage so that what is produced today may be consumed tomorrow.

77
The simple example might be of an agricultural community. The consumption pattern differs
from the supply and thus storage increases the degree of compliance between the two.

In its broadest economic sense then production may be defined as :

"Any activity the net result o f which is to increase the degree o f compliance between the
quantity, form and distribution (spatial and temporal) o f commodities and a given pattern
which rules out the possibility o f increasing production simply by changing tastes

Production would take place even without the aid of man by natural processes. For example
fresh water fruits and sunshine are continuously being produced in unpolluted forests. Goods
so produced are referred to as "Natural Endowment"and in classical economic theory have the
generic term "Land".

In so far as these natural product fails to comply with our preference pattern, either in terms of
quantity, form or place, then some “utility” may be gained by applying human effort and
intelligence to alter the natural process. Effort so extended is called “Labor

This labor may be applied to the productive process in a number o f different ways. i.e. There
exists at any one time a number of "Production Techniques". The land and labor currently
within production process is called "Capital".

These three ingredients in the production process Land, Labor and Capital constitute the
"Factors o f production". Although utility is gained by production it is a net gain because it
involves disutility. This disutility is associated with the use of the factors o f production. In case
of Labor it concerns having to forgo Leisure. Capital which is the amount of land and labor
currently within the production process involves postponing consumption since effort and land
now expended do not result in immediate rewards. If there is uncertainty about the future then
the time elapsed of the process endows it with an element of risk.

Thus, there are three sources of disutility : forgone leisure, postponed consumption and risk.
Typically, these are borne by Laborers, Capitalists and Entrepreneurs, respectively and in
return for bearing them they receive wages interests and profits respectively. Since each factor
of production either entails disutility or is scarce our consideration o f the entire set o f all
possible production techniques can be reduced to a consideration of only the most efficient
techniques. We can ignore all other techniques since the disutility involved in using them to
produce a given output would be higher than necessary or the scarcity of one factor would limit
output below that which would otherwise be possible.

We therefore, have some arbitrarily fixed output a range of factor combinations each o f which
is just capable o f producing that output. This relationship between that output and factors is
called a "Production Function" .

Thus, "Production Function ” is a technical relation between the quantity o f various factors of
production or inputs on the one hand and the amount of product or output which they yield on
the other hand.

The Production Function is a concept in Physical and Biological science. However, it was
largely developed and, until recently, used mainly by economists. Historically, refinements in
78
 concepts relating to production Junctions grew out o f economics probably because offollowing
reasons :

• The nature of production functions is important in economic development and in determining

the extent to which national products can be increased from given resource stocks.
• The magnitude of production co-efficients serve as the base for determining optimum patterns
o f international and/or inter-regional trade.
• The concept is basic to certain theories in the functional distribution of income. The conditions
under which a total output can be imputed to the factors from which it is produced with the
product just exhausted depends on the nature of the production function.
• The production function provides half or one o f two general categories o f the data needed in
determining or specifying the use o f resources and the pattern of outputs which maximize firm
profits.
• The algebraic nature of supply functions rests, in large part, upon the nature o f the production
function.

The equilibrium of a firm is however intertwined with the structure of the industry, it is
difficult to make efficiency comparisons from the price cost output relationships o f a firm
overtime or of two firms unless we can establish similarities of market structures. The notion of
a supply curve useful as it is breaks down as soon as we depart from competitive product
markets. We need therefore, a measurement of productive efficiency and a tool to analyze the
firm's response to changing economic variables which is independent of market and industry
conditions. Such a notion is the production function which as a "technological" relationship
acting as a constraint for a profit maximizing firm is invariant to economic and behavioral
factors. Econometricians have therefore concentrated much more on the estimation of
production functions.

The kind of questions which may be answered by production functions are the following:

1. Retnrns to Scale : For some prescriptions of Pigovian welfare economics we may know
whether a firm or an industry enjoys in increasing or diminishing returns to scale.

2. Allocation Efficiency : We may inquire whether firms purchase and utilize factor inputs
in the most efficient way i.e. matching the marginal products o f factor inputs to their
prices. O f particular interest there may be inter-firm comparisons in resource allocation.

3. Retnrns to Factors : Related to above two questions is the question o f returns of particular
factor. It may be desirable to subsidize (or tax) the use of a particular input if returns to the
factor are increasing (or diminishing) in a certain range e.g., We may wish to encourage the
use o f a high yielding variety of seeds or o f fertilizers by subsidizing them if there are
increasing returns to them.

4. Substitution : A fundamental principle of economic behavior is the tendency to substitute

at the margin changes in the relative prices o f inputs encourage corresponding substitution
in the use of inputs by firms. We may know the extent to which substitution between inputs
is possible. The degree of substitutability between inputs as measured by elasticity of
substitution is crucial to the distribution o f total output between different inputs. We can
examine the effects of exogenous changes in input prices for example, minimum wage
79
 legislation or depreciation allowances and changes in the quantities o f inputs supplied, for
example, by immigration, on returns to factors and their shares in total output o f an
industry or a firm, for example, minimum wage legislation or depreciation allowances and
changes in the quantities of inputs applied, for example, by immigration, on returns to
factors and their to factors and their shares in total output of an industry or a firm.

5. Income Shares : The notion of the production function has also been applied at the
macro-economic level to explain the distribution o f national income between income
between income classes i.e. wages and profits. The pioneering econometric estimation of a
production function by Cobb and Douglas was undertaken precisely for this purpose.

The starting point was observed income shares o f wages and profits in total income
leading to a search for a production function in terms o f output and inputs which would
explain these observed shares. However in recent years there has been some doubt about
the validity of an aggregate production function and the meaningfulness of empirical
estimates using such a production function.

6. Economic Growth : The notion of an aggregate production function has been used to
provide empirical explanations o f inter-temporal differences in the economic growth of
GNP.

3.2 Neo-Classical Production Function :

The Neo-classical production function was formalized first by Wieksell. Formally, a
production function expresses the output of a commodity as a function sometimes a
differentiable function of all its inputs. That is,
Y = / ( x „ x 2,.... , x j eq. (3.2.1)

Y being output and Xj to x,, being inputs. As yet however this is an empty statement. The first
question relates to the level of aggregation to which the function refers. We may ask a question
that, Is Y the output of a plant firm industry or the economy? Micro-economic theory which
uses the notion of production and cost functions relates to a firm producing a single
homogeneous commodity. This concept o f the firm is in many ways an abstraction in the age
of assembly lines, product differentiation, giant multi-product firms and conglomerates. The
level o f aggregation is often determined by statistical sources.

The production function is a "technological" relationship and the more closely it can be
approximated to the technological relationship between output and inputs by desegregation the
more meaningful our results will be.

The second question concerns with the dimensionality o f our Y and xs variables. Are they
stocks at a point of time or flows over a period of time? Great care should be taken while
defining the output in commensurate dimensions. Thus, if output is a flow variable all inputs
should be defined in flow terms. Ideally, a production function expresses a relation between a
flow of output over a defined time interval and a flow o f inputs over the same time interval or
a relevant previous time interval. But variables are mostly available in stock terms capital stock
in terms of value of machinery and buildings and labor in terms of men employed or land in
terms of acres. Inputs also are assumed to be homogeneous. Often in absence o f these flow

80
measures there is a temptation to substitute the equivalent money valuation of these services
as would prevail under competitive conditions given certain restrictive assumptions.

We now move on to the properties and parameters of the production function. The most
important of these is the degree of substitutability between inputs. For the case of two inputs x,
and x2. The degree of substitutability is measured by the elasticity of substitution which is a
parameter of the production function. The elasticity of substitution may be zero or infinity
what is called a fixed coefficient case and a linear isoquant case respectively.

For a given level of output along an isoquant we define the elasticity of substitution between
two inputs as
"the proportional change in the input ratio corresponding to a unit proportional change in the
ratio o f the marginal products o f the inputs."

Confining ourselves to n= 2 in eq (3.2.1) we have elasticity

d{x\/xj) I (x\! xi)

/ (<r/<?*,)))
{{(9 ie > x f /

d\n{x\lxi)
eq. (3.2.2)
d ln[(<^ / dx\! d f / dxi)\

The elasticity of substitution for a production function can be a constant or a variable.

Elasticity can range from zero to infinity.

For a two input production function we can define the properties of the production function as
follows :
a) df/d x, > 0 for (i = 1 ,2 ), all marginal products are positive.
b) /(0,0) = / ( 0,x2) =/(x,,0) all inputs are necessary for production.
c) d2/ / d Xj2 < 0 for all i , diminishing marginal products prevail.
d) df/d Xj —>0 as Xj -»°o and df/d Xj -»oo as Xj -»0 , the isoquants do not touch
the axis.

The second parameter of the production function is the degree of homogeneity of the function
which can be interpreted as a measure of returns to scale. The degree of homogeneity is defined
as the proportionate change in output resulting from an equi-proportionate change in all the
inputs. If we increase both x, and x2 by a proportion X > 0, then output will go up by a
A.r proportion where ‘r’ is the degree of homogeneity of the function. For r= l, we have
constant returns to scale; for r > 1, increasing returns to scale, and for r < 1 diminishing returns
to scale.

The substitution parameter, the efficiency parameter and the returns to scale parameter are then
the three estimable parameters of interest to the econometrician.

81
3.3 Various Forms o f Production Function :
We have considered the following best known production functions as by Intrilligator :

1. THE FIXED PROPORTION O.EONT1ER PRODUCTION FUNCTION

f , , 'N
1 1
Y = min — X l,~ Z X 2 with a = 0 and a , p > 0 . eq. (3.3.1)
\a ft J

2. THE COBB DOUGLAS PRODUCTION FUNCTION :

Y = A x ,“ x / with cr =1 andp=a+p>l. eq. (3.3.2)

3. THE CES PRODUCTION FUNCTION :

Y = y[8 x f p +(1-8) x2-p]“v/p with cr = —-— and p = v, eq. ( 3.3.3)

1+ /7
where, x, and x2 are the inputs a and p are constant elasticities of the inputs A and y are
efficiency parameters, 8 ( 0 < 8 < 1) is the input intensity, oo > p > -1 is the substitution
parameter and v is the returns to scale parameter of the CES production function. Arrow et al.
[1961],

4. THE VES PRODUCTION FUNCTION AND ITS VARIANTS :

The Variable Elasticity of Substitution production function (VES) are often generalizations of
the CES production function. In contrast to CES production function, the VES production
function requires that cr be the same along the expansion path but vary along an isoquant.
Several such functions have been constructed and estimated. Here we summarize some of the
earlier studies of VES production function models as follows :

a) Liu - Hildebrand Function:

Y = v [ (1-8 ) K'p+ K"mpL"(I"m)p ]-1/p eq. (3.3.4)

where, m is a constant. If m=0, the above equation reduces to the familiar CES production
function which includes the Leontief and CD functions as special cases. The elasticity of
substitution for this function

aim) = -------------------------------------------------- --— eq. (3.3.5)

1 + P ~ mp/SJc
where, Sk is the share of capital. The above equation implies that Y/L depends on both the
wage rate w and the capital-labor ratio K/L. Since m and sK are positive, the relationship
between VES , ci(m) and CES (cr) depends on the magnitude of p ; if p > 0, cr > 1 , then a
(m) > a . Thus, when a < 1, cr (m) is larger than a and tends towards unity again
suggesting equilibrating process.

b) Transcendental Production Function [Revankar (1971)]:

Y = y J^iKH+ajL) jp eq. (3.3.6)

82
where, e is a constant. This reduces to CD function if ai = a2 = 0 but it does not generalize to
contain linear production function Y = aK+P L as a special case.
The elasticity of substitution depends upon the ratio of factors of production (K/L) and is
given by the expression
( l - P + a i K ) ( f i + a 2L)
eq. (3.3.7)
(l —P) {P + Qi L) + fi(l —P + d \ K )

c) Constant Marginal Shares (CMS) Function [BRUNO (I960)]:

Y = y Ka Lp - mL eq. (3.3.8)

where, m is a constant. This function is explicitly a generalization of the CD function

(if m=0) and contains the linear function as a special case if a = l, a+p=4, and m is negative.
Its elasticity of substitution is the simple expression
^maP L
<7 = 1- eq.(3.3.9)
KP) Y
which implies that the average productivity Y/L rises as a -»1 and that the value of a does
depend on the level of output Y.

d) Revankar's Variable Elasticity Function :

Revankar [1972] assumed that a varies with the capital-output ratio around the intercept term
of unity, so that the resultant production function model is given by

Y = y Ka(1-8p) [ L + (p -l)K ]a5p y>0, a>0, eq. (3.3.10)

^ > ( l - 8 ) l ( \ - 8 p ) , 0< 8 < 1 , 0 <8p<1

K
For this model the explicit expression for a is a linear function of capital labor ratio which can
be expressed by writing

ct = 1 + P( K/ L) eq. (3.3.11)
If g = 1 (i.e. p = 0), it reduces to CD production function.
e) Lu and Fletcher’s Formulation :
Yao-Chi Lu and Lehman Fletcher [1987] have given the derivation of the VES function from
CES function and also estimated the parameters of VES function under perfect competition
with profit maximization condition.
Hildebrand and Liu [1965] suggested that,
“I f one relies upon the goodness o f fit o f an empirical relationship as the initial basis for
deriving a theoretical one as ACMS did, one probably would have to consider the three
variable relationship (V/L, W, and K/L ) as better established than the two variable one ( V/L
and W )”
Lu and Fletcher [1968] begin with the following relationship:
log (V/L) = log a + b log W + c log (K7L ) + e eq. (3.3.12)
83
where, a, b, and c are constants. When the production function V = F(K , L) is homogeneous
of degree one, then V/L = F( K/L, 1). Set V/L = Y and K/L = X. Then, we have Y = f (x)
or VL f(x). Let W be the wage rate with output as the numeraire. If both labor and product
markets are competitive then
W = / (x) -X f ( x )
W = Y - X (dY/dX)
and r=/(x) eq. (3.3.13)
where, / / (x) is the marginal product of capital; /( x ) -X / / (x) is the marginal product of
labor and r is the returns to capital.
By substituting eq.(3.3.13) into eq. (3.3.12), we get the following differential equation:
log Y = log a + b log A Y - X (dY/ dX) + c log X. eq. (3.3.14)
By solving eq. (3.3.14) for dY/dX and employing the substitution Z = Y ‘'Yb we obtain by
standard methods the function
V = [ (3 K‘p + a r] (K/L)-*(,+p) L‘p ] (-1/p) eq. (3.3.15)
where, p = (1/ b) -1 , r\ = (1-b) / (1-b-c), a = (1-8) y 'p, p = 8 y'p.
This production function has the same form as the CES function except that L'p is multiplied
by (K/L)'°(1+ p). Obviously, if c equals zero, the multiplier becomes unity and the new
function reduces to the CES function; therefore the new function is more general form
which includes the CES function as the special case.

Thus, Lu and Fletcher’s [1969] model can be written as

1
+
a
1

~K~
CN

y = r 8 K P + (l + 8)r} L~P eq. (3.3.16)

JL_

where, y, r|, 8, a 2 and pare the parameters and v is the disturbance term.

It has been shown by Lu that the new production function has the following properties :

1) Positive marginal products,

2) Downward sloping marginal product curves over the relevant ranges of the inputs,
3) Homogeneity of degree one,
4) Variable elasticity of substitution.

The Elasticity o f Substitution for Lu Fletcher’s form is given by

_ _____________ b_____________
\-c { l-c (l + \l{p i a){XA -B))
eq. (3.3.17)
where,
A=(b + c - l ) / b
B= c / (b+ c-1)
which indicates that 0 is an explicit function o f X.

84
Under perfect competition, the average labor productivity relationship with random term u will
be denoted by
[kY 2
Y = j - = A ( w ) ai eq. (3.3.18)
l Lj
where, u = vp/ (1+p)
1 -1 / ( l + p )
~PY
(l - S)r}{a2 + a 2p p)
and
1
1
a,
Expressing eq. (3.3.18) in the logarithmic form we get,

a 0+ a 1logw + ct2log f-1

ViJ
+u eq. (3.3.19)

( K ) r22(1+^>
The above production function has the same form except that L is multiplied by J

and the term with?; = ------------ -— is introduced. It can also be observed that if a equals
1- a~ a2

zero the multiplier becomes unity and this production function reduces to CES production
function as given by Kmenta [1971], etc., which is the same form as given by Revankar.

/) Lovell's Parametric Form:

Alternative parametric form has been given by Lovell [1973] which can be expressed as under :
i
Y = r [(1 + P)KLp~ M + a Ll~p M3]UP+S P, 8 > 0 ; - a / P< k eq. (3.3.20)
and k = K/L
where, y, a , P and 8 are the arbitrary parameters.

The elasticity o f substitution a for the above model is given by

, Mi
or = 1 + -------
\P-Jk
eq. (3.3.21)

ct varies monotonically with k along an isoquant whenever a ^O. If a - 0,the function reduces
to CD function. For the case of a > 0, the elasticity of substitution exceeds unity and decreases
with increase in k.

85
g) Ferguson's VES Production Function:

Ferguson [1965] has given YES production function which can be expressed as

Y = A ex,L“ K{1'a) epK eq. (3.3,22)

where, k = K/L.

The elasticity of substitution for the above production function model is given by

<7= 1------ -------------- o ( k ) > < l; a c r(K )> < 0 ; p > < 0 eq.(3.3.23)
(a + p k ) - a
Thus, 0 varies monotonically along an isoquant with k in the case of p *0 for the above VES
production function models. For any set o f parameters 0 (k) is strictly monotonic in k along an
isoquant.
h) Kadiyala's VES Production Function :
Empirical research in economics has tremendously increased both the quality and quantity
ever since Cobb and Douglas proposed the CD production function for finding
relationships among economic variables. Two important reasons for this are the simplicity
o f the CD function from an estimation point o f view and that it is consistent with most
economic data.
Even though the CD function describes most economic data quite well, it has some serious
drawbacks:
i.) It requires all inputs to be positively employed; and
ii. ) It has a unitary elasticity of substitution for all levels of factors.
The generalized CES production function introduced by ACMS [1961] removes the first of
these criticisms. On the other hand, if the elasticity of substitution were to be an index for
judging a production function as a means o f explaining relationships among economic
variables, the CES production function has the same drawback as the CD production
function. Intuitively speaking, one would expect that as one moves along a given
isoquant the elasticity of substitution increases (decreases) as the relevant input ratio goes to
infinity as well as to zero. It was this fact that Allen stated “the larger is the constant
product curve and the more slowly does the marginal rate o f substitution increase as
B is substituted fo r A The magnitude of 0 is thus an indication of the case with
which product can be maintained by substituting B for A. Obviously, CES and hence CD
production function does not possess this desirable property.
Some attempts have been made to find production functions which could meet this criticism.
In this connection, special reference could be made to the papers by Lu and Fletcher,
Revankar and Sato-Hoffman. The general approach o f these studies has been to assume
that the elasticity o f substitution is a linear function of the ratio o f the two inputs and
then to integrate the resulting differential equation to arrive at the implied production
function.
The resulting production functions do possess the property o f exhibiting VES and in a way,
are a generalization of CES production function. However, by the very nature o f the

86
assumptions made by these production functions have the property that the elasticity o f
substitution is either a Monotone increasing function o f the input ratio or a Monotone
decreasing function o f the input ratio. This means that the elasticity o f substitution either
reaches a maximum or a minimum as the input ratio increases (decreases). Unfortunately,
this property contradicts one’s intuition and plausibility as well since the elasticity of
substitution of the input Xi forX 2 is the same as the elasticity o f substitution o f X2 for
Xi. Therefore, one would expect the elasticity o f substitution, a to monotonically increase
(decrease) as the input ratio X2 /X 1 tends to a “critical” value say xo and to
monotonically decrease (increase) for values of X2 /Xi > xo (at least for different
production processes).
Kadiyala (1972) presents a simple production function which includes the CES function,
the Lu Fletcher function, the Revankar and the Sato-Hoffman functions as special cases and
yet it is quite simple from an estimation point o f view.
A more general case o f the class o f VES production functions can be formulated as given by
Kadiyala (1972]

( \ r
X t , X 2) = E(t)[G)llX l2f’ + 2a)n XiPi X & + e n i X ¥
i
J
eq. (3.3.24)
where,
E is the efficiency term;
p, pi and p2 are the substitution parameters
and coi 1, can, and ©2 2 , are the weights.

Assuming con + 2coi2 + a>22 = 1 and pi + P2 = 2p the above equation reduces to CES production
function if ©]2= 0 , to the VES function as developed by Lu and Fletcher [1968] if ©22 = 0 and
to the Sato Hoffman VES production function if ©n=0. [Sato and Hoffman (1968)].
With the assumption that pi= p2= p , it reduces to

g( x ,,X 2) = £ (» )[ffl|| j r f '+ 2ml2 X f x?+ m n X l ^ " eq. (3.3.25)

which has an elasticity o f substitution as

1
cr{x) = eq. (3.3.26)
1-p+i?
where,
~ p{(Q„ (On ~ G )s)
R=
{(On X " + (O ^C O n * (On X" )
and x = X2 /xi.

By choosing the appropriate values for p this form reduces to CD function (p= 0), fixed
proportion coefficient ( p = +00) and in linear production function (p=l/2 and ©12 = 0). Here the
marginal products are non negative and the elasticity o f substitution is not a monotonic
function o f factor combinations. Also this function can be generalized to many input cases

87
and to the cases where the production function is homogeneous of a degree greater than
one.
i) Sato and Hoffman Production Function:
Sato and Hoffman [1968] has given special cases of VES function which are as under :
1. Where capital’s share a , is a linear function of k i.e a ( k) = a k + b then the VES
function is
Z = A e akkb. eq. (3.3.27)
They have also made some statistical tests for this particular case. First o f all they
considered the share hypothesis a = b + a k by taking the United States data for the year
1909 to 1960. The statistical results t hey found here were poor, but not unexpected
because a was relatively constant since 1900 whereas k had grown almost uninterruptedly
(from about 2 to 4) over the same period.
Secondly, they took the Japanese data. In contrast with the US case the a and k data co-vary
and the regression coefficients met the usual significance tests.
Next, they considered the production function (3.3.27), which may be written as :
logZ = log A + a k lo g e + b lo g k , eq. (3.3.28)
or, where, A = A0 eut.
logZ = log Aq + ut + a k + blogk 0<b<l. eq. (3.3.29)
The statistical estimates derived from the direct application of regression analysis to
above production function were not encouraging; for the US the coefficients were
insignificant, for Japan the coefficients had the wrong sign; in both cases almost all the
explanatory power in the eq. (3.3.29) for the production function was in a trend term
associated with technical progress.
However, applying regression analysis after eliminating the effect of technical progress they
had more satisfactory results; the coefficients had the right sign and were all statistically
significant.
Sato and Hoffman then considered the case where a( k) = ak+b. They reported the
regression estimates for this hypothesis for both US and Japanese aggregate time series data.
The production function (3.3.29) implied by the linear share relation was derived, and
regression estimates for several variants o f the production function were obtained, again
using both US and Japanese. Overall, the results for the regression of the production function
free from the effect of technical progress were more satisfactory.
2. Where a is a linear function of k , i.e. when cr = a + b k , the VES function is given as
Z(Jt) = Afl\k I {a + bk) (m - X, ] aKB‘ i - 1,2,.........,s. eq. (3.3.30)
i=i t J
where, s is determined by the value of (1/a) = (m/n). If b=0, eq. (3.3.30) reduces to a CES
function.
3. where a is a. linear function of time i.e. a = a + b t , then the VES function is
Y = y ( t ) [ A (t) L(o-I/c) + B (t) K(ci“I/a) ] (oAM) eq. (3.3.31)
or particularly,
Y = y0ept [A (t) L(a_1/o) + B (t)K (°-1/o)] eq. (3.3.32)
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Sato-Hoffman [1968] also considered this case for both US and Japanese data and tested the
hypothesis
log Z = log m + a log w + bt log w eq. (3.3.33)
They found the negative estimate for the coefficient on the t log w term which was
disappointing, but with these estimates a = a + bt was remaining positive for over three
centuries. With the Japan data, the a priori expectation of all positive coefficients was
fulfilled.

5. HOMOTHETIC PRODUCTION FUNCTION :

Homothetic production function was provided by Shephard [1953], Fare, Janson and
Lovell [1970], Every homogeneous production function is homothetic but the homothetic
family contains non-homogeneous functions as well i.e., production functions having variable
returns to scale.

As an example consider the general production function

Y = g(/(K ,L)) eq. (3.3.34)
where, /(K,L) is a homogeneous function of arbitrary degree.

For such a function :

i) Returns to scale diminish in a pre-assigned fashion with Y.
ii) The associated average cost curve exhibits decreasing cost at low levels of output
increasing costs at high levels of output.
iii) This function can be generalized to n inputs.

a) Mar2inal products are positive

^ = ^ >0 and eq. (3.3.35)

dL df dL

3l =4 J L >0 eq. (3.3.36)

dK df dK
b) The elasticity of substitution associated with Y=g(/)is the same as that associated with
the function /.

c) If / is a neo classical production function homogeneous of degree a and the function

Y=gif) has a pre-assigned returns to / scale function p (y) the following differential
equation holds :
dg _ y v(y) eq. (3.3.37)
d f f df
By Euler's theorem.

* ( ££ +i£.) = y/u(y) eq. (3.3.38)

df \ dL dK)

89
and since / is homogeneous of degree a /; then
_ cff v df eq. (3.3.39)
L — +K — - a f f
oL dK
By specifying / the elasticity of substitution (variable or constant) can be obtained as long as /
is homogeneous.

6. NON-HOMOTHETIC PRODUCTION FUNCTION :

These functions are characterized by isoclines which are defined as the loci o f points with
constant marginal rates of technical substitution but varying returns to scale and optimal
input ratios. They have flexible functional forms for they do not impose the restrictive
constraints a priori such as homotheticity constancy of the elasticity o f substitution additivity
etc., and are easily adaptable to include multiple products and multiple inputs. An example, of
this class of functions is recently developed transcendental logarithmic production functions
(Christensen, Jorgenson and Lau (1973)] which are often referred to as the "translog"
production frontiers.

The production possibility frontier F is represented by

F(yl5y2,y 3, .... y„> A) = 0. eq. (3.3.40)

where , y; , (i= 1,2,..., n) refer to net outputs and inputs and A is an index of the rate o f
technological progress.

7. GENERALIZED PRODUCTION FUNCTIONS (GPFsl

Generalized production functions (GPFs) form another broad class o f functions, which are
usually non-linear in both parameters and variables. The GPF’s are the generalization referring
to what is assumed about not only the elasticity of substitution but the behavior of the retums-
to-scale. That is, given a neo-classical production function with a given elasticity of
substitution (constant or variable ), this function can be transformed to yield a neo-classical
GPF with the same elasticity o f substitution and with the retums-to-seale variable and
satisfying a pre assigned relationship to the output level. Thus, for example, a GPF may have a
constant elasticity of substitution and returns to scale which diminish in a pre-assigned fashion
with the level of output. Since retums-to-scale may indeed be different at different scales of
operation, GPF’s may be useful in analyzing data relating to production. Also, obviously,
average cost curves associated with GPF’s can show decreasing costs at low levels o f output
and increasing costs at high levels of output.
Thus, these functions have been introduced to permit generalization in two directions. We wish
to have production functions with a pre-assigned elasticity of substitution, say, constant but
unknown, or variable, say some function of capital-labor ratio. In addition to this requirement
on the elasticity of substitution, we want our production function to have returns to scale vary
with the level of output according to a pre-assigned function. Zellner and Revankar [1969]
have provided a method, described below o f generating production functions that meet both the
requirements.

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In deterministic terms, consider the following differential equation :
d V s rcW eq. (3.3.41)
# / af
with solution V = g(/), where a(V) is the retums-to-scale as a function of output V,
/ = /( K, L) is in the form of a neo-classical production function, and a / is the retums-to-scale
parameter associated with /. The function a(V ) is chosen to ensure that (dV/d/ ) > 0 for all / ,
0 < / < oo . This equation (3.3.41) is a monotonic transformation o f / with the property that
the shapes of the isoquants for g (/) will be the same as those for / . Therefore, the elasticity of
substitution parameter, constant or variable, associated with V = g (/) will be the same as that
associated with the function /.
Thus, GPF has been defined by Zellner and Revankar [1969] as follows :
“A production function V = g ( f ) which is a solution to (43) fo r a particular choice o f the
returns - to- scale function a ( V ) is termed as a generalized production function (GPF). ”
Zellner and Revankar [ 1969] have explored some implications of several such functions for the
behaviour of labor’s share. In addition to this, they have provided an illustrative example to
show how the parameters of a GPF can be estimated by the maximum likelihood method, which
can be utilized quite readily in the analysis o f a particular functional form and of other
production functions.
3.4 Production Function in Agriculture :
During the last three and half decades production functions have been put to diverse uses in
agriculture ranging from the simple problem of input-output relations to the relatively more
complex problem o f rationality o f the peasant farmers. Its use has been so pervasive that there
has been hardly any empirical study on agricultural production without fitting a production
function, at least of the CD form. While the main stream economists continue to feel strongly
that production functions are useful, among other things, for the problems of resource allocation
among different factors o f production both at micro and macro levels. There are those who feel
that "Cross sectional production functions are bound to be an unrewarding work, and who call
these studies as vulgar econometric work, because they, having been marked by cross
disregard fo r common sense as well as the elementary principles o f statistics, suffer from
serious methodological drawbacks". Still the nature o f production functions is important in
economic development and in determining the extent to which national products can be
increased from given resources. The magnitude of production co-efficients serve as the base for
determining optimum patterns of international and/or inter-regional trade.
The comprehensive sketch on important stages in the history of economic thought on laws of
production and production functions on agriculture has been drawn below. It begins with
Physiocratic law of diminishing returns and contains brief discussions on the origin and
evolution of classical law of diminishing returns, Neo-classical law o f variable proportions, Neo­
classical production function and production function studies on agriculture.

PHYSIOCRATIC LAW OF DIMINISHING RETURNS :

Turgot, the French Physiocrat was supposed to be the first to formulate the static "law o f
diminishing marginal returns" in 1767. Unlike Stuart's law of diminishing returns due to
extensive margins, his law was due to intensive margins. Statement of this law, in modem

91
paralance, it that as equal quantities o f 'avances' are successively applied to a given piece of
land, marginal product o f each application first increases upto a certain maximum point, beyond
which it progressively diminishes to converge with zero. He was vague in specifying the
variable factor 'avarices' which was supposed to contain 'a basket fu ll o f desperate things',
which later led to divergent interpretations. Douglas interpreted it as labor, whereas
Schumpeter, as capital, though the latter concedes that 'labor, however, do just as well in this
case'. The other weak spot in his statement is that he did not explicitly specify the necessary
condition o f a given once & for all and the other foctors would always increase to any required
extent if allowed to do so, felt that diminishing returns operate in the exclusive domain of
agriculture. Inspite o f this, he was said to have formulated a special case o f the "Law o f
Variable Proportions".

CLASSICAL LAW OF DIMINISHING RETURNS :

Its Oriein:
Independent o f the physiocratic formulation, the classical law o f diminishing returns was
originated from "CORN LAWS" controversies in Great Britain during 19th century. Malthus,
West and Ricardo were the most important classicals associated with it, and others were
Senior, Mecullock and Mill. Malthus made implicit use o f the law in his theory o f
population, which appeared first in his "Essay on Population" (1798). But 17 years passed
before this implicit law was made explicit in 1815 in his "Nature and Progress o f Rent". In the
same year West 'independently' discovered this principle which appeared in his "Essay on the
Application o f Capital to Land'. Two years later it was adopted by Ricardo in his
"Principles o f Political Economy" as the basis for his theory o f distribution. As a result, the
classical law o f diminishing returns is better known by the trio, Malthus, West and Ricardo.

Different Versions o f the L a w :

The law of Diminishing returns meant three different concepts to the classicals :

i) Diminishing Returns due to Extensive margins, which is a simple tautology;

ii) Diminishing Returns due to Intensive margins, which is the modem static technical law
o f diminishing marginal returns; and
iii) Historical or Secular law o f diminishing returns specifying diminishing returns to a
combined dose of labor and capital inspite o f the usual technological improvements. The
last version was crucial for classical policy and the static version o f the law was only a
point o f departure for discussing the secular version and its implications.
The classicals usually did not keep their ideas on diminishing returns distinct and shifted from
one concept to another in the middle o f their analysis with relative ease and unconcern.
Sometimes, they treated the law as referring to diminishing marginal returns with given
techppfpgy, and sometimes secular diminishing returns. This is true even o f Marshall - its
average and marginal versions appear sometimes in the same chapter o f his 'Principles'.
The preference o f majority o f classical writers for the statement o f average (proportional)
rather than marginal returns was either due to confusion between them, or due to their
misconceived importance given to the former nU ki tlw i ftii fatter. The fact that they are

92
not equivalent and that it is marginal rather than average concept which is needed in all
optimization problems, was first started by Edgeworth (1911).
Inspite o f his decisive contribution, the confusion between average and marginal concepts
persisted until it was finally settled by Prof. Menger (1936).
Unlike Turgot's two-factor scheme o f 'avarices' and 'Land', the classicals always used Smith's
three-factor scheme o f Land, Labor and Capital in starting the law. Turgot's 'avances', the
variable factor in classical model is generally combined dose o f labor and capital, (sometimes
stated as combined in fixed proportions) and the fixed factor, Land. Even here they were not
strict in specifying the variable factor. It was sometimes Labor, sometimes Capital, sometimes
work and sometimes Labor and Capital in fixed combinations. Despite the references to the
three-factor scheme, varying in fixed proportions and land being the fixed factor.

Statement o f the Classical L a w :

Statement o f the law by both Malthus and West were not quite clear and that o f the law in
his "Summary View on Population" (1S30), Malthus showed his decided preference to the
reader' situation at the expense o f its careful formulation, and stated that the power to
produce food is "obviously limited by the scarcity o f land and by decreasing proportion o f
the produce which necessarily be obtained by the continual additions o f capital applied to
the land already in cultivation". West's statements o f the law also exhibit similar lack of
clarity. His two oft-quoted statements are:

i) Additional labor cannot be bestowed with the same advantage as before on the old
land, and
ii) "the whole quantity o f work bestowed on la n d ........ extract from soil a gradually
declining proportionate return".

RICARDO'S STATEMENT:
On the other hand, Ricardo's statement o f the law is complete and more elaborate. His
statement, is that when "equal increments o f labor (or o f factors in fix e d combination) are
successively applied to a given piece o f land to raise a given crop, point will be reached
after which the consequent increment, o f that product will decrease to zero, further application
to negative returns". Senior's contribution to the law was the explicit statement of the
necessary condition for its validity - a given and constant technological horizon, whose
importance was already implicitly recognised by Ricardo and others.

Proof o f the L a w :
Most o f the classical economists, as also some after them, regarded the law as a 'simple
generalization o f everyday experience ', which 'must have occupied the thoughtful men in
every densely populated country’. Some felt that it was the 'obvious summation o f common
observations and the like o f it has been said many thousands o f time by some over
centuries. The first and the most 'primitive p r o o f o f the law was offered by the classical trio.
They argued that the mere fact of cultivation o f any but best land was all that was needed for
the proof o f the law. But, the extension o f cultivation to inferior soil is no proof of the static
law. Extension of cultivation is a temporal process with technique o f production altering all the
time, and improvements in technique may make. Later, some minor writers tried to prove
93
the law by a reductio ad absurdum. They argued that if proportional increments of output, the
countries wheat supply could be grown in a flower pot, if the returns in real production is
more than the return in flower pot. Dominating classical micro economics, it was the basis for
classical theory of rent, Malthusian theory of population, the theory wage and profit movements
overtime

THE OLDER MARGINALISTS :

Von Thunen & Longfield :

Meanwhile, two older marginalists. Von Thunen in Germany and Longfield, the minor anti -
Ricardian economist of the classical period in England, had independently broken up
theoretically the combined dose of labor and capital and developed marginal productivity theory
of distribution to explain the relations between marginal productivity of capital and profit, and
between marginal productivity of labor and wages Thunen's statement of the law is that when
each of the factors (labor and capital) is seperately increased while, other held constant, the
product added by each equal increment of a factor is constant fraction of the preceding
incremental product - 2 or 3 in the case of capital, implying an asymptotic marginal product
curve with diminishing negative slope Though Thunen's contribution was virtually ignored by
British and completely neglected by fellow Germans, he was the first to use calculus and
marginal reasoning to provide equilibrium solutions to economic variables Similar fate fell on
Longfield and was completely neglected and forgotten until he was unearthed by Seligman in
1903.
Origin:

Due to the complete neglect of the older marginalists, the marginal productivity theory was
rediscovered in the last quarter of 19th century During that period, a number of economists
were suddenly struck with the idea that Ricardian theory of rent was a special case of a much
more general theory, where all factors are variable With that insight, Marshall and Wicksteed
in England, J B Clark in America, Wicksell in Sweden and Walras in Switzerland generalized the
marginal concept in Ricardian theory of rent to all the factors of production, and formulated the
"law of Variable Proportions" or the marginal productivity theory of production.
The Law:

The law of Variable Proportions states that when one of the three factors is increased keeping
others constant, marginal product of the varying factor first increases upto a certain
maximum point, beyond which it smoothly and continuously declines There is no unanimity
among them regarding the precise statement of the law. Clark's formulation of it is so extreme
as not even to allow any possibility before the onset of diminishing returns. Another extreme
stipulation of it is that marginal product is always positive and converges with zero The Neo­
classical theory of production like the classical one, was used in the theory of distribution
Unlike the Classical law, the Neo-classical one was supposed to apply both to agriculture as
well as industry In fact, the Classical as well as Neo-classical theories of production and
distribution are so closely inter-woven that it would be absurd attempt to separate them

94
NEO-CLASSICAL PRODUCTION FUNCTION:

Orieitt :
Dominant role of marginalism and the concept of substitution at the margin in the Neo­
classical economic theory led to the appearance of explicit mathematical reasoning in pure
theory of economics after 1870 and began to play a significant and indeed a decisive role. The
kind of mathematics that economists employed during this period was combined to calculus
whose logic may be expressed in terms of a small number of concepts such as variables,
functions, limits, continuity, derivatives, differentials, maxima, minima. Application of
differential calculus to the general marginal productivity theory of production, led to the
formulation of the concept of "Production Function" by the end o f 19th century. Ever
since, Neo-classical theory of production was centered around this concept.

In Great Britain:
A discussion on the evolution of the concept of production function is very difficult and
the names of Marshall, Berry, Edgeworth, Wicksteed, Barone and Walras enter in some way
or the other. It was implicit in Marshall's marginal productivity theory of firm and
distribution. Berry's equations of marginal productivity (1890) and Edgeworth (1894 ) explicit
statement o f production function, remained almost unnoticed until they were brought to light
in 1941 by Stigler. In the same year (1894), Wicksteed independently presented an explicit
statement of production function and used it in his proof of the proposition on
distributive shares and Adding up theorem.

On The Continent:
Elsewhere in Switzerland, Walras in his first edition o f "Elements o f Pure Economists"
(1874) originally used what may be called "Degenerate Production unction" with
technologically fixed coefficients. Twenty years later Barone (1894) had suggested him what is
known as Walras - Barone's 'Equation De-fabrication' in which the technologically fixed co­
efficients were transformed into variable coefficients. This was later incorporated by Walras in
his fourth edition o f "Elements" (1990), and used it in his formulation of marginal
productivity theory and distributive shares.

The Concept :
"Production Function is purely a technical concept, which expresses physical relationships o f
maximum quantities o f well defined physical output obtainable from all the technologically
feasible combinations o f equally well definedfactors under given state o f technology". It is
a flow concept where in the output and the inputs are expressed as flows per time unit. It
presupposes that all the engineering decisions have already been made, and hence it represents
production on, "Efficiency Frontier" or the "technological horizon” where only technologically
the most efficient methods of production are considered after eliminating inefficient ones.
The advantage of production function is to divorce factor substitution from technical progress,
thereby segregating movements along the production function from shifts in it. Any
improvement in the existing state of technology caused by a feasibility to produce more output
than is currently possible or by a discovery of new methods of production, alters the existing

95
technological horizon and hence destroys the present production function replacing it by
another. The Unspecified mathematical form of production function is
Y = / ( X \ X * , ..... ,X")
where, Y is a well defined output, and
X; is a well defined input,.
both output and inputs take non-negative values.
With regard to the properties of Neo-classical production function, some are assigned based on
marginal productivity theory of production and others, to invoke differential calculus as a
means of analysis to the problems of optimization. The former category are :
i) . that the first partial derivatives are positive, and
ii) . that the second partial derivatives are positive up to a certain point and negative
afterwards, indicating a single maximum point of marginal product curve. The latter
category is the production function is "continuous" and "Smoothly" differentiable twice
both sides.
From these basic properties some other properties of the function can be derived. They are :
i) . there exists a point beyond which the average productivity of every factor declines,
ii) . the cross derivatives are positive, indicating "positive interaction" among the factors, and
iii) . the isoquants are smooth and convex to the origin, indicating the possibility for
continuous factor substitution.
Another property which was assigned by Wicksell and Wicksteed is its first order
homogeneity, indicating proportionate increase in output to an equi-proportional increase o f all
factors. This property was assigned in order to prove the exhaustive theorem in the Neo­
classical theory of distributive shares. Though there was no unanimity with regard to all finer
details of the Neo-classical theory of production, this seems to be its essence.

'k 'k if k ie 'k is

96