UNIT 2: MICRO-ECONOMICS

2.4 Theory of Production

Concept of Production
Production is essential to fulfill the demand of consumers. Production process is
supposed to be continuous in the economy. Production is the process of transforming inputs
(resources) into output (commodities). Firms combine inputs to produce output.
Theory of production analyzes relation between output and factor inputs. Output
depends on inputs, i.e., output may decrease or increase or remain constant in response to
factor input. There are various laws governing this phenomenon. Theory of production
explains these laws.

Production Function
There is a relationship between inputs and output. When input-output relationship is
expressed in the form of an equation, it is called production function. Production function is
defined as the functional relationship between physical inputs and output. It is expressed as:
Qx = f (Ld, L, K, O, T, M, t)
where, Qx = Output of commodity x
f = Function of (or depends upon)
Ld = land
L = Labour
K = Capital
O = Organization
T = Technology
M = Materials
t = Time
The equation tells us that the output of x depends on the different factor inputs Ld, L, K,
O, T, M, t, etc.
If we limit our analysis into two inputs only, capital and labour, then we can write the
production function as:
Qx = f (K, L)
where, K = Capital
L = Labour
Qx = Output of x.

Types of Production Function

1. Short-run production function: Law of Variable Proportion
The short-run refers to a time period in which some input cannot be changed. The inputs
that can be increased within short time period or immediately (such as raw materials, fuel,
labour, etc.) are called variable factor inputs. The input that cannot be increased within a given
time period (such as machines, building, production plant, etc.) are called fixed factor inputs.
During short-run, some factors are fixed and some factors are variable.
Law of variable proportion is the theory explaining short-run production function.

1
 2. Long-run production function: Law of Returns to Scale
The long run is a period of time during which all inputs can be varied. In this period, there is
no fixed input, all the inputs are variable, i.e., a firm can use more labour, more raw materials,
new equipment, new production plant with improved technology and much more.
Law of returns to scale is the production theory explaining the long-run production function.

Concept of Total Product, Average Product and Marginal Product

1. Total Product (TP):
Total product is the total amount of output produced during a given period of time by a
given number of the factors of production. It can be estimated in two ways.
i. Total product is expressed as the summation of marginal product of no. of units of a
factor employed.
TP = ∑MP
where, TP = Total Product
∑MP = Sum of marginal product
ii. Total product is expressed as the average product multiplied by the no. of units of a
factor employed.
TP = AP X N
where, TP = Total Product
AP = Average Product
N = No. of units of a variable factor

Derivation of Total Product Curve

Total product curve can be derived and explained on the basis of total product schedule
as follows:
Total Product Schedule
Units of labour Total Product (in units)
0 0
1 10
2 30
3 60
4 80
5 90
6 90
7 80

In the table, TP increases in the beginning at an increasing rate up to 3rd unit of labour, then
increases at a diminishing rate from 4th to 6th unit of labour where it is maximum and thereafter
starts to decline which is shown in the figure below:

2
 In the figure, OX axis represents units of labour and OY axis represents total product. As
units of labour increase, TP curve increases at an increasing rate up to the point A, then
increasing at a diminishing rate up to the point B, reaches maximum at point C and falls
thereafter.

2. Average Product:
Average product is per unit product of the variable factor. Average product is given by the
total product divided by the number of units of a variable factor used. It is expressed as:

where, AP = Average Product

TP = Total Product
N = No. of units of a variable factor

Derivation of Average Product Curve

Average product curve can be derived and explained on the basis of average product
schedule as follows:
Average Product Schedule
Units of labour Total Product (in units) Average Product (in units)
0 0 -
1 10 10
2 30 15
3 60 20
4 80 20
5 90 18
6 90 15
7 80 11.4

3
 In the table, AP increases in the beginning up to 3rd unit of labour, then reaches
maximum at 4th unit of labour and declines thereafter which is shown in the figure below:

In the figure, OX axis represents units of labour and OY axis represents average product. As
units of labour increase, AP curve increases up to the point A, then reaches maximum at point B
and falls thereafter.

3. Marginal Product:
Marginal product is the additional output received by the producer when one extra unit of a
variable factor is used. It can be expressed in two ways:
i. Marginal product is the change in total product due to the change in variable factor
used, i.e

where, MP = Marginal product

∆ = Change
TP = Total Product
N = No. of units of a variable factor
ii. Marginal product is the difference between the total products before and after one
unit of a variable factor is used.
MP = TPn – TPn-1
where, MP = Marginal product
TPn = Total product of the nth unit of a factor
TPn-1 = Total product of the (n-1)th unit of a factor

Derivation of Marginal Product Curve

Marginal product curve can be derived and explained on the basis of marginal product
schedule as follows:
Marginal Product Schedule
Units of labour Total Product (in units) Marginal Product (in units)
0 0 -
1 10 10
2 30 15
3 60 20

4
 4 80 20
5 90 10
6 90 0
7 80 -10
In the table, MP increases in the beginning and reaches maximum at 3rd unit of labour,
then starts to decline and reaches 0 at 6th unit of labour and thereafter becomes negative which
is shown in the figure below:

In the figure, OX axis represents units of labour and OY axis represents marginal product. As
units of labour increase, MP curve increases and reaches maximum at the point A, then
declines to 0 at point B and becomes negative thereafter.

Relation between Total Product, Average Product and Marginal Product

The relation between total product, average product and marginal product can be
explained with the help of an example. Suppose that labour is a variable factor.
Land Labour Total Product Average Product Marginal Product
(hectare) (units) (TP) (AP) (MP)
1 1 10 10 10
1 2 30 15 20
1 3 60 20 30
1 4 80 20 20
1 5 90 18 10
1 6 90 15 0
1 7 80 11.4 -10
The table shows the behaviour of the total, average and marginal product. The total
product first increases at an increasing rate, then increases at a diminishing rate, reaches
maximum when 6th unit of labour is used and then declines. The average and marginal product
both increases in the beginning, reaches maximum and declines.
The total, average and marginal product curves can be derived from the table.

5
 It is seen in the figure that TP curve first rises slowly, then more rapidly and then more
rapidly and then more slowly until it finally reaches maximum and then begins to decrease.
Further, both average and marginal product curves initially rise, reach a maximum and
then decline. The marginal product curve exceeds average product curve when average
product is rising, equals average product when average product curve is at maximum and lies
below average product when average product curve is falling. The two curves intersect at the
point where the average product curve reaches its maximum.

Relation between TP and MP

1. When MP is rising, TP is increasing at an increasing rate.
2. When MP is falling, TP is increasing at a diminishing rate.
3. When MP is zero, TP is maximum.
4. When MP is negative, TP starts to fall.

Relation between AP and MP

1. When MP > AP, AP is rising.
2. When MP = AP, AP is at its maximum.
3. When MP < AP, AP is falling.
4. MP may be positive, negative or zero but AP is always positive.
5. When MP is rising, AP must rise but when MP is falling, AP may rise or fall.

Law of Variable Proportion

Introduction
The Law of Variable Proportion is a new name of the Law of Diminishing Returns. The
economists like Marshall, Benham, Samuelson and Mrs. Joan Robinson have contributed to the
development of this law. This law shows the short-run relationship between input and output.
It exhibits the direction and the rate of change in the output when the amount of only one
factor of production is varied.

Statement
This law states that when the amount of a factor (say labour) is increased, given a fixed
quantity of other factors (such as land), the average and marginal product of the factor first
increase, then after reaching the maximum eventually diminish. In accordance with this, total

6
product first rises at an increasing rate, then rises at a diminishing rate and after reaching its
maximum, it starts to decline.

Assumptions
This law is based on the following assumptions:
1. There is no change in technology.
2. One factor is variable and other factors are constant.
3. All units of variable factor are homogeneous.
4. It is possible to make changes in the proportion of variable factor.
5. Fixed factors are indivisible.

Explanation
This law can be illustrated with the help of a table and a figure. Suppose that the fixed
factor land amounts to 1 hectare. The increase in the quantity of the variable factor labour to
increase output is shown in the table below.

Land Labour Total Product Average Product Marginal Product Stages of

(hectare) (units) (TP) (AP) (MP) Production
1 0 0 - -
1 1 10 10 10
1 2 30 15 20 1st Stage
1 3 60 20 30
1 4 80 20 20
1 5 90 18 10 2nd Stage
1 6 90 15 0
1 7 80 11.4 -10 3rd Stage
There are three stages of production as shown in the table.
Stage I: Increasing Returns
At first, TP increases at an increasing rate, then increases at a diminishing rate. MP
increases, reaches maximum when 3 units of labour is used and diminishes thereafter. AP
increases and reaches maximum when 4 units of labour is used. When AP is maximum, AP=MP.
Average product is maximum when marginal product and average product are equal (AP = MP).
This stage ends when AP is maximum. This stage is called the stage of increasing returns
because increase in units of labour results in more output because there is sufficient land size.
Stage II: Diminishing Returns
TP increases at a diminishing rate and reaches maximum when 6 units of labour is used.
MP continues to fall and becomes zero when 6 units of labour is used. AP starts to fall. This
stage ends when TP is maximum and MP is zero. This stage is called the stage of diminishing
returns because increase in units of labour alone cannot produce more output because the land
size becomes insufficient in relation to labour supply.
Stage III: Negative Returns
TP starts to fall, MP becomes negative and AP continues to fall. This stage is called the
stage of negative return because unnecessary use of labour alone creates unhealthy
competition among workers. The management also fails to use them properly.
7
 This law can be illustrated with the figure shown below:

In the figure, OX axis measures the amount of variable factor (labour) and OY axis
measures the total, average and marginal product.
In the 1st stage, when the number of workers are increased, TP curve increases at an
increasing rate up to the point F and after that it increases only at a diminishing rate. The point
F is called the ‘point of inflexion’. AP curve goes on increasing throughout and at the last
becomes maximum. MP curve rises for a large portion in the beginning but at a later portion,
MP curve starts diminishing, but still remains above AP curve. MP curve intersects AP curve at
its highest point. It means that at the end of the 1st stage, AP is maximum and equals MP.
The 2nd stage starts when more than ON workers are employed. During this stage, the
TP curve goes on increasing at a diminishing rate and it reaches to the highest point H when
OM workers are employed. In the beginning of this 2nd stage, AP is maximum and then starts
falling. When AP falls, MP becomes less than AP, but it is still positive. At the end of this 2nd
stage, MP is zero at the point M. Corresponding to this point M, the TP is highest.
The 3rd stage starts when more than OM workers are employed. In this stage, MP
becomes negative and thus MP curve lies below the X-axis. Since MP is negative, TP also falls
and thus the TP curve declines after the point H.

Stage of Operation
A rational producer will always choose second stage to produce because:
 During the first stage of output, an increase in input causes increase in total product and
average product as well as marginal product is positive. Thus, a profit motivated
producer does not stop in stage I.
 In the third stage of output, an increase in input causes decrease in total product and
marginal product becomes negative which is not a rational decision. Thus, a producer
never goes to stage III.
 A rational and profit-motivated producer determines the output somewhere within the
second stage where TP is rising and MP is positive.

8
Application of Law of Variable Proportion
Law of variable proportion was developed in the background of agricultural production
where land and labour are the most important factors. The nature of marginal product along
with the increase in variable input as described by law of variable proportion was experienced
in agriculture. Due to agriculture reference, it is often confused that this law is applicable only
in agriculture.
The application of law of diminishing returns is not confined to agriculture alone.
Several studies in the modern industrial economy have proved that law of variable proportion is
equally applicable in the modern production system. The length of various stages of production
may be different but the nature of MP, TP and AP are almost similar in the agriculture sector.
Hence, this law is applicable anywhere in production if one factor is variable and others are
constant.

Law of Returns to Scale

The law of returns to scale shows the long run relationship between inputs and output.
In the long run, all inputs are variable. This law shows the change in output when all factors are
altered in same proportion. In other word, it explains the change in output due to change in
scale. Here, the change in scale means the change in all factors or inputs in the same
proportion. When all the inputs are increased in the same proportion, there are three
possibilities regarding its effect on output.
1. Increasing Returns to Scale (IRTS)
2. Constant Returns to Scale (CRTS)
3. Decreasing Returns to Scale (DRTS)

1. Increasing Returns to Scale (IRTS):

If output increase in greater proportion than the increase in all inputs, it is the case of
increasing returns to scale. For e.g., if all factors increase by 10% and output increase by 15%,
we have IRTS.

Units of inputs Total Product Marginal Product

(L+K) (units) (units)
0L+0K 0 -
1L+1K 5 5
2L+2K 12 7
3L+3K 22 10

The table shows IRTS because when both the inputs (labour and capital) are increased
from (1L+1K) to (2L+2K) to (3L+3K), the total product increases from 5 to 12 to 22, i.e., total
product increases by greater proportion causing marginal product to increase from 5 to 7 to 10.

2. Constant Returns to Scale (CRTS):

9
 If output increases by the same proportion as increase in all inputs it is the case of constant
returns to scale. For e.g., if all factors increase by 10% and output also increase by 10%, we
have constant returns to scale.
Units of inputs Total Product Marginal Product
(L+K) (units) (units)
0L+0K 0 -
1L+1K 5 5
2L+2K 10 5
3L+3K 15 5

The table shows CRTS because when both the inputs (labour and capital) are increased
from (1L+1K) to (2L+2K) to (3L+3K), the total product increases from 5 to 10 to 15, i.e., total
product increases by same proportion causing marginal product to remain constant at 5.

3. Decreasing Returns to Scale (DRTS):

If output increase in a smaller proportion than the increase in all inputs, it is the case of
decreasing returns to scale. For e.g., if all factors increase by 10% and output increase by 8%,
we have DRTS.

Units of inputs Total Product Marginal Product

(L+K) (units) (units)
0L+0K 0 -
1L+1K 5 5
2L+2K 9 4
3L+3K 12 3

The table shows DRTS because when both the inputs (labour and capital) are increased
from (1L+1K) to (2L+2K) to (3L+3K), the total product increases from 5 to 9 to 12, i.e., total
product increases by smaller proportion causing marginal product to decrease from 5 to 4 to 3.

10
 In the figure, OX-axis represents combination of inputs (labour and capital) and OY-axis
represents marginal product (MP). The curve OABC represents the law of returns to scale. The
upward sloping segment of the curve ‘OA’ represents the increasing returns to scale because it
shows increasing marginal productivity of inputs. The horizontal segment of the ‘AB’
represents the constant returns to scale because it shows constant marginal productivity of
inputs. Finally, the downward sloping segment of the curve ‘BC’ represents the decreasing
returns to scale because it shows decreasing marginal productivity of inputs.

Alternative Method of Explaining Laws of Returns to Scale: Using Isoquant

Isoquant: Production with two variable inputs
The term isoquant has been derived from a Greek word ‘iso’ meaning ‘equal’ and Latin
word ‘quant’ meaning quantity. Therefore, isoquant curve is also known as the ‘equal product
curve’ or ‘production indifference curve’.
An isoquant is the graphical presentation of the different combinations of two variable
inputs (L and K) with which a firm can produce a given amount of output. Any point on an
isoquant shows the minimum amount of the variable inputs needed to produce the given
output. Each point on an isoquant represent same level of output.
Isoquant is drawn on the basis of the following assumptions:
1. There are only two input (L and K) to produce a commodity (say X)
2. The two inputs (L and K) can be substituted for one another at a diminishing rate up to
certain limit.
The concept of isoquant can be illustrated with the help of a table below. Let us
suppose that there are only two factors, i.e., L and K is employed to produce a product.
Factor Factors Output
Combinations L K (in units)
A 1 12 10
B 2 8 10
C 3 5 10
D 4 3 10
E 5 2 10
As shown in the table, each of the factor combinations A, B, C, D and E produce the
same level of output, say 10 units. The combination A with 1L and 12K, B with 2L and 8K, C with
3L and 5K and so on produce 10 units of output. This can be represented by a diagram, which is
known as an isoquant.

11
 In the figure, we have plotted all the combinations. By joining them we get the isoquant
Iq, which shows that each of the combinations produce the same level of output say 10 units.
Since the entrepreneur can employ any one of these combinations to produce a given level of
output, he will be indifferent to them.

Law of Returns to Scale using Isoquant

The law of returns to scale shows the long run relationship between inputs and output.
In the long run, all inputs are variable. This law shows the change in output when all factors are
altered in same proportion. In other word, it explains the change in output due to change in
scale. Here, the change in scale means the change in all factors or inputs in the same
proportion. When all the inputs are increased in the same proportion, there are three
possibilities regarding its effect on output.
1. Constant Returns to Scale (CRTS)
2. Increasing Returns to Scale (IRTS)
3. Decreasing Returns to Scale (DRTS)

1. Constant Returns to Scale (CRTS):

If output increases by the same proportion as increase in all inputs it is the case of constant
returns to scale. For e.g., if all factors increase by 10% and output also increase by 10%, we
have constant returns to scale.

12
 The figure shows that only two factors – labour and capital are used. The straight line OP is
the product line. When CRTS occurs, the successive isoquants are equidistant from each other
along the straight line drawn from the origin which is shown AB = BC =CD. It means that if both
labour and capital are increased in a given proportion, output expands by the same proportion,
i.e., L1L2 = L2L3 = L3L4 and K1K 2= K2K3 =K3K4.

2. Increasing Returns to Scale (IRTS):

If output increase in greater proportion than the increase in all inputs, it is the case of
increasing in returns to scale. For e.g., if all factors increase by 10% and output increase by
15%, we have IRTS.

In the figure, when IRTS occurs, the successive isoquants lie at decreasingly smaller and
smaller distance along the straight line which is shown AB > BC > CD. It means that equal
increase in output is obtained by smaller and smaller increase in inputs, i.e., L1L2 > L2L3 > L3L4 and
K1K 2 > K2K3 >K3K4.

3. Decreasing Returns to Scale (DRTS):

If output increase in a smaller proportion than the increase in all inputs, it is the case of
decreasing returns to scale. For e.g., if all factors increase by 10% and output increase by 8%,
we have DRTS.

In the figure, when DRTS occurs, the successive isoquants lie at progressively larger and
larger distance along the straight line which is shown by AB < BC < CD. It means that equal

13
increase in output is obtained by more and more increase in inputs, i.e., L1L2 < L2L3 < L3L4 and K1K2
< K2K3 < K3K4.

14