Theory of Production

THEORY OF PRODUCTION

Introduction:
Market
What is Production?

Production is a process of
generation of goods and Buyers Sellers
services which can be
exchanged in the market.
These goods and services Demand Supply
has some utility to the
consumers or other
producers. If the consumers The theory of consumer The theory of producer’s
behaviour behaviour
purchase it and derive some
utility the they are called Final Goods and Services. If the producers purchase it, then they use it
mainly for using it in production process further they are called INTERMEDIATE GOODS
AND SERVICES. For example Flour purchased by a consumer to take cake at home is a final
good whereas same flour purchased by a producer to bake a cake and sell it in the market is an
intermediate good.

Since the goods and services that are created through the process of production have some utility,
so production has some utility. Again, in economics, unless a good that is created is for exchange
in the market, it will not be considered as production. For example, meals cooked at home has
utility to those who eat it, but that is not considered as production in economics, but the same
meal cooked in a restaurant, meant to be sold is considered under production. So, exchange is an
important element of production. So, production is redefined as follows: ‘PRODUCTION IS
CREATION OF UTILITY THROUGH EXCCHANGE’. Again technology is also a very
important element in production. So, production presupposes a given state of technology.
PRODUCTION IS VALUE ADDED ACTIVITY. In the process of production, the raw
materials are transformed into output. So, the value of output must be greater than the value of
raw materials.

i.e. Value of Output > Value of Raw Materials

or, Value of output – Value of raw materials > 0

or, Value of output – Value of raw material > 0

or, Value Added > 0

There is positive value addition through production. So, production is a value added activity.
Now, this value is added on the raw materials by the factors of production.

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Factors of Production:

A factor of production is any aspect that influences production is added on the raw materials by
the factors of production. The factors of production help to add value over the raw materials to
produce the final output.

The factors of production are classified into four categories:

1) Labour: Consists of all working people like doctors, clerks, carpenters etc.
2) Land: Consists of all natural resources like agricultural plots, forests, rivers, oceans,
mineral deposits etc.
3) Capital: consists of all produced means of production like machineries, tools, buildings,
man made good etc.
4) Organization: Refers to enterprises which assumes the responsibility of risk bearing,
organizing, planning, controlling and directing resources.

Note: Often economists use the term INPUTS to means measurable economic goods and services
which are used to produce other goods and services.

For example, land and labour used in the production of a given quality of rice are measurable.
The amount of machine time (Capital) used to produce ten computer chips is also measurable.
So, land, labour and capital can be termed as INPUTS. However, ORGANIZATION is a factor
of production but not an INPUT. Similarly, in agricultural production Climate is a factor of
production but not an input of production.

Production Function:

The technical relationship between inputs and outputs, represented mathematically in the form of
a functional relationship is called PRODUCTION FUNCTION.
In other words, production function shows the maximum level of output that can be produced
from all specified combination of inputs, given the state of technology.

As capital and labour are the two most important inputs in production process, so for analytical
simplicity production function considers capital and labour as the two inputs used in production
process.

So, production function is represented as follows:

Q = f (K, L); where Q: output; K: Capital & L: Labour

The nature of production function is specified by the given state of technology. Some examples
of production function are as follows:
Q = K +L
Q=K×L
Q = √𝐾 × 𝐿
Q=𝐾 𝐿 where 0<α<1 and 0<β<1

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Some Assumptions related to Production Function are stated below:

[These are also referred to as the properties of production function]

1) Q = f(K,L) : Here Q represents the maximum output level which can be produced from
all input combinations. This assumption specifies that, the inputs are used most
efficiently;
2) Q = f(K,L) : Here L and K are perfectly divisible. This makes the production function
continuous. This is possible when capital is measured in machine hours and labour is
measured in man hours (i.e. both are represented in time units).
3) If K = 0 and L=0 then Q =0. i.e. production is not possible without employment of at
least one input.
4) In the short run, capital is considered as fixed factor of production and labour is
considered to be the variable factor of production. As labour employment increases given
the fixed amount of capital output changes and this change in output can be explained
through ‘law of variable proportions’.
5) In the long run, capital and labour are both considered to be variable and they are
assumed to be substitutable in production process. i.e. two inputs are technical
substitutes, i.e. the use of a specified amount of one input can be replaced by some
amount of other input without any loss of output.

SHORT RUN AND LONG RUN

In Microeconomics Short run and Long run are defined with respect to two factors.
1) Plant Size
2) Entry and exit possibility of firms

Short run:

Short run is a time period where:

1) Firms operate within a given plant size. The size of a plant is defined by the volume of
capital. [Actually in short run at least one factor of production is fixed factor]
2) There is no entry or exit possibility of firms in the short run that is time period is too
short either for new firms to enter the market or existing firms to leave the market.

Long run:

Long run is the time period where:

1) Firms can adjust plant size. This means that even capital is a variable factor in the long
run. [Actually, in the long run, all factors of production are variable factors]
2) There is entry and exit possibility in the long run, i.e. new firms can enter the market or
existing firms can leave the market.

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Production in the Short Run

In the short run, at least one factor of production is a fixed factor. Generally, capital is considered
as a fixed factor in the short run. For example, Education as an output requires the services of a
teacher as well as infrastructural facilities like the room where students will sit and teacher will
teach using blackboard, projector etc. In the short run, number of teachers can be increased but
number of classrooms cannot be increased. i.e. capital is fixed but labour is variable factor So,
production function in the short run takes the following form:

Q = f (K0, L) where K0 is fixed level of capital

Or, it can be expressed as: 𝑄 = 𝑓(𝐾 , 𝐿) where 𝐾 is the fixed amount of capital employed

Now, if output has to be changed, then labour employment has to be changed. So, in the short
run, output level depends on the level of labour employment as capital is fixed in the short run.

Hence short run production function can be represented as Q= f (L) where, 𝐾 = 𝐾 ;

Alternatively we consider it to be the Total Productivity of Labour function or TP L.

Now, when L changes, given the level of capital(𝐾 = 𝐾 ), i.e. input proportion changes.

Now, when input proportion changes or varies, output changes and this change in output that
takes place due to change in input proportion is described by Law of variable proportions.

Law of variable proportions states that, when labour is increased by equal amounts, given the
level of capital,
1) output initially increases by more and more,
2) eventually by less and less,
3) it reaches maximum
4) and then starts falling.
This Law of variable proportions does not have any theoretical foundation; rather it is an
empirical assertion of reality. From the Law of variable proportions we can derive the Total
Productivity of Labour curve.

Derivation of Total Productivity of Labour Curve (TPL)

In the diagram we find that as L is increasing by equal amounts, given a fixed level of capital,
initially output is rising by more and more. So, initially the TP L is curve is convex to the axis
measuring labour which is shown by OA segment of TP L curve. Eventually output rises by less
and less as L is increased further (in the diagram, beyond L =4).

So, TPL curve becomes, concave to the Labour axis which is shown by the AB segment of the
TPL curve (Concave to Labour axis). At L=9, Output is maximum (point B in diagram) and after
output maximum, it falls. So, TPL curve becomes downward sloping beyond point B (BC

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segment of the curve). So, TPL is ‘S’ shaped. At point A, where the convex curve becomes
concave from below or towards labour axis, is known as ‘Point of Inflection’.

What is the logical explanation for the operations of law of variable proportions?

In the short run, capital is fixed factor and

labour is variable factor. Initially labour
input is relatively scarce than capital. So,
successive equal increase in labour will
increase output by more and more because,
extra units of labour can make more
intensive utilization of the fixed unit
capital. If the labour is kept increasing with
fixed capital, successive units of extra
labour will have less and less units of
capital to work with and eventually output
will rise by less and less units.

Derivation of Average Productivity of Labour Curve (APL) and Marginal Productivity of

Labour (MPL) from Total Productivity of Labour (TPL):

Average and Marginal Productivity of Labour:

In general producers are much concerned about the efficiency of the factors employed. This
helps them to determine whether there is any need to employ additional units of factor of
production. Two very useful measures in this respect are Average and Marginal Productivity of
Labour.

Average Productivity of Labour is defined as Total Output per unit of Labour.

Hence APL=Q/L where Q: Output & L: Labour;

Similarly, Average Productivity of Capital is defined as Total Output per unit of Capital.
Hence APK=Q/K where Q: Output & K: Capital;

Marginal Productivity of Labour is defined as the Output produced by last unit of Labour.
∆ ∆
Hence 𝑀𝑃 = 𝑜𝑟 𝑀𝑃 = 𝑜𝑟 𝑀𝑃 = where Lt ∆ → ∆ =
∆

Marginal Productivity of Capital is defined as the Output produced by last unit of Capital.
∆ ∆
Hence 𝑀𝑃 = 𝑜𝑟 𝑀𝑃 = 𝑜𝑟 𝑀𝑃 = where Lt ∆ → ∆ =
∆

In the short run, when capital is fixed factor, the producer is interested in knowing the
productivity of labour which can be best captured by AP L and MPL. So, now we try to derive the
APL and MPL curves from TPL curve and try to infer about the relation between them.

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Now, APL = Q/L. So, if we take any point on the

TPL curve and join that point with the origin, we
get a ray through origin and the slope of that line
is nothing but average of the curve. i.e. Average
of TPL or Q/L or APL or Average Productivity of
Labour. In the diagram, A is a point on the TPL
curve. This point is joined with the origin.

Slope of the ray through origin OA

= (AB/OB) = Q/L = APL

Similarly we can derive APL for

all points on the TPL curve. The
following diagram illustrates how
we can derive APL from that of
TPL. In Panel I we consider a few
points A, B, C, D, E and F on the
TPL. All these points are joined
with origin and we get the rays
through origin as OA, OB, OC,
OD, OE and OF respectively.

Now as we observe carefully the

slope of all these rays initially kept
on increasing till point D and then
started falling. In other words,
Slope of OA< Slope of OB< Slope
of OC< Slope OD. However
beyond point D, we observe that
slope of the rays through origin
keeps on falling. i.e. Slope of OD>
Slope of OE> Slope of OF.

So, up to point D, i.e. up to OL3

level of labour employment AP L
keeps on increasing and beyond
point D, APL keeps on decreasing.
So, when we plot APL in Panel II,
it turns out to be inverted ‘U’ shaped. The rising portion corresponds to the OD segment of TP L
curve where APL is increasing. The maximum point is reached at OL3 units of labour, which
corresponds to point D on TPL curve.

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The falling portion of APL curve corresponds to DF segment of TP L curve where APL is falling.
Since APL is derived from TPL curve and TPL follows from the law of variable proportion.
Therefore, law of variable proportion is the possible explanation for the inverted U shape of the
APL curve.
Now let us try to derive the MPL curve from TPL.
∆
MPL =
∆

So, if we take any point on the TPL curve and draw

a tangent at that point, then the slope of the tangent
∆
= = MPL. This is shown by the following
∆
diagram. We locate a point ‘A’ on the TPL curve
and a tangent is drawn at point ‘A’.
∆
Slope of tangent = = MPL
∆

In the following diagram, we take

two vertical panels i.e. Panel I
and Panel II. In Panel I we
consider the TPL curve plotted
against Labour Axis. In Panel II,
we try to derive MPL from that of
TPL curve in Panel I.

We consider points A, B, C, D, E
& F on the TPL. Corresponding to
each of these points, tangents are
drawn. The slope of these
tangents implies the MPL
corresponding to that level of
labour employment. Accordingly
we get points like A’’ in Panel II.
It is observed that if we keep on
considering points on TPL like A,
the slope of tangents on them will
gradually keep on increasing till
OL2 level of labour employment.
i.e. corresponding to point C on
TPL, slope becomes maximum
and hence in Panel II, the MPL
initially rises and reaches
maximum at point C’’. Note that,

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OABC portion of the TP L curve is convex towards labour axis or convex from below. Point C is
called the point of inflection at which curvature of the TP L changes. In other words till point C,
TPL keeps on increasing at an increasing rate and then from C to point D keeps on increasing at a
decreasing rate. Accordingly in Panel II, we observe that, MP L starts falling from C’’ and at D’’
it equates with APL. This is because of the fact that, at point D, the tangent on D is also the ray
through origin. Hence corresponding to OL3 level of labour employment, APL and MPL are equal
to each other. Note that, CDE portion of the TPL curve is concave towards labour axis or
concave from below. After D the tangents will keep on becoming flatter and flatter. As a result in
Panel II, the MPL will keep on falling keeps on falling till it reaches the horizontal axis at E’’.
This is corresponding to point E on TP L curve indicating the maximum point of TP L. Now after
E, the TPL gradually diminishes indicating negative value of MP L. Hence corresponding to all
point to the right of E, in panel II we get negative value of MP L. Thus we get inverted ‘U’ shaped
MPL curve. Since MPL is derive from TPL and TPL is derived on the basis of law of variable
proportions, this law actually explain this inverted ‘U’ shape of MP L.

Relationship between APL and MPL:

𝑀𝑃 = and 𝐴𝑃 =

When APL is rising

 >0
When APL is Maximum
 =0
When APL is falling

 <0

This is illustrated using the above

diagram.

= =

= = − = × − × = − = (𝑀𝑃 − 𝐴𝑃 )

Note: =
When APL is rising  >0  (𝑀𝑃 − 𝐴𝑃 ) > 0  𝑀𝑃 > 𝐴𝑃
When APL is Maximum  =0  (𝑀𝑃 − 𝐴𝑃 ) = 0  𝑀𝑃 = 𝐴𝑃
When APL is falling  <0  (𝑀𝑃 − 𝐴𝑃 ) < 0  𝑀𝑃 < 𝐴𝑃

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Geometric Derivation of the relation between APL and MPL:

In the following diagram, we take two

vertical panels i.e. Panel I and Panel II.
In Panel I we consider the TPL curve
plotted against Labour Axis. In Panel II,
we try to derive MPL from that of TPL
curve in Panel I.

We consider points A, B, C, D, E & F

on the TPL. Corresponding to each of
these points, tangents are drawn. The
slope of these tangents implies the MPL
corresponding to that level of labour
employment. Accordingly we get points
like A’’, B’’, C’’, D’’& E’’ points in
Panel II. The locus of all such points
represent MPL curve.

Similarly if we draw rays through

origin connecting points A, B, C, D, E
& F, the slope of those rays represents
the APL corresponding to that level of
labour employment. Accordingly we
get points like A’, B’, C’, D’, E’ and F’
points in Panel II. The locus of all such points represent AP L curve.

Note that, OABC portion of the TPL curve is convex towards labour axis or convex from below.
Point B is called the point of inflection at which curvature of the TP L changes. Note that, OABC
portion of the TPL curve is convex towards labour axis or convex from below. Point C is called
the point of inflection at which curvature of the TP L changes. Till OL3, MPL > APL. At D, APL is
maximum. i.e. if we join D with origin, we get the tangent corresponding to point D. Here, MP L
= APL when APL is maximum. After this level, APL starts falling and we have MPL < APL. At E,
MPL is zero. Here TPL reaches maximum. After this level of labour employment, MP L becomes
negative.

So, we find,

When APL is rising MPL > APL

When APL is Maximum MPL = APL
When APL is falling MPL < APL

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Three Zones of Production:

From the nature of TPL, APL and MPL curve we can divide the production into three different zones. Let us explain using the
following diagram and the table. Note, A’ and A’’ are vertically below A. So is true for other points.
STAGES TPL MPL APL EXPLANATION
Increases
Increasing at
sharply to
(a) an Gradually
reach
O to L2 increasing increases
maximum at Fixed factor
rate till D’’ to
I C’’ Capital (K) is
reach
(Stage of Point of abundant factor as
maximum.
Increasing Inflection compared to
C Maximum
Returns) (slope variable factor
Throughout
maximum) Labour (L)
the stage
Increasing at Starts
(b) L2to MPL>APL
a decreasing falling from
L3
rate C’’
Average and APL OD is both Ray
D Marginal MPL= APL reaches through origin &
same Maximum tangent on TPL
L employment has
II Continues to Continues to
Starts increased. So, both
(Stage of increase at a fall but
falling after the factors are
Diminishing Returns) decreasing remains
D’ judiciously
L3to L4 rate positive
utilized
Positive Tangent on TPL is
E Maximum zero
APL > MPL horizontal
Continues to Continues It is a mirror
III Starts falling
fall and to fall even image of Stage I.
(Stage of Negative after E, but
after E’’ after E’ but Here L is
(-ve) returns remains
become remains abundant factor
L4 onwards positive
negative positive and K is scarce

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Which is considered to be the Economic Zone of Production?

The objective of the Producer is to maximize profit. In zone III, MP L is negative. So, no rational
producer will operate in Zone III. In zone I, both MP L and APL are positive and high. So, a
rational producer will always produce beyond this zone to maximize profit. In Zone II, MP L and
APL are both positive though they are diminishing. So, producer will continue production.
However, producer will never operate beyond this zone as Marginal product of Labour will
become negative. Hence producer operates in Zone II in order to maximize profit.

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PRODUCTION IN THE LONG RUN:

We know that long run is characterised by the substitutability of factors of production where
factors are technical substitutes to one another. In other words, in the long run all factors are
variable. Hence labour can be substituted by capital and vice versa.

Hence the long run production function can be defined as:

Q = f (L,K) [where K and L are both variable factors of production]

It is assumed that, K and L are technical substitutes. i.e. same level of output can be produced
even if some units of capital have been substituted by some units of labour and vice versa. For
example: a washer man may wash 100 kg of clothes, some of them manually and the rest using
washing machine. Now washing manually and washing using machine can be substituted one for
the other maintaining the same level of output of service i.e. washing 100 kg clothes.

Now let us assume that, Q = 10 units are produced using these different technical combinations
of K and L. This is shown using the following table:

A B C
Capital (K) 10 6 4
Labour (L) 1 2 3
Here, we find 10 units of Capital & 1 unit of labour,
6 units of capital and 2 units of labour,
4 units of capital and 3 units of labour
produce the same level of output [Q=10 units].

Let us plot these graphically.

Plotting the above combinations we get three points in K-L
plane. A(1,10); B(2,6); C(3,4);

When we connect point A, B and C with origin, we get three rays through origin OA, OB & OC
which are also called Activity Rays. A, B & C represent points which show different
combinations of K and L which are capable of producing the same level of output. If capital and
labour are infinitely divisible, then we gte many more points like A, B and C in K-L plane which
show different technical combination of K and L that are capable of producing 10 units of
output. Joining these points with origin, we get innumerable Activity Rays.

Taking the locus of all points like A, B and C which show different technical combinations of
capital and labour which is capable of producing identical level of output, we get a smooth
downward sloping curve which is convex to the origin. This curve is known as Isoquant [Iso:
Same & Quant: quantity of output]. At all points on the isoquant, the level of output remains
same. Isoquant is defined as the locus of all different technical combinations of capital and
labour which are capable of producing identical level of output.

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Properties of Isoquant:
(1) Isoquants are downward sloping
(2) Isoquants are convex to the origin
(3) Two isoquants never intersect one another
(4) Further the isoquant from origin, higher is the level of output [A set of parallel isoquants
known as isoquant Map]

Slope of the Isoquant:

The slope of Isoquant at any point is the slope of the tangent

drawn at any point on the Isoquant.
Let, Q0 represents an Isoquant. Let us take any point A on the
∆
IQ. The slope of the tangent at point A is given by . Hence
∆
∆
slope of isoquant at that point is also .
∆

∆
As L rises, K falls and vice versa. Hence is negative. In
∆
other words, Isoquants are negatively sloped.
∆𝑲
What does represent?
∆𝑳

When L rises by ∆𝐿 units, K falls by ∆𝐾 units to maintain same level of output.

∆
When L rises by 1 unit, K falls by units to maintain same level of output.
∆

∆
So, in order to raise L by 1 unit, units of K needs to be sacrificed.
∆
∆
So, is the opportunity cost of using more labour.
∆

∆
Now, also represents the rate at which capital is substituted for Labour to maintain same level
∆
∆
of output. So, is also known as the Marginal rate of technical substitution of Labour for
∆
Capital [MRTSL,K].

MRTSL,K is therefore defined as the sacrifice of capital when labour by 1 unit, to maintain the
same level of output. In other words, it is rate at which capital is substituted by labour in order to
maintain the same level of output.
∆
Slope of the Isoquant = =MRTSL,K
∆
Now, when K is falling by ∆𝐾, the amount of output that is sacrificed is ∆𝐾 × 𝑀𝑃 .
Now, when L is rising by ∆𝐿, the amount of output that is raised is ∆𝐿 × 𝑀𝑃 .

Since, output remains same along an Isoquant, therefore,

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Fall in output due to fall in K = rise in output due to rise in L

 −∆𝐾 × 𝑀𝑃 = ∆𝐿 × 𝑀𝑃
∆
 = −
∆
∆
 Slope of Isoquant = = 𝑀𝑅𝑇𝑆 , = −
∆

Convexity of Isoquant:

Convexity of the isoquant can be explained by the law of diminishing MRTS L,K. As we move
along the isoquant, i.e. as L is increased by equal amounts, the sacrifice of K diminishes while
maintaining the same level of output.

Here in the diagram, we find,

when L is increased from L0 to L1 i.e. ∆LA
amount,
 K falls by ∆KA amount i.e. |K0 – K1|.

Again when L is increased from L1 to L2 i.e.

∆LB amount,
 K falls by ∆KB amount i.e. |K1– K2|.

It is obvious from the diagram that,

|K0 – K1| > |K1 – K2| i.e. ∆KA > ∆KB

while, |L0 – L1| = |L1 – L2| i.e. ∆LA = ∆LB

| | | | ∆ ∆
Hence, >  > |𝑀𝑅𝑇𝑆 , | > |𝑀𝑅𝑇𝑆 , |
| | | | ∆ ∆

As labour employment keeps on increasing, MRTS L,K keeps on falling in order to maintain the
same level of output. This is known as Law of Diminishing MRTSL,K.

Where, |𝑀𝑅𝑇𝑆 , |=

As L increases, 𝑀𝑃 ↓ (Law of diminishing𝑀𝑃 )

As K decreases, 𝑀𝑃 ↑ (Law of diminishing𝑀𝑃 )

↓
Hence, as L rises, |𝑀𝑅𝑇𝑆 , |↓= ↓ falls.
↑

So, we find that, as L rises, MPL falls, which means successive equal increase in labour (L)
produces less and less amount of output. So, producer’s willingness to sacrifice capital decreases.
Hence MRTSL,K falls as L goes up.

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Two unusual Isoquants:

a) The case of perfect substitutes in production:

If one input can be substitutes by K L Total

another at a fixed ratio, then inputs Number
are called ‘perfect substitutes’ to of
each other. For example:- Suppose Inputs
a consumer need 5 units of inputs, 0 5 5
but is indifferent to type of input. 1 4 5
As long as the number of inputs are
five, the producer is not bothered 2 3 5
about the type of input. So, the 3 2 5
producer can substitute labour and
capital at a fixed ratio 1:1. 4 1 5
5 0 5

b) The case of perfect complements in production:

Two inputs are perfect complements if they are used together in production in a fixed ratio. Now
suppose one unit of labour and one unit of capital give a specific level of output to the producer.
If the number of units of labour only increases but the unit of capital remains one, then the output
will be same as that of one labour and one capital (a pair of inputs). Again if the number of right
capital units increase but the number of labour units remain one, then the total output will be
same as the production from one pair of inputs. However two labour and two capital units will
give a higher level of production or output to the producer. So, the isoquant curves will be ‘L’
shaped. Further the IQs from origin, higher will be the level of output.

(1,1), (1,2), (1,3) have same output.

(1,1), (2,1), (3,1) have same output.
 we get indifference curve Q0

But (2,2) has higher output.

(2,2), (2,3), (3,2) have same output.
 we get Isoquant Q1

But (3,3) can give higher output. There exist

similar input bundles like (3,4) and (4,3).
We get Isoquant Q2

Cost Budget:

A firm which plans to use the services of labour and capital for production must have some
budget to meet the cost of these inputs. The term ‘Cost Budget’ refers to amount that the firm has
to pay for it’s inputs.

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Let, C0 be the cost budget which is actually the total cost of the firm. [Here C 0 represents
economic cost of production]

Let ‘r’ be the price of per unit of services of capital In case, the capital is owned by self, then, ‘r’
is called the rental of capital which can be interpreted as opportunity cost of capital, i.e. the
amount that the owner of the capital can earn by shifting the capital to it’s next best alternative
use.

Let, ‘w’ be the wage or per unit service of the labour. If the services of the labour are provided
by the owner himself or herself, then ‘w’ will stand for ‘implicit cost of labour’.

Then, C0 = Cost of Labour + Cost of Capital [where C0 is the total economic cost of production]

If ‘L’ represents the number of units of labour and ‘K’ represents the number of units of Capital
used up in production then, 𝐶 = 𝑤𝐿 + 𝑟𝐾  This is known as Cost Budget Equation of the
firm.

The Cost Budget Equation of the firm shows all possible combinations of Labour and Capital
that a firm can purchase with a given cost budget C 0. Since cost remains unchanged at C0, for all
possible combinations of K and L, this cost budget equation is also called Iso-cost Equation.

Representing the iso-cost equation in the form of a

standard equation of a straight line [y=mx+c] we
get, 𝐾 = − 𝐿 +
[y = mx + c]

The graphical counterpart of the Iso-cost equation

is known as Iso-cost line. Since the slope is
negative, isocost curve is downward sloping.

Vertical intercept:

Horizontal intercept:

Slope = −
This is represented by this diagram.

Economic interpretation of the intercept and slope of the Iso-cost:

Vertical Intercept (VI) = measures the Maximum amount of capital that can be used given C0
if no labour services are used.

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Horizontal Intercept (HI) = measures the Maximum amount of labour that can be used given
C0 if no capital services are used.
Slope = − (-ve sign) imply that, if capital use rises, labour use falls and vice versa. Here is
∆
the wage rental ratio. Here represents the slope which is the sacrifice of capital when labour
∆
rises by 1 unit, keeping total cost same, so it represents the opportunity cost of using labour.

Shift and Rotation of the Iso-cost line:

If C0 rises keeping w/r (wage rental ratio) unchanged then Iso-cost line will shift parallelly
rightward, If C0 falls keeping w/r unchanged then Iso-cost line will shift parallelly leftward.

Case 1: C0 changes, w, r unchanged:

a) C0 rises, w, r unchanged

↑
Vertical intercept ↑ rises;
↑
Horizontal intercept ↑ rises;
𝑤
Slope −𝑟 ↔ unchanged as w, r unchanged.

So, Iso-cost line shifts parallelly rightward.

b) C0 falls, w, r unchanged

↓
Vertical intercept ↓ falls;
↓
Horizontal intercept ↓ falls;
𝑤
Slope − ↔ unchanged as w, r unchanged.
𝑟

So, Iso-cost line shifts parallelly leftward.

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Case 2: w changes, C0 & r unchanged:

a) w rises, C0 & r unchanged

Horizontal intercept ↓ rises;
↑
Vertical intercept ↔ unchanged;
𝑤↑
Slope
𝑟
↑ rises as w rises.
So, Iso-cost line becomes steeper and rotates
inward centering around the point of
intersection on vertical axis.

b) w falls, C0 & r unchanged

Horizontal intercept ↑ rises;

↓
Vertical intercept ↔ unchanged;
𝑤↓
Slope
𝑟
↓ falls as w falls.
So, Iso-cost line becomes flatter and rotates
outward centering around the point of
intersection on vertical axis.

Case 3: r changes, C0 & w unchanged:

a) r rises, C0 & w unchanged

Horizontal intercept ↔ unchanged;
Vertical intercept ↓ falls
↑
𝑤
Slope
𝑟↑
↓ falls as r rises.
So, Iso-cost line becomes flatter and rotates
inward centering around the point of
intersection on horizontal axis.

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b) r falls, C0 & w unchanged

Horizontal intercept ↔ unchanged;

Vertical intercept ↑ rises;
↓
𝑤
Slope
𝑟↓
↑ rises as r falls.
So, Iso-cost line becomes steeper and rotates
outward centering around the point of
intersection on horizontal axis.

Case 4: r, w changes, C0 unchanged:

If r and w changes both changes simultaneously, then, a number of possible changes may occur
𝑤
and the nature of change depends on how is altered.
𝑟

a) Changes in Intercept:
The vertical intercept depends on 𝑟 and the horizontal intercept depends on 𝑤 .
 If 𝑟 rises, the vertical intercept ↓ will fall and if 𝑟 falls, vertical intercept ↑
will rise.
 Similarly, if 𝑤 rises, the horizontal intercept ↓ will fall and If 𝑤 falls, horizontal
intercept ↑ will rise.
Now, which combination of the above possibility will actually take place depends on the
numerical value of r and w.

b) Changes in Slope:
𝑤
The slope of the Iso-cost line depends on wage rental ratio . Hence there are three
𝑟
possibilities:
𝑤
 The slope of the Iso-cost line or wage rental ratio may rise. i.e. ↑. In this case the
𝑟
Iso-cost line will become stepper.
𝑤
 The slope of the Iso-cost line or wage rental ratio may fall. i.e. 𝑟 ↓. In this case, Iso-
cost line will become flatter.
𝑤
 The slope of the Iso-cost line or wage rental ratio may remain unchanged. i.e. ↔. In
𝑟
this case the slope of the Iso-cost line will remain unchanged.

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PRODUCER EQUILIBRIUM

The producer is said to be at equilibrium if her objective is fulfilled, given the constraints. The
rational producer always wishes to maximize the level of output. But his/her decision is
constrained by her cost budget. So, if the producer’s output is maximized given her cost budget,
then the producer will be at equilibrium.

Alternatively, the producer can also try to achieve a given level of output at minimum cost. This
is flip side of the same optimization problem the producer is facing. In this case, producer tries to
minimize the cost subject to a level of output.

In either case, when the objective of the producer is fulfilled he/she will be at equilibrium. We
are going to consider each of these cases separately and try to derive the producer’s equilibrium.

a) Maximizing Output subject to Cost constraint:

Let Q0, Q1 and Q2 be the set of Isoquant

lines in a input space showing different
levels of output. Let C0 represents the
Iso-cost line of the producer. All input
sets on Iso-cost line C0 are purchasable
with the given cost of the producer and
the prices of the inputs. Given the
preference pattern of the producer, as
reflected by the Isoquant lines, input
combinations a, b and c are the three
input combinations from which the
producer has to make her optimum
choice.

[Clearly, Q2 lies above Iso-cost line C0 indicating that it is impossible to reach Q2 with the given
cost budget of the producer. Some points i.e. input combinations lying on the Isoquant line Q 0
inside the Iso-cost line C0 (except points like a & b) are affordable to the producer but they do
not exhaust the entire cost budget of the producer.]

It is obvious that out of the input combinations a, b and c, the producer will always choose input
combination c because, a and b lies on lower Isoquant line whereas c lies on the higher Isoquant
line Q1.

So, given the production technologies of the producer and the limited cost budget, the producer
will maximize his/her output subject to the cost constraint at point c. So, c represents producer
equilibrium because the producer has no other incentive to choose any other input combination.

Equilibrium quantity of 𝐿 = 𝐿 and

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Equilibrium quantity of 𝐾 = 𝐾 .

At c, the Iso-cost line is tangent to the Isoquant line Q1.

i.e. slope of Iso-cost line

= slope of the Isoquant line Q1 at point c.

So, we have, − = 𝑀𝑅𝑇𝑆𝐿,𝐾

∆
Or, = 𝑀𝑅𝑇𝑆 , = −
∆
𝑀𝑃𝐿
Or, = is the necessary condition for attaining equilibrium.
𝑀𝑃𝐾
The convexity of the Isoquant line is the sufficient condition for attaining producer’s
equilibrium.

b) Minimizing Cost subject to a given level of output

Let us consider three parallel Iso-cost lines C0, C1

and C2 showing different levels of cost budget of
the producer. Let Q0 is the Isoquant line in the
input space, representing a given level of output
which producer wish to attain. Note that the output
level at Q0 and the price of inputs (w and r) are
given to the producer. The producer minimizes the
cost subject to the constraint of level of output.
Given the levels of cost budget the producer, as
reflected by the Iso-cost lines, input combinations
a, b and c are the three input combinations lying on
the same Isoquant line from which the producer
has to make his/her optimum choice such that cost
is minimized.

Clearly a, b and c and lie on the Isoquant line Q0, hence giving the producer same level of
satisfaction. Iso-cost line C0 indicates that it is not possible to reach the output level given by Q0.
Points like a & b are also indicating the same level of output as point c, but a & b will require
relatively higher level of cost as compared to c. Hence c is the level of minimum cost at which
producer can attain the given level of output.

It is obvious that out of the input combinations a, b and c, the producer will always choose input
combination c because, a and b lies on higher Iso-cost line whereas c lies on the lower Iso-cost
line C1. So, given the prices and output level of the producer, the producer will minimize her cost

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 Theory of Production

subject to the output constraint at point c. So, c represents producer equilibrium because the
producer has no other incentive to choose any other input combination.

Equilibrium quantity of 𝐿 = 𝐿 and Equilibrium quantity of 𝐾 = 𝐾 .

At c, the Isoquant line Q0 is tangent to the Iso-cost line C1.

i.e. slope of Iso-cost line C1 = slope of the Isoquant line I0 at point c.
So, we have, − = 𝑀𝑅𝑇𝑆𝐿,𝐾
∆ 𝑤
Or, = 𝑀𝑅𝑇𝑆 , = − =−
∆ 𝑟
𝑀𝑃𝐿
Or, = is the necessary condition for attaining equilibrium.
𝑀𝑃𝐾

The convexity of the Isoquant line is the sufficient condition for attaining producer’s
equilibrium.

EXPANSION PATH

Expansion path shows the path of expansion of output, when factor price ratio or wage rental
ratio remains unchanged. Note that, when factor price ratio (w/r) remains unchanged the slope of
isocost line remains unchanged as well.

Suppose Total Cost increases, with factor price remaining unchanged. This implies that, the
isocost line will shift parallelly rightward. For every Isocost line we would have an equilibrium
capital labour combination where the isocost line would be tangent with the Isoquant. Taking the
locus of all such optimal/equilibrium labour
capital combinations associated with different
levels of output at same factor price ratio, we get
the expansion path of a firm. This is illustrated
using the following diagram.

Let Q0, Q1 and Q2 be the set of Isoquant lines in a

input space showing different levels of output and
three parallel Iso-cost lines C0, C1 and C2 showing
different levels of cost budget of the
producer.Here a, b & c represent the producer
equilibrium points, given input price ratios. Note
that, at all these points the equilibrium condition of the firm is satisfied. In other words, on all
such points, the slope of the Isoquant equates with slope of the isocost line.

i.e. = is always satisfied.

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Or, 𝑟. 𝑀𝑃 − 𝑤. 𝑀𝑃 = 0  this is the equation of Expansion Path. Expansion path can be

linear or non-linear depending on the nature of production technology described by the
production function.

Now if (K/L) remains constant throughout the Expansion Path, then it will be linear/straight line.
Now if (K/L) varies along the Expansion Path, then it will be non-linear.

Q. If the production function is given by𝑸 = 𝑳𝜶 𝑲𝜷 ,

What is the equation of expansion path? What is the shape of Expansion path in this case?
Ans. a) The production function is given by 𝑄 = 𝐿 𝐾
Hence, 𝑀𝑃 = 𝛼𝐿 𝐾 & 𝑀𝑃 = 𝛽𝐿 𝐾
At equilibrium, =  = =  =  =

Hence = is the equation of the expansion path.

Here α, β, w & r all are constant. Hence, (K/L) is fixed.
Hence expansion path will be linear or straight line.

Returns to Scale:

In the long run, all inputs are variable. So, in order to change output, the firm can vary all the
inputs. Changing the scale of production means change in the employment of all inputs by same
proportion. Now when all inputs change by same proportion, there is also a corresponding
change in the level of output. The effect on output, when all the inputs are changed by the same
proportion is called returns to scale.

If the proportionate change in output is more than the proportionate change in inputs, then it is
called increasing returns to scale (IRS).
If the proportionate change in output is equal to the proportionate change in inputs, then it is
called constant returns to scale (CRS).
If the proportionate change in output is less than the proportionate change in inputs, then it is
called decreasing returns to scale (DRS).

Suppose, both capital (K) and Labour (L) are increased by ‘λ’ times where s is a positive
number.
If output also increases by ‘λ’ times, then it is called constant returns to scale (CRS).
If output increases by more than ‘λ’ times, then it is called increasing returns to scale (IRS).
If output increases by less than ‘λ’ times, then it is called decreasing returns to scale (DRS).

The effect on output due to change in scale of production can be expressed very easily with the
help of homogenous production function. A production function is called homogenous of degree
‘n’, if output is increased by ‘λn’ times when all inputs are increased by ‘λ’ times. [λ, n both are
positive numbers]

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For example let us consider a neoclassical production function: Q = f (L. K);

where L & K are inputs of production.
Let us consider an increase in both L & K by ‘λ’ times. [λ >0]

Hence the new level of capital is λK and new level of labour is λL. Now if output increases by
λn times, then output becomes λnQ.

Then we have: λnQ = f (λL, λK)

 this is known as a production function which is homogenous of degree n.

Now suppose, n = 1. Then, λQ = f (λL, λK). This implies that, if K and L are increased
simultaneously by same proportion λ, output also increases by the same proportion λ. This
represents the case of Constant returns to scale.
Now suppose, n > 1. Then, λnQ = f (λL, λK). This implies that, there will be more than
proportionate change in the output for a rise in capital and labour employment by λ times. This
represents the case of increasing returns to scale.
Now suppose, n < 1. Then, λnQ = f (λL, λK). This implies that, there will be less than
proportionate change in the output for a rise in capital and labour employment by λ times. This
represents the case of decreasing returns to scale.

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