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Unit-6 Production Theo
Unit-6 Production Theo
Structure
Objectives
Introduction
6.1.1 What is an Input
Production Function: The Concept
6.2.1 Product Cilrves
6.2.2 Law of Diminishing Marginal Product
6.2.3 Fixed and Variable Proportion in Production
6.2.4 Three Stages of Production
6.2.5 Why Law of Diminishing Retur~isOperates?
6.2.6 Iso-Product Curve
6.2.7 Econornic Region of Production
6.2.8 Specific Forms of Productio~iFu~ictions
Input Prices and Iso-Cost Line
6.3.1 Iso-Cost Line
6.3.2 Returns to Scale: A Diagralnrnatic Presentatiocl
Let Us Sum Up
Key Words
Some Usefill Book
Answers or 1-lintsto Check Your Progress Exercises
6.0 OBJECTIVES
1 After going through 111isunit you should be able to:
!
understand the concept of production function as the relation between output
t and inputs;
1 deduce the Scale Line when production is subject to different returns to scale;
I
identify the basis of the choice oftechnique; and
1 analyse the operation of the law of variable proportion under variable rehums to
scale.
6.1 INTRODUCTION
Traditionally production is defined as "the creation ofutility." llzis means we produce
goods and services collsuming which our wants are satisfied. Seen in such a context,
therefore,production includes a wide variety of activities such as making of fabricated
material goods, writing of a book for B.A. (Economics) students,inaking of amovie,
or providing services as a beautician.
I While "production" is referred to creation of any good or service, its concept is
understood better when we speak only of goods. For example, you can say that
Theory of P r ~ d l l c t i o nand Costs you have produced 100 bicycles in the month of January 1997. To produce this
number of bicycles, you have spent some money to buy machinery, steel and labour.
All these activities can now be grouped in two categories to define clearly what is
involved in production. One category is put under output (bicycle in the above
example). Production of output requires putting together the necessary materials.
These constitute the other category and are called 'inputs'. Thus, you put together
the inputs in a certain way to produce a specified quantity of output. A theory of
production analyses how aproducer combines various inputs to produce a specified
quantity of output when the technology of producing the commodity is given. The
relationship between quantitiesof inputs and output produced is termed production
function.
The data in Table 6.1 can be represented in the form of a graph. This is done in
Figure 6.1. In order to draw the graph, it may be useful to remember that output
produced depends on inputs used. It is customary to the independent variable
(labour in our example) on x-axis. The dependent variable (production of paddy) is
r h e o r y of Producti0n cOsis plotted on y-axis. Joining successivepoints of labour-output combinations from
Table 6.1, total product curve is obtained. It is necessary to take note of an important
feature of this curve. It first rises slowly. Then it increases dn increasing rate and
slows down again reaching a maximum. After wards there appears a decreasing
phase.
Fig. 6.1
Fig.6.1: Depicts the relation between variable input, labour, and output. Output tends to
rise as the use of labour increases. After a while, however, it starts declining.
Average and marginal products of labour can be defined on the basis of above
formulation. The average product (AP) of labour is the total product divided by the
number of workers employed (X). That is,
Similarly,the marginal product (MP),of X is the rate of change of the total goduct
with respect to variations in quantity of X. To see the calculation of AP and MP
from total output see Table 6.2 in the following. Features of AP and MP can be
seen from their curves. These are presented in Figure 6.2. See that AP for apoint
on a total product curve equals the slope of a line segment connectingthat point with
the origin. It increases for movements along the total product curve from the origin
upto a point and decreases thereafter. Similarly, MP increases initially and declines
after a point. MP and AP are equal at the maximum AP.
Fig. 6.2
Y
AP
0 X
Fig. 6.2 shows the shapes of AP and d c u r v e s . Notes that MP rises faster than A P ~
-A9
-AX + x Aq = - A9
7I
- . 9 MP
--
€0, q
x, clh, Ax, XI AP
where , Output elasticity with respect to input x,
E ~=
Stage 2
I
,
I
'
I
'
: Units of variable input
I
I ' >
I ' I
I ' I
1 ' 1
I 1 I
I I I
I S I
I ' I
I ' I
AP& MP I # I
I * 1
I ( I
I t I
I ' I
I ' I
I 1 I
I '
l 8 I
I t I
AP
Uuib of variable input
MP
Fig. 6.3 shows the shapes of total, average and marginal product curves. To appreciate
the underlying relation between these, thinkof the figure as consisting of two
parts. I n theupper part see the total product curve (TP). Its relation with average
and marginal product curves (AP and MP) can be seen by coming down to lower
part. The three stages of production are evaluated with the help of TP, AP and
MP
Stage 2
The secorld stage corresponds to use of the variable input between points 5 and 6.
In this part, TP continues to rise at a diminishiilg rate. -The gecond stage ends at
point 3 when TP reaches the maximum. In this stage both AP and MP are diminishing
but are positive. Point 6 givesthe condition where MP is equal to zero and indicates
the end of stage 2. This is known as the stage of diminishing returns as both AP
and MP are diminishing.
Stage 3
Stage 3 is indicated by the use of variable input to the right of point 6. TP declines
and MP becomes negative at this stage. See that MP curve goes down the X - axis.
This stage is called the stage of negative returns. An evaluation of three stages of
prod~ictiondiscussed above will indicate that a rational producer will never produce
at the last sitage. S i n e MP is negative there, the producer will increase the output
by reducing the quantity of variable input.
Theory of Production
6.2.5 Why Law of Diminishing Returns Operates?
The preceding discussion on stages of production indicated a phase when average
and marginal product curves start declining. To understand such a feature see the
following discussion on the law of diminishing returns. This principle statesthat as
one variable input is increased, with all others remaining fixed, a point will be reached
beyond which the marginal physical product of the variable factor will begin to
decrease. To be more specific, take the help of an example. Suppose that paddy is
produced by making use of land, labour and a tractor. The law of diminishingreturns
tells that when the amount of labour is increased holding the use of land and tractor
constant, there will eventually be a stage when rate of increase in production of
paddy will decrease.
Initially, one worker is employed on the farm of the size 10 acres and is given one
tractor to work with. Suppose one more worker is engaged. What type of change
has taken place in the relationship between factors of production? Now each
worker is getting 5 acres of land and '/z of the tractor to work with. Labour's, output
is bound to change. This phenomenon is depicted in the table. When land and capital
are kept fixed and labour input is increased and total, average and marginal products
can be recorded. With one worker 10 units of output are obtained. When the
employment of labour is increased to 8,64 units of output are produced.
Look at the average product and record the changes taking place. With one worker
the average product was 10. When labour was increased to 4, average production
went upto 13. This implied an increase in labour employment resulted in higher
productivity. But when the number of labourers was increased to 5, the average
production came down to 12.2.Further increase in labour inputs pushed down the
average production. A similar picture of increasing at the beginning and decreasing
afterwards was evident from the column giving marginal product. When 3 units of
labour were in employment,the marginal product was the maximum at 15. However,
a decline set in after that. When number of workers employed reached 8, the
marginal product became negative (-2).
'
Table 6.2: Diminishing Average and Marginal Products
Here it is shown that the replacement of capital with labour can keep the level of
output constant only if each additionalunit of labour replaces lesser and lesser amount
of capital. This is due to the operation of the law of diminishing retums in both the
inputs. As capital is reduced and labour is increased two forces operate. First, a
reduction of capital increases its returns. Second, since capital is replaced by labour,
the increased amount of labour has to work with less capital. Hence, labour'smarginal
productivity decreases. This is because no two inputs would be perfect substitutes
of each other, unless they were absolutely identical. In that case, by definition, they
would be the same inputs. Since the marginal productivity of labour decreases and
that of capital increases, with the decrease in capital and correspoildingincrease in '
labour, the substitution of labour for capital to produce a constant level of mtput is
possible only if every extra unit of labour displaces less and less of capital per unit.
The rate, at which labour cah replace capital keeping the level of output constant, is
the marginal rate of technical substitution (MRTS) of labour for capital. MRTS
declines as capital decreases and labour increases or labour-capital ratio increases.
The diagrammatic presentation of the iso-product line takes the shape oka falling
curve, convex to the origin as shown in Figure 6.4. Its properties are the same as
that ofthe usual Indifference curves. This is also called Iso-quant. It is a continuous
curve, which assumes that two inputs are continuously divisible and substitutable.
The slope of the curve
= g ,which is negative.
Since output is constant throughout the curve, the marginal reduction in output with
respect to decrease in capital is just equal to the marginal increase in output as a
result of increase in labour. The marginal reduction in output due to decrease in
capital is MP, x AK where MP, islhe marginal productivity of capital.
The marginal increase in output due to increase in labour = MP, x AL Theory of Production
where MP, is the marginal productivity of labour. Hence, the change in total output
due to substitutionof labour for capital is zero. That is,
This means the marginal rate oftechnical substitution of labour for capital
Fig. 6.4
YI
40
30
Capital
Labour
-
Fig. 6.4 shows that at points A, B, C and Dsame levels of output are being produced.
However, to such a level ofoutput, defferent combinationsofcapital and labour
as given in Table 6.3 are employed
AK
MRTS LK = (-) -
AL
equals the inverse of the ratio oftheir marginal productivities.
The relation between MRTS and the ratio of labour to capital is also dzducible
LK
from Table 6.3. From this relatlon the elasticity of substitutioncan be defined as
Percentage change in MRTS
LK
ESLK= Percentage change in L/K
--A(L/K)
- AMRTS, L/K
MRTS
This elasticity is greater than, equal to, or less than one according as a givenpercent-
age change of L K ratio induces greater, equal, or less percentage change in MRTS
in the opposite direction.
and Costs
l'lieo~+yof P~.ocluctio~~ 6.2.7 Economic Region of Production
In production analysis, generally, isoquants are shown as convex to origin. Their
slopes are monotonically negative. This shape of isoquants gives them a special
feature: these curves represent the input combinations, which are economically
efficient. However, a production function need not give us this shape all the times. It
may have an upward slopingsegmentas well. But that segmentwill not be economically
efficient. We can draw t,wo curves, OC ahd OL, which separate efficient and
inefficient segments of the isoquants. These curves enclose what may be called
'economic production region'. Note that OC passes through all the points on the
isoquants are horizontal, or their slopes are equal to zero. (Fig. 6.5)
Fig. 6.5
I
Capital
',
Labour
Fig. 6.5 shows that the economic production region is enclosed by RidgeLines OC and
OL. The IineOC is the locus of points where Iso-quants arevertical. Similarly,
OL is the locus of points on which Iso-quants are horizontal.
Fig. 6.6 is drawn by assuming that capital and labour are not subititutableand have to
be used in fixed proportions. Thus, when the technique of production is fixed,
the shape of the Iso-product curvais like PQR.The Iso-product curve is flat
running parallel along the capital and labour.
When the technique of production is fixed, the shape of labour and capital axes Theory of Production
=hf (x, y) =h q
Therefore, the expansion of inputs by h has resulted in output expansion by h. This
is what is meant by a constant returns to scale. Such an idea is also presented with
the help of adiagramme in the following.
Fig. 6.7
I
Labour
Fig. 6.7: In figure 6.7, parallel Iso-product curves are drawn. A higher Iso-product
curve using more o f two inputs represents a higher level ofoutput (say, 200
units). A ray th ough theorigin (OA), crossing the Iso-product curves at B,B1
7
and B" is known as the scale line or expansion path of output.
Theory of Production and Costs The parallel Iso-product curves in the figure indicate that a higher level of output is
produced when greater amounts of the inputs. capital and labour are employed. It
also shows that a higher point on the scale line corresponds to a higher Iso-product
curve and indicates a hlgher level of output. If Iso-product curves are parallel, and
the same marginal rates of substitutionbetween inputs prevails on all the points of
intersection of the Iso-productcurves and the rays through the origin, the production
function related to these Iso-Product curves are homogenous. In the figure slopes at
B, B' and B", i.e., points of intersection between OA line and Iso-product curves,
are the same. These Iso-product curves are a set of parallel convex curves, like the
Indiffe~enceCurves. Then, production can be increased by increasingthe inputs by
the same proportion and the scale line is a straight line having a constant slope.
When the production function is linear and homogeneous, as in Figure 6.7,
proportionate increase in output isjust equal to the proportionate increase in inputs
i.e., OB = BB' = B'B". While the scale line is a straight line the proportional increase
in output can be higher than that in inputs and can also be less than that in the inputs.
I11that case, production h c t i o n is not linear, though homogeneous.
c) Non-Homogeneous Production Function and Scale Line
When production function is non-homogeneous,the increase in production is not
proportional to the increase in the inputs, at the given technique of production. In
Figure 6.8, OA is an upward sloping curve through the origin showing that its slope
increases as output increases. This implies that capital intensity of the technique of
production, i.e., the ratio of capital to labour rises as production increases. It is
possible to have a reverse situation where the slope of the expansion curve will
decrease and capital intensity will fall with increase in.output.
Fig. 6.8
Capital
N N'N"
Labour
Fig. 6.8 shows that the slopes of the Iso-product curves are the same on the expansion
curve OA. ,
,
ii) In production under variable proportions the ratio of all variable inputs
varies. ( 1
Capital
Labour
-
Fig. 6.9 shows that OW amount of capital is hired tospend the entire outlay. Similarly,
by spending that outlay, O T units of labour can be hired. The straight line WT
indicates various combinations of capital and labour, which a producer can
employ for the given outlay. It is the Iso-cost line. The Iso-quant (200 units of
output) is tangent to WT at R
Labour
Fig.6.10 shows that change in {nputs, capital and labour, does not lead to proportionate
change in output.
However, I, and I, have drifted farther and farther. That means, larger and larger
amounts ofboth &e factors h e being used but the rise in output remains 'fixed' at the
old level of 100 units. Here the returns to scale are diminishing - the output rises at
a rate, which is slower than the rate ofrise of the use of inputs. Finally, we find that
I, has come closer to I5yet increase in the output remains 100 units - in' other
words, smaller increase in the inputs is able to increasethe output by 100units now.
This is the case of increasing return to scale.
Check Your Progress 2
1) Define an Iso-product curve in one sentence. What are shown along the axes
of the figure to draw an Iso-product curve?
3) Let the price of capital be Rs. 60 and that of labour Rs.50. Write the Iso-cost
equation for the outlay of Rs.2000 and calculate the slope of the Iso-cost curve.
T h e o r y o f Prodaction and C'osts
6.4 LET US SUM UP
In this unit, the concept ofproduction h c t i o n has been explained. It tells that inputs
and outputs are related technically. The idea of Iso-product curve has been
introduced to explain how a constant levelof output can be produced by using two
vaiable inputs like capital and labour in different proportions. The Iso-product curve
is downward sloping. It is also convex to the origin just because the two inputs,
though substitutable, are not perfect substitutes of each other. This cwve is deduced
on the assumption that the marginal rate of technical substitution of labur for capital
declines with the increase in the proportion of labour to capital. This curve is used to
analyse homogeneous, linear homogeneous and non-homogeneous production
fimctions. An analysis of production function helps us to deduce the expansion path,
and to explain the scale line under various returns to scale. In the homogeneous
production hction, the technique of production remains the same with the expansion
ofthe scale of operation.
6.5 KEYWORDS
Constant Returns to Scale If all factorsof production are in-
creased in a given proportion,
the output increases in exactly the
same proportion under constant
returns to scale.
Homogeneous Production Function If a set of Iso-product curves
generated by aproduction h c -
tion has the same slope along a
ray through the origin, then the
production function is called ho-
mogeneous.
Decreasing Returns to Scale Under this law of production,
output increases proportionately
less than inputs.
Expansion Path This is a locus of cost minimising
proportions of two inputs to pro-
duce maximum output resulting
fiom changes in the scale of out-
lays, keeping the input prices
constant. .
Increasing Returns to Scale Under this law of return, output
increases proportionately more
than inputs.
Iso-Cost Line This shows all the different com-
binations oftwo inputs that a firm
can purchase or hire with given
input prices and outlay.
Theory of Production
Iso-Product Curve : This shows all the different com-
binationsoftwo inputs that a k n
can use to produce a specified
quantity of output. -
Non-Homogenesus Production Function : When a production functiongen-
erates a set of Iso-product
curves having different slopes
along a ray through the origin, it
is termed as non-homogeneous
production function.
ProductionFunction : This is a technical relation show-
ing the maximum quantityof out-
put that can be produced from a
set of input combinations on the
basis of existing technology.
Short Run : The time period when at least one
of the inputs (plant size or build-
ing) is fixed.
3) Iso-cost equations:
Total outlay = Price of capital x quantity capital +Price of labour x quantity of
labour
@, Rs.2000 = Rs. 120 x quantity of capital + Rs. 50 x quantity of labour