Unit- 3.

THEORY OF PRODUCTION

BBA semester program

 Concept of Production
• Production is the organized activity of
transforming resources into finished products in
the form of goods and services having the value
and human wants satisfying power
• So , production is the process of transforming
inputs in to output.
• It is a process of creation of utility in goods and
services.
 Production Function
• Production function shows the technological relationship
between production and factors of production such as land ,
labour, capital , entrepreneur , technology, energy, raw
materials etc.  It specifies the maximum quantity of a
commodity that can be produced per unit of time with given
quantities of inputs and technology.
• Algebraically a production function can be expressed as
Q = f ( L , K , La, E, T , R …) …..i
Where, Q: out put
L : labour
K : capital
La : land
E : entrepreneur
T : technology
R : Raw materials
• The above mentioned production function is a general
production. For the sake of simplicity in analysis of
input output relationship we express the production
function including only two major factors of production
labour and capital , which can be expressed as,
Q = f (L, K)…….ii
Q : production
f : function
L : labour
K : capital
 Types of Production Function
1. Short Run production Function : Q = f (K, L),
laws of returns to scale.
2. Long Run production Function : Q = f(K ,L ), law
of variable proportion.
Total Product , Average Product & Marginal Product

Total Product (TP):

Total product is the total amount of production of a
commodity produced by a given set of factors of production
within a certain time period.
In other words, TP is the sum of marginal products
TP = ΣMP
Average product (AP):
Average product is the per unit production of variable factor of
production.
AP is equal to the TP divided by the numbers of variable factor
of production. If labour is used as variable factor , then
average product of labour is,
APL = TP/L
Marginal Product (MP) :
Marginal product is the change in total product due the
change in an additional unit of variable factor. It is ratio
of change in TP to the change in units of variable factor.
Hence MP is the rate of change or slop of TP. If labour is
a variable factor then,
MPL = ΔTP/ ΔL
Or MP = TPn - TPn-1

• The nature and relationship between TP , AP & MP can

be explained with the following table and diagram.
 Unit of L TP AP MP
d, TP max.
0 0 .. .. 90
1 10 10 10 80 TP

TP, AP, MP
2 30 15 20 70
3 60 20 30 60
4 80 20 20 50

.
ax
m
5 90 18 10

is
40

P,
M

=M
a,
6 90 15 0 30

AP
b,
P
7 80 11.4 -10 20 MP>A

10 AP
c
0
1 2 3 4 5 6 7
-2 Units of Labour
MP
 In table & diagram ,as units of labour increase up to 3 unit AP & MP
rd

both are increasing but MP>AP & TP increasing at increasing rate.

 After that MP starts to fall & at 4th unit of L MP = AP where AP is max. and MP is falling
 Beyond that AP & MP both are falling but AP>MP as a result TR starts to increase
at only decreasing rate.
 At 7th unit of L, MP = 0 & TP is max. After that ,MP is negative , so , TP is falling.
 Law of variable Proportion
• Law of variable proportion is short run production
phenomenon. In short run only some factors of
production are used as variable factor remaining factors
are held constant. If only a factor (L) is used as variable
factor keeping other factors(K) constant , the ratio
between two factors goes on changing . So , it is called
variable proportion.
• According to this law, when the amount of only one
factor ,say labour is changed keeping other factors of
production unchanged to change the level of production,
initially total product (TP) increases at increasing rate up
to certain units of labour, beyond that TP starts to
increase at only decreasing rate and finally it reaches at
maximum and than after starts falling.
 Assumptions
• State of technology remains unchanged
• At least one factor of production should be
constant.
• All the units of variable factor should be
homogenous.
• There should be the possibility of varying
proportion of factors of production.
This law can be explained with the help of following table and diagram

K L TP AP MP stage d
90

TP , AP ,MP
80 TP
10 0 -- -- --
10 1 10 10 10 70
60 2nd stage 3rd stage
10 2 30 15 20 1st 1st stage
50 increasing decreasing negative
10 3 60 20 30 return return return
40
10 4 80 20 20
a
10 5 90 18 10 2 nd 30
b
20
10 6 90 15 0
10 AP
10 7 80 11.4 -10 3rd
c
0
1 2 3 4 5 6 7
-10
Unit of labour MP

Law of variable proportion can be explained sage wisely as following,

• Stage I, increasing return : in this stage total product
increases first at increasing rate and then starts to
increase at decreasing rate. Average product goes on
increasing at the end of this stage it is maximum.
Marginal product also increases up to its maximum point
and starts to decline. At the end of this stage AP = MP
,where AP is maximum and MP is falling.
Causes:
1. Increase in the efficiency of fixed factors
2. Increases in the efficiency of variable factor
• Stage ii, diminishing return: in this stage TP goes on
increasing at decreasing rate until its maximum point.
Both AP &MP are falling but AP > MP. At the end of this
stage MP=0 and TP is max.
Causes:
1. Scarcity of fixed factors
2. Individuality of fixed factor
3. Imperfect substitution of factor
• Stage iii, negative return: in this stage MP Is negative as
a result TP is falling.
Causes : same causes of stage ii
Stage of operation: a rational firm operates at the the end of
second stage where total product is maximum. At first stage TP
is increasing so, firm increases production and at third stage TP
is falling so , the firm does not operate in this stage.
 ISOQUANT CURVE
• The word “Isoquant” is the sum of Greek word “iso”
meaning equal and Latin word “quant” meaning
quantity.
• An Isoquant is a graphical representation of different
alternative combinations of two factors of production
which are equally efficient to produce a given level of
output.
• Hence, isoquant curve may be defined as a locus of
various combinations of two factors of productions say
labour and capital which yield the same level of output.
• The concept of isoquant can be explained with the help of following table and diagram.
• ΔL K
Unit of Unit of
Com. L k MRTSLK = ΔK 12 A
ΔL 11
10 ΔK
9
A 1 12 …. 8 B
7
ΔL
B 2 8 1:4 6
5 C
C 3 5 1:3 4
D
3 E
D 4 3 1:2 2 Iq=100
1
E 5 2 1:1 o
1 2 3 4 5 Unit of L

The table is an isoquant schedule which
shows all the combinations of K & L where
all the combinations are equally efficient
to Produce the same level of output.
 In order to maintain the same level of
output some units of K must decrease
to increase a unit of L
 In the diagram, the Iq is derived by joining
all the combinations (A,B,C,D,E) of K& L.
 All these combinations produce the same
level of output.
 Amount of a factor is decreased to increase
the amount of other factor so that out put
remains unchanged
 MRTSLK decrease as we move down along
 an Isoquant, so ,Isoquant is convex to origin
Isoquant Map
An isoquant map shows a bundle of different isoquant
curves where each upper isoquant represents the
higher level of output because as the producer moves
to upper isoquant from lower one, more quantity of
both the factors-labour & capital is employed . So upper
isoquant represents higher level of out put.
Unit of K

00
I Q3 = 3
k2 b
0
a IQ2=20
k1 0
IQ1 =10
O
L1 L2 Unit of L
 Properties of Isoquant Curve

1 . An isoquant curve is downward 2 . An isoquant is convex to origin:

sloping As the producer moves down
To maintain the same level of along an isoquant curve the
output two inputs-labour and MRTSLK declines , so, isoquant
capital are varied inversely curve convex to the origin.

K K MRTSLK = ΔK = ae > bm > cn >>

a ΔL eb mc nd

A
K1 b
e
m c
B d
K2 n
Iq = 100 Iq = Q

O
L1 L2 L O L
Con.
3. Isoquant curves never intersect 4. Upper isoquent represents
each other: Higher level of production:
upper isoquant gives higher level of As we move from lower Iq to
production but when two isoquants upper Iq the quantity of both
intersect at a point , the point of factors-L & K Increase, so,
intersection shows the equal level higher Iq represents higher
of out put which is against the level of production.
assumption of isoquant curve .
Hence, isoquants never intersect
each other.
By assumption IC2 > IC1 K
K
But at point a IC1 = 1C2
Which is not possible

a Iq=300
K1
IC1 = 100 Iq=200
IC2 = 200 Iq=100

O O
L1 L L
 Marginal Rate of Technical Substitution (MRTS)
• Marginal rate of technical substitution (MRTS) is a rate
at which two factors of production are exchanged or an
input is substituted for other without changing level of
output .
• Marginal Rate of Technical Substitution of labour for
capital (MRTSLK ) is a ratio of change in capital to the
change in labour keeping output unchanged.
• Hence, MRTSLK is the slop of Isoquant curve which is
negative because the amount of a factor must decrease
in order to increase the amount of other factor so that
the level of out put remains same.
 K

Com. L K MRTSLK ΔK A
12
= ΔL
ΔK
A 1 12 … 8 B
F ΔL
B 2 8 4 C
5 G
C 3 5 3 D
3 H E
D 4 3 2 2 J
Iq = 100

E 5 2 1 O 1 2 3 4 5 L

• In the table and diagram, Isoquant curve shows the different

combinations (A,B,C,D,E) of capital and labour.
• Moving down from a combination to other along an isoquant curve ,
some units of capital are replaced by one unit of labour so that the
level of output remains unchanged.
• In this way , MRT is the ratio of change in capital to the change
in labour ,i.e.(MRTSLk = - ΔK/ΔL) . Example from A to B (MRTSLk = -4/1 = -4)
So. MRTSLK is the slope of isoquant curve which is negative .
• Along an Isoquant, as the producer moves down from A
combination to E the MRTS goes on diminishing means less and
less units of capital are being substituted for an unit of labour to
maintain the same level of output. In the diagram, From A to B
four units of capital are replaced by one unit labour, from B to C
three units of capital are replaced by one units of labour and so
on. Due to this an Isoquant curve is convex to the origin.
• Moving from a combination to other , addition to the total
product due to increase Is exactly equal to the decrease in total
output due to decrease in capital so that total out put remains
unchanged . i.e.
ΔQ ΔQ
ΔL = - ΔK
ΔL Δk
Or MPL .ΔL = - MPK .ΔK
MPL ΔK
or MRTSLK = MPK = - ΔL < 0 is the slop of Isoquant curve
 Isocost line
• An Isocost line is a graphical representation of various
combinations of two factors (labor and capital) which
the firm can purchase with a given amount total outlay.
• An Isocost line is a locus of the alternative combinations
of two factors-labour & capital that can be purchased
with a fixed amount of money or total cost.
• Let us suppose , C is total cost or outlay L &K are two factors and
wage(w) and interest (r) are their prices respectively, Isocost
equation can be expressed as,
C = wL + rK ……i
example , if C = 1000 , w = 50 & r = 100
1000 = 50L + 100K
• Given C , w & r , to increase the amount of a factor the
amount of other must be reduced , i.e. two factors-L & K
vary inversely, as a result the isoquant line slops
downward.
Derivation of the slop of isocost line
K Now,
C = wL + rK …..i
A , K= C/r or rK = C – wL
C
or K = C/r – w/r L
Taking derivative with respect to L
D
K1 dk d(C/r) w dL
dL = dL – r dL
E
K2
or dk = - W < 0 is the slop
F dL r
of Isocost line
/w
B, L= C L
O L1 L2

At point A , If L= 0 , K = C/r
At point B , If K= 0 , L = C/w
 Shift in Isocost Line
• Isocost line shifts due to the change in total outlay or
cost other things remaining the same.
• Given the factor price increase in total cost shifts isocost
line to the right and decrease in total cost shifts isocost
line to the left
K
A’’ • AB is initial Isocost line
• When total cost increases AB shifts
A to right as A’’B’’ which shows more
of the quantity of both the
factors-L&K can be purchased
A’
and vice versa.

B’ B B’’
O L
 Swing in Isocost line
• Isocost line swings due to the change in the price of any
factor of production

Keeping all other things unchanged
if the price of a factor say labour
decreases Isocost line swings to
the right.
K A
Keeping all other things unchanged
if the price of a factor say labour
increases Isocost line swings to
the left.
K A

B B’ O B’ B
O L L
 • Con.
Keeping all other things unchanged Keeping all other things unchanged
if the price of a factor say capital (K) if the price of a factor say capital (K)
decreases Isocost line swings to decreases Isocost line swings to
the right. the left.
K K
A’ A

A
A’

B B
O O
L L
 Producer’s Equilibrium
• Producer’s equilibrium is such a point where the
producer is able to choose the optimum combination of
factors of production whereby a given level of output
can be produced minimizing the cost or a maximum
quantity of output can be produced given the cost so
that the profit can be maximized.
• A producer to be in equilibrium following two conditions
should be fulfilled
1. First order condition/NC : The Isoquant curve should be tangent
to Isocost line or the slop of isoquant should be equal the slop of
Isocost line .i.e. MRTSLk = w/r
2. Second order condition/SC : At the point of tangency the
Isoquant should be convex to the origin
• Based on the above mentioned two conditions the producer’s
equilibrium can be explained in two ways
1. Maximizing output given the cost : • In the diagram AB is given cost
Under this method the producer line. & Q, Q2 & Q3 are different
Attempts To produce a possibly Isoquant curves.
maximum amount of out put at • At e both the conditions are
a given level of cost. fulfilled so, it equilibrium where
the producer can produce
K Possibly maximum amount
(Q=200) of output purchasing
A the e combination of L and K.
j • The combinations j & k can also
be purchased by the same cost
but these can Only produce
K1 e less (Q=100) amount of Output.
Q=300 • Hence producer attempts
k Q=200
to Choose only the point or
Q=100
B combination e. So, e is the
O equilibrium point not j & k .
L1 L
.
2. Minimizing cost given the out put/ • In the diagram Q is Isoquant curve
Least cost combination : and AB ,A’B’ & A’’B’’ are different
Under this method , the producer, Isocost lines.
• At point e both the conditions are
in order to produce a desired or
fulfilled , So , it is equilibrium where
given level of out put, attempts to
the producer Can produce a desired
choose such a combination of L & K or given level (Q=200) of out put
at which the cost is minimum. purchasing the e Combination
of L& K with possible minimum
K cost AB.
A’’
• The j & k combinations of L &K
A j also can Produce the same level of
output but Require higher cost A’’B’’ .
A’ • Hence , producer does not remain
at J & K and attempts to be only at
K1 e point e purchasing Ok1 of K
k and OL1 of L
Q= 200

B’ B B’’
O L1
L
 Law of Returns to scale

• Law of returns to scale is long run production

phenomenon where all the factors of production are
used as variable factors .
• Law of return to scale describes the relationship
between inputs and out put when all inputs are
changed in same proportion.
• It studies about the rate of change in production due
to the same proportionate change in all the factors of
production in long run.
• In long run when all the factors of production are
changed in same proportion , total production may
change in different three ways.
1. Increasing Returns to scale: If the proportionate
change in output is more than the proportionate
change in inputs is known as increasing returns to
scale.
P Causes of increasing return
K
•Indivisibility of inputs
•Specialization
C
B •Dimensional effect

Q=400
A
Q=200 OA > AB > BC

O Q=100

L
2. Constant returns to scale : If the proportionate change
in output is equal to the proportionate change in inputs
is known as increasing returns to scale.

K
P

OA = AB = BC
C

4K B

Q
2K A
Q
1K
Q
O
1L 2L 4L L
3. Decreasing returns to scale: If the proportionate
change in output is less than the proportionate change
in inputs is known as increasing returns to scale.
Causes of increasing return:
K P •Managerial diseconomies
C •Exhaustation of natural resources
•Labour diseconomies.
B Q=400

Q=200 OA< AB < BC

A

Q=100
O
L

OA < AB < BC
Cobb-Douglas Production Function
Cobb-Douglas production was developed by two
economists Cobb &Doulas which is popular by their
name Cobb-Douglas production . it is a most widely
used and empirically tasted production function .it can
be expressed as,
Q = A KαLβ ………i
Q : output
A : a constant or efficiency parameter
K : capital
L : labour
α & β: are elasticity parameters
 Features of C-D production function
1. C-D production function shows the returns to scale:
if α + β = 1 : Shows constant returns to scale
If α + β > 1 : Shows increasing returns to scale
If α + β < 1 : Shows decreasing returns to scale

2. C-D production function measures the factor intensity:

if α /β > 1 , (K>L) : Capital intensive technology
if α /β < 1 , (L> k) : Labour intensive technology
if α /β = 1 , (L= k) : factor intensive is equal
3. Efficiency in production :
The efficiency of factors of production in the
production process is measured by “A”. Higher the
value of A indicates the higher degree of efficiency in
production and vice versa.

4. C-D production function measures the average

productivity of factors of production:
• Average product of Labour : APL = Q/L
• Average product of Capital : APK = Q/K
5. Marginal product of an input can be expressed
in terms of average product of the input
• Marginal product of labour( MPL)

MPL = ꝺQ/ꝺL

MPL = ꝺ(A KαLβ ) = Aβ KαLβ-1 = β A KαLβ = β Q = β APL

ꝺL L L

• Marginal product of capital (MPK)

MPK = ꝺQ/ꝺK

MPK = ꝺ(A KαLβ ) = A α Kα-1Lβ = α AKαLβ = α Q = α APK

ꝺK K K
6. Marginal Rate of Technical of labour for capital (MRTSLk) can be
expressed in terns of K/L ratio
we know that ,
β Q
MPK L β K Q β K
MRTSLk = = = = α L
MPL α Q αLQ
K
7. C-D production function measures the elasticity of
substitution of factors of production : Elasticity of
. substitution of C-D production is equal to unity (σ =1)

percentage change in (K/L)

percentage change in MRTSLk
Elasticity of substitution (σ) =
or d(K/L) d(K/L)
(K/L) (K/L)
σ = =
d(MRTSLK) d β K
(MRTSLK) α L
β K
α L

d(K/L)
(K/L) (β/α) d(K/L) (K/L)
= = = 1
(β/α) d(K/L) (β/α) (K/L) d(K/L)
(β /α) (K/L)

Hence , Elasticity of substitution (σ) = 1

Exercise:
1) Given the production function:
Q = 10L+ 5L2 – L3
Find TP ,AP and MP when L= 3
Now , Q = TP = 10 x 3 + 5x 32 - 33 = 30+ 45 -27 = 48

AP = TP/L = 48/3 = 16

MP = dQ/dL = d(10L+ 5L2 – L3 ) = 10 + 10L -3L2

dL
MP = 10 +10 x 3 – 3x 32 = 13

2) Suppose the wage rate is RS 50 and interest rate is Rs 70 , find the

slop of Isocost line.
we know that the slop of a Isoquant is the price ratio of two inputs-
L & K, so,
Slop of Isoquant = - w/r = -50/70 - 5/7
3.) suppose a production function is given as,
Q = 10L+ 5L2 – L3
complete the following table.
Unit of TP = Q AP = Q/L MP = dq/dL Hint.
L 10L+ 5L2 – L3 10 + 5L – L2 10 + 10L –3 L2
AP = Q/L= 10 + 5L – L2

1 MP= dQ/dL = 10 + 10L –3 L2

2
3
4
5
6
3) Complete the following table
Com. L K MRTSLK
A 1 12 …
B 2 .. 4
C 3 .. 3
D 4 .. 2
E 5 .. 1

MRTS = dK/dL
4) Suppose a producer has Rs 1000 to spend on two inputs-L & K . If
the price of labour is Rs 50 and price of capital is Rs 100. sketch
the Isocost line. ( See the concept of budget line)
5) Suppose the production function of firm is Q = 30 K3 L2 , and if it
employs 5 units of labour and 6 units of capital , find the total
output .
6) Determine the degree the returns to scale. If the production
function is ,
a) Q = A K0.60 L0.40 , given α =0.60 , β = 0.40 , if α + β = ?
b) Q = A K0.80 L0.30
c) Q = A K0.30 L0.40
Also determine the factor intensity if K/L = ?

a) given, α =0.60 , β = 0.40

K/L =0.60/0.40= 1.5>1 capital intensive technology
7) Consider the following two production preference
schedules:
Com. K L Q C = Lw + rK Com. K L Q C = Lw + rK
A 1 22 500 E 1 20 1000
B 2 17 500 F 2 16 1000
C 3 14 500 G 3 13 1000
D 4 13 500 H 4 12 1000

Suppose the price of per unit labour and per unit capital are Rs 200 & 100
respectively.
 compute total cost for each combination in each schedule and identify the
least cost combination which minimize cost for given level of output .
• A firm can uses different three production technologies with
labour and capital requirement to each level of output as follows:
Technology 1 Technology 2 Technology 3
Daily output K L K L K L

400 6 14 8 10 10 8

500 6 20 8 14 10 10

600 8 22 10 16 12 12

700 10 26 12 20 14 16

For each level of output which technology is the cheaper, when a firm
is operating in a high wage country , with capital per day cost is
Rs 200 and labour cost Rs 160 per day.
For each level of out put which technology is the cheaper with capital
cost Rs 200 and labour cost Rs 80.
Technology 1 Daily out put K L C = wL+rK
400 6 14
500 6 20
600 8 22
700 10 26

Technology 2 Daily output C = wL+rK

400 8 10
500 8 14
600 10 16
700 12 20

Technology 3 Daily output C = wL+rK

400 10 8
500 10 10
600 12 12
700 14 16