Theory of

production
Intermediate Microeconomics
ECO-A-CC-3-5-TH-TU
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02 0704210036 017-1211-0644-21 213017-11-0047

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01 02
Production One variable
function input

03 04
Returns to two
A factor variable
inputs
05
Returns to
scale
 INTRODUCTION
Production is the act of making goods and services and
thereby adding utility to the object. The study of
relationship between inputs and output is known as the
‘theory of production’. Production technology is a
practical way of describing how inputs (factors of
production) can be transformed into outputs.
 Production Function

A production function shows the maximum quantity of a

commodity that can be produced per unit of time with the K
given amount of inputs, when the best production technique Q=f(L,
available is used. K)
● It indicates the highest output Q that a firm can
produce for every specified combination of inputs.
In the form of an algebraic equation, production
function for a good may be expressed as: Q(X)=
f(f1, f2, …, fn) where Q(X) is the quantity of output of
commodity X; and f1, f2,...,fn are the physical
quantities of different inputs used to produce
commodity X.
● If we assume that there are only two inputs, namely
labour (L) and capital (K), then the simple production
L
function can be stated as: Q(X) = f(L, K) In this the
quantity of commodity X produced is the function,
i.e., depends upon, the quantity, of L and K. FIG 1. Production Function

sr
Short run
The short run refers to a period of
time in which the quantities of one or more
factors of production cannot be
changed.
There is at least one factor that cannot be varied;
such a factor is called a fixed input.
Short run versus long run
lr
Long run
The long run is the amount of
time needed to make all inputs variable.
Here, firms can vary the amounts of all their
inputs to minimize the cost of production.
 Production with one variable
input

Considering Q = f(K,L), Capital is fixed, Labour is variable.

● The average product of labor (APL) is the output per unit of a particular
input (labour input). APL=Q/L.
● the marginal product of labor (MPL) is the additional output produced
as the labor input is increased by 1 unit.
MPL= Change in Q/ Change in L.
● Total Product Curve (TPC): As the quantity of a variable factor (L)
applied on the given amount of a fixed factor (K), total product
increases first at an increasing rate, then increases at a decreasing rate,
reaches the maximum and decreases thereafter.
● Both Average Product Curve (APC) and Marginal Product Curve
(MPC) increases first and then falls.

Fig 2. Production with one variable input


1 11
Stage of Increasing Returns:
● TP initially increases at an
increasing rate and subsequently
at a diminishing rate.
● MP increases first, reaches
maximum and then starts
decreasing.
● AP increases throughout and
reaches maximum
● Causes: Fuller utilisation of fixed
factor and increase in efficiency
Three stages of production
Stage of Diminishing Returns:
● TP continues to increase at a
diminishing rate, and eventually
reaches the maximum.
● MP continues to decrease and
eventually becomes zero.
● AP, from the maximum begins to
decrease.
● Causes: Disturbing the optimum
proportion and imperfect
substitutability of factors of
production.
111
Stage of Negative Returns:
● TP , rom maximum begins to
diminish.
● MP, from zero, becomes negative.
● AP, continues to decrease, but is
always positive.
● Causes: Overcrowding and
management problems.

Therefore,we can see that out of the three stages
of production : increasing, diminishing and
negative returns, an economically rational
producer would like to operate somewhere in
stage II, i.e., in the stage of diminishing returns.
● The firms would not like to produce in
stage III because there MP is negative and
TP is declining. Employing more labour
will decrease output.
● He will not produce in stage I because AP
is increasing throughout and the firm has
incentive to employ more of variable
factor to increase profit.
● Therefore, a rational producer would like
to operate in stage II where the production
is close to the maximum possible output.
Returns to a factor
Returns to a factor means change in the physical
quantity of a good when the quantity of one factor is
increased while that of the other factors remain
constant.
The law of diminishing marginal returns (also
known as the law of variable proportions) states that
as more and more units of a variable factor are
applied to the given quantity of a fixed factor, total
product may increase at an increasing rate initially,
but eventually it will increase at a diminishing rate.
● It means that as the use of an input increases
in equal increments (with other inputs fixed),
a point will eventually be reached at which
the resulting additions to output decrease.
● This law usually applies to short-run.
 Production with two variable inputs

Considering Q = f(K,L), both Capital and Labour are variables.

● An isoquant is a curve that shows all the possible combinations of
inputs that yield the same output.
● When a number of isoquants are combined in a single graph, we call
the graph an isoquant map.
● Each isoquant corresponds to a different level of output,
and the level of output increases as we move up and to the right in the
figure.
● Isoquants show the flexibility that firms have when making
production decisions: They can usually obtain a particular output by
substituting one input for another.
● There are diminishing marginal returns to labor both in the long
and short run because adding one factor while holding the other factor
constant eventually leads to lower and lower incremental output.

Fig 3. Production with two variable inputs

 Substituting among inputs

● The slope of each isoquant indicates how the quantity of one input
can be traded off against the quantity of the other, while output is held
constant.
● When the negative sign is removed, we call the slope the marginal rate
of technical substitution (MRTS). The MRTS of labor for capital is the
amount by which the input of capital can be reduced when one extra
unit of labor is used, so that output remains constant.
MRTS = -Change in K/Change in L (for fixed Q).
● We assume that there is diminishing MRTS, i.e., isoquants are convex.
It tells us that the productivity of any one input is limited. As more and
more labor is added to the production process in place of capital, the
productivity of labor falls. Similarly, when more capital is added in
place of labor, the productivity of capital falls. Production needs a
balanced mix of both inputs.
Fig 4. MARGINAL RATE OF ● The MRTS between two inputs is equal to the ratio of the marginal
TECHNICAL products of the inputs. MRTS= MPL/MPK.
SUBSTITUTION
 Returns to scale

Returns to scale is the rate at which output increases as inputs are increased proportionately. We will examine three
different cases:
1 11 111
Increasing Returns: Constant Returns: Decreasing Returns:

● Increasing returns to scale ● Constant returns to scale is a ● Decreasing returns to scale

Situation in which output
more than doubles when all
inputs are doubled.
● Here the isoquants come
closer together as we move
away from the origin as less
than twice of both inputs is
needed to increase
production.
situation in which output
doubles when all inputs are
doubled.
● Here isoquants are at a
constant distance as we move
away from the origin as twice
of both inputs is needed to
increase production.
is a situation in which
output less than doubles
when all inputs are doubled.
● Here isoquants move
farther away as we move
away from the origin as
more than twice of both
inputs is needed.
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