Business Economics

UNIT 4
Production
• Production is the transformation of resources into commodities or
outputs.
• For example, when we grow wheat on a plot of land with the helps of
labour, capital and seeds, it is termed as production of wheat.
• Similarly, when in cloths-mill inputs like labour, capital and threads are
transformed into cloth, it is called production of cloth.
Factors of production
• The resources needed to produce goods are termed as factors of
production or factor inputs.
• Generally, factors of production are two types;
• (a) Fixed factors: those, the application of which does not change with
the change in output, e.g. land
• (b) Variable factors: those, the application of which changes with
changes in output, e.g. labour
Production Function
• The production function expresses the relationship between the
physical inputs and physical outputs of a firm for a given state of
technology

Q=f(I1,I2,I3,………In)
Total Product (TP)
• Total product is the total output produced by a given number of
variable input, keeping other inputs constant
• Suppose, there are two factor-inputs: Labour (L) and Capital (C). If we
keep the capital input fixed at K, then the total product will depend
on the units of Labour L. Hence, the total product function of factor L,
will be as follows:

y= f(L, K)
Average Product
• Average product of a factor is the total product (TP) divided by the
number of units of a factor. Thus, average product (AP) means the per
unit output of a variable input.

AP=TP/N
Marginal Product
• Marginal product (MP) is the change in total product resulting from
the use of one more (or one less) unit of variable input, keeping all
other inputs constant. In short, it is called incremental product.

MP=dTP/dN
MP=TPn-TPn-1
Calculation
Units of labour (L) TP (units) AP (units) (TP/N) MP (units) TPn-TPn-1
0 0
1 10 10/1=10 10-0=10
2 22 22/2=11 22-10=12
3 38 38/3=12.67 38-22=16
4 50 50/4=12.5 50-38=12
5 55 55/5=11 55-50=5
6 57 57/6=9.5 57-55=2
Types of Production Function
• Very short run production function: It refers a production function in which
producer is unable to change any factors of production. As a result, output
can not be changed.

• Short run production function: It refers to the production function in which

one factor is variable (which can be changed) and the other factors are fixed
(which can not be changed). In short run, production can only be increased
when more unit of one variable factors are employed.
• Long run production function: It refers to the production function in which
all the factors can be changed. In long run, there are no fixed factors and all
the factors are variable.
Relationship between TP and MP
The relationship between TP and MP is explained through the Law of
Variable Proportions. As long as the the TP increases at an increasing
rate, the MP also increases. This goes on till MP reaches maximum.
When TP increases at a diminishing rate, MP declines. This continues till
the point where TP is at its highest. When TP reaches its maximum
point, MP becomes zero.
Three stages of production
• The diagram or curve shows three stages of production which are as
follows:

• Stage I: MP > 0, AP is rising. Thus, MP > AP. This is increasing stage;

• Stage II. MP > 0, but AP is falling. Thus, MP < AP, but TP is increasing
because MP > 0. This is diminishing stage.
• Stage III: MP < 0 and TP is falling. This is negative stage.
Relation between AP and MP
Relation between AP and MP
To conclude, the following findings are found
• When TP increases at an increasing rate, MP increases.
• When TP increases at diminishing rate, MP declines
• When TP is maximum, MP is Zero
• When TP begins to decline, MP becomes negative
• When MP > AP, this means that AP is rising
• When MP = AP, this means that AP is maximum
• When MP < AP, this means that AP is falling
Short run: The law of variable proportions or
returns to a factor
• With the increase in a variable factor, keeping other factors constant,
initially the marginal product rises but after reaching a certain level of
employment, it starts declining.
The Law of Diminishing Returns
In economics, diminishing returns is the decrease in marginal (incremental)
output of a production process as the amount of a single factor of production
is incrementally increased, holding all other factors of production equal
(ceteris paribus). The law of diminishing returns (also known as the law of
diminishing marginal productivity) states that in productive processes,
increasing a factor of production by one unit, while holding all others
production factors constant, will at some point return a lower unit of output
per incremental unit of input. The law of diminishing returns does not cause a
decrease in overall production capabilities, rather it defines a point on a
production curve whereby producing an additional unit of output will result in
a loss and is known as negative returns. Under diminishing returns, output
remains positive however productivity and efficiency decrease.
Three Stages of the Law
Stage I
In this stage, total product (TP) increases at an increasing rate and
marginal product (MP) also increases. Since in this stage, MP increases
with the increase in units of a variable factor, it is called the stage of
increasing returns.
Stage II
In this stage, total product (TP) continues to increase but at a
diminishing rate and marginal product (MP) diminishes but remain
positive. In this stage, MP decreases with the increase in the units of a
variable factor, it is termed as the stage of diminishing returns.
Stage III
In this stage, total product (TP) starts declining and marginal product
(MP) deceases and becomes negative. Since, in this stage, MP becomes
negative, it is called the stage of negative returns.
Significances of these three stages
A rational producer would not like to operate in stage III. It is because in
this stage, total product declines and marginal product becomes
negative. Hence, a producer can always increase output by reducing the
amount of variable factor. If he operates in stage III, he incurs higher
cost on the one hand and gets less revenue on the other.
Similarly, a producer does not operate in stage I. In this stage, marginal
product increases with the increase in a variable factor. It indicates that
there is a scope for more efficient utilization of fixed factors by
employing more units of a variable factor. A rational producer would
not, therefore, like to stop in stage I but will expand further.
It is by now, very clear that a rational producer never chooses first and
third stages for production. He is, therefore, likes to operate in stage II
that is the stage of diminishing returns. In this way, stage II of the law of
variable proportions is the most relevant stage of operation for a
producer.
Long Run Production Function and Returns
to Scale
In the long run, since all the factors of production are variable,
therefore, a firm can employ larger quantities of both inputs (capital
and labour) to increase the production.
Returns to scale
In the short run, a firm's growth potential is usually characterized by
the firm's marginal product of labor, i.e. the additional output that a
firm can generate when one more unit of labor is added. This is done in
part because economists generally assume that, in the short run, the
amount of capital in a firm (i.e. the size of a factory and so on) is fixed,
in which case labor is the only input to production that can be
increased. In the long run, however, firms have the flexibility to choose
both the amount of capital and the amount of labor that they want to
employ- in other words, the firm can choose a particular scale of
production. Therefore, it's important to understand whether a firm
gains or loses efficiency in its production processes as it grows in scale.
In the long run, companies and production processes can exhibit
various forms of returns to scale- increasing returns to scale, decreasing
returns to scale, or constant returns to scale. Returns to scale are
determined by analyzing the firm's long-run production function, which
gives output quantity as a function of the amount of capital (K) and the
amount of labor (L) that the firm uses, as shown above. Let's discuss
each of the possibilities in turn.
In the long run, companies and production processes can exhibit
various forms of returns to scale- increasing returns to scale, decreasing
returns to scale, or constant returns to scale. Returns to scale are
determined by analyzing the firm's long-run production function, which
gives output quantity as a function of the amount of capital (K) and the
amount of labor (L) that the firm uses, as shown above. Let's discuss
each of the possibilities in turn.
Increasing returns to scale
Put simply, increasing returns to scale occur when a firm's output more
than scales in comparison to its inputs. For example, a firm exhibits
increasing returns to scale if its output more than doubles when all of
its inputs are doubled. Equivalently, one could say that increasing
returns to scale occur when it requires less than double the number of
inputs in order to produce twice as much output.
Inputs Outputs
1L+2K 100
2L+4K 250
100% increase 150% increase
Constant returns to scale
Constant returns to scale occur when a firm's output exactly scales in
comparison to its inputs. For example, a firm exhibits constant returns
to scale if its output exactly doubles when all of its inputs are doubled.
Equivalently, one could say that increasing returns to scale occur when
it requires exactly double the number of inputs in order to produce
twice as much output.
Inputs Outputs
1L+2K 100
2L+4K 200
100% increase 100% increase
Decreasing returns to scale
Decreasing returns to scale occur when a firm's output less than scales
in comparison to its inputs. For example, a firm exhibits decreasing
returns to scale if its output less than doubles when all of its inputs are
doubled. Equivalently, one could say that decreasing returns to scale
occur when it requires more than double the quantity of inputs in order
to produce twice as much output.
Inputs Output
1L+2K 100
2L+4K 170
100% increase 70% increase
Implications of returns to scale
• Increasing RTS: Economies of scale (advantage of large scale of production
and specialization through better division of labour).

• Constant RTS: As the firm increases its output, a stage comes when all the
economies of scale have been fully exploited and now the output is in the
same proportion as that of inputs.

• Decreasing RTS: Diseconomies of scale that is disadvantages caused when

scale of production expands beyond optimum capacity (Lack of coordination
and other difficulties of management leading to wastage and inefficiency.