Unit - 3

Managerial Economics
Unit - 3
Theory Production
By Dr. Sharif Mohd.
Theory Production Centre for Distance and Online Education

❏ Production Function
● Production Function is the relation between a firm's physical production(output) and the
material factors of production(input). Q= 𝒇 𝑳, 𝑪, 𝑵 Where, Q is quantity of output L is
labour C is capital N is land In simple form Q= 𝒇( 𝑳, 𝑪).
● The production function is a technical or engineering relation between input and output.
As long as the natural laws of technology remain unchanged, the production function
remains unchanged.


❏ Law of variable proportion:

● The law of variable proportion is based on short run production function.
● It is called the Law of Variable Proportions because one factor varies and all others
remain constant, the factor ratio or the factor proportion varies.
● This law states that keeping other factors constant, when units of variable factor are
increased, then the total product initially increases at an increasing rate, then
increases at a diminishing rate, and eventually starts declining.

❏ Assumptions:
1. Constant State of Technology: First, the state of technology is assumed to be given and
unchanged. If there is improvement in the technology, then the marginal product may
rise instead of diminishing.
2. Fixed Amount of Other Factors: Secondly, there must be some inputs whose quantity
is kept fixed. It is only in this way that we can alter the factor proportions and know its
effects on output. The law does not apply if all factors are proportionately varied.
3. Possibility of Varying the Factor proportions: Thirdly, the law is based upon the
possibility of varying the proportions in which the various factors can be combined to
produce a product. The law does not apply if the factors must be used in fixed
proportions to yield a product.

❏ Law of Variable Proportions Explained

● In this example, the land is the fixed factor and labour is the variable factor. The table
shows the different amounts of output when you apply different units of labour to one acre
of land which needs fixing.



2. Law of Returns to Scale :

● In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale
of production can be changed by changing the quantity of all factors of production.
❏ Definition:
● “The term returns to scale refers to the changes in output as all factors change by the same
proportion.” Koutsoyiannis
● “Returns to scale relates to the behaviour of total output as all inputs are varied and is a long
run concept”. Leibhafsky.



1. Increasing Returns to Scale:
● Increasing returns to scale or diminishing cost refers to a situation when all factors of
production are increased, output increases at a higher rate. It means if all inputs are
doubled, output will also increase at the faster rate than double.
● Hence, it is said to be increasing returns to scale.
Reasons:
● Division of labour
● Specialisation
● External economies of scale

2. Diminishing Returns to Scale:

● Diminishing returns or increasing costs refer to that production situation, where if all the factors
of production are increased in a given proportion, output increases in a smaller proportion. It
means, if inputs are doubled, output will be less than doubled.
● If 20 percent increase in labour and capital is followed by 10 percent increase in output, then it is
an instance of diminishing returns to scale.
Reasons:
● Internal and external economies
are less than internal and external
diseconomies.

3. Constant returns to scale:

● Constant returns to scale or constant cost refers to the production situation in which output
increases exactly in the same proportion in which factors of production are increased. In simple
terms, if factors of production are doubled output will also be doubled.
● In this case internal and external economies are exactly equal to internal and external
diseconomies. This situation arises when after reaching a certain level of production, economies
of scale are balanced by diseconomies of scale. This is known as homogeneous production
function.
Reasons:
● Internal diseconomies
● External diseconomies

Causes
Economies
Disconomies
Internal External Internal External
● Management ● Economies of ● Limits of ● Intense

● Financial Information competition
Entrepreneurship
● Technical ● Resources and ● scarcity of factors
● Marketing etc. Development ● Marginal of production
● Economies of Autonomy ● Roads congested
Concentration ● Commercial ● Over use of Raw
● Economies of ● Financial material
Specialisation ● Scarcity and over
● Risk bearing
exploitation of
Skilled labour

Isoquant and Isocost Curve

❏ Isoquant:
● Isoquant is also called as equal product curve or production indifference curve or constant
product curve.
● Isoquant indicates various combinations of two factors of production which give the same
level of output per unit of time. The significance of factors of productive resources is that,
any two factors are substitutable e.g. labour is substitutable for capital and vice versa. No
two factors are perfect substitutes.
● This indicates that one factor can be used a little more and other factor a little less, without
changing the level of output.

❏ Assumptions
● There are two factor inputs labour and capital
● The proportions of factor are variable.
● Physical production conditions are given
● The Scale of operation is variable
● The state of technology remains constant

● We can see that the shape of isoquant plays ● It is a graphical representation of

various combinations of inputs say
an important role in the production theory as Labour(L) and capital (K) which give an
equal level of output per unit of time.
the shape of indifference curve in the Output produced by different
combinations of L and K is say, Q, then
consumption theory. Isoquant map shows all Q=f (L, K)
the possible combinations of labour and

capital that can produce different levels of
output. The isoquant closer to the origin
indicates a lower level of output. The slope of
isoquant is indicated as
● K
● L KL=MRSLk

❏ Properties/Characteristics of Isoquants
● Two isoquants do not intersect each other:

● No isoquant can touch either axis

● Isoquant is oval in shape

● A higher IQ implies a higher level of output

● IQs are never parallel to each other. Interspacing between them is least at the ends and maximum in the
middle.
● IQs are convex to the origin: convex isoquants possess continuous substitutability of K and L over a stretch.
Beyond this stretch, K and L are not substitutable foe each other.
● IQs may be linear when labour and capital are perfect substitute. A linear isoquant implies that either
factor can be used in proportion. If isoquant has several linear segments separated by kinks, the isoquant is
called kinked isoquant or activity analysis isoquant or linear programming isoquant. Such isoquants are used
in linear programming.
● If marginal product of one of the two factors is zero, IQ is parallel to the axis on which the factor with zero
marginal products is represented.
● If one of the two factors has negative marginal product the IQ slopes upwards from left to right.

❏ Isocost curve:
● Isocost curve is the locus traced out by various combinations of L and K, each of which
costs the producer the same amount of money (C ) Differentiating equation with
respect to L, we have dK/dL = -w/r This gives the slope of the producer’s budget line
(isocost curve).
● Iso cost line shows various combinations of labour and capital that the firm can buy for
a given factor prices. The slope of iso cost line = PL/Pk. In this equation , PL is the
price of labour and Pk is the price of capital.
● The slope of iso cost line indicates the ratio of the factor prices. A set of isocost lines
can be drawn for different levels of factor prices, or different sums of money. The iso
cost line will shift to the right when money spent on factors increases or firm could buy
more as the factor prices are given.

Slope of isocost line:

● With the change in the factor prices the slope of isocost line
will change. If the price of labour falls the firm could buy more
of labour and the line will shift away from the origin.
● The slope depends on the prices of factors of production and
the amount of money which the firm spends on the factors.
When the amount of money spent by the firm changes, the
isocost line may shift but its slope remains the same.
● A change in factor price makes changes in the slope of isocost
lines as shown in the figure.



❏ Least Cost Factor Combination or Producer’s Equilibrium or Optimal Combination of Inputs:

● The firm can achieve maximum profits by choosing that combination of factors which will cost it the least. The
choice is based on the prices of factors of production at a particular time.
● The firm can maximize its profits either by maximizing the level of output for a given cost or by minimizing the
cost of producing a given output. In both cases the factors will have to be employed in optimal combination at
which the cost of production will be minimum.
● The least cost factor combination can be determined by imposing the isoquant map on isocost line. The point of
tangency between the isocost and an isoquant is an important but not a necessary condition for producer’s
equilibrium. The essential condition is that the slope of the isocost line must equal the slope of the isoquant.
● Thus at a point of equilibrium marginal physical productivities of the two factors must be equal the ratio of their
prices. The marginal physical product per rupee of one factor must be equal to that of the other factor. And
isoquant must be convex to the origin. The marginal rate of technical substitution of labour for capital must be
diminishing at the point of equilibrium.


❏ Managerial Uses of Production Function:

● It may be used to compute the least-cost combination of inputs for a given output.
● It may be used by the manager to obtain the most appropriate combination of input. Which yields
the maximum level of output with a given level of cost.
● Helps the managers in deciding the additional value of variable input employed in the production
process.
● Production functions help the managers in taking long-run decisions. As with increasing returns to
scale the production may be increased through a proportionate increase in. the factors of
production.

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Managerial Economics

By Dr. Sharif Mohd.

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

❏ Law of variable proportion:

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

❏ Law of Variable Proportions Explained

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

2. Law of Returns to Scale :

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

1. Increasing Returns to Scale:

Theory Production Centre for Distance and Online Education

2. Diminishing Returns to Scale:

Theory Production Centre for Distance and Online Education

3. Constant returns to scale:

Theory Production Centre for Distance and Online Education

Internal External Internal External

● Management ● Economies of ● Limits of ● Intense

Theory Production Centre for Distance and Online Education

Isoquant and Isocost Curve

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

● We can see that the shape of isoquant plays ● It is a graphical representation of

the possible combinations of labour and

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Slope of isocost line:

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

❏ Least Cost Factor Combination or Producer’s Equilibrium or Optimal Combination of Inputs:

Theory Production Centre for Distance and Online Education

Theory Production Centre for Distance and Online Education

❏ Managerial Uses of Production Function:

the maximum level of output with a given level of cost.

Theory Production Centre for Distance and Online Education

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