THEORY OF PRODUCTION AND COST

In economics, the theory of production and cost states that the

cost of a product is determined by the sum total of the cost of all
the resources that went into making it. There are multiple factors
to be considered when determining the cost of a product.
 Once market forces decide demand and supply, the
firm will need to make decisions about production.
Theory of Production relates to the mix of the factors of
production and how to utilize these factors to
maximum effect.

 Factors of production- Land , Labour , capital ,

enterprise
PRODUCTION
 Production means transforming inputs ( land , labour ,
machines , raw materials etc) into an output.

 An input is a good or services that is being used for the

production and output is the goods and services that
comes out of production process
FIXED INPUTS AND VARIABLE INPUTS
 Fixed Inputs- They are the inputs whose quantity is
constant for some period of time or constant for short
run production function. Typically fixed input will
include land and machinery, it may also include
certain type of labour.
 Variable Inputs :- These are inputs whose quantity
can vary, even in the short run or for short period of
time. Example of these input are labor energy fuel etc.

 A fixed input remains fixed up to a certain level of

output whereas a variable input changes with change
in output.
PRODUCTION FUNCTION
 1. Short run Production Function

 2. Long run production function

SHORT RUN PRODUCTION
 In the short run, the output quantity can be
increased (or decreased) by increasing (or
decreasing) the quantities used of only the
variable inputs. This functional relationship (of
dependence) between the variable input
quantities and the output quantity is called the
short run production function.
 Thus an increase in production during this period
is possible only by increasing the variable input.
LONG RUN PRODUCTION
 In the long run, however, all the inputs used by
the firm, the variable inputs and the so called
fixed inputs, all are variable quantities and the
firm’s production is a function of all these inputs.
This functional relation of dependence between
all the inputs used by the firm and the quantity
of its output is called the long run production
function of the firm.

 Thus in long run , production of goods can be

increased by employing both , variable and fixed
factors.
PRODUCTION FUNCTION
 A production function gives the technological
relation between quantities of physical inputs
and quantities of output of goods.
 It can be expressed as

Q = f (K , L)
ASSUMPTIONS
 Production function is related to a specific time
period.

 The state of technology is fixed during this period

of time. .

 The factors of production are divisible into the

most viable units.
 There are only two factors of production, labour
and capital.
 Inelastic supply of factors in the short-run
period.
THE LAW OF PRODUCTION

 In the short run , input-output relations are

studied with one variable input , while other
inputs remains constant. The law of production
under these assumptions are called Law of
variable Proportion.
 In the long run input output relations are studied
assuming all the input to be variable. The long
run input output relations are studied under law
of returns to scale.
LAW OF VARIABLE PROPORTION (LAW
OF DIMNISHING RETURN)

 Law of variable proportions occupies an

important place in economic theory. This law
examines the production function with one
factor variable, keeping the quantities of other
factors fixed. In other words, it refers to the
input-output relation when output is increased
by varying the quantity of one input.
 The law of diminishing returns state that any attempt
to increase output by increasing only one factor faces
diminishing returns.
 The law states that when some factors remains
constant , more and more units of a variable factors
are introduced the production may increase initially at
an increasing rate but after a point it increases at a
diminishing rate.
 Land and capital remains fixed in the short run
labour is variable in nature.
TP increases at the increasing rate till the
employment of 3rd labour . Afterwards it is facing law
of diminishing return
1st Stage- TP , MP ,AP is
increasing at increasing
rate. This stage continues
up to the point where AP is
equal to MP.

2nd Stage- TP continues to

increase but at a
diminishing rate. As the MP
at this stage starts falling ,
the AP also declines. This
stage ends where TP
become maximum and MP
becomes zero.

3rd stage- The MP becomes

negative in this stage . TP
also declines
LAW OF RETURNS TO SCALE

 Returns to scale is the rate at which output

increases in response to proportional increase in
all inputs.
 The increase in output may be proportionate ,
more than proportionate or less than
proportionate.
INCREASING RETURN 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. This increase is due to many reasons
like division external economies of scale.
When labour and
capital increases
from Q to Q1,
output also
increases from P
to P1 which is
higher than the
factors of
production i.e.
labour and
capital.
DIMNISHING RETURN 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.
 The main cause of the operation of diminishing
returns to scale is that internal and external
economies are less than internal and external
diseconomies
Diminishing returns to
scale has been shown. On
OX axis, labour and
capital are given while on
OY axis, output. When
factors of production
increase from Q to
Q1 (more quantity) but as
a result increase in
output, i.e. P to P1 is less.
We see that increase in
factors of production is
more and increase in
production is
comparatively less, thus
diminishing returns to
scale apply.
CONSTANT RETURN 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.

Economies is greater than diseconomies – increasing return

Economies is less than diseconomies – diminishing return
Economies is equal to diseconomies – constant return to scale
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. Cobb-
Douglas linear
homogenous production
function is a good example
of this kind.