THEORY OF PRODUCTION AND COST ANALYSIS

Introduction to Production Function:

Samuelson define the production function as “the technical relationship which reveals the

maximum amount of output capable of being produced by each and every set of inputs”

Michael define production function as “that function which defines the maximum amount of

output that can be produced with a given set of inputs”.

The production function expresses a functional relationship between physical inputs and physical

outputs of a firm at any particular time period. The output is thus a function of inputs.

Mathematically production function can be written as

Q = F(L1,L2,C,O,T)

Where Q is the quantity of production, F explains the functions, that is, the type of relation

between inputs and outputs , L1,L2,C,.O,T refer to land, labout, capital, organization and

technology respectively. These inputs have been taken in conventional terms. In reality,

material also can be included in a set of inputs.

A manufacturer has to make a choice of the production function by considering his technical

knowledge, the process of various factors of production and his efficiency level to manage. He

should not only select the factors of production but also should work out the different

permutations and combinations which will mean lower cost of inputs for a given level of

production.

In case of an agricultural product, increasing the other factors of production can increase the

production, but beyond a point, increase output can be had only with increased use of

agricultural land, investment in land forms a significant portion of the total cost of production

for output, whereas, in the case of the software industry, other factor such as technology , capital

management and others become significant. With change in industry and the requirements the

production function also needs to be modified to suit to the situation.

Production Function with One Variable Input

The laws of returns states that when at least one factor of production is fixed or factor input is

fixed and when all other factors are varied, the total output in the initial stages will increase at an

increasing rate, and after reaching certain level or output the total output will increase at

declining rate. If variable factor inputs are added further to the fixed factor input, the total output

may decline. This law is of universal nature and it proved to be true in agriculture and industry
also. The law of returns is also called the law of variable proportions or the law of diminishing

returns.

Definition According to G. Stigler

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“If equal increments of one input are added, the inputs of other production services being held

constant, beyond a certain point the resulting increments of product will decrease i.e. the

marginal product will diminish”.

According to F. Benham

“As the proportion of one factor in a combination of factors is increased, after a point, first the

marginal and then the average product of that factor will diminish”.

Units of labour Total production(tp)

Marginal

product Average product Stages

(mp) (ap)

0000

1 10 10 10 Stages 1

2 22 12 11

3 33 11 11

4 40 7 10 Stages 2

5 45 5 9

6 48 3 8

7 48 0 6.85 Stages 3

8 45 -3 5.62

From the above graph the law of variable proportions operates in three stages. In the first stage,

total product increases at an increasing rate. The marginal product in this stage increases at an

increasing rate resulting in a greater increase in total product. The average product also increases.
This

stage continues up to the point where average product is equal to marginal product. The law of

increasing returns is in operation at this stage. The law of diminishing returns starts operating from
the

second stage awards. At the second stage total product increases only at a diminishing rate. The

average product also declines. The second stage comes to an end where total product becomes
maximum and marginal product becomes zero. The marginal product becomes negative in the third

stage. So the total product also declines. The average product continues to decline.

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Production Function With Two Variable Inputs And Laws Returns

Production process that requires two inputs, capital© and labour (L) to produce a given

output(Q). There could be more than two inputs in a real life situation, but for a simple analysis, we

restrict the number of inputs to two only. In other words, the production function based on two
inputs

can be expressed as

Q = f( C,L)

Where c= capital , L = labour,

Normally, both capital and labour are required to produce a product. To some extent, these two

inputs can be substituted for each other. Hence the producer may choose any combination of labour
and

capital that gives him the required number of units of output, for any one combination of labour and

capital out of several such combinations. The alternative combinations of labour and capital yielding
a

given level of output are such that if the use of one factor input is increased , that of another will

decrease and vice versa. How ever, the units of an input foregone to get one unit of the other input

changes, depends upon the degree of substitutability between the two input factors, based on the

techniques or technology used, the degree of substitutability may vary.

ISO - QUANTS

The term Isoquants is derived from the words „iso‟ and „quant‟ – „Iso‟ means equal and

„quent‟ implies quantity. Isoquant therefore, means equal quantity. Isoquant are also called
isopridcut

curves, an isoquant curve show various combinations of two input factors such as capital and labour,

which yield the same level of output.

As an isoquant curve represents all such combinations which yield equal quantity of output, any

or every combination is a good combination for the manufacturer. Since he prefers all these

combinations equally, an isoquant curve is also called product indifferent curve.

An isoquant may be explained with the help of an arithmetical example

Combinations Labour (units) Capital (Units) Output (quintals)

B 2 7 50

C 3 4 50

D 4 4 50

E 5 1 50

Combination „A‟ represent 1 unit of labour and 10 units of capital and produces „50‟ quintals of

a product all other combinations in the table are assumed to yield the same given output of a
product say

„50‟ quintals by employing any one of the alternative combinations of the two factors labour and
capital.

If we plot all these combinations on a paper and join them, we will get continues and smooth curve

called Iso-product curve as shown below.

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Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which shows all the

alternative combinations A, B, C, D, E which can produce 50 quintals of a product

Features of isoquant

1. Downward sloping: isoquant are downward sloping curves because , if one input increase, the

other one reduces. There is no question of increase in both the inputs to yield a given output. A
degree of

substitution is assumed between the factors of production. In other words, an isoquant cannot be

increasing, as increase in both the inputs does not yield same level of output. If it is constant, it
means

that the output remains constant through the use of one of the factor is increasing, which is not
true,

isoquant slope from left to right.

2. Convex to origin: isoquant are convex to the origin. It is because the input factors are not perfect

substitutes. One input factor can be substituted by other input factor in a diminishing marginal rate.
If the

input factors were perfect substitutes , the isoqunt would be a falling straight line. When the inputs
are

used infixed proportion, and substitution of one input for the other cannot trake place, the isoquant
will

be L shaped
3. do not intersect: two isoquant do not intersect with each other. It is because, each of these
denote a

particular level of output. If the manufacturer wants to operate at a higher level of output, he has to

switch over to another isoquant with a higher level of output and vice versa.

4. do not axes: the isoquant touches neither X-axis nor Y- axis, as both inputs are required to
produce a

given product.

ISO COST

Iso cost refers to that cost curve that represent the combination of inputs that will cost the

producer the same amount of money. In other words, each isocost denotes a particular level of total
cost

for a given level of production. If the level of production changes, the total cost changes and thus the

isocost curve moves upwards, and vice verse.

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