Production

Production
Introduction
• Production refer to an economic term to describe the inputs that are used
in producing the goods or services in the attempt to make an economic
profit.
Input-> Process (Production)-> Output
• The factors of production include land, labor, capital and

entrepreneurship.
• Basic five “M”s of production or factors of production:
i) Men
ii)Material
iii)Money
iv)Machine
v)Methods
Output, Q = f(Inputs)
Theory of production
• Theory of production is an effort to explain the principles by which a
business firm decides how much of each commodity that it sells (its
“outputs” or “products”) should be produced, and how much of each kind
of input (labour, raw material, fixed capital good, etc.,) needs to be
employed.
• The theory involves some of the most fundamental principles of
economics. These include the relationship between the prices of
commodities and the prices (or wages or rents) of the productive factors
used to produce them.
The Organization of Production
• Inputs
• Labor, Capital, Land
Fixed Inputs and Variable Inputs
• Short Run
• At least one input is fixed
• Long Run
• All inputs are variable
• A firm’s production function is of the form:

Q = f(Ld, L, K, M, T, t)
– where Ld = land and building; L = labour; K = capital; M = materials; T =
technology; and, t = time.
Q = f(K, L)
• Increasing production, Q, will require K and L, and whether the firm can
increase both K and L or only L will depend on the time period it takes
into account for increasing production, that is,
• whether the firm is thinking in terms of the short run or in terms of the
long run.
• In the short run firms can increase production only by increasing labour,
since the supply of capital is fixed in the short run.
• In the long run, the firm can employ more of both capital and labour, as
the supply of capital becomes elastic over time.
Production Function
• Following assumptions are made:
• The firm operates in a short-run production period where
labor is variable, capital is fixed.
• The firm uses the inputs to produce a single product.
• The firm operates with a fixed level of technology.
• The firm operates at every level of output in the most efficient
way.
• The short-run production function is affected by the law of
diminishing returns.
• In the short run, capital is fixed Only changes in the variable labor input
• Can change the level of output
• Short run production function:
Q=f(L, K ), where K is constant
Q= bL
“b” gives constant returns to labor
b= Q
L
Assumptions for short run
production
• At least one input is fixed: labor is the only variable

cost
• Labor is homogeneous,
• The state of technology is given,
• Input prices are given
Production Function with Two
Inputs
Q = f(L, K)
K Q
6 10 24 31 36 40 39
5 12 28 36 40 42 40
4 12 28 36 40 40 36
3 10 23 33 36 36 33
2 7 18 28 30 30 28
1 3 8 12 14 14 12
1 2 3 4 5 6 L
Total Product TP = Q = f(L)
Average Product Q
APL =
L
Marginal Product Q
MPL = L
• MP is change in total production, when we increase one worker,
eg: from 3 workers now we have 4.
Production or MPL
EL =
Output Elasticity APL
Practice
• Calculate Total, Marginal, and Average Product of Labor, and Output
Elasticity for following Labor and Output.
S. No L Q
1 1 3
2 2 8
3 3 12
4 4 14
5 5 14
6 6 12
L Q MPL APL EL
0 0 - - -
1 3 3 3 1
2 8 5 4 1.25
3 12 4 4 1
4 14 2 3.5 0.57
5 14 0 2.8 0
6 12 -2 2 -1
Laws of Production
Two laws of production:
1.Law of Variable proportion (Short run)
Q=f(L)
2. Law of return to scale (Long run)

Q=f(L, K)
Law of Variable proportion
Statement: When more and more number of units of variable
input are applied to a given quantity of fixed input, the total
output may initially increase at an increase rate then at a
constant rate but it eventually increase at a diminishing rate.
*We may get negative returns (Stage 4).
• The law is also called law of diminishing returns.

Identify the various stages of production
with the given production function.
Table 1
Three stages in production
• Stage I: Stage of Increasing Returns
• In Stage I, MP and AP both are rising, and the MP is more than AP.
• Stage II: Stage of Decreasing Returns
• In Stage II, MP and AP both are falling and MP through positive, is less
than AP.
• Stage III: Stage of Negative Returns
• In Stage III, MP of variable factor is negative and the TP is also decreasing.
Cont…
Determining Optimum employment of labor
• How many workers will the firm employ for maximum

profit.
• Number of workers to be employed depends upon the
output that maximizes the firms profit.
• Condition for profit maximization, MC=MR (Marginal cost
=marginal revenue)
In the short run, labor is only variable input, so marginal
cost= marginal wages, i.e., MC=MW
• MR= MRP (Marginal revenue productivity)= MP* P
[MPL , Marginal physical productivity of labor multiplied by
Price (P) of the product and MP is marginal productivity of
labor]
Practice
• Considering the available production function,
Calculate the optimal level of input if the marginal
wage is Rs. 660/- and selling price of output is Rs.10
per unit.
• For L=7, MP=78 (From Table 1)
Marginal revenue productivity, MRP= 78*10= 780> MW
• For L=8, MP=66 (From Table 1)
Marginal revenue productivity, MRP= 66*10= 660= MW
Thus the optimal level of labour is 8 units.
Considering L=9, MRP= 480<MW. This will add to cost and the
company will incur losses.
Law of Return to Scale (Long run)
• All inputs are variable

• Output changed by varying usage of all inputs
• Average product of labor: AP = Q/L
• Marginal product of labor:
MPL = Q
L
• Average product of Capital: AP = Q/K
• Marginal product of Capital: MPK = Q

K
Returns to Scale
Constant Increasing Decreasing

Returns to Returns to Returns to
Scale Scale Scale
• When a firm expands its scale, i.e., both the inputs
proportionately then there are three possibilities:
• Total output may increase more than proportionately
(Increasing returns),
• Total output may increase proportionately (Constant returns),
• Total output may increase less than proportionately
(Decreasing returns)
Increasing Returns to Scale
• When inputs K, and L are increased at a certain
proportion and output increases more than
proportionately, it exhibits increasing returns to scale.
L K Q
10 10 100
20 20 240
30 30 330
Constant Returns to Scale
• When increase in input is proportionate to
increase in output, it exhibits constant returns to
scale.
L K Q
10 10 100
20 20 200
30 30 300
Diminishing Returns to Scale
• When a proportionate increase in inputs, K & L,
leads to a less than proportionate increase in
output.
L K Q
10 10 100
20 20 180
30 30 250
Q=f(L,K)
If there is an increase in the input by ‘h’ times let the output may
increase by ‘k’ times.
kQ=f (hL,hK)
If h<k, this indicates increasing returns to scale
h=k, this indicates constant returns to scale
h>k, this indicates diminshing returns to scale
Optimal Input Combination or Least Cost
Combination
• For Calculating the cost, price of each input must be known.
• Budget or Expenditure of a firm =
(units of labour* price of labour)+ (units of capital*price of capital)
E= L*PL + K*PK
Also MRTS (Marginal rate of Technical Substitution) = (MPL/ MPK) = (PL/PK)
Economies and Diseconomies of Scale
Economies of Scale occurs where factors of production are
perfectly divisible. And technology is such that labor- capital
ratio is fixed.
• When the factors of production are perfectly divisible, showing
constant returns to scale.
Diseconomies of Scale:
The diminishing return to management, that is managerial
economies.
• As the size of the firms expands, managerial efficiency
decreases.
• Limitedness or exhaustibility of the natural resources.
• Eg: doubling of coal mining plant may double the coal output because of
limitedness of coal deposits.

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Production

• The factors of production include land, labor, capital and

• A firm’s production function is of the form:

• At least one input is fixed: labor is the only variable

2. Law of return to scale (Long run)

• The law is also called law of diminishing returns.

• How many workers will the firm employ for maximum

Thus the optimal level of labour is 8 units.

• All inputs are variable

• Marginal product of Capital: MPK = Q

Constant Increasing Decreasing

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