Supply and Production
Decisions
MODULE - 2
Contents
➢The law of supply
➢Theory of production: Factors affecting production, production function
➢Short run analysis
➢Law of variable proportions
➢Isoquant curves
➢Long run production function
➢Cobb-Douglas production function
➢Cost-output function
➢Economies and diseconomies of scale
Law of supply
Law of supply states that, all other factors
being equal, as the price of a good or service
increases, the quantity of goods or services
that suppliers offer will increase, and vice
versa.
The law of supply says that as the price of an
item goes up, suppliers will attempt to
maximize their profits by increasing the
number of items for sale.
Because businesses seek to increase revenue,
when they expect to receive a higher price for
something, they will produce more of it
Elasticity of Supply
Elasticity of a commodity is defined as the responsiveness of quantity supplied to a unit change
in the price of that commodity. i.e a change in quantity supplied with respect to change in its
price
Types of Elasticity of Supply
Perfectly elastic supply
Relatively elastic supply
Unit elasticity of supply
Relatively inelastic supply
Perfectly inelastic supply
Elasticity of supply
S1 - Perfectly elastic supply
S2 - Relatively elastic supply
S3 - Unit elasticity of supply
S4 - Relatively inelastic supply
S5 - Perfectly inelastic supply
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
Elasticity of supply =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
Theory of Production
Basic Terminologies:
Production
A process which converts the inputs to its output.
In short it is a process of adding up value.
Inputs: Factor of production such as land, labour, money, technology etc
Outputs: Goods and services produced.
Production function
A functional relationship between the inputs and the outputs during the process of production.
Q = f(Land, labour, capital, organization, technology etc)
Fixed cost Vs Variable cost
Cost means any expense a business incurs during manufacturing or producing the goods and
services. i.e money company spends.
These are generally classified as :
Fixed cost
Any expense that remains the same, no matter how much a company produces. Ex: rent,
property tax, insurance etc.
Variable cost
Any expense that changes, based on how much a company produces or sells. It increases as the
production level increases and vice versa. Ex: labour cost, raw materials, packaging, commission
etc.
Factors affecting theory of production
Technology
Inputs:
◦ Land : Availability, resources, mobility
◦ Capital: Fixed, variable
◦ Labour: Supply, limitations, mobility
Time period of production: Short run/ long run
Short run production function
(Production function with at least one variable factor
keeping the quantities of other inputs as fixed)
Total product TP : It is the total amount of output Variable Total Marginal Average
resulting from the use of different quantities of
inputs. input product product product
(L) (TP) ∆𝑇𝑃 𝑇𝑃
MP = ∆𝐿 AP = 𝐿
Marginal product: It is change in the total product
per unit change in the variable unit.
For Ex: Labour unit is assumed to be variable(L), 0 0 - -
and capital (K) is held constant, then marginal
product can be stated as 1 5 5 5
∆𝑇𝑃 2 15 10 7.5
MP =
∆𝐿
3 35 20 11.67
Average product: It is defined as total product per
unit of input 4 45 10 11.25
For Ex: In earlier case 5 50 5 10
𝑇𝑃
AP = 6 45 -5 7.5
𝐿
Law of Variable proportion
It explains the short run production function (Production function with at least one variable factor
keeping the quantities of other inputs as fixed)
When the number of one factor is increased or decreased, while other factors are constant, the
proportion between the factors is altered.
For ex: there are two factors of production, land and labour.
Land is a fixed factor whereas labour is a variable factor.
Suppose we have a land measuring 5 hectares. We grow wheat on it with the help of variable factor
i.e., labour. Accordingly, the proportion between land and labour will be 1: 5.
If the number of laborers is increased to 2, the new proportion between labour and land will be 2:
5.
Due to change in the proportion of factors there will also emerge a change in total output at
different rates. This tendency in the theory of production called the Law of Variable Proportion.
Law of Variable proportion & its
assumptions
The law states that:
“If one of the variable factor of production used more and more unit, keeping other inputs fixed,
the total product (TP) will increase at an increasing rate in the first stage and in the second stage
TP continuously increase but at a diminishing rate and eventually TP decreases.”
Assumptions:
(i) Constant Technology
(ii) Factor Proportions are Variable
(iii) Homogeneous Factor Units
(iv) Short-Run
Explanation: Law of variable proportion
Stage1
In the first stage average production increases as
there are more and more doses of labour and capital
employed with fixed factors (land).
We see that total product, average product, and
marginal product increases but average product and
marginal product increases up to 40 units.
Later on, both start decreasing because proportion of
workers to land was sufficient and land is not properly
used.
This is the end of the first stage.
Stage 2
The second stage starts from where the first
stage ends or where AP=MP.
In this stage, average product and marginal
product start falling.
Marginal product falls at a faster rate than the
average product.
And total product increases at a diminishing
rate.
It is maximum at 70 units of labour where
marginal product becomes zero while average
product is never zero or negative.
Stage3
The third stage begins where second stage
ends.
This starts from 8th unit.
Here, marginal product is negative and total
product falls but average product is still
positive.
At this stage, any additional dose leads to
positive nuisance because additional dose
leads to negative marginal product.
Graphical Presentation
Economies of Scale
Economies of scale are cost advantages by companies when production becomes efficient.
Companies can achieve economies of scale by increasing production and lowering cost.
This happens because costs (fixed and variable) are spread over larger number of goods, and
thus gets divided.
Economies of scale are of 2 types
Internal economies
External economies
Internal economies of scale
Production economies:
- Labour
- Technical
- Inventory
Marketing economies:
- Advertising economies
- Channel of distributions
Managerial economies:
- Specialisation
- Team work
External economies of scale
The parameters which are not within the organization.
Ex: Waste collection (Scrap), Subsidiary agency, raw material suppliers etc
Diseconomies of scale
Managerial diseconomies
EX: Hierarchy in organization: Information,
Control
External diseconomies: Resources, input prices,
Infrastructure facility
Economies & Diseconomies of Scale
Indian railways:
Internal: Large employees
Specialized labour
Large coverage & connectivity
Price discrimination
Transportation
External: Holiday packages, Monopoly, brand name, Internet portal, premium trains and services
Diseconomies of scale:
Supervision, reporting structure, government intervention, loss due to calamities, third party
support
Isoquants
Iso-equal & quant-quantity/product
An isoquant is a curve representing the various
combinations of two inputs that produce the same
amount of output.
It is also called as iso-product curve or production
indifference curve.
Most typically, an isoquant shows combinations of
capital and labour and the various trade-off between the
two.
The isoquant curve assists companies and businesses in
making adjustments to their manufacturing operations,
to produce the most goods at the most minimal cost.
Isoquants Assumptions
1. Two Factors of Production:
Only two factors are used to produce a commodity.
2. Divisible Factor:
Factors of production can be divided into small parts.
3. Constant Technique:
Technique of production is constant or is known before hand.
4. Possibility of Technical Substitution:
The substitution between the two factors is technically possible. That is, production function is of ‘variable proportion’
type rather than fixed proportion.
5. Efficient Combinations:
Under the given technique, factors of production can be used with maximum efficiency.
Isoquant schedule and curve
Properties of Isoquants
An isoquant is a downward-sloping to the
right, implying that if one more of one factor is
used, less of other factor is needed for
producing same level of output.
Higher isoquant represents larger output i.e
with the same amount of one input and the
greater amount of the second input, larger
output will result.
No two isoquants intersects or touch each
other.
Isoquants are convex to the origin.
Isoquants need not be parallel to each other
Long run production function
(Law of return to scale)
If given certain combination of factors of L K Total Average
production, producing a given output, all the product product
factors are increased in same proportion and 1 1 100 100
output increases in same proportion, return to
scale is constant. 2 2 250 125
3 3 450 150
If output increases more than proportionate,
then increasing return 4 4 760 190
5 5 950 190
If output increases less than proportionate
then decreasing return. 6 6 1140 190
7 7 1260 180
8 8 1280 160
Cost output function
Cost of production of any good or service includes several costs.
Thus, cost function expresses the relationship between cost and its determinants, like the size of
plant, input prices, technology, level of output etc.
Mathematically it can be stated as:
C = f ( S, O, P, T….)
C-Cost
S-Size of plant
O-Level of output
P-Price of inputs
T-Nature of technology
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