Production Function

Production
An activity that creates value,
product, and services

Production Process
Inputs for Production
Raw materials
Labor
Land
Capital
Entrepreneurial or managerial talent.
Objective of Production function
To attain Producer’s equilibrium, through
Profit maximisation
Cost minimisation
Optimisation of output

Optimise output by cost minimizing and profit

maximizing with available resources
Production Function

Production function is the mathematical

representation of relationship between
physical inputs and quantity of output
produced in an organization.
Q = f (X1,X2,X3,X4,…,Xn)
where Q is the quantity of output
that can be produced with amounts
of inputs, X1,X2,X3,X4,…,Xn.
Short run Production function
Time period so short that the amounts of
some inputs can not be changed
For example, the quantity of plant & heavy
equipment can not be changed in a short
time period.

Long run Production function

Time period long enough for all inputs to be
changed
Fixed input
An input whose quantity can not be changed
in the short run
Examples: Plant, Machinery, Equipment,
etc.
Variable input
An input whose quantity can be changed in
a short period of time
Examples: labor, raw materials
Short run Production function
• Short run production function is explained in
terms of one variable input
• One FOP (say labour) is varying in nature, it
increases as output increases.
• Another FOP (capital) is kept constant.
• The total product (TP), average product (AP)
and marginal product(MP) are derived from
the schedule given below:
Short run Production function
• Total Product (TP): Total volume or amount
of final output produced by a firm using given
inputs in a given period of time.
• It is represented as Q
• Average Product : Average product of labor
(APL), is total product (TP) divided by the total
quantity of labor. It is the average amount of
output each worker can produce.
• APL = TP/QL
Short run Production function

• Marginal Product (TP): Marginal product or

marginal physical productivity of an input
(factor of production) is the change in output
resulting from employing one more unit of a
particular input (for instance, the change in
output when a firm's labor is increased from
five to six
• MPL = TPn –TPn-1
• MPL =∆TP/∆QL
Short run Production function
ASSUMPTION
• There are 2 FOP – labour & capital
• Perfect divisibility of both i/p & o/p
• Technology is given
• Labour is homogenous
• Prices of the input are given
• There is inelastic supply of fixed FOP in
the SR.
Production with
One Variable Input (Labor)
Amount Amount Total Average Marginal
of Labor (L) of Capital (K) Output (Q) Product Product

I stage
Increasing
returns

II stage
Decreasing
returns

III stage
Negative
returns
TOTAL PRODUCT
Production with 120
One Variable Input (Labor) 110
100
90
TP
80

TOTAL OUTPUT
70
60

50
40
30
20
10

0
1 2 3 4 5 6 7 8 9 10

QUANTITY of L
APL & MPL
Production with 30
One Variable Input (Labor)
25

20

TOTAL OUTPUT
15

10
AP
5

0
1 2 3 4 5 6 7 8 9 10

QUANTITY of L
MP
TP MAXI. OBSERVATIONS
TOTAL PRODUCT
3 STAGES OF DEVELOPMENT
I STAGES: TP increases at increasing rate

I II III II STAGES: TP increases at decreasing rate

reaches its maximum
III STAGES: TP starts declining

AVERAGE PRODUCT
AP increases in the initial stages, when TP starts
increasing at decreasing rate, AP starts
decreasing and continuously declines

MARGINAL PRODUCT
When MP = 0, TP is at its maximum
When MP > AP, AP is increasing
MP = 0. When MP < AP, AP is decreasing
When MP = AP, AP is at its maximum
Short run Production function with
One Variable Input (Labor)

The Law of Diminishing Marginal Returns

Law of diminishing returns states that as

as we employ additional variable input,
there will be smaller increase in the output,
due to decrease in the marginal product of
labour.
Profit maximization condition

MARGINAL REVENUE = MARGINAL WAGE

MRP= MW

MRP= MPL x Px

Given, Px = Rs. 10/ QUINTAL

Given, W = Rs. 300
Production with
One Variable Input (Labor)
Amount Amount Total Average Marginal
MRP=MP*P
of Labor (L) of Capital (K) Output (Q) Product Product

-
100
200
300
200
150
130
40
0
-40
-80
PROFIT MAXIMISATION IN SR
PRODUCTION FUNCTION
wage
MRPL = MW

E
W= 300 W  MC

MRPL
optimal labour
L
Q=3
Production Function
in the Long Run
LONG RUN PROD. FUNCTION
All the inputs (labour and capital) are variable in nature

ASSUMPTIONS

• 2 FOP. Labour and capital. They both are

variable factor.
• Supply to both the inputs is elastic
• Principle of Law of returns to scale
• Iso quant curves
• Technology of production is given
ISOQUANT CURVE
Isoquant schedule
ISO means Equal
PTS LABOUR CAPITAL
QUANT means Quantity
A 25 4
This is also called as
Production indifference curve
B 20 6
Labour and Capital are
substitutes C 15 10
Total output Q = 100 units
D 10 16
Isoquant schedule explains
the pattern of curve
E 5 24
QUANTITY of K
ISOQUANT CURVE
E
25

20
D
15

C
10
B
A
5
IQ=100

0
5 10 15 20 25

QUANTITY of L
QUANTITY of K
ISOQUANT CURVE
E 100 units of output can be
K5 produced in many different ways:

L1 units of labor & K1 units of capital,

D
K4 L2 units of labor & K2 units of capital,

L3 units of labor & K3 units of capital,

C &
K3
L4 units of labor & K4 units of capital.
B
K2 A
L1 + K1 = 100 units of Q
K1 IQ=100
L2 + K2 = 100 units of Q
0 And so on
L5 L4 L3 L2 L1

QUANTITY of L
QUANTITY of K
ISOQUANT CURVE
E
DEFINITION
K5
An isoquant curve (IQ) is
locus of points representing
D various combinators of 2
K4
inputs- labour and capital,
yielding the same level of
K3
C output
B
K2 A
K1 IQ=100

0
L5 L4 L3 L2 L1

QUANTITY of L
PROPERTIES OF ISOQUANTS

1. An isoquant is downward
sloping to the right.

2. Isoquant is convex to the origin.

3.No two isoquants intersect or

touch each other.
4.A higher isoquant represents
larger output.
PROPERTIES OF ISOQUANTS

1. An isoquant is downward
sloping to the right.

2. Isoquant is convex to the origin.

3.No two isoquants intersect or

touch each other.
4.A higher isoquant represents
larger output.
PROPERTIES OF ISOQUANTS

1. An isoquant is downward
sloping to the right.

2. Isoquant is convex to the origin.

3.No two isoquants intersect or

touch each other.
4.A higher isoquant represents
larger output.
MARGINAL RATE OF TECHNICAL
SUBSTITUTION
The slope of the isoquant
The rate at quantity of labour is substituted with quantity
of capital, to produce the same amount of output.
For example, To produce 100 units of output, producer
can use 25 units of labour and 2 units of capital.
or
Producer can use 20 units of labour and 4 units of
capital. And so on
MARGINAL RATE OF TECHNICAL
SUBSTITUTION
Isoquant schedule

In short MRTS, the formula │ΔL/ΔK│

PTS LABOUR CAPITAL ΔL ΔK
ΔK/ΔL = - MPK/MPL
A 25 4 - - -

Observation – MRTSk,L B 20 6 -5 2 2.5

values,
As quantity of labour is C 15 10 -5 4 1.25
substituted with quantity of
capital, rate of substitution D 10 16 -5 6 0.83

goes on decreasing.
E 5 24 -5 8 0.62
Optimal Combination of Inputs
Objective of the firm:
A profit maximizing firm seeks to minimize its cost for
a given output or to maximize its output for a given
total cost.
To fulfill this objective the firm has combine the firm’s
production and cost functions.

This can obtained – interaction of

Isocost curve and Isoquant curves
Optimal Combination of Inputs
Isocost curve
Isocost curve indicate the combination of
input for a given cost.
Cost formula:
C = K * PK + L * PL
Where,
C = cost of production
K = quantity of capital
PK= Price of capital
L = quantity of labour
PL= Price of labour
Optimal Combination of Inputs
Given, cost and price of capital (interest rate) and
labour (wage rate), producer can derive the quantity
of labour and capital from the cost function/ cost
equation C = K * PK + L * PL

C Pl
Quantity of K K = C − Pl L and
K = Pk − Pk L and
Pk Pk
C Pk
L = C −P K
Quantity of L L = Pl − Pkl K
Pl Pl
C Pl
K = − L an
Optimal Combination of Inputs Pk Pk
C Pl C Pk
Assume, Budget cost is Rs.100, K= − L and L = − K
Pk Pk Pl Pl
Price of K is 5% and
Pkof L
C Ratio
Price of L is Rs.20 L= − K LABOUR CAPITAL Ratio of K
Pl Pl
100 5 0 0
A

BUDGET 80 4 19 20
Y

LINE or
ISOCOST
QUANTITY

60 3 38 40

40 2 57 60

20 1 76 80
0
B
QUANTITY X
0 0 95 100
Optimal Combination of Inputs
Assume, Budget cost is Rs.100,
Price of K is 5% and The isocost curve is the budget
constraint for the producer,
Price of L is Rs.20
where he has to allocate his
money between the utilization of
A labour and capital.
BUDGET
The slope of isocost
Y

LINE or
ISOCOST

-
QUANTITY

= ΔK/ΔL

Marginal rate of exchange (MRE)

0
B
QUANTITY X
Least cost criterion
To determine the optimal input combination or the
least – cost combination of inputs.

Combine equate slope of isocost with slope of isoquant

There are 2 conditions for the least-cost combination of

inputs:
(i) the first order condition.

(ii) the second order condition.

Least cost criterion
The first order condition
Given the inputs K and L, the slope
of the isocost should be equal to A

QUANTITY OF K
slope of isoquant.
i.e. MRE = MRTS
E
MRE (marginal rate of exchange) is QK
IQ
the slope of isocost.
MRTS (marginal rate of technical
substitution) is the slope of 0
B
isoquant. QL
QUANTITY OF L

Least-cost combination exists at a

point where isoquant is tangent to The least-cost combination of K and
the isocost. L is graphically shown in the
graph. MRE = @ pt E, OQL & OQK
Least cost criterion
The second order condition

It requires that the first order condition be

fulfilled at the highest possible isoquant.

It is be noted that point A and D satisfy the A

Y
first order condition but they are not in the BUDGET

QUANTITY
highest isoquant curve. LINE or
X ISOCOST

E IQ 3
Therefore point P only satisfy the first QK
order and second order condition. IQ 2
IQ 1
Hence, point P determines the optimum Y
input combination or the least-cost 0
B
combination of inputs. QL
QUANTITY X
Laws of returns to scale

Explains the behaviour of output in response

to a proportional and simultaneous change in
inputs.
3 kinds of returns of scale
1. Increasing returns to scale
2. Constant returns to scale
3. Diminishing returns to scale
Laws of returns to scale
1. Increasing returns to scale

It is defined as proportionate change in both the inputs, (capital & labour),

leads to a more than proportionate change in output

2. Constant returns to scale

It is defined as proportionate change in both the inputs, (capital & labour),

leads to equal change in output

3. Diminishing returns to scale

It is defined as proportionate change in both the inputs, (capital & labour),

leads to a less than proportionate change in output
Laws of returns to scale

1. Increasing returns to scale 2. Constant returns to scale 3. Diminishing returns to scale

Cost

Cost is defined as the

expenditure incurred in
the process of goods and
services.
Short Run Cost Curves
Long Run Cost Curves
Short Run Cost Curves
Short Run Cost
The basic analytical cost concepts used in the
analysis of cost behaviour are
➢Total cost (TC)
➢Average cost (AC)
➢Marginal cost (MC)

4
Total cost (TC)

➢Total cost (TC) is the actual cost that must

be incurred to produce a given output
➢SRTC(short run total cost) comprises of 2
major elements
i) Total Fixed Cost(TFC): plant, machinery,
building, etc.
ii) total variable cost(TVC): raw material,
labour cost, etc.
Therefore, TC=TFC+TVC
5
Average cost (AC)
➢Average cost is the per unit of cost incurred
for a given quantity of output (Q)
AC=TC/Q = (TFC+TVC)/Q
AC = AFC +AVC
AFC - Average Fixed cost
=TFC/Q
AVC= Average variable cost
= TVC/Q

6
Marginal cost (MC)

MC is defined as the change in the total cost

divded by the change in the total output.
TC TC
i.e. MC= or or TCn – TCn-1
Q Q

Since TC = TFC + TVC , in the short run,

TFC = 0

And where Q = 1 and MC = TVC

7
Short cost functions and cost curves
➢The shape of the cost curves depends on the
nature of the cost function
➢The cost curves can be produced by
1. Linear function
2. Quadratic function
3. Cubic cost function

8
Linear cost function
TC= a + b Q
Where,
TC is the total cost,
Q is the quantity produced,
a is TFC and
bQ is TVC

Given the cost function

TC
AC=TC/Q=(a+bQ)/Q MC= Q =b
=(a/Q)+(bQ/Q) b is the constant,
=(a/Q)+b MC remains
constant

9
TC, TVC, & TFC CURVES
Assuming the cost function as:
TC= 60+10 Q,
The cost curves TC,TVC and TFC are drawn in the graph
AC & MC CURVES
AC=60/Q+10 and MC= 10, the curves are shown in the graph

11
QUADRATIC COST FUNCTION
TC= a + bQ + Q2
Where a is constant and b is coefficient of Q and TC and Q are Total
Cost and total output resp.
From the cost function, AC and MC can be obtained as
TC a + bQ + Q 2
AC = =
Q Q
a
= +b+Q
Q
TC
MC = = b + 2Q
Q

Assume the cost function as: TC=50+5Q+Q2

AC = 50/Q +5 + Q
MC=5 + 2Q
The curves are shown in the graph
12
QUADRATIC COST FUNCTION

FC,TVC, &TC CURVES MC,AVC & AC CURVES

13
CUBIC COST FUNCTION
TC= a +bQ – cQ2 + Q3
a, b and c are the parametric constants
TC a + bQ − cQ 2 + Q 3
AC = =
Q Q
a
= + b − cQ + Q 2
Q
TC
MC = = b − 2cQ 2 + 3Q 2
Q
TVC = bQ − cQ 2 + Q 3

Given TC= 10+6Q-0.9Q2+0.05Q3

TVC= 6Q-0.9Q2+0.05Q3

14
TC 10 + 6Q − 0.9Q 2 + 0.05Q 3
AC = =
Q Q
10
= + 6 − 0.9Q + 0.05Q 2
Q
TC
MC = = 6 − 1.8Q 2 + 0.15Q 2
Q
TFC = a = 10
TFC 10
AFC = =
Q Q
TVC 6Q − 0.9Q 2 + 0.05Q 3
AVC = =
Q Q
= 6 − 0.9Q + 0.05Q 2
The cost schedule is prepared with the above example cost equations
Q Q
TC = TC = 6
MC
MC = = 6 − 1.8Q 2
Q
TVC= 6Q-0.9Q2+0.05Q3 Q
TFC = a
TC=TFC+TVC = 10= a = 10
TFC
TFC TFC
10
=
AFC = AFC = =
Q QQ
TVC 6Q − 0.
TVC
AVC = AVC =
= =
Q Q
= 6 − 0.9=Q6+−00
.05Q
.9Q
Q FC TVC TC AFC AVC AC MC

0 10 0.0 10.00 - - - -
1 10 5.15 15.15 10.00 5.15 15.15 5.15
2 10 8.80 18.80 5.00 4.40 9.40 3.65
3 10 11.25 25.25 3.33 3.75 7.08 2.45
4 10 12.80 22.80 2.50 3.20 5.70 1.55
5 10 13.75 23.75 2.00 2.75 4.75 0.95
6 10 14.40 24.40 1.67 2.40 4.07 0.65
7 10 15.05 25.05 1.43 2.15 3.58 0.65
8 10 16.00 26.00 1.25 2.00 3.25 0.95
9 10 17.55 27.55 1.11 1.95 3.06 1.55
10 10 20.00 30.00 1.00 2.00 3.00 2.45
11 10 23.65 33.65 0.90 2.15 3.05 3.65
12 10 28.80 38.80 0.83 2.40 3.25 5.15
13 10 35.75 45.75 0.77 2.75 3.52 6.95
14 10 44.80 54.80 0.71 3.20 3.91 9.05
15 10 56.25 66.25 0.67 3.75 4.42 11.45
17
16 10 70.40 80.40 0.62 4.40 5.02 14.15
Graph I Total fixed cost, total variable cost and total cost

18
SHORT RUN COST CURVES
OBSERVATIONS
TFC, TVC & TC
TFC remains constant as output increases
TVC initially increases at increasing rate, then at
decreasing rate, after a point it starts increasing at
increasing rate
TC also has the same pattern as TVC initially
increases at increasing rate, then at decreasing rate,
after a point it starts increasing at increasing rate

19
SHORT RUN COST CURVES
AFC, AVC AND AC

MC AC
COST

AVC

AFC
0
OUTPUT
SHORT RUN COST CURVES
AFC, AVC AND AC
OBSERVATIONS

1)Over the range of output AFC and

AVC fall, AC also falls because
AC=AFC+AVC
2)When AFC falls but the AVC
increases, change in AC depends on
the rate of change in AFC and AVC

i) If ↓ in AFC > ↑ in AVC, then AC

falls,
ii) If ↓ in AFC = ↑ in AVC, AC
remains constant and
iii) If ↓ in AFC < ↑ in AVC, then AC
increases.
21
SHORT RUN COST CURVES
OBSERVATIONS

MC

The behaviour of MC
curve show that if more
and more units of a
variable input are applied
to a given amount of a
fixed input, the marginal
cost initially decreases,
but eventually increases.
This is called as Law of
diminishing returns

22
SHORT RUN COST CURVES
OBSERVATIONS
The relationship between AC and MC

i) when MC falls, AC follows, over a certain range of initial

outputs. When MC is falling, the rate of fall in MC is
greater than that of AC.
ii) When MC increases, AC also increases but at a lower
rate.

iii) MC intersects AC at its minimum point where AC=MC.

23
Output optimization in the short run
TC=10 +6Q-0.09q2+0.05Q3
Condition is to minimize AC to optimize the output
The level of output that minimizes AC is 10 when
we look into cost schedule and the graph.

COST
AC Thus, the critical value
of output in respect of
AC is 10. That is a firm
reaches its minimum
AC average cost is at Q=10.
=
3.00

0 OUTPUT
Q = 10
Long Run
Total Cost Curve
In long run all factors of production are
assumed to be variable
A business can vary all of its inputs and
change the whole scale of production.
The firm expands its business by starting
plant2, plant3 and increases its output in the
long run.

The long run cost curves, are summation of

all the short run costs.
Long run cost curves

• The long run cost curves are discussed in

terms of:
1. Long run total cost (LTC)
2. Long run average cost (LAC)
3. Long run marginal cost (LMC)
4. Optimum level of output
Long run total cost curve

• Long run total cost (LTC) curves is defined

as the combination of all short run total cost
curves over a period of time.

• The graph below depicts the long run total

cost curve.
Long run total cost curves
Long run total cost curves
Nature of LRTC
• Long run total cost curve is derived by
joining the optimum output (A,B, and C)
points of all the short run total cost curve.
• The LRTC initially increases at increasing
rate, then increases at constant rate and
increases at decreasing rate.
Long run average cost curve

Long run average cost curves is derived

from the combination of all the short run
cost curves over a period of time.
Long run average cost curve
Long run average cost curve

Q’1 Q’3
Long run average cost curves
At initial stages of business, the firm
produces at a certain level of average cost
(A1), as the business expands, the average
cost reduces to A2. Further, the average cost
increases to A3. Joining the A1,A2, and A3
points long run average cost curve is
obtained.
Long run marginal cost curve
LMC

SMC3
SMC1 Y

SMC2

Q’1 Q’3
LMC
COST

OUTPUT
Long run marginal cost curve
• Long run marginal cost curves (LMC) are
derived by the joining the intersection
points of SMC and LAC. All the SMC
curves are intersecting LAC at B1,A2, and
B3. Therefore by joining these points, LMC
curve is obtained.
Optimum level of output
• The optimum level of output is achieved
where SMC=SAC=LAC=LMC.
• Therefore at point A2 the firm is able to
fulfill this condition.
• The firm will produce OQ2 quantity (the
optimum level) of output at A2Q level of
average cost in the long run.
• And after this level of average cost any
increase in the quantity would increase the
cost per unit.
LMC
COST LAC
SAC

SMC

Q
OUTPUT
@ pt E, SMC=SAC=LAC=LMC.
ECONOMIES AND DISECONOMIES OF
SCALE
ECONOMIES AND DISECONOMIES OF SCALE
ECONOMIES AND DISECONOMIES OF SCALE
In the LAC till the optimum level
of output is reached the cost per
unit continues to decrease due
to economies of scale i.e at OQ
level of output.

The cost per unit increases for

every increase in output after OQ
due to diseconomies of scale.
ECONOMIES OF SCALE COST

It is defined as the advantageous

factors that decrease the cost per
ECONOMIES OF SCALE LAC
unit or average cost during the
large scale production

AC = TC / Q is at its minimum

Economies of Scale – spreads total

costs over a greater range of output
C
Represent the cost-savings and
competitive advantages larger
businesses have over smaller ones.
Q
OUTPUT
TYPES OF ECONOMIES OF SCALE
Internal economies:
specific to an individual firm or
with in firm

External economies:
advantages that benefit the industry as a
whole or from outside the firm
TYPES OF ECONOMIES OF SCALE
Internal Economies External Economies
Those Specifically related to Benefits the whole industry and
the business itself. eg:- not specific firms
1. Production efficiency 1. Skilled labour in the area
2. Purchasing efficiency 2. Better road and rail networks
3. Marketing efficiency 3. Improves the reputation of the
area
4. Financial efficiency
4. Attracts other businesses
5. Managerial efficiency
5. Banking system
6. Supplier relationship
DISECONOMIES OF SCALE
COST
It is defined as the
disadvantageous factors that
DISECONOMIES OF SCALE
LAC
increase the cost per unit or
average cost during the large
scale production.
After minimum AC, the firms tend to
experience technical inefficiencies,
that increases the cost
C
These disadvantages translate
into higher unit costs
(or productive inefficiency)
Q
DISECONOMIES OF SCALE
Internal Diseconomies External Diseconomies
Within the firm Outside the firm
1. Production – outdated m/c 1. Government subsidies
reduces
2. Purchasing – procurement of RM
2. Bank system interest rate
3. Marketing – advertisement exp increases
4. Financial - interest rate 3. Emergence new
5. Managerial - inefficiency competitors
4. Inflation
5. Imported goods