Chapter Three

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Theory of production
Learning Objective
Define production, input, and output;
Distinguish the differences between short-run and long-run production period;
Define production function;
Explain the concepts of production function with one variable input;
Distinguish the difference between total, average, and marginal product;
Show the relationship between average product and marginal product;
Describe the law of diminishing marginal product;
Identify and analyze the steps of productions;
Explain the concepts of production function with two variable input;
Define Isoquant curve schedule and map;
State the basic characteristics of Isoquant;
Identify the economic region of production; and
Show the effects of technological change on production.
Definition of Production Example
For example, when we get wheat
on a plot of land with the help of
inputs like labor, capital and seeds,
it is termed as production of wheat.

Similarly, when, in a cloth mill,

inputs like labor, capital and
threads are transformed into cloth,
it is called the production of cloth.

Similarly, in an economy, services

are also produced. For instance,
the services of a teacher, an
advocate, a doctor, a singer and
servant are also called production
in economics.
Factors of Production or Inputs
1. Land: Refers to all natural resources (land
itself, minerals, forests, water, oil, and 4. Entrepreneurship: Involves the ability to
other natural assets) organize the other factors of production
effectively to create goods and services.
❑ Limited in supply and Cannot be produced
by human effort
❑ Entrepreneurs take risks to innovate, start
businesses, and manage resources.
2. Labour: Represents human effort, both
physical and mental, used in the
production process. ❑ Key Features:
❑ Includes all types of work performed by • Combines land, labor, and capital to
individuals to create goods and services. produce goods or services.
• The reward for entrepreneurship is
3. Capital: Refers to man-made resources profit.
used to produce goods and services.
❑ Includes machinery, tools, buildings, and ❑ Example: Startup founders, business
technology. owners.
Classification of Raw Materials: Land or working capital

• Examples of Raw Materials as Part of Land:

• Minerals and Ores: Iron ore, bauxite, gold, silver, and other natural mineral deposits.
• Forests: Trees that are part of a forest before they are cut down for wood or paper
production.
• Soil and Agricultural Land: Fertile soil that supports farming activities or land used for
growing crops.
• Water Bodies: Water in its natural state (e.g., rivers, lakes, or underground aquifers) before
being processed or transported.
• Oil and Natural Gas: Crude oil or natural gas in reservoirs beneath the Earth's surface.
• Fisheries and Marine Resources: Fish in the ocean or other aquatic resources before being
harvested.

• Transition from Land to Working Capital:

• As Part of Land: While raw materials are still in their natural state (e.g., trees in a forest, oil
underground), they are considered part of land.
• As Part of Working Capital: Once these resources are extracted, harvested, or processed (e.
g., logs from trees, crude oil in barrels), they become part of the working capital used in
production.
Production Function
• The production function is purely a technological relationship that
expresses the relationship between the output of a good and the different
combinations of inputs used in its production.
Fixed and Variable Input
•

Period of
Production
• The total product (TP) is the total output amount resulting from different quantities of
inputs. If we assume labour (L) as the variable input assuming (capital, etc., held
constant).

• Marginal product of labour (MPL) is defined as the change in total product (TP) per
unit change in variable input, say labour (L), that is,
• MPL = ∆ TP /∆ L……. (2)

• Similarly, Average product of labour may be defined as

APL = TP / L……. (3)
Hypothetical Schedule of TP, MP and AP and Diagram
Stages of Production
Relationship Between Total Product, Marginal
Product, and Average Product
The relationship When MP > AP, this means that AP is rising,
between MP and AP:
When MP = AP, this means that AP is maximum,

When MP < AP, this means that AP is falling.

Graphically, the So long as the MP curve lies above the AP curve, the AP curve is a positively sloping curve, AP
relationships between rises
the MP curve and AP When the MP curve intersects the AP curve, AP is at maximum,
curve are as follows
(see Figure 4.1):
When the MP curve lies below the AP curve, the AP curve slopes downward, i.e., AP declines.

The relationship When TP increases at an increasing rate, marginal product increases,

between TP and MP:
While TP increases at a diminishing rate, MP declines,

When total product reaches its maximum, marginal product becomes zero,

When TP begins to decline, MP becomes negative.

The Law of
Diminishing
Marginal Returns

The law states that as more and

more of one-factor input is
employed, assuming all other input
quantities held constant, a point will
eventually be reached where
additional quantities of the varying
input will yield diminishing marginal
contributions to total product.
The Law of
Diminishing
Marginal Returns

Note that:
• The law operates only if
technology does not change
• The law starts to operate after the
MP curve reaches its maximum
(see Figure 4.1)
• The law is universal because the
tendency of diminishing return is
all pervading, and so it applies
sooner or later in every field of
production.
Long Run Analysis –Q=f(L,K)
Production process and iso-quant

• Technical Efficiency: Technical efficiency

happens when a firm produces a given level
of output by using least number of inputs.

• Economic Efficiency: Economic

efficiency happens when a firm produces a
given level of output at least cost. So
economically efficient method of production
depends on the relative costs of resources.
Production Function with Two Variable
Inputs

A tabular representation of the

various combinations of two
variable inputs which give the
same level of output is called
an isoquant schedule or equal
product schedule.
Isoquant curve and
Isoquant map

Isoquant: An isoquant is a curve representing

the various combinations of two inputs that
produce the same amount of output.

An isoquant may, therefore, be defined as a

curve which shows the different combinations of
the two inputs that produce a given level of
output.
Properties of
Isoquants
• An isoquant is downward-sloping to the right, (i.e.
, negatively inclined), implying that if more of one
factor is used, less of the other factor is needed for
producing the same level of output.
• No two isoquants intersect or touch each other.
If two isoquants intersect or touch each other it
means that there is a common point on the two
curves (point A in Figure 4.6). This common point
would imply that the same amount of labour and
capital can produce two levels of outputs (example,
60 and 70 units, here), which is impossible.
• Isoquants are convex to the origin. The property
of convexity implies that the slope of the isoquant
diminishes from left to right along the curve.
Convexity of an isoquant is the result of the principle
of diminishing marginal rate of technical substitution
(MRTS) of one factor in place of the other. We
discuss MRTS more in a later sub-section.
Economic Region of Production
A ridge line is the locus of points of isoquants where marginal
product of input is zero.

the upper ridge line joins all such points (for example, a, b,
etc.) where marginal product of capital (MPk ) is zero

lower ridge line joins points where marginal product of labour

(MPL ) is zero (points c, d, etc.).

The production techniques are technically efficient inside the

ridge lines.

Outside the ridge lines, the marginal products of inputs are

negative, i.e., more of both inputs are required to produce a
given level of output.

Obviously, no rational producer would like to operate outside

the ridge line. Thus, the economic region of production is the
region bounded by the ridge lines.
Marginal Rate of Technical Substitution
(MRTS)
A marginal rate of technical
substitution is the rate at which
factors can be substituted at the
margin without altering the level of
output.

More precisely, marginal rate of

technical substitution of labour for
capital may be defined as the number
of units of capital which can be
replaced by one unit of labour, the
level of output remaining unchanged.
• MRTS of labour for capital = ΔK / ∆L

MRTS =Amount of capital given up / Amount of

labor used ……(4)

Formula ΔK represents change in units of capital

and ∆L, change in units of labour.

Note:
• MRTS at a point on an isoquant = the
slope of the isoquant at that point.
• The property of diminishing MRTS
results in convexity of the isoquant.
Returns to Scale (Production with all Variable
Inputs)

Returns to Scale (RTS): Returns to scale refers to the rate by which output changes if all
inputs are changed by the same proportion.

1. Increasing Returns to Scale. It occurs when output increases by a greater proportion

than the proportion of increase in all the inputs.
2. Constant Returns to Scale. It happens when output increases by the same
proportion as of inputs increase.
3. Diminishing Returns to Scale. It occurs when output increases by a smaller
proportion than the proportion of in input increases.
hypothetical schedule and
diagram
Returns to Scale and Homogeneity of The Production
Function
Suppose we increase both factors of the function : X0 = f (L, K)

by the same proportion t, and we observe the resulting new level of output X*: X* = f (tL, tK)

• If t can be factored out (that is, may be taken out of the brackets as a common factor), then the new
level of output X * can be expressed as a function of t (to any power v) and the initial level of output

• X * = t v f (L, K) or X*= tv x0

• and the production function is called homogeneous. If t cannot be factored out, the production
function is non-homogeneous. Thus:

• A homogeneous function is a function such that if each of the inputs is multiplied by t, then t can
be completely factored out of the function. The power v of t is called the degree of homogeneity of the
function and is a measure of the returns to scale:

1. If v = 1 CRTS . 2. If v < 1 ; DRTS. 3. If v > 1; IRTS

Example of Non- homogeneous Homogeneous Production
production function function with constant
returns to scale

X0 = f (L, K) =L+K2
Q =K 0.3 L0.7
= tL+t2 K2 = (tK) 0.3 (tL0.7)
Some =t (L+tK2) =t0.3 K 0.3 t 0.7 L0.7

example X* ≠ t X0 = t0.3 t 0.7 (K 0.3 L0.7)

=t1 (K 0.3 L0.7)
Q * = t1 Q

Q= K 0.3 L 0.2 Q= K 2 + L2 Q=2k2+L+KL Q=2k2+L2+KL Q=4k+4L2

Reasons for
Increasing and
Decreasing Returns
Reasons for operation of increasing returns to scale are:
• Greater division of labour and specialisation which
increases productivity.
• Use of more productive specialised machinery.
•
Reasons for operation of diminishing returns to scale are:

• The main reason for operation of diminishing return to

scale is difficulty in management and coordination when
scale of operation becomes bigger and bigger.
E ect of Technological Change on
Production Function

• Technological change refers to a

change in the underlying
techniques of production, as occurs
when a new process of production
is invented or an old process is
improved. In such situations, the
same output is produced with fewer
inputs or more output is produced
with the same inputs. These
changes in technology are called
technological progress or
innovation in processes.
Assignment on Technical and economic
E ciency

Assignment Title: An economically efficient method of production process

is also technically efficient. However, a technically efficient method of
production may not be an economically efficient one.

• Size: A4, Fonts: Time new Romans ; Line Space: 1.5