Long-Run Production Function

(With Diagram)
Article Shared by <="" div="" style="margin: 0px; padding: 0px; border:
0px; outline: 0px; font-size: 14px; vertical-align: bottom; background: transparent; max-width:
100%;">
ADVERTISEMENTS:

Production in the short run in which the functional relationship

between input and output is explained assuming labor to be the
only variable input, keeping capital constant.

In the long run production function, the relationship between input

and output is explained under the condition when both, labor and
capital, are variable inputs.

In the long run, the supply of both the inputs, labor and capital, is
assumed to be elastic (changes frequently). Therefore, organizations
can hire larger quantities of both the inputs. If larger quantities of
both the inputs are employed, the level of production increases. In
the long run, the functional relationship between changing scale of
inputs and output is explained under laws of returns to scale. The
laws of returns to scale can be explained with the help of isoquant
technique.

ADVERTISEMENTS:

Isoquant Curve:
The relationships between changing input and output is studied in
the laws of returns to scale, which is based on production function
and isoquant curve. The term isoquant has been derived from a
Greek work iso, which means equal. Isoquant curve is the locus of
points showing different combinations of capital and labor, which
can be employed to produce same output.

It is also known as equal product curve or production indifference

curve. Isoquant curve is almost similar to indifference curve.
However, there are two dissimilarities between isoquant curve and
indifference curve. Firstly, in the graphical representation,
indifference curve takes into account two consumer goods, while
isoquant curve uses two producer goods. Secondly, indifference
curve measures the level of satisfaction, while isoquant curve
measures output.

Some of the popular definitions of isoquant curve are as

follows:
ADVERTISEMENTS:

According to Ferguson, “An isoquant is a curve showing all possible

combinations of inputs physically capable of producing a given level
of output.”

According to Peterson, “An isoquant curve may be defined as a

curve showing the possible combinations of two variable factors
that can be used to produce the same total product”

From the aforementioned definitions, it can be concluded that the

isoquant curve is generated by plotting different combinations of
inputs on a graph. An isoquant curve provides the best combination
of inputs at which the output is maximum.

Following are the assumptions of isoquant curve:

ADVERTISEMENTS:

i. Assumes that there are only two inputs, labor and capital, to
produce a product

ii. Assumes that capital, labor, and good are divisible in nature

iii. Assumes that capital and labor are able to substitute each other
at diminishing rates because they are not perfect substitutes

iv. Assumes that technology of production is known

On the basis of these assumptions, isoquant curve can be drawn

with the help of different combinations of capital and labor. The
combinations are made such that it does not affect the output.
Figure-4 represents an isoquant curve for four
combinations of capital and labor:

In Figure-4, IQ1 is the output for four combinations of capital and

labor. Figure-4 shows that all along the curve for IQ1 the quantity of
output is same that is 200 with the changing combinations of
capital and labor. The four combinations on the IQ1 curve are
represented by points A, B, C, and D.

Table-4 shows the relationship between input and output

for IQ1 curve:

In Table-4, as we move from A to D, capital starts decreasing with

the increase in labour. This shows that capital is substituted by
labor, while keeping the output unaffected.

As discussed earlier, isoquant curve is almost similar to indifference

curve. The properties of isoquant curve can be explained in terms of
input and output.

Some of the properties of the isoquant curve are as

follows:
i. Negative Slope:
ADVERTISEMENTS:
Implies that the slope of isoquant curve is negative. This is because
when capital (K) is increased, the quantity of labor (L) is reduced or
vice versa, to keep the same level of output. As shown in Table-4,
when the quantity of labor is increased from one unit to two units,
the quantity of capital is decreased from four to three, to keep the
level of output constant, which is 200.

ii. Convex to Origin:

Shows the substitution of inputs and diminishing marginal rate of
technical substitution (which is discussed later) in economic region.
This implies that marginal significance of one input (capital) in
terms of another input (labor) diminishes along with the isoquant
curve. For example, in Table-4, it can be seen when more and more
units of capital are used to produce 200 units of output, less or less
units of labor are used.

iii. Non-intersecting and Non-tangential:

ADVERTISEMENTS:

Implies that two isoquant curves (as shown in Figure-4) cannot cut
each other.

Figure-5 shows the intersection of two isoquant curves:

In Figure-5, the two isoquant curves intersect at point A. The point

B on isoquant having Q2 = 300 and point C on isoquant curve
having Q1 = 200 with the same amount of labor that is OL2.
However, the capital is different that is BL2 in case of point B and
CL2 in case of point C. A is the common point of isoquant for B and
C points.

ADVERTISEMENTS:
Now, according to isoquant definition, the output produced at A is
the same as produced on B and C points. On isoquant curve Q1, the
output produced at A and C is 200 while on Q2 curve the output
priced at A and B is 300.

To make the input at point B and C equal, the following

formula is used:
OL2 + BL2 = OL2 + CL2

BL2 = CL2

However according to Figure-5, BL2 > CL2 but the intersection of

two isoquants implies that BL2 and CL2 are equal with respect to
their output, which is not possible. Therefore, it is stated that
isoquant curves cannot intersect; otherwise the law of production
would not be applicable.

iv. Upper isoquant have high output:

Implies that upper curve of the isoquant curve produces more
output than the curve beneath. This is because of the larger
combination of input result in a larger output as compared to the
curve that s beneath it. For example, in Figure-5 the value of capital
at point B is greater than the capital at point C. Therefore, the
output of curve Q2 is greater than the output of Q1.

Marginal Rate of Technical Substitution:

Marginal Rate of Technical Substitution (MRTS) is the quantity of
one input (capital) that is reduced to increase the quantity of the
other input (L), so that the output remains constant.

Table-5 shows the marginal rate of technical substitution:

Table-5 shows that how much labor is required to replace one unit
of capital while keeping the output same for all combinations of
capital and labor, which is 150.

In such a case, MRTS can be calculated with the help of the

following formula:
MRTS = ∆K/∆L

Where, ∆K = Change in Capital

∆L= Change in Labor

For example, in Table-5 at point Q MRTS can be calculated

as follows:
∆K = new capital – old capital

∆K= 15 – 11

∆K = 4

∆L = 2 – 1

∆L= 1

Therefore, MRTS at point Q would be:

MRTS = ∆K/∆L

MRTS = 4/1 or 4:1

Similarly, we can calculate MRTS at different points, which are R, S,

and T.

Figure-6 shows the curve of MRTS:

Forms of Isoquants:
The shape of an isoquant depends on the degree to which one input
can be substituted by the other. Convex isoquant represents that
there is a continuous substitution of one input variable by the other
input variable at a diminishing rate.

However, in economics, there are other forms of

isoquants, which are as follows:
i. Linear Isoquant:
Refers to a straight line isoquant. Linear isoquant represents a
perfect substitutability between the inputs, capital and labor, of the
production function. It implies that a product can be produced by
using either capital or labor or using both, if capital and labor are
perfect substitutes of each other. Therefore, in a linear isoquant,
MRTS between inputs remains constant.

The algebraic form of production function in case of linear

isoquant is as follows:
Q = aK + BL

Here, Q is the weighted sum of K and L.

Slope of curve can be calculated with the help of following

formula:
MPK = ∆Q/∆K = a
MPL = ∆Q/∆L = b
MRTS = MPL/MPK
MRTS = -b/a

However, linear isoquant does not have existence in the real world.

Figure-7 shows a linear isoquant:

ii. L-shaped Isoquant:
Refers to an isoquant in which the combination between capital and
labor are in a fixed proportion. The graphical representation of fixed
factor proportion isoquant is L in shape. The L-shaped isoquant
represents that there is no substitution between labor and capital
and they are assumed to be complementary goods.

It represents that only one combination of labor and capital is

possible to produce a product with affixed proportion of inputs. For
increasing the production, an organization needs to increase both
inputs proportionately.

Figure-8 shows an L-shaped isoquant:

In Figure-8, it can be seen OK1 units of capital and OL1 units of

labor are required for the production of Q1. On the other hand, to
increase the production from Q1 to Q2, an organization needs to
increase inputs from K1 to K2 and L1 to L2 both.

This relationship between capital and labor can be

expressed as follows:
Q = f (K, L) = min (aK, bL)

Where, min = Q equals to lower of the two terms, aK and bL

For example, in case aK > bL, then Q = bL and in case aK < bL then,
Q = aK.

L-shaped isoquant is applied in many production activities and

techniques where labor and capital is in fixed proportion. For
example, in the process of driving a car, only one machine and one
labor is required, which is a fixed combination.

iii. Kinked Isoquant:

Refers to an isoquant that represents different combinations of
labor and capital. These combinations can be used in different
processes of production, but in fixed proportion. According to L-
shaped isoquant, there would be only one combination between
capital and labor in a fixed proportion. However, in real life, there
can be several ways to perform production with different
combinations of capital and labor.

For example, there are two machines in which one is large in size
and can perform all the processes involved in production, while the
other machine is small in size and can perform only one function of
production process. In both the machines, combination of capital
employed and labor used is different.

Let us understand kinked isoquant with the help of another

example. For example, to produce 100 units of product X, an
organization has used four different techniques of production with
fixed-factor proportion.

The combination between inputs and their ratio is

provided in Table-6:
In Table-6, OA, OB, OC, and OD represents the four production
techniques. The fixed capital-labor ratio for OA technique is 10:2,
for OB it is 6:3, for OC 4:6, and for OD is 3:10. Therefore, different
production techniques use different fixed combinations of capital
and labor.

The graphical representation of kinked isoquant is shown

in Figure-9:

Elasticity of Factor Substitution:

We have studied that MRTS is associated with the slope of an
isoquant and represents ratio of marginal changes in inputs. MRTS
does not represent the substitutability between the two inputs,
capital and labor, with different combinations of inputs.

However, it is important to measure the degree of substitutability

between the two inputs. Therefore, economists have developed a
formula for estimating the extent of substitutability between the two
inputs, capital and labor, which is known as elasticity of factor
substitution.

Elasticity of factor substitution (a) refers to the ratio of percentage

change in capital-labor ratio to the percentage change in MRTS.

It is mathematically represented as follows:

σ = percentage change in capital labor ratio/percentage change in
MRTS

Or,

σ = [(AK/AL) /AMRTS] * [MRTS/ (K/L)]

If change produced in capital-labor ratio by change in MRTS-is
equal and in opposite direction, then σ = 1. If the change produced
in capital-labor ratio is greater than the change in MRTS, then σ > 1.
In case the change in capital-labor ratio is greater than the change
in MRTS, then σ < 1. High elasticity of substitution between factors
implies that the factors can easily substituted to each other, while a
low elasticity represents that substitution of factors is possible to a
certain extent.

The degree of elasticity depends on the shape of isoquant curve. If

the shape of isoquant curve is linear and factors are perfect
substitutes, then the substitution elasticity would be infinite. In case
the factors are complementary to each other and isoquants are L-
shaped, then the substitution elasticity is zero. The elasticity of
substitution is negative between factors due to the inverse relation
of factor-ratio and MRTS. The elasticity of substitution would be
less as the convexity of the isoquant curve increases

Short-Run and Long-Run

Production Functions
Article Shared by <="" div="" style="margin: 0px; padding: 0px; border:
0px; outline: 0px; font-size: 14px; vertical-align: bottom; background: transparent; max-width:
100%;">
ADVERTISEMENTS:

The upcoming discussion will update you about the

difference between short-run and long-run production
functions.
The firm may change only the quantities of the variable inputs in
the short run when the quantities of the fixed inputs remain
unchanged.

That is, in the short run, the output quantity can be increased (or
decreased) by increasing (or decreasing) the quantities used of only
the variable inputs. This functional relationship (of dependence)
between the variable input quantities and the output quantity is
called the short run production function.

ADVERTISEMENTS:

We have to remember here, of course, that in the short-run, the firm

uses a particular combination of fixed inputs, and its short-run
production function is obtained in respect of that combination.

In the long run, however, all the inputs used by the firm, the
variable inputs and the so called fixed inputs, all are variable
quantities and the firm’s production is a function of all these inputs.
This functional relation of dependence between all the inputs used
by the firm and the quantity of its output is called the long run
production function of the firm.

We may illustrate the difference between the short-run and the long
run production functions in the following way. Let us suppose that
the firm uses only two inputs X and Y to produce its output of one
commodity, Q, and of these two inputs X is a variable input and Y is
a fixed input.

Therefore, in this case, the firm’s short-run production

function may be written as:
ADVERTISEMENTS:

q = f(x, y̅) (8.5)

where y̅ is the fixed quantity of the fixed input y. The

firm’s long run production function in this example would
be:
q = f(x, y) (8.6)

where x and y are the variable quantities of the inputs X and Y.

ADVERTISEMENTS:

We may write the firm’s short-run production function

(8.5) in the following form also:
q = h(x) (8.7)
For, in our example, in the short-run, the change in the firm’s
output depends on the change in the quantity used of the input X
only.

The short run production production assumes there is at least one fixed factor input

Production Functions

 The production function relates the quantity of factor inputs used by a

business to the amount of output that result.

We use three measures of production and productivity:

Total product (total output). In manufacturing industries such as motor vehicles, it is

straightforward to measure how much output is being produced. In service or knowledge
industries, where output is less “tangible" it is harder to measure productivity.

Average product measures output per-worker-employed or output-per-unit of capital.

Marginal product is the change in output from increasing the number of workers used by
one person, or by adding one more machine to the production process in the short run.

The length of time required for the long run varies from sector to sector. In the nuclear
power industry for example, it can take many years to commission new nuclear power plant
and capacity. This is something the UK government has to consider as it reviews our future
sources of energy.

Short Run Production Function

 The short run is a time period where at least one factor of production is in fixed
supply
 A business has chosen its scale of production and sticks with this in the short
run
 We assume that the quantity of plant and machinery is fixed and that
production can be altered by changing variable inputs such as labour, raw
materials and energy
Diminishing Returns

 In the short run, the law of diminishing returns states that as more units of
a variable input are added to fixed amounts of land and capital, the change in
total output will first rise and then fall
 Diminishing returns to labour occurs when marginal product of labour starts to
fall. This means that total output will be increasing at a decreasing rate

What might cause marginal product to fall?

One explanation is that, beyond a certain point, new workers will not have as much capital
equipment to work with so it becomes diluted among a larger workforce I.e., there is less
capital per worker.

In the following numerical example, we assume that there is a fixed supply of

capital (capital = 20 units) to which extra units of labour are added to the production process.

 Initially, marginal product is rising – e.g. the 4th worker adds 26 to output and
the 5th worker adds 28 and the 6th worker increases output by 29.
 Marginal product then starts to fall. The 7 th worker supplies 26 units and the
8th worker just 20 added units. At this point production demonstrates
diminishing returns.
 Total output will continue to rise as long as marginal product is positive
 Average product will rise if marginal product > average product

Numerical Example of the Law of Diminishing Returns

Capital Input Labour Input Total Output Marginal Product Average Product of Labour
20 1 5 5
20 2 16 11 8
20 3 30 14 10
20 4 56 26 14
20 5 85 28 17
20 6 114 29 19
20 7 140 26 20
20 8 160 20 20
20 9 171 11 19
20 10 180 9 18

Diminishing returns and marginal cost

Criticisms of the Law of Diminishing Returns

 How realistic is this assumption of diminishing returns? Surely ambitious and

successful businesses will do their level best to avoid such a problem
emerging?

 It is now widely recognised that the effects of globalisation and the ability
of trans-national businesses to source their inputs from more than one country
 and engage in transfers of business technology, makes diminishing returns less
relevant

 Many businesses are multi-plant meaning that they operate factories in

different locations – they can switch output to meet changing demand

Demand Forecasting
Demand forecasting is a combination of two words; the first one is
Demand and another forecasting. Demand means outside
requirements of a product or service. In general, forecasting means
making an estimation in the present for a future occurring event. Here
we are going to discuss demand forecasting and its usefulness.

Demand Forecasting
It is a technique for estimation of probable demand for a product or
services in the future. It is based on the analysis of past demand for
that product or service in the present market condition. Demand
forecasting should be done on a scientific basis and facts and events
related to forecasting should be considered.

Therefore, in simple words, we can say that after gathering

information about various aspect of the market and demand based on
the past, an attempt may be made to estimate future demand. This
concept is called forecasting of demand.

For example, suppose we sold 200, 250, 300 units of product X in the
month of January, February, and March respectively. Now we can
say that there will be a demand for 250 units approx. of product X in
the month of April, if the market condition remains the same.

Usefulness of Demand Forecasting

Demand plays a vital role in the decision making of a business. In

competitive market conditions, there is a need to take correct decision
and make planning for future events related to business like a sale,
production, etc. The effectiveness of a decision taken by business
managers depends upon the accuracy of the decision taken by them.

Demand is the most important aspect for business for achieving its
objectives. Many decisions of business depend on demand like
production, sales, staff requirement, etc. Forecasting is the necessity
of business at an international level as well as domestic level.

Demand forecasting reduces risk related to business activities and

helps it to take efficient decisions. For firms having production at the
mass level, the importance of forecasting had increased more. A good
forecasting helps a firm in better planning related to business goals.

There is a huge role of forecasting in functional areas of accounting.

Good forecast helps in appropriate production planning, process
selection, capacity planning, facility layout planning, and
inventory management, etc.

Demand forecasting provides reasonable data for the

organization’s capital investment and expansion decision. It also
provides a way for the formulation of suitable pricing and
advertisement strategies.

Following is the significance of Demand Forecasting:

 Fulfilling objectives of the business

 Preparing the budget
 Taking management decision
 Evaluating performance etc.
Moreover, forecasting is not completely full of proof and correct. It
thus helps in evaluating various factors which affect demand and
enables management staff to know about various forces relevant to
the study of demand behavior.

Source: Alamy

The Scope of Demand Forecasting

The scope of demand forecasting depends upon the operated area of

the firm, present as well as what is proposed in the future.
 Forecasting can be at an international level if the area of operation is
international. If the firm supplies its products and services in the local
market then forecasting will be at local level.

The scope should be decided considering the time and cost involved
in relation to the benefit of the information acquired through the
study of demand. Cost of forecasting and benefit flows from such
forecasting should be in a balanced manner.

Types of Forecasting

There are two types of forecasting:

 Based on Economy
 Based on the time period
1. Based on Economy

There are three types of forecasting based on the economy:

i. Macro-level forecasting: It deals with the general

economic environment relating to the economy as measured by the
Index of Industrial Production(IIP), national income and general
level of employment, etc.
ii. Industry level forecasting: Industry level forecasting deals with
the demand for the industry’s products as a whole. For example
demand for cement in India, demand for clothes in India, etc.
iii. Firm-level forecasting: It means forecasting the demand for a
particular firm’s product. For example, demand for Birla cement,
demand for Raymond clothes, etc.
2. Based on the Time Period

Forecasting based on time may be short-term forecasting and long-

term forecasting
 i. Short-term forecasting: It covers a short period of time,
depending upon the nature of the industry. It is done generally for
six months or less than one year. Short-term forecasting is
generally useful in tactical decisions.
ii. Long-term forecasting casting: Long-term forecasts are for a
longer period of time say, two to five years or more. It gives
information for major strategic decisions of the firm. For example,
expansion of plant capacity, opening a new unit of business, etc.

Solved Example on Demand Forecasting

Q. Which of the following is not correct about demand
forecasting?

a. Predicts future demand for a product or service.

b. Based on the past demand for the product or service.
c. It is not based on scientific methods.
d. Helps in the managerial decision making.
Ans: The correct option is C. Demand Forecasting is based on
scientific methods and proper judgment in order to correctly predict
the future demand for a product or service. It gathers information
about various aspects of the market like future changes in the selling
price, product designs, changes in competition, advertisement
campaigns, the purchasing power of the consumers, employment
opportunities, population, etc. All the information gathered is
scientifically analyzed so as to forecast the future demand for the
product.