Theory of Production
Definition of Production
Production is the process of transforming inputs into outputs.
Input refers to the factors of production that a firm uses in the production process.
Output refers to what we get at the end of the production process, that is, finished
products.
Classification of Factors of Production
Land: All natural resources or gifts of nature.
Labour: Physical or mental activities of human beings.
Capital: Part of man-made wealth used for further production.
Entrepreneur: A person who combines the different factors of production, and
initiates the process of production and also bears the risk.
The Production Function
The production function is a statement of the functional relationship between
inputs and outputs, where the maximum output that can be produced is shown
with given inputs.
The production function is a simple way to show how inputs (like labor and
capital) are transformed into outputs (goods or services) by a firm.
Q = (K, L)
Where Q = Output
K = Capital
L = Labour
Short Run Production Function
The short run refers to a period of time during which at least one factor of
production is fixed.
Q = (�, L)
Where Q = Output
L = Labour
K = Capital (Fixed)
Total Product (TP): The amount of output produced when a given amount of that
input is used along with fixed inputs.
Average Product (AP): Divide the total product by the amount of that input used
in the production.
푇표� 푃푟표� �
푇표� 퐿 푏표 푟
Average Product =
Marginal Product (MP): Marginal Product is the change in output that results
from adding one more unit of input.
The marginal product refers to the additional output achieved due to the
employment of one more unit of a variable factor of production, keeping all other
factors constant.
As more variable factors are added within the short run, the marginal product
typically rises, reaches a peak, and then starts to decline due to the law of
diminishing marginal returns.
This phenomenon occurs because once a certain level of fixed factors is reached,
adding more variable factors doesn't lead to proportionally greater output. Instead,
the gain in output slows down and eventually plateaus or drops off
�ℎ 푛 푖푛 푇표� 푃푟표� �
�ℎ 푛 푖푛 푇표� 퐿 푏표 푟
Marginal Product (MP) =
Law of Diminishing Marginal Returns
It states that if the quantities of certain factors are increased while the quantities
of one or more factors are held constant, beyond a certain level of production, the
rate of increase in output will decrease.
Stages of Production
Stage of Increasing Returns: At the beginning, adding more of a variable input
(like labor) to fixed inputs (like capital) leads to increasing production efficiency,
and output grows faster.
Here, each additional unit of input contributes more to total production than the
previous unit.
Stage of Diminishing Returns: After a point, adding more of the variable input
still increases output, but at a decreasing rate. Marginal returns start to diminish.
Here, each additional unit of input contributes less to total production than the
previous unit.
Stage of Negative Returns: Eventually, adding more of the variable input results
in a decrease in overall production. The firm is now experiencing negative
marginal returns, and efficiency declines.
Here, the additional units of input actually lead to a reduction in total production.
L
The Long Run
The long run refers to a period of time during which all factors of production are
variable.
Isoquant
Isoquant represents all possible combinations of variable inputs that are used to
generate the same level of output (total product).
Isoquant analysis illustrates that there are various ways to generate a given
quantity of output in one time period.
Isoquant Schedule
There are various combinations of capital and labour. Different combination of
inputs can yield diffrerent outputs.
For example, using 2 units of capital and 8 units of labor, total output would be
100 units.
Isoquant Curve
4 Properties of Isoquant
1. Down to the right: Isoquant curves slope downwards, indicating a negative
slope.
2. Convex to the origin: It means isoquants curve towards the origin, reflecting
diminishing marginal rate of technical substitution.
3. Two isoquants can not intersect each other: It implies that each combination of
inputs yields a unique level of output.
4. Higher isoquant shows higher output: It signifies that moving to a higher
isoquant means achieving greater output levels.
Isoquant Map
A number of isoquants that are combined in a single graph can be used to
estimate the maximum attainable output from different combinations of inputs.
A higher isoquant curve represents a higher level of output.
Marginal Rate of Technical Substitution (MRTS)
The technique to estimate the amount of capital input to be replaced by labour
input without increasing or decreasing output.
�ℎ 푛 푖푛 � 푝푖�
�ℎ 푛 푖푛 퐿 푏표푟
MRTS =
��
�퐿
MRTS = -
MP L represents the marginal product of labor.
MP K represents the marginal product of capital.
Scales of Production
Decreasing Returns to Scale
All the factors of production are increased in a given proportion, and output
would increase by a smaller proportion.
For example, Imagine a bakery with one oven and two bakers. If they hire
another baker but don't upgrade their equipment, they might find that the third
baker slows down the process because there's not enough space or resources to
accommodate the increased workforce effectively. So, adding more workers
decreases the efficiency of each additional worker.
Constant Returns to Scale
All the factors of production are increased in a given proportion, and output
would increase by the same proportion.
For example, Consider a toy factory with ten workers and five machines. If they
double their workforce and double the number of machines, their output will also
double. So, the increase in inputs leads to a proportional increase in output,
maintaining constant efficiency.
Increasing Returns to Scale
All the factors of production are increased in a given proportion, and output
would increase by a greater proportion.
For example, Let's say a software company hires more programmers and invests
in better infrastructure. With more brains and better tools, they might develop
software much faster than before. So, increasing inputs leads to a more than
proportional increase in output, resulting in increased efficiency.
Differentiate Between Increasing Return to Scale and Decreasing Return to Scale
Aspect Increasing Returns to Scale Decreasing Returns to Scale
When increasing inputs result When increasing inputs result
Definition
in a more than proportional in a less than proportional
increase in output. increase in output.
Output grows faster than input Output grows slower than
Output Effect
increases. input increases.
Experienced, leading to lower Not experienced, average costs
Economies of
average costs per unit. may rise with scale.
Scale
Higher efficiency due to Lower efficiency as production
Efficiency
spreading fixed costs over becomes less organized or
more units. more cumbersome.
Doubling inputs leads to more Doubling inputs leads to less
Example
than double the output. than double the output.
