Content

Content

1. Overview

2. Concept of production functions

3. Specifying the production function

4. Production function as a graph

5. Stages of production

6. The law of diminishing returns

7. Examples

8. Shifting a production function

References

1. Overview
When most people think of fundamental tasks of a firm, they think first of production.
Economists describe this task with the production function, an abstract way of discussing how
the firm gets output from its inputs. It describes, in mathematical terms, the technology
available to the firm.
In microeconomics and macroeconomics, a production function is a function that
specifies the output of a firm, an industry, or an entire economy for all combinations of
inputs. This function is an assumed technological relationship, based on the current state of
engineering knowledge; it does not represent the result of economic choices, but rather is an
externally given entity that influences economic decision-making. Almost all economic
theories presuppose a production function, either on the firm level or the aggregate level. In
this sense, the production function is one of the key concepts of mainstream neoclassical
theories. Some non-mainstream economists, however, reject the very concept of an aggregate
production function.
In microeconomics, a production function expresses the relationship between an
organization's inputs and its outputs. It indicates, in mathematical or graphical form, what
outputs can be obtained from various amounts and combinations of factor inputs. In particular
it shows the maximum possible amount of output that can be produced per unit of time with
all combinations of factor inputs, given current factor endowments and the state of available
technology. Unique production functions can be constructed for every production technology.
Alternatively, a production function can be defined as the specification of the
minimum input requirements needed to produce designated quantities of output, given
available technology. This is just a reformulation of the definition above.
The production function can thus answer a variety of questions. It can, for example,
measure the marginal productivity of a particular factor of production (i.e., the change in
output from one additional unit of that factor). It can also be used to determine the cheapest
combination of productive factors that can be used to produce a given output.

2. Concept of production functions

In micro-economics, a production function is a function that specifies the output of a
firm for all combinations of inputs. A meta-production function (sometimes metaproduction
function) compares the practice of the existing entities converting inputs into output to
determine the most efficient practice production function of the existing entities, whether the
most efficient feasible practice production or the most efficient actual practice production. In
either case, the maximum output of a technologically-determined production process is a
mathematical function of one or more inputs. Put another way, given the set of all technically
feasible combinations of output and inputs, only the combinations encompassing a maximum
output for a specified set of inputs would constitute the production function. Alternatively, a
production function can be defined as the specification of the minimum input requirements
needed to produce designated quantities of output, given available technology. It is usually
presumed that unique production functions can be constructed for every production
technology.
By assuming that the maximum output technologically possible from a given set of
inputs is achieved, economists using a production function in analysis are abstracting from the
engineering and managerial problems inherently associated with a particular production
process. The engineering and managerial problems of technical efficiency are assumed to be
solved, so that analysis can focus on the problems of allocative efficiency. The firm is
assumed to be making allocative choices concerning how much of each input factor to use and
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how much output to produce, given the cost (purchase price) of each factor, the selling price
of the output, and the technological determinants represented by the production function. A
decision frame in which one or more inputs are held constant may be used; for example,
(physical) capital may be assumed to be fixed (constant) in the short run, and labour and
possibly other inputs such as raw materials variable, while in the long run, the quantities of
both capital and the other factors that may be chosen by the firm are variable. In the long run,
the firm may even have a choice of technologies, represented by various possible production
functions.
The relation between the inputs to a production process and its output is
conventionally termed the "returns to scale" of that process, but economists have placed a
restricted interptetation upon that term. Alfred Marshal interpreted it to mean what happens
when producers make the most efficient possible use of existing technology. (That restriction
limits the possibility of empirical verification: it excludes the use of a time series of
observations because of the possible intervention of changes of technology, and other sources
of data are hard to find.) He also drew a distinction between what happens in the short run,
before the production manager is able to correct an imbalance between the quantities of
labour and capital; and the long run during which the optimum proportion of capital to labour
can be restored. Economists have also reasoned that to apply the concept to a single
production unit would be to overlook possible interactions with competitors who might be
assumed to be bidding for the same input resources, and that consequently its net effect may
be apparent only at industry level and above. In the absence of convincing empirical evidence,
the subject has usually been approached by postulating plausible relationships and adopting
those that prove useful in a wider context.

3.Specifying the production function

In its most general mathematical form, a production function is expressed as:
Q= f(X1,X2,X3...)
where:
Q= quantity of output
X1, X2, X3, etc.= factor inputs (such as capital, labour, raw materials, land,
technology, or management)
There are several ways of specifying this function. One is as an additive production
function:
Q= a + b X1 + c X2 + d X3
where a, b, c, and d are parameters that are determined empirically.
Another is as a Cobb-Douglas production function (multiplicative):
Q= a X1b X2c
Other forms include the constant elasticity of substitution production function (CES)
which is a generalized form of the Cobb-Douglas function, and the quadratic production
function which is a specific type of additive function. The best form of the equation to use and
the values of the parameters (a, b, c, and d) vary from company to company and industry to
industry. In a short run production function at least one of the Xs (inputs) is fixed. In the long
run all factor inputs are variable at the discresion of management.

4. Production function as a graph

A production function can be represented in a table such as the one below. In this table
five units of labor and two of capital can produce 34 units of output. It is, of course, always
possible to waste resources and to produce fewer than 34 units with five units of labor and
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two of capital, but the table indicates that no more than 34 can be produced with the
technology available. The production function thus contains the limitations that technology
places on the firm.
A Production Function
Labor
5
4
3
2
1

30
26
21
16
10
1

34
30
25
20
13
2

37
33
28
23
15
3
Capital

Any of the above equations can be plotted on a graph. A typical (quadratic) production
function is shown in the following diagram. All points above the production function are
unobtainable with current technology, all points below are technically feasible, and all points
on the function show the maximum quantity of output obtainable at the specified levels of
inputs. From the origin, through points A, B, and C, the production function is rising,
indicating that as additional units of inputs are used, the quantity of outputs also increases.
Beyond point C, the employment of additional units of inputs produces no additional outputs,
in fact, total output starts to decline. The variable inputs are being used too intensively (or to
put it another way, the fixed inputs are under utilized). With too much variable input use
relative to the available fixed inputs, the company is experiencing negative returns to variable
inputs, and diminishing total returns. In the diagram this is illustrated by the negative
marginal physical product curve (MPP) beyond point Z, and the declining production function
beyond point C.

Quadratic Production Function

From the origin to point A, the firm is experiencing increasing returns to variable
inputs. As additional inputs are employed, output increases at an increasing rate. Both
marginal physical product (MPP) and average physical product (APP) is rising. The inflection
point A, defines the point of diminishing marginal returns, as can be seen from the declining
MPP curve beyond point X. From point A to point C, the firm is experiencing positive but
decreasing returns to variable inputs. As additional inputs are employed, output increases but
at a decreasing rate. Point B is the point of diminishing average returns, as shown by the
declining slope of the average physical product curve (APP) beyond point Y. Point B is just
tangent to the steepest ray from the origin hence the average physical product is at a
maximum. Beyond point B, mathematical necessity requires that the marginal curve must be
below the average curve.
The production function can also be illustrated in a graph such as that below. This
graph looks exactly like a graph of indifference curves because the mathematical forms of the
production function and the utility function are identical. In one case, inputs of goods and
services combine to produce utility; in the other, inputs of resources combine to produce
goods or services. A curved line in the graph shows all the combinations of inputs that can
produce a particular quantity of output. These lines are called isoquants. As one moves to the
right, one reaches higher levels of production. If one can visualize this as a three-dimensional
graph, one can see that the production surface rises increasingly high above the surface of the
page; the isoquants indicate a hill. The firm must operate on or below this surface.

5. Stages of production
To simplify the interpretation of a production function, it is common to divide its
range into 3 stages. In Stage 1 (from the origin to point B) the variable input is being used
with increasing efficiency, reaching a maximum at point B (since the average physical
product is at its maximum at that point). The average physical product of fixed inputs will
also be rising in this stage (not shown in the diagram). Because the efficiency of both fixed
and variable inputs is improving throughout stage 1, a firm will always try to operate beyond
this stage. In stage 1, fixed inputs are underutilized.
In Stage 2, output increases at a decreasing rate, and the average and marginal
physical product is declining. However the average product of fixed inputs (not shown) is still
rising. In this stage, the employment of additional variable inputs increase the efficiency of
fixed inputs but decrease the efficiency of variable inputs. The optimum input/output
combination will be in stage 2. Maximum production efficiency must fall somewhere in this
stage. Note that this does not define the profit maximizing point. It takes no account of prices

or demand. If demand for a product is low, the profit maximizing output could be in stage 1
even though the point of optimum efficiency is in stage 2.
In Stage 3, too much variable input is being used relative to the available fixed inputs:
variable inputs are overutilized. Both the efficiency of variable inputs and the efficiency of
fixed inputs decline through out this stage. At the boundary between stage 2 and stage 3, fixed
input is being utilized most efficiently and short-run output is maximum.

6. The law of diminishing returns

There is one rule that seems to hold for all production functions, and because it always
seems to hold, it is called a law. The law of diminishing returns says that adding more of
one input while holding other inputs constant results eventually in smaller and smaller
increases in added output. To see the law in the table above, one must follow a column or
row. If capital is held constant at two, the marginal output of labor (which economists usually
call marginal product of labor) is shown in the table below. The first unit of labor increases
production by 13, and as more labor is added, the increases in production gradually fall.
The Marginal Product of Labor
Labor
Marginal Output
First
13
Second
7
Third
5
Fourth
5
Fifth
4
The law of diminishing returns does not take effect immediately in all production
functions. It is possible for the first unit of labor to add only four units of output, the second to
add six, and the third to add seven. If a production function had this pattern, it would have
increasing returns between the first and third worker. What the law of diminishing returns
says is that as one continues to add workers, eventually one will reach a point where
increasing returns stop and decreasing returns set in.
The law of diminishing returns is not caused because the first worker has more ability
than the second worker, and the second is more able than the third. By assumption, all
workers are the same. It is not ability that changes, but rather the environment into which
workers (or any other variable input) are placed. As additional workers are added to a firm
with a fixed amount of equipment, the equipment must be stretched over more and more
workers. Eventually, the environment becomes less and less favorable to the additional
worker. People's productivity depends not only on their skills and abilities, but also on the
work environment they are in.
The law of diminishing returns was a central piece of economic theory in the 19th
century and accounted for economists' gloomy expectations of the future. They saw the
amount of land as fixed, and the number of people who could work the land as variable. If the
number of people expanded, eventually adding one more person would result in very little
additional food production. And if population had a tendency to expand rapidly, as
economists thought it did, one would predict that (in equilibrium) there would always be
some people almost starving. Although history has shown the gloomy expectations wrong, the
idea had an influence on the work of Charles Darwin and traces of it still float around today
among environmentalists.
The concept of diminishing returns can be traced back to the concerns of early
economists such as Johann Heinrich von Thnen, Turgot, Thomas Malthus and David
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Ricardo. However, classical economists such as Malthus and Ricardo attributed the successive
diminishment of output to the decreasing quality of the inputs. Neoclassical economists
assume that each "unit" of labor is identical = perfectly homogeneous. Diminishing returns
are due to the disruption of the entire productive process as additional units of labor are added
to a fixed amount of capital.
Karl Marx developed a version of the law of diminishing returns in his theory of the
tendency of the rate of profit to fall, described in Volume III of Capital.

7. Examples
Suppose that one kilogram of seed applied to a plot of land of a fixed size produces
one ton of crop. You might expect that an additional kilogram of seed would produce an
additional ton of output. However, if there are diminishing marginal returns, that additional
kilogram will produce less than one additional ton of crop (ceteris paribus). For example, the
second kilogram of seed may only produce a half ton of extra output. Diminishing marginal
returns also implies that a third kilogram of seed will produce an additional crop that is even
less than a half ton of additional output, say, one quarter of a ton.
In economics, the term "marginal" is used to mean on the edge of productivity in a
production system. The difference in the investment of seed in these three scenarios is one
kilogram "marginal investment in seed is one kilogram." And the difference in output, the
crops, is one ton for the first kilogram of seeds, a half ton for the second kilogram, and one
quarter of a ton for the third kilogram. Thus, the marginal physical product (MPP) of the seed
will fall as the total amount of seed planted rises. In this example, the marginal product (or
return) equals the extra amount of crop produced divided by the extra amount of seeds
planted.
A consequence of diminishing marginal returns is that as total investment increases,
the total return on investment as a proportion of the total investment (the average product or
return) decreases. The return from investing the first kilogram is 1 t/kg. The total return when
2 kg of seed are invested is 1,5/2 = 0,75 t/kg, while the total return when 3 kg are invested is
1,75/3 = 0,58 t/kg.
This particular example of Diminishing Marginal Returns in formulaic terms: Where

D = Diminished Marginal Return, X = seed in kilograms, and = crop yeld in tons gives
us:

Substituting 3 for X and expanding yields:

= 0,583 t/kg.
Another example is a factory that has a fixed stock of capital, or tools and machines,
and a variable supply of labor. As the firm increases the number of workers, the total output
of the firm grows but at an ever-decreasing rate. This is because after a certain point, the
factory becomes overcrowded and workers begin to form lines to use the machines. The longrun solution to this problem is to increase the stock of capital, that is, to buy more machines
and to build more factories.
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8. Shifting a production function

By definition, in the long run the firm can change its scale of operations by adjusting
the level of inputs that are fixed in the short run, thereby shifting the production function
upward as plotted against the variable input. If fixed inputs are lumpy, adjustments to the
scale of operations may be more significant than what is required to merely balance
production capacity with demand. For example, you may only need to increase production by
a million units per year to keep up with demand, but the production equipment upgrades that
are available may involve increasing productive capacity by 2 million units per year.

If a firm is operating at a profit-maximizing level in stage one, it might, in the long

run, choose to reduce its scale of operations (by selling capital equipment). By reducing the
amount of fixed capital inputs, the production function will shift down. The beginning of
stage 2 shifts from B1 to B2. The (unchanged) profit-maximizing output level will now be in
stage 2.

References
1. http://www.scribd.com/doc/417083/A-Brief-History-of-Production-Functions
2. Robert U. Ayres and Benjamin Warr, The Economic Growth Engine: How useful work
creates material prosperity, 2009. ISBN 978-1848441828
3. http://en.wikipedia.org/wiki/Production_function
4. http://ingrimayne.com/econ/TheFirm/ProductionFunct.html
5. Heathfield, D. F. (1971) Production Functions, Macmillan studies in economics,
Macmillan Press, New York.
6. Pearl, D. and Enos, J. (1975) Engineering production functions and technological progress,
The Journal of Industrial Economics, vol 24, September 1975
7. http://www.wordiq.com/definition/Production_function
8. http://www.britannica.com/EBchecked/topic/477999/production-function
9. S K Mishra: A brief history of the Production Function, SSRN Working Paper
10. http://en.citizendium.org/wiki/Production_function
11. Perloff, Microeconomics, Theory and Applications with Calculus. Pearson 2008
12. http://en.wikipedia.org/wiki/Diminishing_returns