Production means a process

of converting raw materials

into finished product
causing value addition. In
fact, production is a process
of utility creation and value
addition. Utility may be
form utility, place
utility, time utility etc.
Meaning of Production
Production means a process
of converting raw materials
into finished product
causing value addition. In
fact, production is a process
of utility creation and value
addition. Utility may be
form utility, place
utility, time utility etc.
The Production Theory (NOTES)
Meaning of Production: Production means a process of converting
raw materials into finished product causing value addition. Infact,
production is a process of utility creation and value addition. Utility may
be form utility, place utility, time utility etc.

Factors of Production
Land: Land means all the gifts given by the nature to us. For example:
the surface of the earth, the soil, forests, oceans, mountains, climate
etc. Eminent economist Alfred Marshall says that, “Land means the
materials and forces which nature gives freely for man’s aid in land and
water, in air and light and heat.” Thus all the natural resources are
taken in the category of land.

Labour : Labour means mental or/and physical work exercised by an

individual for some monetary reward. In economic , labour includes
the services of a factory worker, chief executive officer of a
company, an engineer, an advocate, an accountant, a doctor, a
watchman etc. It should be kept in mind that in economics mental or
physical work exercised by someone for pleasure or happiness without
any monetary or benefit is not labour.
Capital: Capital includes tools, equipments, buildings, plants,
machines, roads, railways etc. These are physical capital, but modern
economists say that human capital is also included in capital. Human
capital means the process of addition to knowledge, skills, and
capacities of all people of a nation.

Entrepreneurship: Entrepreneurship Land, labour and capital are

located at different places i.e. they are not available at one place. An
entrepreneur brings them together to do business bearing risk.

Production function
Production function: production function is a technical
relationship between input and output.

In other words, if we have a particular technology, a production

function can tell us how much quantity of a good can be produced with
a given amount of labour and capital. Symbolically, a production
function can be presented as follows:

Quantity of output=Q=f (L , K )Therefore, if with a given technology f(L ,

K)=2 L+3 K is a production function, then it means with 5hours of
labour and 4 machines (capital) the quantity of output is f(5, 2)=2 ×5+3
× 4=22units.

Types of Production function

 Short run production function(Production Function with one
Variable Inputs)
 Long run production function(Production Function with two
Variable Inputs)
Short Run Production Function : Function Short run is a period of
time in which a firm can not change its all the inputs (labour and
capital).In other words, short run means a period of time in which
quantities of one or more inputs (alsoknown as factors of production)
remain constant or unchanged and generally this constant input
iscapital. Short run production function shows the behavior of the total
output when one input isconstant and the other input is variable.
Symbolically short run production function can berepresented as
follows: Q=f (L ,´K)Or Q=f (´L , K)Where the bar over K and L represent
that K is constant and L is constant respectively.

SHORT RUN PRODUCTIO FUNCTION GENERATES LOW OF

VARIABLE PROPORTIONS (Production Function with two
Variable Inputs)
The low of variable proportions states that increasing application of the
variable factor (fixed factor remaining constant) must ultimately cause
a situation when marginal product (and eventually average product ) of
the variable factor starts declining.

BASIC CONCEPTS TO LOW OF VARIABLE PROPORTIONS

 TOTAL PRODUCT
 AVERAGE PRODUCT
 MARGINAL PRODUCT

Total Product: In simple terms, we can define Total Product as the

total volume or amount of final output produced by a firm using given
inputs in a given period of time.
  One factor kept constant, total product will vary with the
quantity used of the variable factor.
 Formula is: Total Product = Ʃ Marginal Product

Average Product: It is defined as the output per unit of factor inputs or

the average of the total product per unit of input and can be calculated
by dividing the Total Product by the inputs (variable factors).

Average Product = Total Product/ Units of Variable Factor Input

Marginal Product: The additional output produced as a result of

employing an additional unit of the variable factor input is called the
Marginal Product. Thus, we can say that marginal product is the addition
to Total Product when an extra factor input is used.

Marginal Product = Change in Output/ Change in Input

Thus, it can also be said that Total Product is the summation of Marginal
products at different input levels.
 Total Product = Ʃ Marginal Product

Relationship between Marginal Product and Total Product

The law of variable proportions is used to explain the relationship

between Total Product and Marginal Product. It states that when only
one variable factor input is allowed to increase and all other inputs are
kept constant, the following can be observed:

 When the Marginal Product (MP) increases, the Total Product is

also increasing at an increasing rate. This gives the Total product
curve a convex shape in the beginning as variable factor inputs
increase. This continues to the point where the MP curve reaches its
maximum.
 When the MP declines but remains positive, the Total Product is
increasing but at a decreasing rate. This give ends the Total product
curve a concave shape after the point of inflexion. This continues
until the Total product curve reaches its maximum.
 When the MP is declining and negative, the Total Product declines.
 When the MP becomes zero, Total Product reaches its maximum.

Fixed factor Variable factor Total product Marginal product

1 0 0 _

1 1 10 10

1 2 30 20
1 3 45 15

1 4 52 7

1 5 52 0

1 6 48 -4
Relationship between Average Product and Marginal Product

There exists an interesting relationship between Average Product and

Marginal Product . We can summarize it as under:

 When Average Product is rising, Marginal Product lies above

Average Product.
 When Average Product is declining, Marginal Product lies below
Average Product.
  At the maximum of Average Product, Marginal and Average
Product equal each other.

Fixed factor Variable Average Marginal Total

factor product product product

1 0 _ _ 0

1 1 10 10 10

1 2 15 20 30

1 3 15 15 45

1 4 13 7 52

1 5 10.40 0 52

1 6 8 -4 48

ASSUMPTIONS TO THE LAW

 One of the factor is variable while all other factors are fixed.
 All units of the variable factor are homogenous.
 State of technology is constant.
  Factors of the production can be used in different proportions.

LONG RUN PRODUCTION FUNCTION GENERATES RETURN TO

SACLE (Production Function with two Variable Inputs)
Returns to scale states that as the scale of input is raised (factor ratio
remaining constant) behaviour of output passes through three different
phases.

 Phase of increasing returns, when output increases

proportionately greater than the increase in input 2
 Phase of constant returns when output increases in the
same proportion as the increase in inputs, and
 Phase of diminishing returns, when output increases
proportionately less than the increase in input. As the scale
of output continues to be expanded, eventually diminishing
return must set in

 If by increasing two factors, say labour and capital, in the

same proportion, output increases in exactly the same
proportion, there are constant returns to scale. If in order
to secure equal increases in output, both factors are
increased in larger proportionate units, there are
decreasing returns to scale. If in order to get equal
increases in output, both factors are increased in smaller
proportionate units, there are increasing returns to scale.
 The returns to scale can be shown diagrammatically on an
expansion path “by the distance between successive
 ‘multiple-level-of-output” isoquants, that is, isoquants that
show levels of output which are multiples of some base level
of output, e.g., 100, 200, 300, etc.”

Increasing Returns to Scale: the case of increasing returns to scale

where to get equal increases in output, lesser proportionate increases
in both factors, labour and capital, are required.

It follows that in fig.

100 units of output require 3C + 3L

200 units of output require 5C + 5L

300 units of output require 6C + 6L

So that along the expansion path OR, OA > AB > BC. In this case, the
production function is homogeneous of degree greater than one. The
increasing returns to scale are attributed to the existence of
indivisibilities in machines, management, labour, finance, etc. Some
items of equipment or some activities have a minimum size and cannot
be divided into smaller units. When a business unit expands, the
returns to scale increase because the indivisible factors are employed
to their full capacity .

Decreasing Returns to Scale: the case of decreasing returns where to get

equal increases in output, larger proportionate increases in both labour
and capital are required.

It follows that:

100 units of output require 2C + 2L

200 units of output require 5C + 5L

300 units of output require 9C + 9L

So that along the expansion path OR, OG < GH < HK

In this case, the production function is homogeneous of degree less

than one. Returns to scale may start diminishing due to the following
factors. Indivisible factors may become inefficient and less productive.
Business may become unwieldy and produce problems of supervision
and coordination.
Large management creates difficulties of control and rigidities. To these
internal diseconomies are added external diseconomies of scale. These
arise from higher factor prices or from diminishing productivities of the
factors. As the industry continues to expand the demand for skilled
labour, land, capital, etc. rises.

Constant returns to scale: the case of constant returns to scale. Where

the distance between the isoquants 100, 200 and 300 along the
expansion path OR is the same, i.e., OD = DE = EF. It means that if units
of both factors, labour and capital, are doubled, the output is doubled.
To treble the output, units of both factors are trebled

It follows that:

100 units of output require

1 (2C + 2L) = 2C + 2L

200 units of output require

2 (2C + 2L) = 4C + 4L

300 units of output require

3 (2C + 2L) = 6C + 6L
The returns to scale are constant when internal economies enjoyed by
a firm are neutralised by internal diseconomies so that output increases
in the same proportion. Another reason is the balancing of external
economies and external diseconomies.

ELASTICITY OF SUBSTITUTION: Where there are two factors and a

homogeneous production function, the elasticity of substitution
σ(w1/w2) measures the responsiveness of the ratio in which factors are
used to the ratio of factor prices. Thus it is the absolute value of the
ratio of the percentage by which a cost-minimizing firm changes the
ratio in which it uses the factors in response to a change in the ratio of
factor prices to he percentage change in the ratio of factor prices. The
elasticity of substitution is just the negative of the elasticity of the
function h with respect to its argument w1/w2.

Constant Elasticity of Substitution: A very interesting special class of

production functions is those for which the elasticity of substitution is a
constant σ. These have come to be known as CES production functions.
This class of functions was first explored in a famous paper published in
1961 by Arrow, Chenery, Minhas, and Solow [1].3 These authors prove
that a production function with n inputs has constant elasticity of
substitution σ between every pair of inputs if and only if the production
function is either of the functional form f(x1, . . . , xn) = A Xn i=1 λix ρ i !