Production

functions

Firm, production, optimal input

combination
Coverage
The concept of production function
Properties of the production functions
Conditions
for
achieving
peak
production
efficiency
and
for
optimizing the mix of resource inputs
in short and long run
Technical and economic efficiency
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Production?

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Production
Any activity which creates value is
production.
e.g. transporting sand, collecting
tax, operating a jeweler store, drilling
for oil, recruiting new employees,
driving a garbage truck, designing a
system to measure air pollution.
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Production process
An integrated system of activities by which
inputs are transformed into the production of
goods and services over some period of time.
Production
processes
composed
of
sequentially organized phases e.g.;
Adding laborsaving equipment > material
specifications and modifying skill levels of
labor > procurement pattern and hiring and
training programmes
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Production Function
Q= f(x1, x2, x3, x4, . . . . . . . Xn)
Where x1 = labour
x2 = land
x3 = capital
x4 = organization
tools,
machines,
infrastructure,
transport,
electricity, fuel, time, advertisement, supervision,
planning, control and coordination, leadership,
managerial talent, R&D, government policies licenses, tax, rules, and regulations etc.
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6

Factors of production

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Factor definitions
Land- all natural resources, including the sea
and outer space. Fixed supply and a factor in its
unimproved state
Labour- number of people and physical and
intellectual skills and efforts
Capital- capable of generating incomes, holding
stored value means it represents deferred
consumption or use
Organizer or entrepreneur- who perceives
market opportunities in uncertainty. Involved in
risk taking, invention
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Inputs fixed and variable

Time periods- market, short and long
Rational producer
Productivityevaluates
the
effectiveness of production process
Measurements of productivity total
production (TP), average production
(AP), marginal production (MP)

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Short run production function

The law of diminishing returns or

The law of variable proportions
Q = f (L, K)
Where L = labour
K = capital
As the use of one input increases
keeping other inputs fixed, a point will
eventually be reached at which the
resulting additions to output decrease.
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10

The law of variable proportions

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APL = Q/L

MPL =
Q/L

10

10

10

10

10

10

30

15

20

10

60

20

30

10

80

20

20

10

95

19

15

10

108

18

13

10

112

16

10

112

14

10

108

12

-4

10

10

100

10

-8

11

Example - law of diminishing returns

Yield of wheat under different fertilizer rates,
1989-90, q/ha
FERTILIZER
LEVEL Kg/ha
N
P2O5

EXPERIMENTA
L FARM (Y1)
Y1
(N+P2O5)
Y1

DEMONSTRATIO
N FARM (Y2)
Y2
Y2

F1

15

7.5

22.5

19.76

19.76

29.85

29.85

F2

30

15.0

22.5

32.30

12.54

38.99

9.14

F3

45

22.5

22.5

35.82

3.52

37.16

-1.83

F4

60

30.0

22.5

36.10

0.28

29.50

-7.66

Annual Report, Agricultural Research Station, Arjia, Bhilwara,

Rajasthan, 1990
N- Nitrogen, P2O5- Phosphorus pentoxide

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12

Thomas Malthus (1766-1834)

1798 -1826 six editions
An Essay on the Principle of Population
The law of diminishing returns and the food crisis
Index of world food consumption (per capita)

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Year

Index

1948-1952
1955
1960
1965
1970
1978
1987
1991

100
109
115
116
123
128
133
142

13

Determining optimal input

proportions long run analysis

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Production function for long run three options

maximize output for a given cost
minimize cost for a given output
produce output that max. profit

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Production table
Rate of Capital
Input (K)
8

283

400

490

565

632

693

748

800

265

374

458

529

592

648

700

748

245

346

424

490

548

600

648

693

224

316

387

447

500

548

592

632

200

283

346

400

447

490

529

565

173

245

300

346

387

424

458

490

141

200

245

283

316

346

374

400

100

141

173

200

224

245

265

283

Rate of Labor Input (L)

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Isoquants or Isoproduct curve

A line showing all the alternative combinations
of two factors that can produce a given level
of output.

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Characteristics of an Isoquant
all rational combinations of inputs lie on
negatively sloped and convex to the
origin portion
nonintersecting
higher isoquant gives higher output
inputs are imperfectly substitutable

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MRTS
The rate at which firm is able to substitute
labor for capital
Loss in Q due to decline in K
= K.MPK
Gain in Q due to increase in L
= L.MPL
Loss = Gain
- K.MPK = L.MPL
K/ L = MPL/ MPK
Imperfect substitution, perfect substitution
and perfectly complimentary
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Isocost curve or cost constraint

TC = PL.L + PK.K
Slope of isocost
= TC/PK/TC/PL= - PL/PK
the rate at which firm is
economically able to substitute
labor for capital

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The optimum mix of resource inputs

Least-cost input combination - Optimization
where isocost and isoquent are tangential
MRTSLK = - PL/PK
MPL/MPK = PL/PK
Maximum-output input combination
Maximum-profit input combination - the
expansion path
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Profit maximization
maximize = TR - TC = PQ PL.L - PK.K
where = profit
P = product price
Q = 549.92 +12.98L + 26.72K + 0.196 LK - 0.104L2 0.319K2
maximize = (0.1585) (549.92 + 12.98L + 26.72K +
0.196LK- 0.104L2- 0.319K2) - 0.75L 0.50K
L,K 0
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Unconstrained max. problem for which two first order partial derivatives be zero
d /dL = (0.1585) (12.98 + 0.196K 0.208L) 0.75 = 0
d /dK = (0.1585) (26.72 + 0.196L 0.638K) 0.50 = 0
Simplifying these we get
(0.1585) (12.98 + 0.196K 0.208L) = 1
0.75
And (0.1585) (26.72 + 0.196L 0.638K) = 1
0.50
Yields profit max. input combination
L =103
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K = 68
23

Q = 549.92 + 12.98 (103) + 26.72 (68) +

0.196 (103)(68) 0.104 (103)2 0.319
(68)2
= 2498 profit max. output
corresponding max. profit
= (0.1585)(2498) 0.75(103) 0.50(68)
= 395.9 111.2
= 284.7
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 Ridge lines
The impact of change in resource
price
Cost effect = substitution effect +
output effect
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25

Energy consumption (in thousand Btu) per dollar

of value added in selected industries
Sectors
All
Manufacturing

Year

Paper

Petroleum Steel Aluminum

Organic
Chemicals Refining

1971

52.5

316.2

277.9

631.4

314.7

418.5

1977

42.3

308.7

193.9

573.4

282.7

379.9

Percent
Change

-19.4

-2.4

-30.2

-9.2

-10.2

-9.2

Source: U.S. Department Of Commerce, Bureau Of The Census,

Statistical Abstract Of The United States: 1981
(Washington, D.C.:U.S. Government Printing Office, 1981).

Prices rose 1971-80

Crude oil 240%, natural gas 347%, coal 113%
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26

Returns to scale
Refers to the character of changes in output
when all resource inputs are changed in equal
proportions.
increasing returns to scale-short range(b>a)
constant returns to scale- lengthy range(b=a)
decreasing returns to scale- (b<a)
L+K=Q
aL + aK = bQ
RTS is reflection on TFP

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Exercise - Returns to scale

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II

31

III

59

IV

72

107
28

Factors responsible for returns to

scale
Economies
Internal

Internal
External

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Diseconomies

External

29

Factors for increasing returns to scale

labor economies, division of labor, specialization
indivisibility of factors of production - technical economies
dimensional economies
economies of mass production low cost, less spare parts
managerial economies
marketing economies
financial economies
economies of risk spreading
external economies

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Factors for constant returns to scale

producing in the most efficient plant size
Factors

for

decreasing

returns

to

scale
diseconomies related to management,
labor, transport

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All input elasticity of output

Responsiveness of output to the change in
all inputs
EQ,I = %Q/% in all inputs

=DQ/Di.I/Q
=Q/I.I/Q

EQ,I > 1 Increasing RTS

EQ,I = 1Constant RTS
EQ,I < 1Decreasing RTS

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Cobb-Douglas production function

Introduced to relate output in manufacturing
industries from 1899-1922 to labor and capital
inputs
Q = AKL
Q = A(2K)(2L)
Q = 2 2(AKL)
but Q= AKL. Hence the factor = 2+ and will be
less than 2, equal to 2, or greater than 2,
depending on +
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sum of exponents
(+ )

returns
to scale

less than one

decreasing

equal to one

constant

greater than one

increasing

Q = 10K0.5L0.6

+ = 0.5+0.6 = 1.1 > 1

increasing return to scale
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Case on C-D function

Agricultural economist E O Heady conducted

an experiment on 302 pigs weighing between
34-250 pound

G = 1.60P.30C.53 for the weight

interval 34-75 pounds
G = 0.71P.14C.77 for 75-150 pounds

G = 0.46P.09C.86
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for 150-250 pounds

35

where G is weight gain, P is input of

soybean oil meal (protein), and C is input
of corn (carbohydrate) all measured in
pounds per pig.
Source:
E O Heady, An econometric
investigation of the technology of
agricultural production functions.
Econometrica, V25 (April, 1957)

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Estimates of 1, 2, 3 for selected industries 1963-80

Industry
Gas
Railroads
Goal
Food
Metals and machinery
Communications
Cotton
Jute
Sugar
Coal
Paper
Chemicals
Electricity
Food2
Paper2
Telephone
Chemicalsb
Aircraftb

Country
France
United States
United Kingdom
United States
United States
Russia
India
India
India
India
India
India
India
United States
United States
Canada 1972
United States
United States

1+2+3

.83
.89
.79
.72
.71
.80
.92
.84
.59
.71
.64
.80
.20
.63
.62
.70
.54
.79

.10
.12
.29
.35
.26
.38
.12
.14
.33
.44
.45
.37
.67
.44
.37
.41
.38
.18

.28
.11
.04

0.93
1.29
1.08
1.07
0.97
1.18
1.04
0.98
0.92
1.15
1.09
1.17
0.87
1.07
098
1.11
1.03
1.01

Q = AL1K 2M 3

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L - labor
K - capital
M - raw material
37

Economies of Scope
Savings when two or more products are
produced jointly
S = 50,000+30,000 70,000
------------------------------ = 0.14
70,000

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Factor productivity
Single factor productivity (SFP) - ratio of volume
of output to the quantity of the factor of
production for which productivity is to be
estimated.

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 APL = Q/L
200/10=20, 240/11=21.8
Whether labour productivity has
increased by 9%?
No consideration for capital used

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Multi factor (or total factor) productivity

(MFP or TFP)
Ratio of volume of output to a weighted sum of the
inputs used in the production process
TFP tries to circumvent the problem encountered in
interpretation of SFP estimates due to changing factor
intensities
Broadest measure of productivity and efficiency in
resource use
Decomposes changes in Q due to changes in quantity
of inputs used and changes in all the residual factors
Also called as index of ignorance (ABROMOVITZ,
1986)
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TFP = Q/r.K + w.L

Case 1
w1=2

Q=500

K1=8

K2=11

w2=4

L1=20

L2=10

500
1
6.94
4(8) 2(20)

r1=4
r2=2

2 = 500/ 2(11) + 4(10) = 8.06

16.13% increase in TFP in terms of output
per rupee of inputs
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42

11

500

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10

20

43

Case 2

Q1=500K1=20
L1=40 r1=2 W1=4
Q2=600
K2=22 L2=43

500
1
2.50
2( 20 ) 4( 40 )
600
2
2.78
2( 22) 4( 43 )
11.2% increase in TFP
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Relative contribution of factors in TFP in India

1960-80
Industry type

TFP

K (%)

L(%)

O(%)

All selected

1.1385

15.7

47.8

36.5

Basic goods

1.1070

5.5

63.7

30.8

Intermediate
goods

1.1591

25.5

45.9

28.6

Consumer goods

1.1357

39.5

36.5

24.0

Trivedi, 2002, Managerial Economics,Tata McGraw, p 288

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The impact of technological advance upon

production function
Several forms of technical efficiency
a new production process permits same amount of
resources combined differently to yield more.
a new process uses same type of inputs but less of
one or several inputs and no more of others to
produce same type of output.
a new process may require inputs or yield output,
that are of a kind not used until now or available at
all.
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Economic efficiency
Any change that harms no one and
improves the lot of some people, if
all such changes are carried out and
thus no opportunity to make such
changes remains - situation is
termed as economic efficient
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