1. ProductionProduction
TheoryTheory

2. ProductionProduction
 The process of transformation of resourcesThe process of transformation of resources
(like land, labour, capital and(like land, labour, capital and
entrepreneurship) into goods and servicesentrepreneurship) into goods and services
of utility to consumers and/or producers.of utility to consumers and/or producers.
 Goods includes all tangible items such asGoods includes all tangible items such as
furniture, house, machine, food, car,furniture, house, machine, food, car,
television etctelevision etc
 Services include all intangible items, likeServices include all intangible items, like
banking, education, management,banking, education, management,
consultancy, transportation.consultancy, transportation.

3. Types of InputsTypes of Inputs
TechnologyTechnology
 determines the type, quantity and proportion ofdetermines the type, quantity and proportion of
inputs.inputs.
 also determines the maximum limit of total outputalso determines the maximum limit of total output
from a given combination of inputs.from a given combination of inputs.
 at anyat any pointpoint of time, technology will be given; impactof time, technology will be given; impact
of technology can be seen only over aof technology can be seen only over a periodperiod ofof
time.time.
Fixed and Variable InputsFixed and Variable Inputs
 Variable inputVariable input : that can be made to vary in the short run,: that can be made to vary in the short run,
e.g. raw material, unskilled/semi skilled labour, etc.e.g. raw material, unskilled/semi skilled labour, etc.
 Fixed input:Fixed input: that cannot be varied in the short run, e.g. land,that cannot be varied in the short run, e.g. land,
machine, technology, skill set, etc.machine, technology, skill set, etc.

4. Factors of ProductionFactors of Production
 LandLand
 Anything which is gift of nature and not the result of human effort,Anything which is gift of nature and not the result of human effort,
e.g. soil, water, forests, mineralse.g. soil, water, forests, minerals
 Reward is called asReward is called as rentrent
 LabourLabour
 Physical or mental effort of human beings that undertakes thePhysical or mental effort of human beings that undertakes the
production process. Skilled as well as unskilled.production process. Skilled as well as unskilled.
 Reward is called asReward is called as wages/ salarywages/ salary
 CapitalCapital
 Wealth which is used for further production as machine/Wealth which is used for further production as machine/
equipment/intermediary goodequipment/intermediary good
 It is outcome of human effortsIt is outcome of human efforts
 Reward is called asReward is called as interestinterest
 EnterpriseEnterprise
 The ability and action to take risk of collecting, coordinating, andThe ability and action to take risk of collecting, coordinating, and
utilizing all the factors of production for the purpose of uncertainutilizing all the factors of production for the purpose of uncertain
economic gainseconomic gains
 Reward is called asReward is called as profitprofit

5. Production FunctionProduction Function
 A technological relationship between physicalA technological relationship between physical
inputs and physical outputs over a given periodinputs and physical outputs over a given period
of time.of time.
 shows theshows the maximummaximum quantity of the commodityquantity of the commodity
that can be produced per unit of time for each setthat can be produced per unit of time for each set
of alternative inputs, and with a given level ofof alternative inputs, and with a given level of
production technology.production technology.
 Normally a production function is written as:Normally a production function is written as:
Q = f (L,K,I,R,E)Q = f (L,K,I,R,E)
 where Q is the maximum quantity of output of awhere Q is the maximum quantity of output of a
good being produced, and L=labour; K=capital;good being produced, and L=labour; K=capital;
l=land; R=raw material; E= efficiency parameter.l=land; R=raw material; E= efficiency parameter.

6. Production Function with OneProduction Function with One
Variable InputVariable Input
 Also termed asAlso termed as variable proportion productionvariable proportion production
functionfunction
 It is the short term production functionIt is the short term production function
 Shows the maximum output a firm can produce whenShows the maximum output a firm can produce when
only one of its inputs can be varied, other inputsonly one of its inputs can be varied, other inputs
remaining fixed:remaining fixed:
where Q = output, L = labour and K = fixed amount ofwhere Q = output, L = labour and K = fixed amount of
capitalcapital
 Total product is a function of labour:Total product is a function of labour:
 Average Product (AP) is total product per unit of variableAverage Product (AP) is total product per unit of variable
inputinput
 Marginal Product (MP) is the addition in total output perMarginal Product (MP) is the addition in total output per
unit change in variable inputunit change in variable input
),( KLfQ =
),( LKfTPL =
L
TP
APL =
L
TP
MPL
∆
∆
=

7. 11.1-301009
Negative
returns
16.3-201308
21.501507
25101506
28201405
Diminishing
returns
30301204
3040903
2530502
Increasing
returns
20-201
StagesAPMPTotal Product
(’000 tonnes)
Labour
(’00
units)
-50
0
50
100
150
200
1 2 3 4 5 6 7 8 9
Labour
Output
Total Product
(’000 tonnes)
Marginal
Product
Average
Product
Law of Variable Proportions
 As the quantity of the variable factor is increased with other fixed
factors, MP and AP of the variable factor will eventually decline.
 Therefore law of variable proportions is also called as law of
diminishing marginal returns.

8. Labour
Total
Output
O
MPL
APL
Labour
Total
Output
O
TPL
A*
A
Stage I
B*
B
Stage II
C
C*
Stage III
First stage
Increasing Returns to
the Variable Factor
MP>0 and MP>AP
Second stage
Diminishing Returns to
a Variable Factor
MP>0 and MP<AP
Third Stage
Negative Returns
MP<0 while AP is falling
but positive
Technically inefficient
stage of production
A rational firm will never
operate in this stage
Law of Variable Proportions

9. Production Function with Two VariableProduction Function with Two Variable
InputsInputs
 All inputs are variable in longAll inputs are variable in long
run and only two inputs arerun and only two inputs are
usedused
 Firm has the opportunity toFirm has the opportunity to
select that combination of inputsselect that combination of inputs
which maximizes returnswhich maximizes returns
 Curves showing suchCurves showing such
production function are calledproduction function are called
isoquantsisoquants oror iso-product curvesiso-product curves..
 AnAn isoquantisoquant is the locus of allis the locus of all
technically efficienttechnically efficient
combinations of two inputs forcombinations of two inputs for
producing a given level ofproducing a given level of
outputoutput
108
912
818
728
640
Labour
(’00 units)
Capital (Rs.
crore)
0
5
10
15
20
25
30
35
40
45
6 7 8 9 10
Labour ('00 units)
Capital(Rs.Crore)

10. Characteristics of Isoquants
 Downward sloping
 Convex to the origin
 A higher isoquant represents a higher output
 Two isoquants do not intersect
O Labour
Capital
Q0
B
Q1
A
C
Q2
B Q1
O
Labour
Capital
C
Q2
A

11. Marginal Rate of TechnicalMarginal Rate of Technical
SubstitutionSubstitution
 Measures the reduction in one input, dueMeasures the reduction in one input, due
to unit increase in the other input that isto unit increase in the other input that is
just sufficient to maintain the same leveljust sufficient to maintain the same level
of outputof output..
 It is also equal to the ratio of the marginalIt is also equal to the ratio of the marginal
product of one input to the marginalproduct of one input to the marginal
product of other inputproduct of other input
L
K
MRTSLK
∆
∆
−=
L
K
MP
MPMRTS K
L
LK
∆
∆
−==

12. Isocost LinesIsocost Lines
•The isocost line
represents the locus
of points of all the
different
combinations of two
inputs that a firm
can procure, given
the total cost and
prices of the inputs.
Total Cost is sum of Labour cost and Capital
cost
The (absolute) slope of this line is
equal to the ratio of the input prices.
B1
A1
B2
A2
Labour
Capital
O B
A

13. Producer’s EquilibriumProducer’s Equilibrium
Labour
Capital
O
A
B
Q2
Q3
Q0
Q1
C
E
L*
K*
D
Necessary condition for equilibrium
Slope of isoquant = Slope of
isocost line
Maximization of output subject to
cost constraint
 AB is the isocost line
 Any point below AB is feasible but not
desirable
 E is the point of tangency of Q2 with
isocost line AB
 Corresponds to the highest level of
output with given cost function.
 Firm would employ L* and K* units of
labour and capital
 Q3 is beyond reach of the firm
 Points C and D are also on the same
isocost line, but they are on isoquant Q1,
which is lower to Q2. Hence show lower
output.
 E is preferred to C and D, which is on
the highest feasible isoquant.

14. Producer’s EquilibriumProducer’s Equilibrium
B2
A2
B
A
B1
A1
L
K
O
Labour
Capital
Q
Minimization of cost for a given
level of output
 Firm has decided the level output to be
produced shown by the isoquant Q
 Will be indifferent between output
combinations shown by R, S, E on
isquant Q.
 Has to ascertain that combination of
inputs Labour and Capital which
minimizes the cost of production
 Hence a map of isocost lines will be
prepared
 The isocost lines are parallel to each
other because price of the inputs is
given.
 A1B1 line is not feasible
 It will use OK and OL of capital and
labour respectively, at point E which is
also on AB, the lowest possible isocost
line.
 R, S are not desirable because they are
on higher cost line A2 B2.
Necessary condition for equilibrium
Slope of isoquant = Slope of
isocost line
E
R
S

15. Expansion Path
E2
E1
Expansion Path
O
Labour
Capital
Line formed by joining the tangency points between various
isocost lines and the corresponding highest attainable isoquants
is known as Expansion Path.
For homogeneous production function and given factor prices
(and hence factor ratio):
expansion path is a straight line through the origin.
For non- homogeneous production function:
optimal expansion path is non linear.

16. Returns to ScaleReturns to Scale
 Constant Returns to ScaleConstant Returns to Scale :: When aWhen a
proportional increase in all inputs yields an equalproportional increase in all inputs yields an equal
proportional increase in outputproportional increase in output
 Increasing Returns to ScaleIncreasing Returns to Scale :: When aWhen a
proportional increase in all inputs yields a moreproportional increase in all inputs yields a more
than proportional increase in outputthan proportional increase in output
 Decreasing Returns to ScaleDecreasing Returns to Scale :: When aWhen a
proportional increase in all inputs yields a lessproportional increase in all inputs yields a less
than proportional increase in outputthan proportional increase in output
 Returns to Scale show the degree by which the level of
output changes in response to a given change in all the
inputs in a production system.

17. Technical ProgressTechnical Progress
 Refers to research and development andRefers to research and development and
investments made to manage technicalinvestments made to manage technical
know howknow how
 Technical change may beTechnical change may be
 Embodied or investment specific,Embodied or investment specific, wherewhere
new capital is used in the productionnew capital is used in the production
apparatus, which requires investment toapparatus, which requires investment to
take place; ortake place; or
 Disembodied or investment neutral,Disembodied or investment neutral,
wherewhere output increases without anyoutput increases without any
increase in investment but by anincrease in investment but by an
innovation through research andinnovation through research and

18. Technical ProgressTechnical Progress
 Types of Technical Progress (Hicks)Types of Technical Progress (Hicks)
 Neutral Technical Progress:Neutral Technical Progress: changeschanges
in the marginal product of labour (MPL)in the marginal product of labour (MPL)
and capital (MPK) are sameand capital (MPK) are same
 Labour augmenting TechnicalLabour augmenting Technical
ProgressProgress: MPL increases faster than the: MPL increases faster than the
MPKMPK
 Capital augmenting TechnicalCapital augmenting Technical
ProgressProgress : MPK increases faster than: MPK increases faster than
MPLMPL