ECONOMICS
Theory of Production
Short revision series

Production
 Production means transforming inputs (labor,
machines, raw materials etc.) into an output.
 The production process does not necessarily
involve physical conversion of raw materials in
to tangible goods, it also includes conversion
of intangible inputs to intangibles outputs.
E.g., layer, doctor, social workers etc.
 An input is good or service that goes into the
process of production and output is any good
or service that comes out of production
process.

Fixed and Variable Inputs
 A fixed input is one whose supply is inelastic
in the short run.
 A variable input is defined as one whose
supply in the short run is elastic, e.g. labor,
raw materials etc.
 A fixed input remains fixed up to a certain
level of output whereas a variable input
changes with change in output.

Production Function
 A firm has two types of production function:
1. Short run production function
2. Long run production function

Short Run Production
 It refers to a period of time in which the
supply of certain inputs (e.g., plant,
building, machines, etc) are fixed or
inelastic.
 Thus an increase in production during this
period is possible only by increasing the
variable input.

Long Run Production
 It refers to a period of time I which supply of
all the input is elastic, but not enough to
permit a change in technology.
 In the long run, the availability of even fixed
factor increases.
 Thus in the long run, production of
coomodity can be increased by employing
more of both, variable and fixed inputs.

Production Function
 Production function is defined as the
transformation of physical input in to physical
output where output is a function of input.
 It can be expressed algebraically as;
Q = f (K, L etc.)
 Where,
 Q = the quantity of output produced during a
particular period
 K, L etc. are the factors of production
 f = function of pr depends on.

Production Function Assumptions
 The production functions are based on
certain assumptions:
1. Perfect divisibility of both inputs and
output
2. Limited substitution of one factor for the
others
3. Constant technology
4. Inelastic supply of fixed factors in the
short run

Factors of Production
 The classic economic resources include land,
labor and capital.
 Entrepreneurship is also considered an
economic resource because individuals are
responsible for creating businesses and
moving economic resources in the business
environment.
 These economic resources are also called the
factors of production.

Land
 Land is the economic resource encompassing
natural resources found within a nation.
 Nations must carefully use their land
resource by creating a mix of natural and
industrial uses.
 Using land for industrial purposes allows
nations to improve the production processes
for turning natural resources into consumer
goods.

Labor
 Labor represents the human capital
available to transform raw or national
resources into consumer goods.
 It is a flexible resource as workers can be
allocated to different areas of the economy
for producing consumer goods or services.
 It can also be improved through training or
educating workers.

Capital
 Capital can represent the monetary
resources companies use to purchase
natural resources, land and other capital
goods.
 Capital also represents the major physical
assets (e.g., buildings, production facilities,
equipment, vehicles and other similar items)
individuals and companies use when
producing goods or services.

Entrepreneurship
 It is also considered a factor of production
since someone must complete the
managerial functions of gathering, allocating
and distributing economic resources or
consumer products to individuals and other
businesses in the economy.

The Law of Production
 In the short run, input-output relations are
studied with one variable input, while other
inputs are held constant. The law of
production under these assumptions are
called “The Laws of Variable Production”.
 In the long run input output relations are
studied assuming all the input to be
variable. The long-run input output relations
are studied under Laws of Returns to Scale.

Law of Diminishing Returns (Law of
Variable Proportions)…
 The law which brings out the relationship
between varying factor properties and
output are known as the law of variable
proportion.
 The variation in inputs lead to a
disproportionate increase in output more
and more units of variable factor when
applied cause an increase in output but
after a point the extra output will grow less
and less. The law which brings out this
tendency in production is known as Law of
Diminishing Returns.

Continue…
 The law of diminishing returns levels that any
attempt to increase output by increasing only
one factor finally faces diminishing returns.
 The law states that when some factors remain
constant, more and more units of a variable
factors are introduced the production may
increase initially at an increasing rate; but
after a point it increases only at diminishing
rate.
 Land and capital remain fixed in the short-
term whereas labor shows a variable nature.

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 The following table explains the operation
of the Law of Diminishing Returns:
No. of
Workers
Total
Product (TP)
Average
Product (AP)
Marginal
Product (MP)
1 10 10 10
2 22 11 12
3 36 12 14
4 52 13 16
5 66 13.2 14
6 76 12.7 10
7 82 11.7 6
8 85 10.5 3
9 85 9.05 0
10 83 8.3 (-2)

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 Average product is the product for one unit of
labor, arrived by dividing the total product by
number of workers.
 Marginal product is the additional product
resulting term additional labor, calculated by
dividing the change in total product by the
change in the number of workers.
 From table we can see that the total output
increases at the increasing rate till the
employment of the 4th worker. Any additional
labor employed beyond the 4th labor clearly
faces the operation of the Law of Diminishing
returns.

Continue…
 The graphical representation of the table is as below:

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 The law of diminishing returns operation at
three stages.
 At the first stage, total product, marginal
product, average product increases at an
increasing rate. this stage continues up to
the point where AP is equal to MP.
 At the second stage, the TP continues to
increase but at a diminishing rate. As the
MP at this stage starts falling, the AP also
declines. This stage ends where TP become
maximum and MP becomes zero.

Continue…
 The marginal product becomes negative in
the third stage. Total product also declines.
The average product continues to decline in
the third stage.

Assumptions of Law of Diminishing
Returns
 The Law of Diminishing Returns is based on
the following assumptions:
1. The production technology remains
unchanged.
2. The variable factor is homogeneous.
3. Any one factor is constant.
4. The fixed factor remains constant.

Law of Returns to Scale
 Returns to scale is the rate at which output
increases in response to proportional
increases in all inputs.
 The increase in output may be
proportionate, more than proportionate or
less than proportionate.

Increasing Returns to Scale
 Proportionate increase in all factor of
production results in a more than
proportionate increase in output.
 Increasing Returns => Output > Input
 Example :
Output Input
100 Unit = 3L + 3K
200 Unit = 5L + 5K
300 Unit = 6L + 6K
 Where L = labor and K=capital (in unit)

Constant Returns to scale
 When all inputs are increased by a certain
percentage, the output increases by the same
percentage, the production function is said to
exhibit constant returns to scale.
 Constant Returns => Output = Input
 Example :
Output Input
100 Unit = 3L + 3K
200 Unit = 6L + 6K
300 Unit = 9L + 9K
 where L = labor and K=capital(in unit)

Diminishing Returns to Scale
 The term ‘diminishing’(Decreasing) returns to
scale where output increases in a smaller
proportion than the increase in all inputs.
 Diminishing Returns => Output < Input
 Example :
Output Input
100 Unit = 3L + 3K
200 Unit = 7L + 7K
300 Unit = 12L + 12K
 Where L = labor and K=capital(in unit)

Economies of Scale
 The factors which cause the operation of the
laws of returns to scale are grouped under
economies and diseconomies of scale.
 Increasing returns to scale operates because
of economies of scale and decreasing returns
to scale operates because of diseconomies of
scale where economies and diseconomies
arise simultaneously.

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 When a firm increases all the factor of
production it enjoys the same advantages of
economies of production.
 The economies of scale are classified as:
1. Internal economies
2. External economies

Internal Economies of Scale
 Internal economies are those which arise
from the explanation of the plant-size of the
firm.
 Internal economies of scale may be classified
as:
1. Economies in production
2. Economies in marketing
3. Economies in management
4. Economies in transport and storage

Economies in Production
 It arises from
1. Technological advantages
2. Advantages of division of labor and
specialization

Economies in Marketing
 It facilitates through:
1. Large scale purchase of inputs
2. Advertisement economies
3. Economies in large scale distribution
4. Other large-scale economies

Managerial Economies
 It achieves through:
1. Specialization in management
2. Mechanization of managerial fucntion

Economies in Transport and Storage
 Economies in transportation and storage
costs arise from fuller utilization of transport
and storage facilities.

External Economies of Scale
 External economies to large size firms arise from
the discounts available to it due to
1. Large scale purchase of raw materials
2. Large scale acquisition of external finance at
low interest
3. Lower advertising rate from advertising media
4. Concessional transport charge on bulk
transport
5. Lower wage rates if large scale firm is
monopolistic employer of certain kind of
specialized labor.

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 External economies of scale are strictly
based on experience of large-scale firms or
well managed small scale firms.
 Economies of scale will not continue for ever.
 Expansion in the size of the firms beyond a
particular limit, too much specialization,
inefficient supervision, improper labor
relations etc will lead to diseconomies of
scale.

END