Unit 3: Theories of Production and Market Structures

Concept and Types of Production; The Production Function: Short-run and Long-run;
Isoquants and their Properties; The Law of Variable Proportions, Returns to Scale,
Economies and Diseconomies of Scale; Meaning and Types of Costs (Fixed, Variable, Total,
Average, and Marginal Costs); Concepts of Revenue, Average and Marginal Revenue
Curves; Different Market Structures: Perfect Competition, Monopoly, Monopolistic
Competition, Price and Output Determination under Different Market Structures. Oligopoly
(Features Only).Unit 3: Theories of Production and Market Structure

Concept of Production Function

Production is the result of co-operation of four factors of production viz., land, labor,
capital, and organization. This is evident from the fact that no single commodity can be
produced without the help of any one of these four factors of production. Therefore, the
producer combines all the four factors of production in a technical proportion. The producer
aims to maximize his profit.

Meaning of Production Function

In simple words, production function refers to the functional relationship between the
quantity of a good produced (output) and factors of production (inputs).

“The production function is purely a technical relation which connects factor inputs and
output.” Prof. Koutsoyiannis

Defined production function as “ The relation between a firm’s physical production (output)
and the material factors of production (inputs). ” Prof. Watson

Mathematically, such a basic relationship between inputs and outputs may be expressed as:

Q = f( L, C, N )

Where Q = Quantity of output

L = Labour
C = Capital
N = Land.
Hence, the level of output (Q), depends on the quantities of different inputs (L, C, N)
available to the firm. In the simplest case, where there are only two inputs, labor (L) and
capital (C) and one output (Q), the production function becomes.
Q =f (L, C)

Fixed and Variable Inputs and Short and Long Run, Total, Average and Marginal Products, Total,
Average and Marginal Curves

Types of Production Function

Introduction: The production function depicts the relation between physical outputs of a
production process and physical inputs, i.e. factors of production. The practical application of
production functions is obtained by valuing the physical outputs and inputs by their prices.
This is the principle of how the production function is made a practical concept, i.e.
measurable and understandable in practical situations like

 Fixed proportion and variable proportion Production function

 Short period and long period Production function
 Cobb – Douglas Production function

Fixed Proportion Production Function

Definition: The Fixed Proportion Production Function, also known as a Leontief Production
Function implies that fixed factors of production such as land, labor, raw materials are used
to produce a fixed quantity of output and these production factors cannot be substituted for
the other factors.

In other words, a fixed quantity of inputs is used to produce the fixed quantity of output. All
the factors of production are fixed and cannot be substituted for one another. Suppose there
are 50 workers required to produce 500 units of a product, then the technical Coefficient of
production will be 1/10. In the case of a fixed proportion production function, this one-tenth
of labor must be employed for the production of fixed output and no other factors of
production can be substituted in place of labor.

The concept of fixed proportion production function can be further understood with the help
of a figure as shown below:
In the given figure, OR shows the fixed labor-capital ratio, if a firm wants to produce 100
units of a product, then 2 units of capital and 3 units of labor must be employed to attain this
output.

Similarly, for the production of 300 and 500 units of a product, 5 units of capital and 6 units
of labor and 7 units of capital and 9 units of labor must be employed respectively.

It may be noticed that along the isoquant curve the marginal product of a factor is zero, let's
say, for the production of 300 units of a product, the capital is fixed (say 5 units), then any
additional units of labor won’t make any difference in the total production, hence, the
marginal product of labor is zero.

Variable Proportion Production Function

Definition: The Variable Proportion Production Function implies that the ratio in which
the factors of production such as labor and capital are used is not fixed, and it is variable.
Also, the different combinations of factors can be used to produce the given quantity, thus,
one factor can be substituted for the other.

In the case of the variable proportion production function, the technical Coefficient of
production is variable, i.e. the required quantity of output can be achieved through the
combination of different quantities of factors of production, such as these factors can be
varied by substituting other factors/ factors in its place.

Suppose 40 workers are required to produce 200 units of a product, then the technical
Coefficient of production will be 1/5. In the case of a variable proportion production function,
one-fifth of labor is not necessarily to be employed, but the different combinations of factors
of production can be used to produce a given level of output. Thus, the labor can be
substituted for any other factors.
The concept of variable proportion production function can be further understood from an
isoquant curve, as shown in the figure below:

In the figure, the isoquant curves show that the different combinations of factors of technical
substitution can be employed to get the required amount of output. Thus, for the production
of a given level of product, the input factors can be substituted for the other.

Short-run Production

A short-run production function refers to that time, in which the installation of a new plant
and machinery to increase the production level is not possible

The short-run production function alludes to the time, in which at least one factor of
production is fixed.

 Law of variable proportion

 No change in scale of production.
 Factor ratio changes
 There are barriers to entry and the firms can shut down but cannot fully exist.

Long-run production

The long-run production function is one in which the firm has got sufficient time to install
new machinery or capital equipment, instead of increasing the labor units.

The long-run production function connotes the time, in which all the factors of production are
variable.

 Law of returns to scale

 Change in the scale of production.
 Factor ratio does not change.
 Firms are free to enter and exit.
The Cobb-Douglas Production Function

The below-mentioned article provides a close view of the Cobb-Douglas Production

Function.

The Cobb-Douglas production function is based on the empirical study of the American
manufacturing industry made by Paul H. Douglas and C.W. Cobb. It is a linear homogeneous
production function of degree one which takes into account two inputs, labor, and capital, for
the entire output of the .manufacturing industry.

The Cobb-Douglas production function is expressed as: Q = ALα Cβ

Where Q is output and L and С are inputs of labor and capital respectively. A, a, and β are
positive parameters where = a > O, β > O.

The equation tells that output depends directly on L and C, and that part of output which
cannot be explained by L and С is explained by A which is the ‘residual’, often called
technical change.

Criticisms of C-D Production Function:

The C-D production function has been criticized by Arrow, Chenery, Minhas, and Solow as
discussed below:

1. The C-D production function considers only two inputs, labor, and capital, and neglects
some important inputs, like raw materials, which are used in production. It is, therefore, not
possible to generalize this function to more than two inputs.
2. In the C-D production function, the problem of measurement of capital arises because it
takes only the quantity of capital available for production. But the full use of the available
capital can be made only in periods of full employment. This is unrealistic because no
economy is always fully employed.

3. The C-D production function is criticized because it shows constant returns to scale. But
constant returns to scale are not an actuality, for either increasing or decreasing returns to
scale apply to production.

4. The C-D production function is based on the assumption of substitutability of factors and
neglects the complementarity of factors.

5. This function is based on the assumption of perfect competition in the factor market which
is unrealistic. If, however, this assumption is dropped, the coefficients α and β do not
represent factor shares.

6. One of the weaknesses of C-D function is the aggregation problem. This problem arises
when this function is applied to every firm in the industry and the entire industry. In this
situation, there will be many production functions of low or high aggregation. Thus the C-D
function does not measure what it aims at measuring.

The Law of Variable Proportions

Law of Variable Proportions

Introduction

Law of Variable Proportions occupies an important place in economic theory. This

law is also known as the Law of Proportionality. Keeping other factors fixed, the law
explains the production function with a one-factor variable. In the short run when the output
of a commodity is sought to be increased, the law of variable proportions comes into
operation.

Definitions:

“As the proportion of the factor in a combination of factors is increased after a point, first the
marginal and then the average product of that factor will diminish.” Benham

Assumptions: Law of variable proportions is based on the following assumptions:

(i) Constant Technology:

The state of technology is assumed to be given and constant. If there is an improvement in

technology the production function will move upward.

(ii) Factor Proportions are Variable:

The law assumes that factor proportions are variable. If factors of production are to be
combined in a fixed proportion, the law has no validity.

(iii) Homogeneous Factor Units:

The units of variable factor are homogeneous. Each unit is identical in quality and amount
with every other unit.

(iv) Short-Run:

The law operates in the short run when it is not possible to vary all factor inputs.

Explanation of the Law:

To understand the law of variable proportions we take the example of agriculture. Suppose
land and labor are the only two factors of production.

By keeping land as a fixed factor, the production of variable factor i.e., labor can be shown
with the help of the following table:

Graphic Presentation:

.
Three Stages of the Law:

1. First Stage: The first stage starts from point ‘O’ and ends up to point F. At point F average
product is maximum and is equal to the marginal product. In this stage, the total product
increases initially at an increasing rate up to point E. between ‘E’ and ‘F’ it increases at a
diminishing rate. Similarly, the marginal product also increases initially and reaches its
maximum at point ‘H’. Later on, it begins to diminish and becomes equal to the average
product at point T. In this stage, the marginal product exceeds the average product (MP >
AP).

2. Second Stage: It begins from point F. In this stage, the total product increases at a
diminishing rate and is at its maximum at point ‘G’ correspondingly marginal product
diminishes rapidly and becomes ‘zero’ at point ‘C’. The average product is maximum at point
‘I’ and thereafter it begins to decrease. In this stage, marginal product is less than average
product (MP < AP).

3. Third Stage: This stage begins beyond point ‘G’. Here total product starts diminishing.
The average product also declines. The marginal product turns negative. The Law of
diminishing returns firmly manifests itself. In this stage, no firm will produce anything. This
happens because the marginal product of the labor becomes negative. The employer will
suffer losses by employing more units of laborers. However, of the three stages, a firm will
like to produce up to any given point in the second stage only.
Condition or Causes of Applicability:

Many causes are responsible for the application of the law of variable proportions.

They are as follows:

1. Under Utilization of Fixed Factor:

In the initial stage of production, fixed factors of production like land or machine, are under-
utilized. More units of variable factors, like labor, are needed for its proper utilization.

2. Fixed Factors of Production.

The foremost cause of the operation of this law is that some of the factors of production are
fixed during a short period. When the fixed factor is used with the variable factor, then its
ratio compared to the variable factor falls.

3. Optimum Production:

After making the optimum use of a fixed factor, then the marginal return of such variable
factor begins to diminish. The simple reason is that after the optimum use, the ratio of fixed
and variable factors become defective.

4. Imperfect Substitutes:

Mrs. Joan Robinson has put the argument that imperfect substitution of factors is mainly
responsible for the operation of the law of diminishing returns. One factor cannot be used in
place of the other factor.

Applicability of the Law of Variable Proportions:

The law of variable proportions is universal as it applies to all fields of production. This law
applies to any field of production where some factors are fixed and others are variable. That
is why it is called the law of universal application.

1. Application to Agriculture:

With a view of raising agricultural production, labor and capital can be increased to any
extent but not the land, being fixed factor.

2. Application to Industries:
To increase the production of manufactured goods, factors of production have to be
increased. It can be increased as desired for a long period, being variable factors.

Isoquant Curves: These lines represent various input combinations that produce the same
levels of output. The producer can choose any of these combinations available to him because
their outputs are always the same. Thus, we can also call them equal-product curves or
production indifference curves.

Consider the table below. It shows four combinations, i.e. A, B, C, and D, which produce
varying levels of output.

Factor combinations Units of Labour Units of Capital

A 5 9
B 10 6
C 15 4
D 20 3

Plotting these figures on a graph provides us with this curve (Figure 1):

The X-axis shows units of labor, while the Y-axis represents units of capital. Points A, B, C,
and D are combinations of factors on which IQ is the level of output, i.e. 100 units. IQ1 and
IQ2 represent the greater potential output.

Properties of Iso-quant Curve

The iso-quant curve is negatively sloped,
which means, to have the same level of
production, the more use of units of one input
factor is to be offset with the lesser units of
another input factor. This complies with the
principle of Marginal Rate of Technical
Substitution (MRTP). For example, with more
units of capital, the lesser units of labor are to
be employed to have the same level of output.
In the figure, it is clear that the reduction in capital is to be set off with the increase in labor,
and thus, the IQ is negatively sloped.

The iso-quant curve is convex to the

origin because of the MRTP effect. This
shows that factors of production are
substitutable for each other and with the
increase in one factor the other has to be
reduced to have the same level of production.

Iso-quant curves cannot intersect or be tangent to

each other. If these intersects, then the results will be
incorrect. A common factor combination on both the
curves will show the same level of output, which is not
feasible.

As per the figure, at point A, different combinations on

IQ1 and IQ2 produce the same level of output which is
not feasible. Since both, the curves show different levels of output i.e. 100 and 200 units
respectively.

Upper iso-quant curves yield higher outputs.

This is possible because, at a higher curve, more
factors of production are employed either the
capital or the labor, which results in more production. The arrow in the figure shows an
increase in the output with a right and upward shift of an iso-quant curve.

No iso-quant curve touches either of the axis, X or Y. If it does so, then the rate of
technical substitution would be void since it will show that a single factor is producing the
given level of output without any units of other factor being employed.

As per the figure, if an iso-quant curve IQ2 touches the X-axis, this means no units of labor
are employed, and only capital is required to produce the given level of output, which is not
correct.

Iso-quant curves need not be parallel to each

other because the rate of technical substitution
between the factors may vary in all the iso-quant
curves.

Each iso-quant curve is oval-shaped, which enables

a firm to identify the most efficient factor of
production. In the figure, point N and M show the
same level of output with different combinations of
labor and capital. Similarly, the combination at point
K can be ruled out because of the positive slope. This
means that, with an increase in labor, more capital is to
be employed to have a constant production.

Conclusion: Hence, it is clear from the properties of an iso-quant curve that a firm can have
the same level of production with different combinations of labor and capital that must be
utilized in such a way that the overall profitability of the firm increases.

Isocost Lines

Isocost lines represent combinations of two factors that can be bought with different
outlays. In other words, it shows how we can spend money on two different factors to
produce maximum output. These lines are also called budget lines or budget constraint lines.
Properties of Iso cost:

1. Isocost line shows various combinations of inputs that a firm can purchase or hire at a
given cost. By the use of isocosts and isoquants, a firm can determine the optimal input
combination to maximize profit.

2. It is a graphical representation of various combinations of inputs say Labor(L) and capital

(K) which give an equal level of output per unit of time. Output produced by different
combinations of L and K is say, Q, then Q=f (L, K). A higher isoquant refers to a larger
output, while a lower isoquant refers to a smaller output.

3. Isocost line Suppose a firm uses only labor and capital in production. The total cost or
expenditures of the firm can be represented by: C = wL + rK

4. In the Isocost line there are two-factor inputs labor and capital, the proportions of
factors are variable, physical production conditions are given and the state of technology
remains constant

The Choice of Optimal Expansion Path

Introduction: The choice of optimal expansion path refers to the combinations of factors of
production that enable the firm to produce various levels of output at the least cost while
relative factor prices remain constant. Its analysis is done concerning the short run and the
long run.

Assumptions:
This analysis is based on the following assumptions:

(1) There are two factors of production, labor, and capital, which are variable.

(2) All units of labor and capital are homogeneous.

(3) The price of labor (w) is constant.

(4) The price of capital (r) is constant.

(5) The firm increases its total outlay to expand its output.

Optional Choice of Inputs

A producer may maximize his profit in four ways. They are

 A producer can either minimize the cost of production for any given level of output.
 Maximize the output at any given level of outlay.
 Expansion path
 Cost minimization

Hence, we can once again say that the producer will be in equilibrium at the point where the
slope of the isoquant is equal to the slope of isocost.

Expansion path

Given these assumptions, to maximize its profits or to have the least cost combination, the
firm combines labor and capital in such a way that the ratio of their MP is equal to the ratio of
their prices, i.e., MPL/MPK = w/ r. This equality occurs at the point of tangency between an
isocost line and an isoquant curve.

This is explained in Figure 18, where С1L1 C2L2 and C3L3are the different isocost lines.
Line C2L2shows a higher total outlay than line C1L1 and С3L3 still a higher total outlay than
line C2L2. They are shown parallel to each other thereby reflecting constant factor prices.
There are three isoquants 100, 200, and 300 representing successively higher levels of output.
The firm is in equilibrium at point P where the isoquant 100 is tangent to its corresponding
isocost line С1L1 and similarly the other two isoquants 200 and 300 are tangent to isocost
lines С2L2and C3L3 respectively at points Q and R. Each point of tangency implies the
optimal combination of labor and capital that produces an optimal output level. The line OS
joining these equilibrium points P, Q, and R through the origin is the expansion path of the
firm. The firm expands its output along this line keeping factor prices constant.

Law of returns to scale

Introduction: In the long run all factors of production are variable. No factor is fixed.
Accordingly, the scale of production can be changed by changing the quantity of all factors of
production.

Definition:

“The term returns to scale refers to the changes in output as all factors change by the same
proportion.” Koutsoyiannis

“Returns to scale relates to the behavior of total output as all inputs are varied and is a long-
run concept”. Leibhafsky

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Explanation:

In the long run, the output can be increased by increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an increase in output due to an increase in all
factors in the same proportion. Such an increase is called returns to scale.

Suppose, initially production function is as follows:

P = f (L, K)

Now, if both the factors of production i.e., labor and capital are increased in the same
proportion i.e., x, product function will be rewritten as.

The above-stated table explains the following three stages of returns to scale:

1. Increasing Returns to Scale:

Increasing returns to scale or diminishing cost refers to a

situation when all factors of production are increased,
output increases at a higher rate. It means if all inputs
are doubled, the output will also increase at a faster rate
than double. Hence, it is said to be increasing returns to
scale. This increase is due to many reasons like division
external economies of scale. Increasing returns to scale can be illustrated with the help of
diagram 8.

In figure 8, the OX axis represents the increase in labor and capital while OY axis shows the
increase in output. When labor and capital increase from Q to Q1, output also increases from
P to P1 which is higher than the factors of production i.e. labor and capital.

2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production

situation, where if all the factors of production are increased in
a given proportion, output increases in a smaller proportion. It
means, if inputs are doubled, the output will be less than
doubled. If 20 percent increase in labor and capital is followed
by 10 percent increase in output, then it is an instance of
diminishing returns to scale.

3. Constant Returns to Scale:

Constant returns to scale or constant cost refer to the production situation in which output
increases exactly in the same proportion in which factors of production are increased. In
simple terms, if factors of production are doubled output will
also be doubled.

In this case, internal and external economies are exactly

equal to internal and external diseconomies. This situation
arises when after reaching a certain level of production,
economies of scale are balanced by diseconomies of scale.
This is known as the homogeneous production function.