FARM MANAGEMENT HANDOUT

CHAPTER FOUR

Production Functions and Relations (6 Hours)

Production function is defined as the technical relationship between inputs and output
indicating the maximum amount of output that can be produced using alternative amounts of
variable inputs in combination with one or more fixed inputs under a given state of
technology. It is usually presumed that unique production functions can be constructed for
every production technology. The relationship of output to inputs is non-monetary; that is, a
production function relates physical inputs to physical outputs, and prices and costs are not
reflected in the function.

Forms and Types of Production Functions

Production Function Forms
Production functions can be expressed in three forms: tabular, graphic and algebraic forms.
Tabular form: Production function can be expressed in the form of a table where one
column represents input and the other indicates the corresponding total output for each input
level. The two columns constitute production function.

Input (x) Output (y)

0 2
10 5
20 11
30 18
40 25

Graphical Form: The production function can also be illustrated in the form of a graph. In
graphical form the horizontal axis (X-axis) represents input and the vertical axis (Y- axis)
represents the output.

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From the graph above, we notice that:

 the production function is a continuous curve
 inputs and outputs are perfectly divisible (otherwise, it would look like a series of
dots)
 inputs and outputs are homogenous
Algebraic Form: Algebraically production function can be expressed as Y= f(X). Where
‘Y’ represents dependent variable - output (yield of crop, livestock enterprise) and ‘X’
represents independent variable- input (seeds, fertilizers, manure etc), ‘f =’ denotes function.
When all inputs in the production process individually expressed, the function is represented
as Y=f(X1, X2, X3, X4 ……… Xn). In the case of single variable production function, only
one variable is allowed to vary keeping others constant, the function can be expressed as:
Y=f(X1 | X2, X3 ………. Xn). The vertical line used mark between variable and fixed input
type. In such expression all inputs before the line represent variable type. The function
denotes that the output Y depends on the variable input X1, with all other inputs held
constant. If more than one variable input is varied and others are held constant, the
relationship can be expressed as:
Y=f(X1, X2 | X3, X4 …….. Xn)
There are different functional forms to represent production function. Some of the functional
forms include:
Linear production function, Y= a+bX
Quadratic equation, Y = a+bX ± cX2
The constant ‘a’ represents the amount of product obtained from the fixed factor if none of
the variable input is applied, while ‘b’ is the amount of output produced for each unit of X
(input) applied.
Exponential function, -commonly known as Cobb-Douglas production
function
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The representation of the various symbols used in the above function is given below
Y- Dependent variable,
a - constant,
b - Coefficient,
X’s - independent variable
Types of Production Functions
Continuous Production Function: A production function applicable for those inputs which
can be split up in to smaller units. All those inputs which are measurable result in continuous
production function. Example: Fertilizers, Seeds, Plant protection chemicals, Manures,
Feeds, etc.
Discontinuous or discrete Production Function: Such a function is obtained for resources or
work units which are used or done in whole numbers. In other words, production function is
discrete if inputs cannot be broken in to smaller units. Alternately stated, discrete production
function is obtained for those inputs which are counted. Example: Ploughing, Weeding,
Irrigation etc.
Short Run Production Function (SRPF): Production Function in which some inputs or
resources are fixed. Y= f (X1 | X2, X3,…………..,Xn) Eg: Law of Diminishing returns or
Law of variable proportions
Long Run Production Function (LRPF): Production function which permits variability in
all factors of production. Y = f (X1, X2, X3… Xn).
Production Relations
Production of farm commodities involves numerous relationships between resources and
products. Some of these relationships are simple, others are complex. Knowledge of these
relationships is essential as they provide the tools or means by which the problems of
production or resource use can be analyzed. The major production relationships include:
Factor -Product relationship, Factor -Factor relationship and Product-Product relationship

Factor-Product Relations
The Factor-Product Relations deal with the production efficiency of resources. The rate at
which the factors are transformed in to products is studied by this relationship. The central
goal of this relationship is optimization of production. The relationship is known as input-
output relationship by farm management specialists and fertilizer responsive curve by
agronomists. Factor-Product relationship guides the producer in making the decision on ‘how
much to produce?’ It helps the producer to decide the optimum input level to use and
optimum output level to produce. The decision on the optimal levels of input and output is
made by using price ratio as the choice indicator. Algebraically, this relationship can be
expressed as

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Y = f (X1 / X 2, X3………………Xn)

The factor - product relationship or the amount of a resource that should be used and
consequently the amount of output that should be produced is directly related to the operation
of law of diminishing returns. This law explains how the amount of product obtained changes
as the amount of one of the resources is varied keeping other resources fixed. It is also known
as law of variable proportions or principle of added costs and added returns.
The law of diminishing returns states:
An increase in capital and labor applied in the cultivation of land causes in general less than
proportionate increase in the amount of produce raised, unless it happens to coincide with the
improvements in the arts of agriculture

If the quantity of one of productive service is increased by equal increments, with the
quantity of other resource services held constant, the increments to total product may
increase at first but will decrease after certain point

The Law originally developed by early economists to describe the relationship between
output and a variable input keeping all other inputs constant if increasing amount of one
input is added to a production process while all others are constant, additional output will
eventually decline the law implies there is a “right” level of variable input to use with the
combination of fixed inputs

Limitations:
The law of diminishing returns fails to operate under certain situations. They are called
limitations of the law. These limitations under which the law doesn’t hold include: improved
methods of cultivation, new soils and insufficient capital.
Why the law of diminishing returns operates in agriculture?
The law of diminishing returns is applicable not only to agriculture but also manufacturing
industries. This law is as universal as the law of life itself. If the industry is expanded too
much, supervision will become difficult and the costs will go up. The law of diminishing
returns, therefore, sets in. The only difference is that in agriculture it sets in earlier and in
industry much later. There are several reasons for the operation of law of diminishing returns
in agriculture. Among them is:
 Excessive dependence on weather
 Limited scope for mechanization
 Soil gets exhausted due to continuous cultivation
 Cultivation extends to inferior lands
Concepts of product curves
Total product (TP): Amount of product which results from different quantities of variable
input. Total product indicates the technical efficiency of fixed resources.
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Average Product (AP): It is the ratio of total product to the quantity of input used in
producing that quantity of product. AP= Y/X where Y is total product and X is total input.
Average product indicates the technical efficiency of variable input.
Marginal product (MP): Additional quantity of output resulting from an additional unit of
input used. MP = Change in total product / Change in input level (ΔY/ΔX) for discrete
change.
Total Physical Product (TPP): It is the Total Product (TP) expressed in terms of physical
units like Kgs, quintals, etc. Similarly if AP and MP are expressed in terms of physical units,
they are called Average Physical Product (APP) and Marginal Physical Product (MPP)
respectively.
Total Value Product (TVP): Expression of TPP in terms of monetary value is known as Total
Value Product. TVP = TPP*Py or Y*Py
Average Value Product (AVP): The expression of Average Physical Product in money value.
AVP = APP * Py
Marginal Value Product (MVP): When MPP is expressed in terms of money value; it is
called Marginal Value Product. MVP = MPP * Py or (ΔY/ΔX) * Py or ΔY* Py / Δ X
Relationships between Total Product (TP) and Marginal Product (MP):
– If Total Product is increasing, the Marginal Product is positive.
– If Total Product remains constant, the Marginal Product is zero.
– If Total Product is decreasing, Marginal Product is negative.
– As long as Marginal Product increases, the Total Product increases at increasing rate.
– When the Marginal Product remains constant, the Total Product increases at constant
rate.
– When the Marginal Product declines, the Total Product increases at decreasing rate.
– When Marginal Product is zero, the Total Product is at maximum.
– When marginal product is less than zero (negative), total physical product is declining
at increasing rate.
Relationship between Marginal and Average Product
– If Marginal Product is more than Average Product, Average Product is increasing.
– If Marginal Product is equal with the Average Product, Average Product is
Maximum.
– When Marginal Product is less than Average Product, Average Product is decreasing.

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Table 1: Relationship between TP, AP and MP

Input Total Product Average Marginal
(X) (Y) Product Product Remark
(AP= Y/X) (MP=ΔY/ΔX
0 1 - -
1 2 2 1
Increasing Returns
2 5 2.5 3
3 9 3 4
4 14 3.5 5
Constant Returns
5 19 3.8 5
6 23 3.83 4
7 26 3.71 3
8 28 3.5 2 Decreasing Returns
9 29 3.22 1
10 29 2.9 0
11 28 2.54 -1
Negative Returns
12 29 2.16 -2
Three Regions of Production Function
The production function showing total, average and marginal product can be divided into
three regions or stages or zones in such a manner that one can locate the zone of production
function in which the production decisions are rational or not. The three sages are shown in
the figure below.

Figure 1: Stages of production

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Stage I: In this stage, the average rate at which variable input (X) is transformed into product
(Y) increases until it reaches its maximum (i.e., Y/X is at its maximum). This maximum
indicates the end of Stage I.
The first stage starts from the origin i.e., zero input level. In this zone, Marginal Physical
Product is more than Average Physical Product and the Average Physical Product increases
throughout zone. Marginal Physical Product (MPP) is increasing up to the point of inflection
and then declines. Since the marginal Physical Product increases up to the point of inflection,
the Total Physical Product (TPP) increases at increasing rate. After the point of inflection, the
Total Physical Product increases at decreasing rate. Elasticity of production is greater than
unity up to maximum Average Physical Product (APP) and becomes one at the end of the
zone (MPP = APP). In this zone fixed resources are in abundant quantity relative to variable
resources. The technical efficiency of variable resource is increasing throughout this zone as
indicated by Average Physical Product. The technical efficiency of fixed resource is also
increasing as reflected by the increasing Total Physical Product. Marginal Value Product is
more than Marginal Factor Cost (MVP >MFC) and Marginal revenue is more than marginal
cost (MR > MC). This is irrational or sub-optimal zone of production. And this zone ends at
the point where MPP=APP or where APP is Maximum.

For Economic decisions Stage I is irrational zone of production. Any level of resource use
falling in this region is uneconomical. The technical efficiency of variable resource is
increasing throughout the zone (APP is increasing). Therefore, it is not reasonable to stop
using an input when its efficiency is increasing. Which means more products can be
obtained from the same resource by reorganizing the combination of fixed and variable
inputs. For this reason, it is called irrational zone of production.
Stage II: The second zone starts from where the technical efficiency of variable resource is
maximum i.e., APP is Maximum (MPP=APP)
– In this zone Marginal Physical Product is less than Average Physical Product.
Therefore, the APP is decreasing throughout this zone.
– Marginal Physical Product is decreasing throughout this zone.
– As the MPP declines, the Total Physical Product increases but at a decreasing rate.
– Elasticity of production is less than one between maximum APP and maximum TPP
and becomes zero at the end of this zone.
– In this zone variable resource is more relative to fixed factors.
– The technical efficiency of variable resource is declining as indicated by declining
APP.
– The technical efficiency of fixed resource is increasing as reflected by increasing
TPP.
– The condition Marginal Value Product is equal to Marginal Factor Cost (MVP=MFC)
and Marginal Revenue is equal to Marginal Cost (MR= MC) exists in this stage
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– This is rational zone of production in which the producer should operate to attain his
objective of profit maximization.
– This zone ends at the point where Total Physical Product is at maximum or Marginal
Physical Product is zero.
Stage II is rational zone of production. The area within the boundaries of this region is of
economic relevance. Optimum point must be somewhere in this rational zone. It can,
however, be located only when input and output prices are known.
Stage III: This zone starts from where the technical efficiency of fixed resource is
maximum (TPP is Maximum). In Stage II:
– Average Physical Product is declining but remains positive
– Marginal Physical Product becomes negative
– The Total Physical Product declines at faster rate since MPP is negative.
– Elasticity of production is less than zero (Ep < 0)
– In this zone variable resource is in excess capacity
– The technical efficiency of variable resource is decreasing ( declining APP)
– The technical efficiency of fixed resource is also decreasing ( declining TPP)
– Marginal Value Product is less than Marginal Factor Cost (MVP < MFC)
– Marginal Revenue is less than Marginal Cost ( MR < MC)
– This zone is irrational zone of production.
Producer should never operate in this zone even if the resources are available at free of cost.
Stage III is also an area of irrational production. TPP is decreasing at increasing rate and
MPP is negative. Since the additional quantities of resource reduces the total output, it is not
profitable zone even if the additional quantities of resources are available at free of cost. If
farmer operates in this zone, he will incur double loss, that is, reduced production and
unnecessary additional cost of inputs.
In summary, for a Factor-Product type production relation, the optimal use of variable factor
is the level for which the VMP is equal to the factor price. It is located in stage II. The
economic meaning of the optimal solution would mean:
Increasing use of a factor by one unit is profitable if the increase in the total revenue
resulting from increased input (= the VMP) is higher than the increase in cost (i.e., the price
Px paid for one unit of the factor). If this condition fulfilled profit is maximized.

Factor-Factor Relations
This relationship deals with the resource combination and resource substitution. Cost
minimization is the goal of factor-factor relationship. Under factor-factor relationship, output
is kept constant while inputs are varied in quantity. This relationship guides the producer for
a decision on ‘how to produce’. Such a relation is explained by the principle of factor
substitution or principle of substitution between inputs. Factor-Factor relationship is

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concerned with the determination of least cost combination of resources. The choice
indicators are the physical substitution ratio and price ratio. It is expressed algebraically as:
Y = f(X1, X2, / X3, X4… Xn), where we consider two variable inputs
In the production process inputs are substitutable. For instance, capital can be substituted for
labor and vice versa; grain can be substituted for fodder and vice versa. The producer has to
choose that input or inputs, practice or practices which produce a given output with minimum
cost. The producer aims at cost minimization through choice of inputs and their
combinations.
Concept of Isoquants:
The relationship between two factors and output cannot be presented with a two-dimensional
graph. Three variables can be presented in a three-dimensional diagram giving a production
surface. An isoquant is a convenient method for compressing three-dimensional picture of
production into two dimensions. Hence, isoquant is defined as all possible combinations of
two resources (X1 and X2) physically capable of producing the same quantity of output.
Isoquants are also known as isoproduct curves or equal product curves or product
indifference curves. Graphical representation of isoquant is given below.

Y X1 X2 Output
3 20 60
4 15 60
6 10 60
X2 Isoquant 10 6 60
15 4 60
X 20 3 60
O
X1
Isoquant Map or Isoproduct Contour
If a number of isoquants are drawn on one graph it is known as isoquant map. Isoquant map
indicates the shape of production surface which in turn indicates the output response to the
inputs.

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Y3= 30
X2
Y2= 20
Y1= 10
O
X1
Figure 2: Isoquant Map
Isoquants further from the origin represent higher production level. The Y’s in the graph are
ordered as Y1< Y2< Y3
Characteristics of Isoquant
– Slope downwards from left to right or negatively sloped
– Convex to the origin
– Nonintersecting
– Isoquants lying above and to the right of another represent higher level of output
– The slope of isoquant denotes the marginal rate of technical substitution (MRTS).
Marginal Rate of Technical Substitution (MRTS)
MRTS refers to the amount by which one resource is reduced as another resource is
increased by one unit. Or the rate of exchange between some units of X1 and X2 which are
equally preferred. MRTS can be represented as:

MRTS X1 for X2 = ΔX2/ΔX1

MRTS X1 for X2 = ΔX1/ ΔX2

MRTS gives the slope of Isoquant. Substitutes indicate a range of input combinations which
will produce a given level of output. When one factor is reduced in quantity, a second factor
must always be increased. Hence MRTS is always less than zero or it is negative.
Types of factor substitution
The shape of isoquant and production surface will depend up on the manner in which the
variable inputs are combined to produce a particular level of output. There can be three such
categories of input combinations.

Fixed Proportion combination of inputs: Under fixed combination, to produce a given level
of output, inputs are combined together in fixed proportion. Isoquants are ‘L’ shaped. It is
difficult to find examples of inputs which combine only in fixed proportions in agriculture.

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An approximation to this situation is provided by tractor and driver combination. To operate

another tractor, normally we need another driver.
Constant rate of Substitution: For each one-unit gain in one factor, a constant quantity of
another factor must be sacrificed. When factors substitute at constant rate, isoquants are
linear & negatively sloped.
Decreasing Rate of substitution: Every subsequent increase in the use of one factor in the
production process can replace less and less of the other factor. In other words, each one unit
increase in one factor requires smaller and smaller sacrifice in another factor.
Ex: Capital and labour, concentrates and green fodder, organic and inorganic fertilizers etc.
Isoquants are convex to the origin when inputs substitute for each other at decreasing rate.
Decreasing rate of factor substitution is more common in agricultural production.

Figure 3: Input Substitution Types

Isocost Line (price line or budget line)

Isocost line defines all possible combinations of two resources (X1 and X2) which can be
purchased with a given outlay of funds. Isocost line is used in the concept of optimal input
combination in the production process.
Characteristics of Isocost line:
As the total outlay increases, the isocost line moves farther away from the origin.
Isocost line is a straight line because input prices do not change with the quantity purchased.
The slope of isocost line determined as the ratio of factor prices.
Least Cost Combination of inputs
There are innumerable possible combinations of factors which can be used to produce a
particular level of output. The problem is to find out a combination of inputs which cost the
least; a cost minimization problem. There are three methods to find out the least cost
combination of inputs. These methods are explained below.

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1. Simple Arithmetical calculations (presented in Table)

Units of X1 Units of X2 cost of X1 Cost of X2 Total Cost
(price 3 Birr/unit) (Price 2 Birr/unit)
10 3 30 6 36
7 5 21 10 31
5 6 15 12 27
3 8 9 16 25
2 12 6 24 30

One possible way to determine the least cost combination is to compute the cost of all
possible combinations of inputs and then select the combination with minimum cost. This
method is suitable where a limited number of combinations produce a particular level of
output. The above table shows five combinations of inputs which can produce a given level
of output. The price per unit of X1 is Birr 3 and of X2 is Birr 2. The total cost of each
combination of inputs is computed and given in the column with Total Cost. Out of five
combinations, 3 units of X1 and 8 units of X2 is the least cost combination of inputs at a cost
of Birr 25 to produce the specified unit of a product.
2. Algebraic method:
Compute Marginal Rate of technical substitution
MRTS = Number of units of replaced resource / Number of units of added resource
MRTS X1 for X2 = Δ X2/ΔX1
MRTS X2 for X1 = ΔX1/ΔX2
Compute Price Ratio (PR)
PR=Price per unit of added resource/Price per unit of replaced resource
PR=Px1/Px2 if MRTS X1X2 or PR= Px2/ Px1 if MRTS X2X1
Least combination occurs at a point where MRTS and PR are equal. i.e.
ΔX2/ΔX1= P x1/Px2 MRTS X1X2
ΔX1/ΔX2= Px2/ P x1 MRTS X2X1
The same can be expressed as
ΔX2* Px2= Px1*ΔX1 or ΔX1*Px1 =ΔX2*Px2
The least cost combination is obtained when Marginal Rate of substitution is equal to Price
Ratio. If they cannot be exactly equal because of the choices available in the table, take
closer figures without letting the price ratio exceed the substitution ratio.

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Units of X1 Units of X2 MRTSX2 X1 PR = Px2 /Px1

10 3 - 0.67
7 5 (7-10) /(4-3) = 3.00 0.67
5 6 (5-7) /(6-5) = 2.00 0.67
3 8 (3-5) / (8-6) = 1.00 0.67
2 12 (2-3) /(12-8) = 0.25 0.67
Price of X1 is Birr 3 per unit, and price of X2 is Birr 2 per unit

3. Graphical Method: Contemporary

Since the slope of isoquant indicates MRTS and the slope of isocost line indicates factor
price ratio, minimum cost for a given output will be indicated by the tangency of these
isoclines (isocost and isoquant lines). For this purpose, isocost line and isoquant are drawn on
the same graph. The least cost combination will be at the point where isocost line is tangent
to the isoquant line i.e., slope of isoquant=slope of isocost line i.e., MRTS=PR
X Isocost

LCC

X2
Isoquant
X
O
X1

Product-Product Relations
Product-Product relationship deals with resource allocation among competing enterprises
(individual crop production and animal rearing). The goal of Product-Product relationship is
profit maximization through optimal combination of enterprises. Under Product-Product
relationship, inputs are kept constant while products (outputs) are varied. This relationship
guides the producer in deciding on ‘What to produce?’ Product-Product relationship is
explained by the principle of product substitution. The relationship is concerned with the
determination of optimum combination of production (enterprises). The choice indicators are
product substitution ratio and price ratio. Algebraically, product-product relation is expressed
as:
Y1=f (Y2, Y3… Yn)
Production Possibility Curve (PPC)
Production Possibility Curve is a convenient device for depicting two production functions
on a single graph. Production Possibility Curve represents all possible combinations of two
products that could be produced with a given amounts of inputs. Production Possibility Curve
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is known as Opportunity Curve because it represents all production possibilities or

opportunities available with limited resources. It is called Isoresouce Curve or Isofactor
curve because each output combination on this curve has the same resource requirement. It is
also called Transformation curve as it indicates the rate of transformation of one product into
another.
How to draw Production Possibility Curve
Production Possibility Curve can be drawn either directly from production function or from
total cost curve. The method of drawing Production Possibility Curve from Production
Function is explained below.

A farmer has five acres of land and wants to produce two products namely cotton (Y1) and
Maize (Y2). Assume all other inputs are fixed. Now the farmer has to decide how much of
land input to use for each product. This implies that amount of land that can be used to
produce Cotton (Y1) depends upon the amount of land used to produce Maize (Y 2).
Therefore, Y 1= f (Y2)
The allocation of land resource between the two products and the output from different doses
of land input are presented below

Allocation of Land in Acres Output in quintals

Y1 Y2 Y1 Y2
0 5 0 60
1 4 8 48
2 3 15 36
3 2 21 24
4 1 26 12
5 0 30 0

As evident from the above data, if all 5 acres of land are used in the production of Y2 we
obtain 60 quintals of Y2 and do not get any of Y1. On the other hand, if all the five acres of
land are used in the production of Y1 we can obtain 30 quintals of Y1 and do not get any of
Y2. But these are the two extreme production possibilities. In between the two, there are
many other production possibilities. Plotting these two points on a graph, we get the
Production Possibility Curve.

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Production Possibility Curve (PPC)

Output of Y2

O
Output of Y1

Production Possibility Curve

Types of Product-Product Relationships or Enterprise Relationship
Farm commodities bear several physical relationships to one another. These basic product
relationships include:
1) Joint Products: such relationship happen when two products are produced through single
production process. As a rule the two are combined products. Production of one (main
product) without the other (by-product) is not possible. The level of production of one
decides the level of production of another. Most farm commodities are joint products.
Ex: Wheat and Straw, cattle and manure, beef and hides, mutton and wool etc.

Y2 A

O
Y1

Graphically the quantities of Y1 and Y2 that can be produced at different levels of resources
will be shown as points AB in the figure.
2) Complementary enterprises: Complementarity between two enterprises exists when
increasing the production from one enterprise increases the production of the other
enterprise. Change in the level of production of one enterprise causes change in the other
enterprise in the same direction. That is when increase in output of one product, with
resources held constant, also results in an increase in the output of the other product.
Temporarily, the two enterprises do not compete for resources but contribute to the mutual
production by providing an element of production required by each other. The marginal rate
of product substitution is positive (> 0). Ex: crops and livestock enterprises.

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As shown in the figure, range of complementarities is from point A to point B when increase
in the production of one enterprise (crop) followed by increase in the production of the other
enterprise (Livestock). After point B the enterprises will become competitive. All
complementary relationships should be taken advantage by producing both products up to the
point where the products become competitive.
3) Supplementary enterprises: Supplementarity exists between enterprises when increase
or decrease in the output of one product does not affect the production level of the other
product. They do not compete for resources but make use of resources when they are not
being utilized by one enterprise. The marginal rate of product substitution is zero. For
example, small poultry or dairy or piggery enterprise is supplementary on the farm. All
supplementary relationships should be taken advantage by producing both products up to the
point where the products become competitive.

A
Y2

Y1

The two products (Y1 and Y2) stay supplementary from A to B as shown in the graph. After
point B they become competitive enterprises.

4) Competitive enterprises: This relationship exists when increase or decrease in the

production of one product affect the production of other product inversely. That is when
there is an increase in output of one product, with resources held constant; production of the
other product decreases. Competitive enterprises compete for the same resources. Two
enterprises are competitive in the use of given resources if output of one can be increased
only through sacrifice in the production of another. The marginal rate of product substitution
is negative (< 0)
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Marginal rate of product substitution (MRPS)

The term marginal rate of product substitution under the product-product relationship has the
same meaning as MRTS under the factor-factor relationship. Marginal rate of the product
substitution refers to the absolute change in one product associated with a change by one unit
of the competing product. The quantity of one product to be sacrificed so as to gain another
product by one unit is given by MRPS.
MRPS = Number of units of replaced product / Number of units of added product
MRPSY1 for Y2 = ∆Y2/∆Y1
MRPSY2 for Y1 = ∆Y1/∆Y2
Types of Product Substitution
When two products are competitive, they substitute either at constant rate or increasing rate
or at decreasing rate.
1) Constant rate of Substitution:
For each one unit increase or gain in one product, a constant quantity of another product must
be decreased or sacrificed. When products substitute at constant rate, the Production
Possibility Curve is linear and negatively sloped. Or Production Possibility Curve is linear
when products substitute at constant rate. When two products substitute at constant rate, only
one of the two products will be economical to produce depending on their relative prices.
This is to say that specialization is the general pattern of production under constant rate of
product substitution. This relationship can be expressed as

∆1Y2/∆1Y1 = ∆2Y2/∆2Y1 = ……. = ∆nY2/∆nY1

Y1 Y2 ∆Y1 ∆Y2 ∆Y2/∆Y1

16 2 - - -
12 4 4 2 0.5
8 6 4 2 0.5
4 8 4 2 0.5

2) Increasing rate of product substitution:

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Each unit increase in the output of one product is accompanied by larger and larger sacrifice
(decrease) in the level of production of other product. Increasing rates of substitution holds
true when the production for each independent commodity is one of decreasing resource
productivity (decreasing returns) and non-homogeneity in quality of limited resource. The
production Possibility Curve is concave to the origin when product substitutes at the
increasing rate. Increasing rate of the product substitution is common in agricultural
production. The general pattern of production is diversification i.e., profits are maximized by
producing both products.

∆1Y2/∆1Y1 < ∆2Y2/∆2Y1 < ……. < ∆nY2/∆nY1

Y1 Y2 ∆Y1 ∆Y2 ∆Y2/∆Y1

1 14 - - -
2 11 1 3 3
3 7 1 4 4
4 2 1 5 5
3) Decreasing rate of Product Substitution:
Each unit increase in the output of one product is accompanied by lesser and lesser decrease
in the production of another product. This type of product substitution holds good under
conditions of increasing returns. Production Possibility Curve is convex to the origin when
products substitute at decreasing rate. This relationship is algebraically expressed as

∆1Y2/∆1Y1 > ∆2Y2/∆2Y1 > ……. > ∆nY2/∆nY1

Y1 Y2 ∆Y1 ∆Y2 ∆Y2/∆Y1

1 10 - - -
2 6 1 4 4
3 3 1 3 3
4 1 1 2 2

IsoRevenue Line
Isorevenue line represents all possible combination of two products which would yield an
equal (same) revenue or income. Let R is the revenue from two products Y1 and Y2 and the
prices for both products is given as Py1 and Py2 respectively. The Isorevenue equation will be
given as:

R= Y1 * Py1 + Y2 * Py2, the line is linear as long as prices for both products do not change

Characteristics:
Isorevenue line is a straight line because product prices do not change with quantity sold.
As the total revenue increases, the isorevenue line moves away from the origin
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The slope indicates ratio of product (output) prices. As long as product prices remain
constant, the isorevenue line showing different total revenues are parallel. But change in
either price will change the slope.
Determination of optimum combination of products (Economic decision):
The Economic optimum combination of the two products can be determined through three
different ways:

1) Algebraic Method:
There are three steps to determine the optimum product combination through algebraic
method.
a) Compute Marginal Rate of Product Substitution
MRPS =Number of units of replaced product/Number of units of added product
MRPSY1 for Y2 = ∆Y2/∆Y1
MRPSY2 for Y1 = ∆Y1/∆Y2
b) Workout price ratio (PR)
Price Ratio (PR) = Price per unit of added product/Price per unit of replaced product
PR= P y1/Py2 if it is MRPSY1Y2
PR= Py2/ Py1 if it is MRPSY2Y1
c) Find the combination at a point where substitution ration (MRPS) is equal to price ratio
(PR). This gives us the Optimum combination of enterprises.

∆ Y2/∆Y1= Py1/Py2 or ∆Y1/∆Y2 = Py2/ Py1

For profit maximization, a rational producer should operate in the range where two products
are competitive and within this range the choice of products should depend upon the MRS
and PR.

2) Graphic Method:
In this method follow the procedure given below to find the optimal product combination.
Draw production possibility curve and isorevenue line on one graph.
Slope of production possibility curve indicates MRPS and the slope of isorevenue line
indicate price ratio of products.
The point of optimum combination of products is at a point where the isorevenue line is
tangent to the production possibility curve.
At the tangency point, slope of the isorevenue line and the slope of the production possibility
curve will be the same. In other words, the MRPS=PR which gives the optimum
combination.

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Production Possibility Curve

Optimum Combination of products

Y2

Isorevenue Line

O
Y1

3) Tabular Method:
Compute total revenue for each possible output combination and then select that combination
of outputs which yields maximum total revenue. This method is useful only when we have
few combinations.

Revenue from Y1 Revenue from Y2

Y1 Y2 Total Revenue
(Py1=50) (Py2=80)
8 2 400 160 560
5 3 250 240 490
6 4 300 320 620
4 5 200 400 600
3 7 150 560 710

Accordingly, the optimum combination includes 3 units of Y1 and 7 units of Y2 where the
revenue at this combination is the maximum as indicated in the table.
Table 2: Summary of basic production relationships
Factor – Product Factor – Factor Product – Product

Deals with resource use Deals with resource Deals with resource
efficiency combination and resource allocation among enterprises
substitution

Optimization of the Cost minimization is the goal Profit optimization is the

production is the goal goal

Answers the question ‘How Answers the question ‘How Answers the question ‘What
much to produce?’ to produce?’ to produce?’

Considers single variable Inputs or resources varied Output of products are varied
production function keeping the output constant keeping the resource constant

Guides in the determination Concerned with the Helps in the determination of

of optimum input to use and determination of Least cost optimum combination of
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optimum output to produce combination of resources products

Price ratios are choice Substitution ratio and Price Substitution ratio and price
indicator ratio are the choice ratios are choice indicators
indicators.

Explained by the law of Explained by the principle of Explained by the principle of

diminishing returns factor substitution product substitution

Y=f(X1 | X2, X3 ……Xn) Y = f(X1 X2 / X3, X4 ...Xn) Y1=f(Y2 ,Y3, ……. Yn)

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