Chapter 5: Theory of Production

1. Basic Concept of Production:

Production is sometimes defined as the creation of utility as well as the creation of value-satisfying goods
and services. Utilities are created in three forms: (i) form utility, (ii) time utility, and (iii) place utility.
Production essentially means transforming one set of goods into another. A good may be transformed by
being physically changed (form utility), transported to the place of use (place utility), or kept in storage until
required (time utility).

Factors of Production: The resources required to produce a given product are called factors of production.
a) Land: In economics, land includes all natural resources provided freely by nature, such as soil, air,
water, and minerals. It is distinct from soil in its broader sense. Peculiarities:
 A gift of nature, not man-made but fixed in quantity.
 Permanent with inherent indestructible qualities. Immobile geographically.
 Unique in fertility and situation, contributing to varying economic rent.

b) Labor: Labour refers to any physical or mental work undertaken for monetary reward. Activities done
for pleasure or love are excluded. Peculiarities:
 Inseparable from the laborer, so must be sold in person.
 Perishable—labor not used is lost forever.
 A fall in wages may sometimes increase labor supply, contrary to usual supply-demand rules.

c) Capital: Capital consists of man-made resources used to produce further wealth, such as machinery,
tools, and raw materials. Peculiarities:
 Capital is produced and differs from land, which is a natural gift.
 Capital is mobile, unlike the immobility of land.
 Capital can increase in quantity, but land is limited.

d) Entrepreneur (Enterprise): Entrepreneurs combine and manage other factors of production, assuming
the risks and rewards of the venture. Functions:
 Coordination: Organizing land, labor, and capital.
 Risk-taking: Bearing uncertainties in business outcomes.
 Innovation: Introducing new products, methods, markets, or organizational strategies.

Variable vs Fixed Factors:

Basis Variable Factors Fixed Factors
Meaning Variable Factors refer to those factors Fixed Factors refer to those factors which
which can be changed in the short run. cannot be changed in the short run.
Relation with They vary directly with output. They do not vary directly with the level of
Output output.
Example Raw material, casual labor, power, fuel, etc. Building, Plant and machinery, permanent
staff, etc.
 2. Production Function
Production Function is the technical relationship between inputs (land, labor, capital) and outputs (quantity
produced). Material inputs include variable and fixed factors of production. In a standard equation, the
Production function is represented by Q, Labour (Variable element) is represented by L, and Capital (Fixed
element) is represented by K. Q = f (L, K)

e) Types of Production Functions: PF based on time period can be divided into two categories:
Basis Short Run Long Run
Meaning It refers to a period in which output can be It refers to a period in which output can be
increased by changing only variable factors. increased by changing factors of
production.
Classificatio Factors are classified as variable (labor, All the factors are variable in the long run.
n capital) and fixed (land) in the short run.
Price Demand is more active in price Both demand and supply play an equal role
determination as supply cannot be increased in price determination as both can be
immediately with an increase in demand. increased.

3. Concept of Product
Product or output refers to the volume of the goods that the company produces using inputs during a
specified time. The concept of product can be looked at from three different angles:

a) Total Product: Total Product (TP) refers to the total quantity of goods that the firm produced during a
given course of time with the given number of inputs. For example, if 6 laborers produce 10 kg of
wheat, then the total product is 60 kg.
Total Product = Ʃ Marginal Product

b) Average Product: Average Product refers to output per unit of a variable input. AP is calculated by
dividing TP by units of the variable factor. For example, if the total product is 60 kg of wheat produced
by 6 laborers (variable inputs), then the average product will be 60/6, i.e., 10 kg.

c) Marginal Product: Marginal Product refers to the addition to the total product when one more unit of a
variable factor is employed. It calculates the extra output per additional unit of input while keeping all
other inputs constant. or

4. Law of Variable Proportions

The Law of Variable Proportions, also known as the Law of Diminishing Returns, describes how the output
of a production process changes as the quantity of one input (labor or capital) varies while other inputs
(land) are kept constant. This law is applicable in the short run, where at least one factor of production is
fixed.
 Example of Law of Variable Proportion: Let’s say a farmer has 1 acre of land and wants to use labor
(i.e., variable factor) to improve the production of rice there. The output increased initially at an
increasing rate, then at a decreasing rate, and finally at a negative rate as he employed more and more
units of labor.
FF VF TP MP Phase
Land Labor kg kg
1 1 5 5 Phase I: Increasing
1 2 20 15 Returns to a Factor
1 3 32 12 Phase II: Decreasing
1 4 40 8 Returns to a Factor
1 5 40 0
1 6 35 -5 Phase III: Negative
Returns to a Factor

 Phases of Law of Variable Proportion

As per the law of variable proportions, the changes in TP and MP can be categorized into three phases:

 Phase I: Increasing Returns to a Factor: In the initial stage, each additional variable component raises
the TP and MP at an increasing rate. Reasons for Increasing Returns:
 More Effective Use of Fixed Factor: Fixed factors are underutilized in the beginning. Adding more
variable factors allows the fixed factor to be used more efficiently and maximizes its potential until
the ideal ratio of fixed to variable inputs is achieved.
 Increased Efficiency of Variable Factor: The additional variable factors complement the fixed factor,
leading to greater cooperation and specialization. This synergy among inputs improves their overall
efficiency and boosts output.

 Phase II: Decreasing Returns to a Factor: Every extra variable in the second phase increases the TP
and MP at a decreasing rate. Reasons for Decreasing Returns:
 Optimum Combination of Factors: There is a specific combination of fixed and variable inputs
where total product (TP) is maximized.
 Imperfect Substitutes: Fixed factors have limitations. Increasing variable factors beyond their
capacity leads to inefficiencies and a decline in TP & MP. For example, too many workers using the
same tools may cause congestion and reduce overall productivity.

 Phase III: Negative Returns to a Factor: The third phase shows a decline in TP due to the use of more
variable factors and MP has now become negative. Reasons for Negative Returns:
1. Limitation of Fixed Factor: Fixed factors cannot be expanded in the short run. Overloading the fixed
factor with too many variable inputs leads to inefficiencies and a decline in output. For example,
excessive labor on a fixed plot of land can lead to overworking the soil, reducing productivity.
 2. Decrease in Efficiency of Variable Factor: Specialization and division of labor lose their
effectiveness as more units of the variable factor are added. This overcrowding reduces the
efficiency of individual workers or units, further contributing to negative returns.

 Phase of Operation: A logical or rational producer will always attempt to operate in Phase II since the
MP of each variable factor is positive and TP is at its highest level. A rational manufacturer would never
engage in Phase III due to technical inefficiency and negative return.
 Limitation of the law:
a) Technological Improvements: The law assumes that the state of technology remains unchanged. Any
technological advancement or innovation would alter productivity, invalidating the law's predictions.
b) Invalid for the long run: The law does not apply when all inputs are varied proportionately in long run;
such scenarios fall under the concept of Returns to Scale.
c) Underutilized Capital: If capital was previously insufficient, adding more may initially yield higher-
than-proportional returns.

5. The Law of Returns to Scale

Returns to scale refer to the change in output that results from a change in the factor inputs simultaneously
in the same proportion in the long run. But, when a firm changes the quantity of all inputs in the long run, it
changes the production scale for the goods.
 Three stages of the law of return to scale:
Unit of Unit of % Increase in Total % increase in Stages
Labour capital labor and capital production TP
1 3 – 10 –
Increasing returns to scale
2 6 100% 30 200%
3 9 50% 60 100% Constant scale returns
4 12 33% 80 33%
Decrease in returns to scale
5 15 25% 100 25%
Increasing returns to scale: It describes a condition in which all of the factors of production are raised,
resulting in a higher output rate. Reasons: Due to the benefits of large-scale production and better
logistic support. And, Specialization through better division of labor
Constant returns to scale: It describes a condition in which all production factors are increased
simultaneously, resulting in steady output growth. Reasons: As the firm’s production grows, it reaches a
point where all of the economy’s resources have been fully utilized, and output equals input.
Diminishing returns to scale: When all factors are increased simultaneously, output grows slower.
Reasons: Diseconomies of scale occur when a company has grown to such a size that is difficult to
manage and coordinate all activities.

6. Production Possibilities Frontier (PPC)

Production Possibility Curve (PPF) is the graphical re.0
presentation that shows different combinations of two goods, that an economy can produce by fully utilizing
its resources, assuming a fixed technology level.

 Assumptions of PPF: Production Possibility Curve is based on the following assumptions:

 Fixed Resources: The quantity of resources available in the economy is assumed to be fixed. This
includes labor, capital, land, and technology. However, one can transfer the resources from one use to
another.
 Full Employment of Resources: The PPC assumes that all available resources in the economy are fully
employed and utilized efficiently.
 Two Goods: The PPC assumes that with the given resources, only two goods can be produced.
 Unequal Efficiency in Production: Under PPC, it is assumed that the resources are not equally efficient
in the production of all goods. Therefore, when the resources are transferred from one use to another
(production of one good to another), productivity declines.

Possibility Appl Orange (MOC MRT

e )
A 15 0 – –
B 14 1 1 1A : 1O
C 12 2 2 2A : 1O
D 9 3 3 3A : 1O
E 5 4 4 4A : 1O
F 0 5 5 5A : 1O

 Change in PPF (Shift and Rotation): If we consider today’s changing environment, due to the
increase or decrease in resources, the production capacity of an economy keeps on changing constantly.
These changes result in a change in PPC.

i) Rightward Shift in PPF: When there is advancement in

technology or growth in resources, concerning both goods,
the PPC will shift in the right direction.
ii) Leftward Shift in PPF: When there is a degradation in
technology or a decrease in resources due to natural disasters,
concerning both goods, the PPC will shift in the left
direction.

7. Uses of the Production Possibility Curve (PPC)

Let’s explore its practical uses in simple terms:
a) Resource Allocation in Developing Economies: In developing countries, governments often need to
decide how to use scarce resources: At an early stage of development, they may prioritize necessities
 (food and housing). Later, they might shift resources toward luxury goods (cars and entertainment) or
producer goods (factories and machinery).

b) Balancing Public and Private Goods In democratic countries, governments must decide how much to
allocate toward privately manufactured goods (cars, electronics) or public goods (education, healthcare).

c) Investing in Capital Goods for Future Growth One of the critical uses of the PPC is guiding decisions
about investment in capital goods (like machines, tools, and infrastructure). investment leads to greater
production capacity and higher economic growth in the future.

d) Analyzing Economic Growth: When an economy grows due to technological advancements, better
resource use, or increased resources, Policymakers can use the PPC to track progress and make informed
decisions about future investments.
8. Isoquant Curve and Iso-cost line:
An isoquant curve is a curve that shows different possible combinations of two factors of production
(capital and labor) that a firm utilizes to get the same amount of output. The term isoquant is derived from
the word ‘iso" which means equal, and ‘quant’ which means quantity. So, the Isoquant Curve is also called
an equal product or production indifference curve.

From the analysis of the curve, there are some insights:

 When capital is being used more than labor called capital-
intensive production like point A (9K + 5L).
 When labor is being used more than capital called labor-
intensive production like point A (3K + 20L).
 The below curve points show a lower output level due to
inefficient production. Whereas, the above curve points
are unattainable combinations due to lack of resources.

The Properties of an Isoquant Curve

 An isoquant curve slopes downward due to take-off or Marginal Rate of Technical substitution (the rate
at which firms sacrifice a factor of production like labor to gain another factor of production like
capital).
 Isoquant curves in the upper portions of the chart yield higher outputs because a higher curve is more
heavily employed with capital and labor than the lower’s.
 An isoquant curve should not touch the axis because a firm cannot produce outputs without any of them.
 Isoquant curves cannot be tangent or intersect one another.
 The rate of technical substitution between factors may
have variations because capital equipment can produce
more outputs than labor.
Iso-Cost lines represent the prices of factors. An iso-cost line graphically represents all the combinations of
the inputs that the firm can achieve with a given production budget.

9. How can a firm can gain profit maximization?

Iso-costs and Isoquants can together help us to determine the
profit for a firm. We can achieve profit maximization in two
ways:

a) Optimum production: To maximize profits, a firm will

wish to produce at the point of the highest possible
isoquant and minimum possible iso-cost line.

b) Cost minimization: Another way of seeking to

maximize profits is to target an output level and then
find the iso-cost with the lowest possible cost.

 Practical Applications: Isoquants and Iso-cost have several real-world applications:

Cost Minimization: By analyzing isoquants, firms can determine the most cost-effective combination of
labor and capital to produce a specific level of output. This knowledge aids in minimizing production costs,
increasing profitability, and remaining competitive in the market.
Input Substitution: Isoquants help firms identify when and how to substitute one input for another while
maintaining the same level of output. This is useful when facing changes in input prices or availability.
Resource Allocation: The iso-cost line is used with the isoquant to find the optimal factor combination or
an optimal combination of inputs. This helps firms to get maximum output at minimum cost.

10. Division of Labour and Capital Formation

Division of Labour is the process of Splitting the production of an item into various tasks, with each task
handled by a specific group of workers. It enhances productivity and efficiency.

Capital Formation refers to the increase in the stock of real capital (tools, machinery, infrastructure, etc.). It
requires saving and investment. Stages:
 Creation of Savings: it can be achieved by individuals, businesses, and governments.
 Mobilization of Savings: It requires an efficient capital market to channel savings to entrepreneurs.
 Investment in Real Capital: Entrepreneurs use savings to produce capital goods.