'y E h

Production

Production is one of the important economic activities. Consumption of commodities

is not possible without production. Production, in Economics, means transformation
of inputs in to output. The inputs used !n produetion are otherwise known as raw
materials. Production is the process of converting raw material in to finished products.

Factors of Production

For producing any commodity. certain factors are essential. There are four factors of
production - land, labour, capital and organisation.

Land:

Land, as the word gets used in Economicg has a wider connotation. Land includes all
those natural resources which are'free gifts'of nature and comprises of surface land,
all flora and fauna, mineral resources, water resources, agro-climatic features, etc. Since
a significant proportion of land is privately owned, land has a private market with a
price for each item included in !t. For example: land surface has a price fixed for unit
area, say Rs.10000 for one hectare. Similarly, there are markets for all other natural
resources like minerals, petroleum, fo rest products, natural gas, wood, fish, marine
products, etc. The value of natural resources is derived from its scarcity. The reward for
lanrl ic rrllad ran+

Labour:

The human efforts taken up for producing a commodity is called labour. Human effort
may be physical or menta!. Physlcal labcur or manual labour means thcse efforts which
depend on bodily energy of human beings. For eg: cutting a tree using an axe requires
much physical effort by an individual. Mental labour includes the use of intrinsic human
potentials like thinking, calculation, analysis, planning, problem-solvin9, etc. For
example, an accountant has to use all these faculties to successfully complete his work.
He is doing a mental work rather than a physical work. Some physical works like
reading, writing, etc. are also needed, but his work depends on bodily energy only in
a less intensive manner. The reward for labour is called wage.

Capital:

In order to simplify the production process and in order to do certain production

operations which human beings cannot do, plant, machinery, tools and implements
are required. These are together ealled capital or more properly as physical capital'
Physical capital includes all physical assets which help in production process and yet

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 are not part of final product. In that sense it includes buildings, furniture, vehicles, etc.
which are used to assist production.

In the wider sense of the word, capital includes finance capital and human capital.
Finanee capital is the money requireel to pure hase all the items for. starting a productive
operation and it includes borrowed funds and share capital. Human capital is the skill
and ability of human beings which make them productive in a sector. The reward for
capital is called interest.

Organisation:

The availability of land, labour and capital does not simply mean that the production
would happen. some kind of human effort to organize all these three together with
the purpose of produeing a eommodity is very important. This role is played by
entrepreneurs who come forward to establish {actories, farm operations, service
centers, commercial operations etc. Thus, organization is otherwise known as
entrepreneurship. The reward for organization is called profit.

Theory of Production

The supply of a product depends upon its cost of production which in turn depends
on (1)physical relationship between inputs and outputs and (2) the prices of inputs.
The general description of this physica! relation between input and output which
form the subject matter of the theory of production. In other words, the theory of
production relates to the physical laws governing production of goods. The relation
between inputs and output of a firm has been called the production function. Thus,
theory of prcducticn is the study of preduction functions.

The purpose of production function in economics theory is to provide a foundation on

technology from which to derive the 'supply curves' of firm in product market and the
'demand curves' of firm in factor markets.

Production Function

The production function expresses the functional relationship between the guantities
of inputs and outputs. It shows how and to what extent output changes with variations
in inputs dui'ing a specified pei'iod of time. in the words of Stigler, ,,the [Link]
function is the name given to the relationship between the rates of inputs of productive
services and the rate of output of product. It is the economist's summary of technical
knowledge".

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 T

A production process (method for activity or technique) is a combination of factor

inputs required for producing one unit of output. Alternative processes of production
are available for producing a commodity. A productive activity may involve increase
in the quantity of good, change in the form of the good, or change in the distribution
of a good.

Production function is a technical or physical relationship between input and

output that delivers maximum output from various input combination.
Production function presupposes technically efficient methods of production.

Technical Efficienry and Economic Efficiency

The theory of production considers only technically efficient process of production. A

production prc,cess is technically efficient if it deliverc maximum output for a
given input combination. Among the processes Pr, Pz, P:, the processes P1 is
technically efficient as it utilizes less quantity of one of the inputs and produces unit
level of output.

D^
Pr P:
Input 1 6 6 6
Input 2 3 7 9

Thus, utilisation of inputs is related to technical effieiency. The choiee of a particular

technique is primary related to economic efficiency. A process is economically
efficient if it is a least cost combination of inputs. A process is selected when it is
both technically and economically efficient. When the price of the input 1 is rupees
5 and that of input 2 is rupees 10, the cost of produclng one unit of the good using
the process P1 is rupees 50 and unit cost using the second process is rupees
100. Therefore, the first process is technically as well as economically efficient.

Basically, production function is a technological or engineering concept which can be

expressed in the form oI a table, graph and equation showing the amount of output
obtained from various combinations of inputs used in production, given the state of
technology. Algebraically, it may be expressed in the form of an equation as
Q= f (L,M,N,K,r)
where Q = Output. L- Labour, M- M anag ement(or g anisation), N -aatural resoirces
(land)), K -capital,T = given tecttnolo7y, f - ftmctional relationship
Production function with many inputs cannot be depicted on a diagram. Moreover,
given the specific values of the various inputs it becomes difficult to solve such a

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production function mathematically. Economist, therefore, use a two input production
function which assumes the form
q - f{L,x)
The production function as determined by technical conditions of production is of two
types. It may be rigid or flexible. The former relates to the short-run and the latter to
the long run.

Time Considerations in Production - Very Short-run, Short-run and Long-run

On the basis of the possibility for expanding the production, we have three types of
time frames - very short-run, short-run and long-run. Very short-run is a very llmited
time span within which a producer cannot increase production through making any
variations in the level of inputs used. In the very short-run supply is fixed and price
level is then determined by level of demand. For example, if all car manufacturing firms
are operating at their maximum capacity utilization, then it takes at least 3 to 6 months
further to establish a new plant for increasing production. In that duration, it is not
possible to increase supply. For Car industry, this period is very short-run.

Short-run is a period in which some of the factors of production are variable where as
some others are fixed. For exarhple, a textile making unit can increase the labour hours
per day to stitch more products during a festival season. But it is difficult to have more
stitching machines and othertools and instruments Since much investment is required.
Securing financg finding space for work etc. would take some more time. It means
that quantity of some factors can be increased to expand output in the short-run. In
our example labour is the variable factor and capital is the fixed factor.

In the [Link] is no distinetion between variable faetor and fixed factor since
long-run is the sufficient time span within which all inputs can be increased. In the case
of car manufacturing, a new plant can be set up within 6 months and beyond that time
period can be considered as long-run. In the long-run additional machines may be
purchased, edditlonal units of land can be prccur"ed, and more labourers may be
employed in order to expand output. Time is not constraint here in expanding the
output.

Total Product, Average Product and Marginal Product Ge AP and MP)

The concepts oftotal product average product and marginal product are meaningful
only in relation to a factor, say capital or labour. Total product (TP) is the aggregate
level of output produced using the given level of an input. For example, suppose using
25 hours of labour, the level of output produced is 1 00 units of a particular commodity.
Then, the total product of labour is 100.

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 )

Average product (AP) is the output produced per unit of an input used in production.
It is the ratio of total product to number of units of input used. Let us explain this
numerically with the previous example. Here average product of labour equals 100125
= 4. This means that on an average, each labour hour produced 4 units of the output.

Mathematically, Average Proiluct : -"^r*#:i:## *r"*

Marginal product (MP) is the addition to total product due to a unit increase in the
quantity of the input. It shows the change in the level of output due to increasing the
level of input by one unit.

Mathematically, Margina) Product = #;:ffiffi

AQo' AQ
aL aK

In our example. 25 units of labour produced 100 units of output. Suppose that 26th
unit of labour is also employed and as a result total output increased to 103. Then, the
marqinal product of 26th unit of labour hour is 3.
M PL * TPn - TPa-r
M P251 = TP2G - TPzs

=103-100 = 3

Short-run Law of Production (Law of Variable Proportions)

As we have seen, short-run is a time span within which some factors of production are
variable .,vher.e as some others are fixed. La'w of variable propol'tion, firstly propounded
by Alfred Marshall, depicts the relationship between output and a variable factor in the
short-run by assuming that all other factors are kept constant. For instance, the law
explains how output would vary in the short-run with increase in labour, keeping all
otirer factors including eapital urrclianged. The iaw states that "As the proportion of
one factor in a combination of factors is increased, after a point, first the marginal and
then the average product of that factor will diminish." (F. Benham). The law identifies
three distinct stages on the basis of the rate of change in output - the first stage is one
of increasing returns, second one is that of diminishing returns and third one is one of
negative retu rns.

Assumptions

i. The theory assumes that there is no change in the ievei of technoiogy' if

technology improves, the diminishing marginal product may not occur

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 ii' Another assumption of the theory is that production is possible with variable
factor proportions. If factor proportion is fixed, then the theory does not have an
applicatlon.
iii. All units of variable factors are equally efficient
iv. Factors of production are not per{ect substitute of each other

Let us explain the theory using an illustration. suppose that there is a wheat farmer
who uses more and more units of labour by keeping the amount of land constant.
-rable 3.'! shc'r"s the changes in Tp, trlp and A,p for the difr;erent units of labour
employed.

Table 4.1. Tp, Mp and Ap of variable factor

I lni+c af Ta+rl Marginal Average Stage
Labour Product (TP) Product (MP) Troduct (AP)
I 2 2 2
2 6 4 3 Stage 1
3 12 6 4
4 16 4 4
5 1B 2 3.6
6 Stage 2
1B 0 3
7 14 -4 2
8 Staqe 3
8 -6 'i

Stage 1: Increasing Returns

In the first stage, the marginal product increases for each subsequent unit of labour
employed in production. As a result, total product increases at an increasing rate. The
reason for increbsing marginal product is the more efficient utilization of fixed factors
as more units of variable factor are employed. In this stage Ap also increases
continuously and reaches the maximum. This stage ends at the point where the
average product reaches its maximum while the Mp curve starts its downward
movement after attaining the maximum.

Stage 2: Diminishing Returns

In this stage, total product continues to increase but at a diminishing rate and reaches
the maximum. Both MP and Ap are diminishing but are positive. The stage ends when
MP is zero and rP is at its maximum. The diminishing stage occurs due to the
inadequacy of fixed factors to match up with the increase in variable factor. This leads
to inefficient factor proportions.

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 v

Stage 3: Negative Returns

ln the third stage there ls negative marginal product due to factor proportions which
are totally inefficient. The variable factor becomes too much compared to fixed factors.
As a result, total product slopes downward. Average product declines continuously but
continues to be positive before eventually become zero and negative.

Figure 4.1
Stages of Law of Variable proportion

IP

rP

St eeI St8s. il Stagr IX

lrlcreasiDg Retun/
l\legative Setumt

o
Quanig. ct Labour

The law of variable proportion is diagrammatically represented in Figure 3.1. Each

stage is marked through labels. It can be seen that rp increases at an increasing rate
in the first stage. Marginal product is greater than Average product in this stage. Tp
increases at diminishing rate in the second stage. Both Mp and Ap are diminishing. In
the third stage TP is decreasing and Mp is negative. Ap falls continuously in this stage.

Importance of the Theory

The law of variable proportion has universal applicability because of the operation of
diminishing marginal product in every field. The trzlalthusian theory of population
developed by Thomas Malthus states that growth of population would always be faster
than growth of food suppiy. He based his ar-gument on the diminishing marginal
product in agriculture. The theory gives an important message to producers that there
is an optimum factor proportion.

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Limitations of the Theory

The theory of variable proportion suffers from serious limitations. First the theory
assumes that the level of technology is given although the technology develops
continuously. When technological progress occurs, it can delay the process of
diminishing marginal product. second, in the production of many commodities fixed
factor proportion is necessary and in such cases the theory is not applicable. Third, the
theory is applicable only in the short-run since in the long-run all factors are variable.

The point of inflection or inflection point

The point of inflection is a point at which the concavity of the fun€tion changes. It
means that the function ChangeS from conCave up tO concave down Or vice versa.

In the figure, the point of

inflection is F. At point F, the
TP
total product curve changes
its natu re from increasing at
Poirit of F an increasing rate to
Iufleetior
increasing at a decreasing
rate.

Economies of Scale

The reduction in average cost (per-unit cost of production) ciue to an increase in the
scale of production is known as economies of scale. This is measured in terms of the
reduction in average cost of production. Average cost is the cost of production per
unit output. For eg: suppose that for producing 200 units of a commodity, total cost is
Rs.I0000, then average cost is 10000/200 = 50. Ifthe production is in large scale, say,
100000 units, then average cost can be reduced significantly to a minimum level of 30
or 35.

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The economies of scale or scale economies are divided broadly in to two - internal
economies of scale and external economies of scale. Let us explain these details briefly.
I. Internal Economies of Scale
The cost advantages which a firm has on account of the expansion of the output by
that firm itself are known as internal economies of scale. Some of the important
internal economies are iisted below,
a. Technical Economies: When production happens in large scale, the firm can
employ an optimum plant size along with the best technology available. This reduces
the cost of production.
b. Marketing Economies: A large firm can market their products at lower costs
compared to small firms. This reduces their overall costs.
c. Financial Economies: For large firms, loans are available at low interest rate
since they take a large amount ol borrowings. Since large firms have good credibility.
banks and other lenders would be happy to give them credit even at lower rates.
d. Managerial Economies: In large firms there will be a team of expert managers
who implement policies like division of labour, assignment of duties to labourers in an
efficient manner, logistic management, procurement management etc. This reduces
cost considerably.
e. Commercial Economies: Since large firms are bulk purchasers of raw materials,
they get raw materials at lower price by regular suppliers. These firms have a good
bargaining power compared to other due to large scale of their purchases.
U. External Economies of Scale
External economies are those cost advantages occurring to a firm due to the expansion
of the industry as a whole and not particularly due to increased production in that firm.
All the firms in an expanding industry receive these benefits. When an industry
expands, organizations may benefit from better transportation network infrastructure,
and other facilities. This helps in decreasing the cost of an organization. Major kinds
of external economies are listed below,
a. Economies of Concentration: When an industry expands there is possibility
for concentration of firms in to a central location. For eg: software firms are all located
in some centers across India like Bangalore, Chennai, Kochi, etc. As a result the firms
get skilled man power, quality raw materials, better credit facilities and other logistical
supports.
b. Easy availability of Skilled Labour Force: With the emergence of software
industry in various regions of India, many engineering colleges in and around cities
like Bangalore started supplying highly skilled software engineers. Also, many finishing

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 schools started functioning to provide cutting-off edge technicar knowledge to job
aspirants.
c- Better Transportation and communication Facirities: with the expansion
of
an industry, there wourd be aggromeration of so many firms in the
industry. This reads
to better transport and communication facirities and reduced average cost.
d. Attention from the Government when an industry expands. the sector gets
government attention and policy support in the form
of tax-offs, subsidies. export
promotion, measures, etc..
3,3. Diseconomies of Scale
when the expansion of output by a firm exceeds a lirnit, the economies
of scale cease
to exist and certain kinds of cost disadvantages start emerging. The factors which
increase the average cast beyond a particurar rever of expansion
of the output by a
firm is known as diseconomies of scare. Here arso, a crassification can be made
as
internal diseconomies and exter^nal diseconomies.
I. Internal diseconomies of scale:
Refer to diseconomies that raise the cost of production of a firm.
The main factors that
influence the cost of production of a firm incrude the manageriar
inefficiency,
technoiogicai inadequacies, etc. which occur- due to too n-iich production.
tr External diseconomies of scale:
The diseconomies occurring to each firm due to the expansion
of an industry as a
whole is known as external diseconomies of scale. The factors that act
as restraint to
expansion include increaseci cost of procluction, scarcity of raw materiais,
and low
supply of skilled labourers.
3.4. Long-run Law of production (Law of Returns to Scale)
we have seen that in the long-run ail factors of production are variable. The law
of
returns to scale explains how the output changes when all the factors
are increased in
a given proportion. The theory states the rerationship in terms of three
stages - first
stage of Increasing Returns to scale, second stage of constant Returns
to scale and
third stage of Diminishing Returns to scale. In the first stage when all inputs are
increased in a given proportion or scare, then the output increases
more than
proportionatery. In the second stage for a proportionate change in
ail inputs, output
increases at the same proportion. Finally, in the third stage output
increases only less
than proportionately. The theory is based on following assumptions.
Assumptions
i. All the factors of production are variable
ii. The level of technology is given and constant
ii!. Output !s [Link] in physical ter.r-ns

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 b

Let us use an illustration to explain the theory. Table 3.2 shows a hypothetical input
levels and corresponding output levels. Inputs are increased always in a given
proportion of 100o/o. Then proportionate change in output also shown in the table.
We consider only two factors, labour (L) and capital (C).

Scale of Total Marginal

Stage
Production retums Returns
L=1, K=2 4 4
'
L=2, K=4 10 6 Increasing Returns to Scale
L=3, K=6 1B
L=4, K=B 1d 10
L=5, K=10 38 10 Constant Returns to Scale
AA
L=6, K=12 10
I =7 K=14 55 I Diminishing Returns to Scale
L=8, K=16 62 6

First Stage (Increasing Returns to Scale)

in this stage a firm enjoys various internal and externai economies of scaie. Economies
of scale are those advantages which a firm receives in terms of expansion of production
in to a larger scale (A detailed description is given in previous sections). When a firm
produces in large scale it has many advantages. For example a firm can implement
division of labour in an effective manner if the production is in large scale. Similarly,
larger scale production allows for better organization of inputs like labour and capital.
Such advantages lead to increasing marginal returns for each factor and increasing
returns to scale. In this stage output increases more than proportionately for a given
proportionate increase in all inputs.

Second Stage (Constant Returns to Scale)

ln the second stage scale economies starts to weaken whereas diseconomies or

ciisadvantages of iarge scale production starts emerging. However, they balance each
other for some time that a firm has constant return to scale. Diseconomies arise due
to difficulties in managing large scale production while expanding demand beyond a
limit. In this stage, output increases exactly in the same proportion in which inputs
were increased.

Third Stage (Diminishing Returns to Scale)

In this stage, the diseconomies of large scale production outweigh the scale economies
and as a result for a proportionate change in all inputs the increase in output is only
less than proportionately. The marginal products to each factor start diminishing.

11,
 Figurc 4.2
Stages in Law of Returns to Scale

_:
- : '::ii

a!
,;

a 12! 7 B 9 JO

Scals O{ lnput6

Figure 3.2 diagrammatically explains the law of returns to scale. on the X- axis scale of
inputs is taken and, on the Y-axis, marginal product is taken. The upward sloping part
of the graph shows increasing returns to scale, the middie portion which is horizontal
shows constant returns to scale and the last portion which is downward sloping shows
diminishing returns to scale.
 hey of Production: Production with Two Variable Inpus
ss
isssstsss
E 9phic technique (showing illustrate tne
TP, AP and MP curves) used to law
o
dnishng returns cannot be used conveniently illustrate input-oup
to
cidionships with two variable inputs. Economists have devised a more convenient
technique to explain and illustrate the laws of return to scale. The technique is caled
production isoquant curves.
The isoquant curves

he term 'isoquant' has been derived from a Greek word 'iso' meaning equal ana a

Latin word 'quantus' meaning quantity. The 'isoquant curve' is, therefore, also known
as Equal Product curve and Production Indifference curve.
By definition, an isoquant is the locus of points representing different
combinations of two factors of production yielding the same output. It is the
locus of combinations of
technically efficient methods for producinga given
level of output. It is based on the assumption that a large variety of techniques or
production is available.
For example, a certain acres of wheat crop can be harvested per unit of time by 20
labour with 20 sickles (i.e., little of capital) or two labours and a harvesting machine (a
large capital). Consider another example. A certain length of road can be constructed
per unit of time by using 50 labours and 20 spades and leveling instrument or by using
only 5 labours and a road roller, and so on. These technical possibilities are shown by
an isoquant curve.

Forms of Isoquants
The isoquants may assume various shapes depending on the degree of substitutability
of factors.

1. Linear isoquant: This isoquant assumes perfect substitutability of factors of

production (Figure A). A given commodity may be produced by using only capital or
only labour or by an infinite combination of capital (K) and labour (L).

2. Input Output Isoquant This assumes a strict complementarity that is zero

substitutability of factors of production. There is only one method of production for
any one commodity (Figure B). The isoquant takes the shape of a right angle. This tyoe
of isoquant is called Leontif isoquant after Leontief who invented the input outout

analysis.

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 assumes
Limited Substitutability of capital and labour
canital

[Link] isoquant. This

Tor producing any one com
CFiqure C). There
are only a
fe processes
nodity.
at the kinks. This form is alco
of the factors is posSible oniy called
Substitutability
or linear programming
isoquant because it is basicallv c r
activity analysis isoquant
in linear programming.

Ihis rorm assumes continuous substitutability of

4. Smooth convex isoquant:
over a certain range, beyond which factors cannot s uhchits do

capital and Labour only

each other. The isoquant appears as a smooth curve convex to the origin (Fiqure D)

K Input Output Isoquant

K

Linear Isoquant

K Kinked Isoquant

P1
P2 Convex Isoquant
Pa

-P4

It should be noted that the

kinked isoquants are more realistic. Engineers, managers
and production executive consider the
production processes as discrete rather tnan
continuous. However, traditional
economic theory has mostly adopted the continuous
isoquant because of its simplicity to handle by mathematical rules of calculus.

Assumptions of Continuous Isoquant:

0 There are only two inputs, labour (L) and capital (K), to produce a commodity, sdyX
(he twO inputs (L and K) diminishing rate
can be substituted for one another at a
upto a certain limit; and

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(11) Production function is
continuous, implying that labour and capital are perrecuy
divisible and can be substituted in smallany quantity.
Given these assumptions, it is possible to produce a given quantity of commodity X
(100 units) vyith various combinations of capital and labour, which is given below.

Combination Labour Capital Output MRSxy

a 1 45 100
b 2 30 100 1:15
3 20 100 1:10
d 14 100 1:6
e 9 100 1:5
6 6 100 1:3
100 1:1
Isoquant

AK 20

AL d
e f

Laoour

The factor capital is measured on Y axis and labour on X axis. The points a, b, c, d 8&e
on the isoquant, show different combinations of inputs, K and L The movement from
a to f indicates decreasing quantity of K and increasing number of L. This implies
substitution of labour for capital such that all the input combinations yield the same

quantity of commodity X, i.e., Q 100.

=

Substitution (MRTS)
Marginal Rate of Technical
Diminishing Marginal Rate of Technical substitution is the rate at which one input
be substituted for another, keeping output constant. MRIS shows the slope of the

isoquant.
-AK
MRTSLK AL =
slope of isoquant

15
 constant,
dA
Eimes
marginal
product of
capital must
f co
equal
the output i. e.,
To keep labour.
product of
AL times marginal
= [Link]
-[Link]
-AK MP
AL MPx
MP
MRTSixMPx

Properties of Isoquant
lenants have a negative slope:. An isoquant has a negative slope in the economic

Ihe economic region is the region on the isoau1ant

region or in the relevant range.
eficient. The negative slone
which substitution between inputs technically
is
piane in
of the isoquant implies substitutability between the inputs. It means that if one of the
inputs is increased, the other input has to be increased that the total output remains
unaffected.
2. Isoquants are convex to origin:
Convexity of isoquants implies not only the substitution between the inputs but also
diminishing marginal rate of technical substitution between the inputs in the economic
region. The reason is that no factor is perfect substitute for other. Therefore, more and
more units of an input are needed to replace each successive unit of the other input.
3. Isoquant cannot intersect with each other: The intersection or tangency of two
soquant implies that same combination of labour and capital can produce different
quantities of output. This is in contradiction with the definition of isoquant.
4. Upper isoquant represent a higher level of output: The upper isoquant implies a

arger input combination, which, in general, produces more output. Therefore, upper
Isoquant indicates higher level of output.

Difference between Isoquant and Indifference Curve

An 150quant curve is analogous to consumer indifference cunve with two differences:

(0while an indifference curve represents different combinations of two goods yielding

the same level of satisfaction, an isoquant curve represents different combinations o

wOproducer goods (labour and capital) producinqg the same quantity of a commodity.
(4) while an indifference curve represents immeasurable 'utility, Le, te el of
satistaction, an isoquant represents a measurable quantity

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Isoquant Map and Economic region of
production
An isoquant map is a set of isoquants presented on a two-dimensional plane as sno
y dants Q Q2 Qs and Q« in the below figure. Each isoquant shows varu
combinations of labour and capital that can be used to produce a given level ot outu

On 3
ddonal economic theory efficient ranges of output.
concentrates on
zero is the limit
Onvex isoquant, the MRTS decreases along the isoquant and reaches
to which the MRTS can decrease, i.e, at that point marqinal product of factor becomes
of the factors
Zero. The locus of points of isoquants where the marginal product
are zero form the ridge lines. The upper ridge line implies that the marginal
product of capital is zero. The lower ridge line implies that the marginal product
of labour is zero. Production techniques are only technically efficient inside the ridge
but
lines. That is the ranges over which the marqinal product of factors is diminishing
positive.
on isoquants Q1 Q2
In the figure marginal product of capital is zero at points a, b.c.d
line. The lower
Q3 and Qa The line OMjoining the points a, b, cand d is the upper ridge
of labour
ridge line is obtained by joining points e.f.g and h where marginal product
IS zero. The area between the two ridge lines OM and ON is called economic

region or technical efficient region of production

Outside the ridge

Upper Ridge Line
lines, the marginal
M
products of factors
N Lower ridge
Line
are negative and the
K
methods of
C
Q4 production are

inefficient since they

Qs require more quantity
of both factors for
2 producing a given
level of Output.
e Q1 Inefficient methods
are not considered by
Labour the theory of
production since they
imply a rational behaviour of the firm.

17
MRTS refers the ratio of marginal change in factors of production. It does not reveal
the degree of substitutability of one factor for another. Economists have introduced a
method to measure the degree of substitutability of factors of production called
elasticity of substitution. The elasticity of substitution is defined as the percentage
change in the capital labour ratio (K/L) divided by the percentage change in the
marginal rate of substitution (MRTS).

Elasticity of substitution a = Percenatagechangein K/L

Percentage change in MRTS

Elasticity of substitution d(K/L/(K/

d(MRTSL)/(MRTSLR)
The value of o is always positive ranges from zero to infinity.

Capital

MRTSA

B MRTSB

(K/)a
(K/LJ8
Labour

Isocost Line
In the real world, firms have limited resources and
they are
supposed to maximise
profit from their given resources. The profit maximization is achieved by
the output and maximizing
by minimizing the cost. The output maximization is achieved
firm by selecting by the
technically efficientproduction process and cost minimization by
choosing economicaly efficient production process. Therefore,
equilibrium when the production process is producer or firm is in
Economists have introduced the tools
technically and economically efficient.
isoquant and isocost line to explain the
producer's equilibrium. The tool isoquant is used to
cost line to choose the explain technical efficiency and iso
economically efficient production method or least cost
combination of inputs.

18
Derivation of Iso cost line
In order to
construct a cost
spend as its total cost. The function, it is assumed that a firm has a
cost of limited to
employed and unit
price factors.
of production depends on number of units or
Therefore, total cost ta
C Kx Pe+LxPL
We can find
out different
arbitranly to combinations of labour and capital by values
can hire
either labour capital. (The maximum
or assigy
given the number of units or m
total outlay is
calculated by assigning labour capio
dbove
equation. Similarly, the maximum equals
zero in nE

Cdiculated by number of labour units a firm can hire, can De

assigning zero value to capital. By joining these maximum values
labour and O
capital, we get a cunve named isocost
line).
An isocost line
is the locus of all
with given total
combinations of factors the firm can purchase
outlay and factor prices. The slope of the isocost line is equal to the
ratios of the prices of factors of
production.
slope of isocost line
Producer's Equilibrium or
Choice of Optimal Combination of factors of
production
In the real world, firms havelimited resources and they are supposed to maximise
profit from their given resources. The profit maximization is achieved by maximizing
the output and by minimizing the cost. The output maximization is achieved by the
firm by selecting technically efficient production process and cost minimization
by
choosing economically efficient production process. Therefore, producer or firm is in
equlibrium when the production process is technically and economically efficient. The
producer's equilibrium is the point at which firm maximises its profit by choosing
the optimal combination of factors of production. Economists have introduced the
tools isoquant and isocost line to explain the producer's equilibrium. The tool isoquant
is used to explain technical efficiency and iso cost line to choose the economically
efficient production method or least cost combination of
inputs.
Producer's equilibrium can be analysed in two ways maximizing output for a given
cost and minimizing cost subject to given output.

Maximisation of output subject to cost constraint (financial constraint)

The maximum level of output the firm can produce, given the cost constraint is defined
by the tangency of the isocost line and the highest isoquant. The optimal combination

19
 and tor prices w and r. The producer eauilihri
of factors of production is K2 L;,
desirable but not attainahle din
level of output is
t
cost
point E. The higher
AB or below it lies on a lower
isoquant than X, Hence
constraint. The
other points on

[Link] the maximum output

possible at given cost outlay, given production function and
of tangency, tne siope of isoquant is equal to the slooe af
factor orices. At the point

the isoquant.

X3

X2

2 B

Conditions of Producer's Equilibrium

the slope of isocost line
a) Slope of isoquant is equal to
MP MRTSLx
of
b) The isoquant must be convex to the origin: If the isoquant is concave the point
curves does not define an equilibrium position.
tangency of the isocost and isoquant
Minimisation of Cost for a given level of output

The conditions for equilibrium of the firm are explained above. ie, there
the same as

must be tangency of the given isoquant and

lowest possible isocost line and isoquant
different in the case of cost
must be convex. However, the problem is conceptually
or a building.
minimization. For example, the entrepreneur want to construct bridge
a

Producer's objective is to
In this particular case, the output level is given there.
construct the bridge with minimum cost outlay.
level of output, but we
In this case we have a one isoquant which denotes the desired
lower total
have a set of isocost curves. The isocost curve closer to the origin show a

cost outlay.

20
 The firm minimises its Ccosts by
employing the combinations of K and L
determined by the tangency point of
the isoquant f with the lowest possible
isocost line. Point E is the equilibrium

point. Points below E are desirable

because they show lower cost but not
attainable.

Expansion Path
in the
long run the firm
change its old machines, equipment and plants, scale or
can
production, organisation and management in order to expand its output. The firm's
objective is the choice of optimal expansion path in order to minimise its cost or
maximize its profit. The expansion path is the locus of different points of firms
equilibrium when it changes it total outlay to expand output while relative factor
prices remains constant. In other words, the expansion path shows how tactor
proportions change when output changes, relative factor prices remaining
constant. These curves are also known as outlay lines, price lines, input-price lines,
factor-cost lines, constant-outlay lines, etc.

With given factor prices and given production function, the optimal expansion path
is determined by the point of tangency of successive isocost lines and successive
isoquants. This is explained in the figure below.

(A) (B)
Expansion Path
Price-Factor
Curve

200
10
Rs.100

Rs 50 Rs.75
B D G
Labour Labour

AB, CD and EF are the different isocost lines. The line CD shows higher total outlay
than the line AB and EF shows higher total outlay than the line CD. They are shown
parallel to each other thereby reflecting constant factor prices. There are 3 isoquants
100, 200 and 300 representing successively higher levels of output. The firm is in
21
eguilibrim t point where the isoxerant 10K) is tangent to its corresponding isocost
line AR end similarty the other two isoonuants 200 and 300 are tangent to isocost lines
CD and FF recpectvely at ponts M and N Fach point of tangenry implies optimal
combination of labonr and capital that prodce an optimal output level The line 05
ioining these equilibrium points L. M and N through the origin is the evpansion path
of the frm The fim evpands its oritout akong this line keeping factor prices constant
liee the price-income line in the indifference curve analysis a relative cheapening of
one of the factore to that of another will extend the iso cost line to the right. tf one of
the factors becomes relativetly dearer. the iso cost line will contract inward to the left.
Given the price of capital, if the price of labour falls the iso cost line EF in Panel (B) will
evtend to the right as EG and if the price of labour rises the iso-cost line EF will contract
irward to the left as EH if the equilibrium points L M, and N are joined by a line it is
called the price-factor curve.

If the production function is homogeneous

(constant K/ ratio). the expansion path will be
a straight line through the origin. If the

production function is non homogeneous, the

optimal expansion path will not be a straight
line from the origin rather it will be a zigzag
line as shown in the figure.

Ltbor

Optimal expansion in the short run

In the short run, the firm can increase

only the variable factor and not the
fixed factors in order to increase its
output. Suppose capital is the fixed
factor and labour is the variable tactor
With the constant factor prices, the firm
cannot choose the optimal expansion
path due to the constraint of capital
The firm can expand only along the line
CC in the short run. This situation is
shown in the figure below