Production

It is process by which the inputs or factors of production are transformed into

output. Production is the activity of making the final goods and services. In a
cement factory, inputs include labour of its workers, raw materials such as
limestone, sand, clay, and capital invested in equipment required to produce
cement. Output of cement industry would be different varieties of cement.

Inputs or factors of production

There are four factors of production, land, labour, capital and organization. All
these are brought together in the process of production to form a final output. Land
represents natural resources like land plots, minerals, water, oil, etc. Labour is
considered to be a very important part of the process of production. Both skilled
and unskilled labour is required by the firm. Capital represents physical capital in
the form of machinery, equipment, and other physical assets. Finally,
organization/entrepreneur brings all these factors of production together to
transform them into a finished product.

Production function
The relationship between inputs and output which gives maximum output is called
production function. Production function gives different combinations inputs that
produce maximum level of output. A production function is written as Q = f
(I1....In) where, Q is output, f is a functional relationship and I1 to In are quantities of
different inputs. To keep the things as simple as possible, at this stage, we will
define production function as follows

Q = f (L, K)

Where

Q is output

L is labour used in process of production

K is capital used in the process of production

Types of Production Function
Production function on the basis of the time period can be divided into two
categories: Short Run Production Function and Long Run Production
Function. In these production functions, the combination and behavior of
variable factors and fixed factors are different.

1. Short Run Production Function: Short Run is a period of time where output
can only be changed by changing the level of variable inputs. In the short run,
some factors are variable and some are fixed. Fixed factors remain constant in the
short run like land, capital, plant, machinery, etc. Production can be raised by
only increasing the level of variable inputs like labour. Therefore, the situation
where the output is increased by only increasing the variable factors of input and
keeping the fixed factors constant is termed as Short Run Production Function.
This relationship is explained by the 'Law of Variable Proportions.'

2. Long Run Production Function: Long Run is a span of time where the output
can be increased by increasing all the factors of production whether it is fixed
(land, capital, plant, machinery, etc.) or variable (labour). Long run is enough
time to alter all the factors of production. All factors are said to be variable in the
long run. Therefore, the situation where the output is increased by increasing all
the inputs simultaneously and in the same proportion is termed Long Run
Production Function. This relationship is explained by the 'Law of Returns to
Scale.'

What is the Law of Variable Proportions?

The Law of Variable Proportions, also known as the Law of Diminishing
Returns, is a fundamental principle in economics that describes how the output
of a production process changes as the quantity of one input varies while other
inputs are kept constant. This law is applicable in the short run, where at least one
factor of production (such as capital) is fixed.
Returns to Factor: Law of Variable Proportion

Returns to a Factor refer to the rise in the total product that results from
increasing just one factor while holding the other factors constant.
The production of the firm displays the Law of Variable Proportions in the short
term when one input is variable, and the other inputs are fixed.

Statement of Law of Variable Proportion

The Law of Variable Proportions states that as we increase the quantity of only
one input while keeping other inputs fixed, the total product increases initially at
an increasing rate, then at a decreasing rate, and finally at a negative rate.

As per the law of variable proportions, the changes in TP and MP can be

categorized into three phases:

Phase 1: TP rises at an increasing rate, and MP increases.

Phase 2: TP rises at a decreasing rate, MP decreases and is positive.

Phase 3: TP falls, and MP becomes negative.

Assumptions of the Law of Variable Proportion

1. It operates in the short run because the factors are categorised as variable and
fixed.

2. The law is applicable to all fixed factors, including land.

3. The law of variable proportions allows for the combination of several variable
units with fixed factors.

4. This law primarily applies to the production sector.

5. It is simple to calculate the impact of a change in output caused by a change in

variable factors.

6. It is considered that after a certain point, factors of production become

imperfect substitutes for one another.

7. In order for this law to function, it is assumed that the state of technology
would remain constant.
Example of Law of Variable Proportion

Let's say a farmer has 1 acre of land (i.e., fixed factor) and wants to use labour
(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 labour. The below table displays the
output behaviour in this case.

Fixed Variable
Factor Factor TP MP
(Land) (Labour) (units) (units) Phase

1 1 5 5
Phase I: Increasing Returns to a
Factor
1 2 20 15

1 3 32 12

Phase II: Decreasing Returns to

1 4 40 8 a Factor

1 5 40 0

Phase III: Negative Returns to

1 6 35 -5 a Factor
Phases of Law of Variable Proportion
Phase I: Increasing Returns to a Factor (TP increases at an increasing rate)

In the initial stage, each additional variable component raises the total production
by an increasing amount. This indicates that each variable's MP rises and that TP
rises at an increasing rate.

 It occurs as a result of the initial variable input quantity being too small in
comparison to the fixed input. Due to the division of labour, efficient use of
the fixed input during manufacturing increases the productivity of the variable
input.

 One labour generates 5 units, as shown in the schedule and diagram, whereas
two labours produce 20 units. It means that MP rises until it reaches its
maximum point at point P, which signifies the end of the first phase, while TP
rises at an increasing rate (up to point Q).

Point of Inflexion: A point from where the slope of TP curve changes is known
as point of inflexion. Till the point of inflexion, TP increases at an increasing
rate, and from this point downwards, it increases at a diminishing rate.

Phase II: Decreasing Returns to a Factor (TP increases at a decreasing rate)

Every extra variable in the second phase increases the output by a less and
smaller amount. This indicates that when the variable factor increases, MP
decreases, and TP rises at a decreasing rate. This stage is known as the
diminishing returns to a factor.

 This occurs as a result of pressure on fixed inputs that results in a decline in

variable input productivity after a certain level of output.

 When MP is zero (point S), and TP is at its maximum (point M) at 40 units,

the second phase comes to an end.

 The second phase is highly important because a rational producer will always
try to produce during this time because MP and TP are both positive for each
variable factor.
Phase III: Negative Returns to a Factor (TP falls)

The third phase shows a decline in TP due to the use of more variable factors. MP
has now become negative. As a result, this stage is referred to as negative returns
to a factor.

 It occurs when the amount of variable input exceeds the fixed input by a great
difference, which causes TP to decrease.

 The third phase in the above graph begins after points S on the MP curve and
M on the TP curve.

 In the third phase, MP for each variable factor is negative. Therefore, no

company would deliberately decide to operate at this phase.

Law of Returns to Scale (long run)

The Law of Returns to Scale is an economic principle that explains how output
(production) changes when all inputs (factors of production, like labor, capital, and
raw materials) are increased in the same proportion in the long run. Thus, it shows
whether output increases more than, equal to, or less than the increase in inputs.

Since all inputs can be varied in the long run, the law of returns to scale focuses on
the relationship between input size and output size.

Law of Returns to Scale

Types of Return to Scale

According to the Law of Returns to Scale, when all the factor inputs are varied in
the same proportions, then the scale of production may take three forms: Increasing
Returns to Scale, Constant Returns to Scale, and Diminishing Returns to Scale.

Increasing Returns to Scale (IRS)

In the first stage of Returns to Scale, the proportionate increase in total output is
more than the proportionate increase in inputs. In simple terms, if all the inputs
increase by 100%, then the increase in output will be more than 100%.
Example:

Inputs (Units) Percentage Percentage

(K = Capital, L = Output Increase Increase
Labour) (Units) in Inputs in Outputs

2K + 4L 200 - -

4K + 8L 450 100% 160%

6K + 12L 600 100% 120%

Constant Return to Scale (CRS)

In the second stage of Returns to Scale, the proportionate increase in the total
output is equal to the proportionate increase in inputs. In simple terms, if all the
inputs increase by 100%, then the increase in output will also be 100%.

Example:

Inputs (Units) Percentage Percentage

(K = Capital, L = Output Increase Increase
Labour) (Units) in Inputs in Outputs

6K + 12L 600 - -

8K + 16L 800 100% 100%

10K + 20L 1,000 100% 100%

Once the firm has achieved the point of optimum capacity, it operates on Constant
Returns to Scale. After the point of optimum capacity, the economies of production
are counterbalanced by the diseconomies of production.

Diminishing Returns to Scale (DRS)

In the third stage of Returns to Scale, the proportionate increase in the total output
is less than the proportionate increase in inputs. In simple terms, if all the inputs
increase by 100%, then the increase in output will be less than 100%.

Example:

Inputs (Units) Percentage Percentage

(K = Capital, L = Output Increase Increase
Labour) (Units) in Inputs in Outputs

10K + 20L 1000 - -

12K + 24L 1,800 100% 80%

14K + 28L 2,300 100% 75%