Module 3
Theory of production, & short run
Production function
By: Gaurav Shreekant
The Theory of Production
In any production process inputs combine
together in certain proportion to yield output.
Inputs (factors of production): - Land, labour,
capital, & enterprise.
Inputs and output to be considered only in
quantitative terms.
Factors of Production
Inputs (factors of production) are classified as:
– Land – all natural resources of the earth – not
just land. Reward to land is called Rent
– Labour – all physical and mental human effort
involved in production. Reward to labour is
known as Wages
– Capital – buildings, machinery and equipment
used in production process. Factor reward to
capital is known as Interest
– Enterprise – initiative and risk taken by the
entrepreneur. Factor reward here is called Profit
Production Function
• Mathematical representation
of the relationship:
Q = f (K, L,S,O)
• Output (Q) is dependent upon the amount of
capital (K), Labour (L), Land (S) and
Enterprise (O – organisation) employed.
Production function
• Depicts the relationship between inputs (factors of
production) and output
• i.e. how output changes when inputs proportions
change
• Concept of short run
– Producers can only change variable inputs in
order to change output
• Concept of long run
– Period long enough during which producers can
change all inputs (in order to change output)
Returns to a factor – means change in physical
output when the quantity of only one input is
increased, other inputs held fixed.
• Labour is generally considered to be the
variable input (factor).
• That is here we attempt to observe that when
say labour is increased, does the output
increases in same, higher or lower proportion
or fall and why?
Returns to Scale – means change in physical
output when the quantity of all the inputs is
increased simultaneously and in same
proportion.
Law of Variable Proportions (Law of eventually
diminishing returns)
• A concept of returns to a factor
• Here we observe the changes in physical units of
output as one variable input (say labour) is varied,
other inputs held constant.
Assumption of the Law: -
i. Technology remains unchanged as more units of
variable factor are applied
ii. It is possible to vary the proportion of inputs within
the given technology
iii. Only one input is varied, others are held constant.
Statement of the Law of Variable Proportions
As more and more units of the variable factor
are applied to a given set of fixed factors,
the addition to total product beyond a point
declines.
Example of the Law of Variable Proportions
Producing Wheat in a farm, where we keep
on increasing labour units on the same
farm land, and observe its effect on TP,
AP, and MP.
CONCEPTS IN SHORT-RUN
– Total product (TP)
– Average product (AP)
AP = TP/L
– Marginal product (MP)
MP = TP/L
MPn = TPn – TPn-1
Wheat production per year from a farm (Tonnes)
Units of variable TP AP = TP/L MP
factor (Labour), L
0 0 - -
1 3 3 3
2 10 5 7
3 24 8 14
4 36 9 12
5 40 8 4
6 42 7 2
7 42 6 0
8 40 5 -2
Wheat production per year from a particular farm
d
40
TP
Tonnes of wheat produced per year
30 Maximum output (TP)
Diminishing returns
set in here (Point of inflection)
20
b b to d, TP increases at diminishing rate
10
0
0 1 2 3 4 5 6 7 8
Number of farm workers
Wheat production per year from a particular farm
40
Tonnes of wheat per year
TP
30
20 b
Diminishing returns
10 set in here
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
Tonnes of wheat per year
12
10
4 AP
2
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MP
Wheat production per year from a particular farm
40
Tonnes of wheat per year
TP
30
20
b
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
Tonnes of wheat per year
12
10
4 AP
2
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MP
Three Stages of Production
STAGE I: INCREASING RETURNS
• Starts when AP is rising. Ends when AP is
maximum.
• MP in this stage initially increases and latter on
declines, but remains greater than AP.
• MP of fixed factor is negative in during this stage,
i.e. the quantity of fixed factor is too much relative to
the quantity of variable factor. In other words, fixed
factor during this stage is underutilized.
Three Stages of Production
STAGE II: DIMINISHING RETURNS
• Begins when AP starts falling. Ends when TP is
maximum (or MP is zero)
• Both MP and AP are declining, but positive
• In this stage MP of both variable as well as fixed
factors are positive.
STAGE III: NEGATIVE RETURNS
• Begins when TP starts falling
• MP of variable factor becomes negative, while that
of fixed factor is positive.