The Theory of Production

Aims & Objectives

After studying this lesson, you will be able to understand:

● Theory of Production
● The production function
● Short run vs Long run
● Total, Average and Marginal Product
● Law of Diminishing Returns to a factor
● Stages of Production
● Total Revenue Product and Marginal Revenue
Product
● Long run production function and Returns to Scale
● Estimation of Production
● Importance of Production Function in Managerial
Decision Making
● Producer’s equilibrium
Theory of Production
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Production Functions
 Is a technical relation that connects factor inputs and output.
 It specifies the maximum output that can be produced with a given
quantity of inputs. It is defined for a given state of engineering and
technical knowledge
 It may be represented as
Q = Q (K, L)
Where, the production process employs only two inputs Labour (L) and
Capital (K) and Q is the quantity of output

● A general form of production function can be expressed as

Q = Q (I1, I2, I3……….In)
Where Q is the quantity of output and inputs are represented as
I1,I2……..In
● Cobb- Douglas is a type of production function and is given as
Q = AKLβ
Where A denotes state of technology, K & L are the inputs/factors and 

& β are called the transformation parameters

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Short run Vs Long run

● Short run in production refers to a time period when
some inputs used in production are fixed and some
are variable
● Long run in production refers to a time period when
all inputs used in production are variable
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TP, AP, MP
● Three very important concepts related to production
analysis are:
● Total product (TP)
● Average product (AP)
● Marginal product (MP)
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Total Product
● Total product is total output.
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Average Product
● It is the total product divided by the number of
variable input employed. That is, it is the production
per unit of input. It may be represented as,
● APx = Q/x
Where Q denotes total product and x denotes
quantity of
variable input x
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Marginal Product
● Marginal Product is the change in output caused by
increasing input use.
● It is represented as: MPX=∂Q/∂X where x is the quantity of
variable input
● If MPX=∂Q/∂X> 0, total product is rising.
● If MPX=∂Q/∂X< 0, total product is falling (rare).
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AP curve rises at first, reaches a

maximum and falls thereafter.
MP also rises at first, reaches a
maximum and falls thereafter.
When AP is rising MP > AP
When AP is maximum MP = AP
When AP is falling MP < AP
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Law of diminishing returns to variable

factor/law of variable proportion
● As more and more of a variable input is added in
production while holding all other inputs fixed, the
additional output obtained is gradually lesser and
lesser
● Alternatively stated, the Marginal Product of each
unit of input will decline as the amount of that input
increases, holding all other inputs constant.
● Diminishing Returns to a Factor explains the shape
of the TP curve and also explains the most efficient
stage of production
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Stages of production
Stage I – origin
to X1
Stage II – X1 to
X3
Stage III- beyond
X3
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Stage I – origin to X2
Stage II – X2 to X3 – the
most
efficient
stage of
production
Stage III- beyond X3
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Total Revenue Product (TRP) &

Marginal Revenue Product (MRP)
• Total revenue product (TRP) = market value of the firm’s
output, computed by multiplying the total product by the
market price

TRP = TP x P = Q x P

• Marginal revenue product (MRP) = change in the firm’s

TRP resulting from a unit change in the number of inputs
used

MRP = MP x P =
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Long-run Production Function

• In the long run, a firm has enough time to change the
amount of all its inputs

• The long run production process is described by the

concept of returns to scale

• Returns to scale = the resulting increase in total output as

all inputs increase
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Returns to Scale
● One way to measure returns to scale is to use a coefficient
of output elasticity:
Percentage change in Q
EQ 
Percentage change in all inputs
● Three types of returns to scale

 Increasing returns to scale (IRS) ⇒ ∂Q/Q ÷ ∂Xi/Xi > 1

 Constant returns to scale (CRS) ⇒ ∂Q/Q ÷ ∂Xi/Xi = 1
 Decreasing returns to scale (DRS) ⇒ ∂Q/Q ÷ ∂Xi/Xi < 1

Where ∂Q/Q denotes proportional change in output

∂Xi/Xi denotes proportional change in input
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Returns to Scale - Example

• If all inputs into the production process are doubled, three
things can happen:
▫ output can more than double
 ‘increasing returns to scale’ (IRTS)

▫ output can exactly double

 ‘constant returns to scale’ (CRTS)

▫ output can less than double

 ‘decreasing returns to scale’ (DRTS)
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Returns to Scale - Graphically

• Graphically, the returns to scale concept can be illustrated
using the following graphs

IRTS CRTS DRTS

Q Q Q

X,Y X,Y X,Y

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Returns to Scale and Returns to a

Factor
● Returns to scale measure output effect of increasing
all inputs.- Long run phenomenon
● Returns to a factor measure output effect of
increasing one input. – Short run phenomenon
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Estimation of Production Functions

• Production function examples

• Cobb-Douglas function: exponential for two inputs

Q = aLbKc

if b + c > 1, IRTS
if b + c = 1, CRTS
if b + c < 1, DRTS
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Importance of Production
Functions in Managerial Decision
Making
• Careful planning can help a firm to use its resources in a
rational manner.
▫ Production levels do not depend on how much a
company wants to produce, but on how much its
customers want to buy.
▫ There must be careful planning regarding the quantity
of fixed inputs that will be used along with the variable
ones.
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Importance of Production Functions in

Managerial Decision Making
• Capacity planning: planning the quantity of fixed inputs
that will be used along with the variable inputs

Good capacity planning requires:

▫ accurate forecasts of demand

▫ effective communication between the production and
marketing functions
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Importance of Production Functions in

Managerial Decision Making
• The intensity of current global competition often requires
managers to go beyond these simple production function
curves.

• Being competitive in production today mandates that

today’s managers also understand the importance of
speed, flexibility, and what is commonly called “lean
manufacturing”.
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Producer’s equilibrium and Input

Combination Choice
● Two tools are used
● Production Isoquants and
● Isocost lines
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Isoquants
● Drawn in an input space it shows the different
combination of inputs that can produce the same
level of output.
● Characteristics of an isoquant
 Downward sloping – implies input substitutability.
 Concave to the origin
 No two isoquants intersect each other - imply imperfect
substitutability
 Higher isoquants represent higher levels of output
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Marginal Rate of Technical

Substitution
● This shows the rate at which one factor may be
substituted for another as one moves down along an
isoquant. Its is given as
MRTSLK = - dK/dL
● MRTSLK gives the slope of an isoquant
● As one moves down an isoquant:
● Additional output from increased use of labor =
● Reduction in output from decreased use of capital =
● Because we are keeping output constant by moving
along an isoquant, the total change in output must be
zero. Thus,

● Now, by rearranging terms we see that

MARGINAL RATE OF
TECHNICAL
SUBSTITUTION
Like indifference
curves, isoquants are
downward sloping and
convex. The slope of
the isoquant at any
point measures the
marginal rate of
technical substitution
—the ability of the firm
to replace capital with
labor while
maintaining the same
level of output.
ISOQUANTS WHEN
INPUTS ARE
PERFECT
SUBSTITUTES
When the isoquants are
straight lines, the MRTS
is constant. Thus the
rate at which capital
and labor can be
substituted for each
other is the same no
matter what level of
inputs is being used.
Points A, B, and C
represent three
different capital-labor
combinations that
generate the same
output q3.
FIXED-
PROPORTIONS
PRODUCTION
FUNCTION
When the isoquants are
L-shaped, only one
combination of labor
and capital can be used
to produce a given
output (as at point A on
isoquant q1, point B on
isoquant q2, and point
C on isoquant q3).
Adding more labor
alone does not increase
output, nor does adding
more capital alone.
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Isocost line
● This shows the various combinations of the inputs
that can be had for the same cost outlay.
● It is represented as C = PL. L + Pk. K
Where C denotes the total cost outlay
L & K are the quantity of the two inputs used
w & r are the given respective prices of the
two
K
inputs
C = PL. L + Pk. K

K
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Producer’s equilibrium
● Producer reaches his equilibrium when he maximizes
his profit by
● Producing the maximum possible output for a given cost or

..….a
● Minimizing cost for a given level of output
……b
K Case: a K Case: b

E
E

L L
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Producer’s equilibrium
 Equilibrium in both these cases occurs when an
isocost line gets tangent to an isoquant
 In case a, the given isocost line became tangent to
the highest possible isoqant at E
 In case b, the lowest possible isocost line became
tangent to the given isoquant
 The condition for producer’s equilibrium is thus, the
same in both case:
Slope of isoquant = slope of isocost
MRTSLK = PL/PK
Or MPL/MPK = PL/PK
● Additionally, the isoquant must be concave to the
origin
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Thank You