UNIT 3
What is PRODUCTION?
❑ What is PRODUCTION?
• In economics the term ‘production’ means a process by
which resources (men, material, time, etc.) are transformed
in to a different and more useful commodity or service.
• Production is basically an activity of transformation, which
connects factor inputs and outputs.
• Production is the process of converting an input into a
more valuable output.
• Example- A sugar mill uses inputs like sugarcane, labor,
capital invested in the machinery , factory building, etc. to
produce sugar.
• The process of transforming inputs into outputs can be any
of the three kinds: change in form (e.g. raw material
transformed to finished goods), change in space (i.e.
transformation) and change in time (i.e. storage).
❑ Production Function:
• Production function refers to the functional relationship
between the quantity of a good produced (output) and factors
of production (inputs).
• A method of production (process or activity) is a
combination of the factor inputs required for the production
of one unit of output.
• According to Prof. L.R. Klein: “The production function is
a technical or engineering relation between input and output.
As long as the natural laws of technology remain unchanged,
the production remain unchanged”.
• An empirical production function:
Q = f (Ld, L, K, M, T, t)
• Production Function:
Q = f (L, K)
• The production function is constructed based on the
assumption that:
i. Perfect divisibility of both inputs and output;
ii. There are only two factors of production- labour (L)
and capital (K);
iii. When the technology changes, the production
function itself changes;
iv. The inputs are utilized in the best possible way, i.e.
optimum utilization of inputs;
v. Limited substitution of one factor for the other;
vi. The state of technology is given and output can be
increased by increasing inputs;
vii. Inelastic supply of fixed factors in the short-run.
❑ Features of Production Function:
i. Substitutability: The factors of production or inputs
are substitutes of one another which make it possible
to vary the total output by changing the quantity of
one or a few inputs, while quantities of all other inputs
are held constant.
ii. Complementary: The factors of production are also
complementary to one another, that is, the two or more
inputs are to be used together as nothing will be
produced if the quantity of either of the inputs used in
the production process is zero.
iii. Specificity: It reveals that the inputs are specific to the
production of a particular product. (Ex- Machines and
equipments, specialized workers and raw materials)
❑Long run production function :
The long run refers to a period of time in which the
quantities of all the factors of production can be
changed. In other words, the long run is the amount of
time needed to make all inputs variable.
• Production Function:
Q = f (L, K)
❑ Iso-cost Line:
Iso-cost lines represent the prices of factors. An iso-cost line graphically
represents all the combinations of the inputs which the firm can achieve with
a given budget for production or given outlay.
An isocost line is a graphical representation of various combinations of two
factors (labour and capital) which the firm can afford or purchase with a
given amount of money or total outlay. It is an important tool for determining
what combination of factor-inputs the firm will choose for production
process.
❑ Iso-quant:
❑ Production Optimisation:
❑ Laws of Production:
Laws of Production
Law of Variable Proportion Laws of Returns
(Short-term phenomenon) (Long-term phenomenon)
• Law of Variable Proportion: The law is also known as
the ‘law of diminishing returns’ or the ‘principle of
diminishing marginal productivity’ or the ‘law of
diminishing marginal returns’.
• As one variable input is increased, with all others
remaining fixed, a point will be reached beyond which
the marginal physical product of the variable factor will
begin to decrease.
❑ Three Stages of the Law of Variable Proportions:
• Laws of Returns: The laws of returns to scale refer to the
effects of scale relationships which implies that in the long
run output can be increased by changing all factors by the
same proportion, or by different proportions.
• Initial level of production function: Q = f (L, K)
• If we increase all the factors of production by the same
proportion p. New Q* = f (pL, pK)
If Q* increases more than proportionately with an increase in
the factor inputs, we have increasing Returns to Scale (IRS).
If Q* increases less than proportionately with an increase in the
factor inputs, we have decreasing Returns to Scale (DRS).
If Q* increases in the same proportion as the inputs, p, we say
that there is constant Returns to Scale (CRS).
Q0 = f (L, K)
Q* = f (pL, pK) (increase all the factors by the p)
Q* = pv f (L, K)
Q* = pv Q0
If p can be factored out, the production function is
homogeneous. If p cannot be factored out, the production
function is non-homogeneous.
The homogeneous production function is such that if each of
the inputs are multiplied by p, then p can be completely
factored out of the function. The power v of p is called the
degree of homogeneity of the function and is a measure of the
returns to scale.
If, v= 1, we have CRS, which is also called linear homogeneous
production function.
If v< 1, we have DRS. If v>1, we have IRS.
❑ Returns to Scale:
• Returns to Scale is the Rate at which output increases
as inputs are increased proportionately.
• Increasing Returns to Scale: situation in which
output more than doubles when all inputs are doubled.
If output increases more than proportionately with an
increase in the factor inputs.
• Constant Returns to Scale: situation in which output
doubles when all inputs are doubled.
• Decreasing Returns to Scale: situation in which
output less than doubles when all inputs are doubled.
❑ Various Returns to Scale:
