CHAPTER – 3 THEORY OF PRODUCTION AND COST

UNIT – 1 THEORY OF PRODUCTION

LEARNING OUTCOMES

After completing this unit, you will be able to:

1. Define Production and explain the Production Function.

2. Understand the Characteristics of Factors of Production.
3. Distinguish between Short-run and Long-run Production Functions.
4. Illustrate:
o Law of Diminishing Returns.
o Returns to Scale.
5. Describe Production Optimization using Isoquants and Iso-cost curves.

1.0 MEANING OF PRODUCTION

A. Importance:

 Essential for firm survival in a competitive market.

 Determines economic performance and standard of living.

B. Definition in Economics:

 Production = Transformation of resources into goods and services that satisfy

human wants.
 Includes both material goods and services (e.g., doctors, teachers, retailers).

C. Quote:

 “Production is the organised activity of transforming resources into finished

products…” – Bates & Parkinson

D. Misconception Clarified:

 Production ≠ Creation of matter

 It is creation/addition of utility (value-added process).

E. Types of Utility Created Through Production:

1. Form Utility: Changing the shape/form of raw materials (e.g., wood to table).
 2. Place Utility: Moving goods to places where they are more useful (e.g., tin from
Malaya to factories).
3. Time Utility: Making goods available when needed (e.g., storing food grains).
4. Personal Utility: Using human services (e.g., transport workers, retailers).

Example: Wool to cloth → transported → stored → sold using services = all forms of utility
involved.

F. Non-Production Activities (Not included in economics):

 Household chores done out of love.

 Voluntary services.
 Goods for self-consumption.
 Key Condition: Must be intended for exchange in the market.

G. Cost of Production:

 Refers to money spent on converting inputs into outputs.

 Though not central in production theory, crucial in business decisions.
 Will be discussed in depth in future units.

1.1 FACTORS OF PRODUCTION

Inputs used in the production process: Land, Labour, Capital, and Entrepreneurship

1.1.0 LAND

Definition:

 Includes all natural resources (not just soil).

 A “free gift of nature.”

Characteristics:

1. Free gift of nature – No human effort required to obtain.

2. Fixed supply – Quantity cannot be increased.
3. Permanent & indestructible – According to Ricardo.
4. Passive factor – Requires human input for productivity.
5. Geographically immobile – Cannot be moved from place to place.
6. Multiple uses – Can be used for different purposes.
7. Heterogeneous – Not all land is equally fertile or situated.
1.1.1 LABOUR

Definition:

 Physical or mental effort performed for economic gain.

Conditions:

 Must be for income – Not done for love or pleasure (e.g., maid’s work = labour;
housewife’s work ≠ labour).

Characteristics:

1. Human effort – Distinct from other inputs due to emotional/psychological needs.

2. Perishable – A day's labour can’t be stored or recovered.
3. Active factor – Initiates production.
4. Inseparable from labourer – Service must be delivered in person.
5. Heterogeneous – Varies by skill, intelligence, motivation, etc.
6. May not be productive – Efforts might not yield output.
7. Poor bargaining power – Cannot store labour; often compelled to accept low
wages.
8. Mobile – Can change jobs/locations, but faces real-world obstacles.
9. Slow supply adjustment – Labour supply doesn’t quickly respond to changes in
demand.
10. Work-leisure trade-off – Higher wages initially increase labour, but beyond a point,
workers prefer more leisure (backward-bending supply curve).

1.1.2 CAPITAL

Definition:

 That part of wealth used to produce more wealth.

 A man-made means of production (unlike land or labour).
 Stock concept (wealth at a point in time) vs. Flow concept (income over time).

Capital ≠ Wealth:

 Idle wealth = not capital.

 Only productive wealth = capital.

Examples:

 Machines, tools, buildings, transport, dams, etc.

Types of Capital:

Type Description Example

Fixed Capital Used over multiple cycles Machinery
Circulating Capital Used up in a single use Fuel, raw materials
Real Capital Physical goods Machines, buildings
Human Capital Skills, education, abilities Skilled worker
Tangible Capital Can be seen/touched Tools
Intangible Capital Cannot be sensed physically Patents, goodwill
Individual Capital Owned personally Personal business equipment
Social Capital Owned by society/government Roads, bridges

Capital Formation (Investment):

Definition: Increasing the stock of real capital goods used in further production.

Need for Capital Formation:

 Replacement & renovation of old capital.

 Creation of new productive capacity.
 Higher capital formation = higher production, employment, and economic growth.

Stages of Capital Formation:

1. Savings:
o Comes from current income.
o Ability to save: Related to income.
o Willingness to save: Related to future outlook, incentives, and policies.
o Government tools: Compulsory savings, tax deductions, insurance, provident
funds.
2. Mobilisation of Savings:
o Savings must be converted into usable investment funds.
o Requires financial institutions (banks, mutual funds, etc.).
o Government's role: Incentives + directing savings to productive uses.
3. Investment:
o Final stage where savings are used to build capital goods.
o Requires entrepreneurs who take risks and create assets.
📘 1.1.3 Entrepreneur

🔷 Definition & Role of Entrepreneur

1. The entrepreneur is the fourth factor of production alongside land, labour, and
capital.
2. Key functions:
o Mobilizes and coordinates land, labour, and capital.
o Initiates production.
o Bears risk and uncertainty.
o Decides scale of operation, production methods, and use of resources.
3. Referred to as organizer, risk-taker, and innovator.
4. Differs from a manager – the entrepreneur bears the ultimate risk, while routine
tasks can be managed by others.

🔷 Functions of an Entrepreneur

(i) Initiating Business Enterprise & Resource Coordination

1. Senses opportunities and generates business/project ideas.

2. Decides:
o Product or service type.
o Scale and scope of business.
o Production methods and technology.
3. Combines resources: Hires labour, land, and capital.
4. Pays fixed returns:
o Wages to labour.
o Rent for land.
o Interest on capital.
5. Keeps profit or loss as reward for risk and coordination.
6. Profit is not guaranteed – it's a variable and uncertain return.

(ii) Risk/Uncertainty Bearing

1. Faces financial risks: Business may incur losses due to unexpected changes.
2. Faces technological risks: Innovations may make existing processes obsolete.
3. Faces market risks: Changes in demand, preferences, or competition.
4. Frank Knight’s Theory:
o Differentiates between risk (can be insured) and uncertainty (cannot be
insured).
o Profit is reward for bearing uncertainty.
5. Cannot delegate uncertainty-bearing to anyone else.

(iii) Innovation (Schumpeter’s View)

 1. Main function of an entrepreneur is to introduce innovations.
2. Innovations include:
o New or improved products/services.
o New methods of production.
o New sources of raw materials.
o Entry into new markets.
o Innovative business models.
3. Leads to temporary monopoly profit (until others imitate).
4. Drives technological advancement and economic growth.
5. Innovation involves risk; not everyone can be a successful innovator.

📘 Enterprise’s Objectives and Constraints – Detailed Points

🔷 Objectives of an Enterprise

(1) Organic Objectives

1. Survival: Basic requirement – business must at least recover costs.

2. Growth:
o Once survival is ensured, aims to expand and grow.
o Growth evaluated by increase in size, revenue, assets, etc.

➤ R.L. Marris’s Balanced Growth Theory:

 Managers aim to maximise firm's growth rate, not just profit.

 Utility conflict:
o Owners prefer profit, capital appreciation.
o Managers seek status, job security, power.
 Both groups indirectly benefit from firm’s growth.

(2) Economic Objectives

1. Profit maximisation is the classic objective of firms.

2. Important for:
o Paying dividends.
o Attracting investment.
o Ensuring long-term sustainability.
3. Economic vs Accounting Profit:
o Accounting profit = Revenue – Explicit costs.
o Economic profit = Revenue – (Explicit + Implicit costs).
o Normal profit = Minimum needed to stay in business.
o Supernormal profit = Above normal, reflects true economic gain.
➤ Critiques of Profit Maximisation:

 H.A. Simon – firms aim for satisficing behaviour.

 Baumol – firms focus on sales maximisation.
 Williamson – managers focus on utility maximisation (perks, status).
 Cyert & March – firms have multiple goals (profit, market share, inventory goals,
etc.).

(3) Social Objectives

1. Maintain quality products free from adulteration.

2. Avoid profiteering and unethical practices.
3. Generate employment.
4. Prevent environmental pollution.
5. Improve quality of life in the community.

(4) Human Objectives

1. Provide fair treatment and compensation.

2. Facilitate skill development and training.
3. Encourage employee participation in decision-making.
4. Ensure job satisfaction through meaningful work.

(5) National Objectives

1. Align with national plans and policies.

2. Promote self-reliance and reduce foreign dependency.
3. Create equal opportunities and fair treatment.
4. Develop youth skills through training/apprenticeship.

🔷 Constraints Faced by Enterprises

1. Lack of Knowledge/Information:
o Firms often operate in uncertain environments.
o Forecasting demand, prices, and tech changes is difficult.
2. Governmental & Institutional Constraints:
o Legal restrictions on location, production, pricing.
o Trade union restrictions on labour mobility.
3. Infrastructure Challenges:
o Power shortages, raw material issues, poor logistics.
4. Economic Fluctuations:
o Inflation, changing tax policies, exchange rate shocks.
5. Labour Market Issues:
o Shortage of skilled workers.
o High cost of training and retention.
📘 Enterprise's Problems – Detailed Breakdown

🔷 1. Problems Relating to Objectives

 Multiple and conflicting objectives.

o E.g., Profit vs. Market Share, Innovation vs. Employment.

🔷 2. Location and Size of Plant

 Decision factors:
o Raw material proximity.
o Labour and transport cost.
o Market access.
 Size considerations:
o Technical feasibility.
o Financial resources.
o Market demand and management ability.

🔷 3. Organizing Physical Facilities

 Choice of:
o Production process.
o Machinery and layout.
 Based on:
o Efficiency.
o Cost-effectiveness.
o Volume of production.

🔷 4. Financial Planning Problems

 Key decisions:
o Capital requirement.
o Sources of funding.
o Project profitability.
o Timing of financing.

🔷 5. Organisational Structure

 Must define:
o Roles and responsibilities.
o Departmental divisions.
o Authority and reporting structure.

🔷 6. Marketing Challenges
  Identify target customers.
 Make decisions on 4 P’s:
o Product: Quality, packaging, design.
o Price: Strategy, discounts, credit terms.
o Promotion: Advertising, selling.
o Place: Distribution channels, store layout.

🔷 7. Legal Formalities

 Adherence to:
o Tax rules, pollution norms.
o Labour laws, licensing, reporting.

🔷 8. Industrial Relations

 Issues:
o Gaining worker cooperation.
o Dealing with unions and strikes.
o Maintaining discipline.
o Promoting worker participation in management.

📘 1.2: Production Function – Detailed Point-wise Notes

🔷 1. Meaning and Definition of Production Function

1. The Production Function shows the technical relationship between inputs and
output.
2. It expresses how scarce resources (inputs) like land, labour, capital, and
entrepreneurship are converted into goods and services (output).
3. Mathematical Form:
o Q = f(a, b, c, d…n)
 Q = Quantity of output
 a, b, c, d…n = Inputs used (land, labour, capital, etc.)
4. The output (Q) is a function of the quantities of different inputs used per unit of
time.

🔷 2. Assumptions of the Production Function

1. Time-bound Relationship:
o Input-output relation holds for a specific period.
o Q is not a cumulative or total output over time.
 2. Constant Technology:
o Assumes no change in technology during the analysis.
o Innovation (like robotics or new software) would shift the production function.
3. Maximum Efficiency:
o Inputs are used efficiently to produce the maximum possible output.
o Waste or under-utilisation of inputs is not assumed.

🔷 3. Alternative Definitions

1. According to Samuelson:
o The production function shows the maximum output that can be produced
with given inputs and existing technology.
2. Another View:
o It shows the minimum amount of inputs required to produce a given level
of output.

🔷 4. Nature of Inputs and Outputs

1. Output:
o Measured as volume of goods or services.
2. Inputs:
o Land (natural resources)
o Labour (workers, human effort)
o Capital (machinery, equipment)
o Entrepreneurship (decision-making, risk-taking)
3. Example (Beverage Company):
o Inputs: Machinery, water, sugar, flavours, bottles, workers, supervisors
o Output: Packaged beverages

🔷 5. Simplified Production Function (Two Inputs)

1. For ease of analysis, often reduced to Labour (L) and Capital (K):
o Q = f(L, K)
 Q = Output
 L = Labour
 K = Capital

🔷 6. Short Run vs Long Run Production Function

 Short Run:

1. At least one input is fixed, usually capital.

2. Output is changed by varying only variable inputs like labour.
3. Firms cannot expand capacity (e.g., buy new machines).
4. Law of Variable Proportions applies.

Long Run:

1. All inputs are variable.

2. Firms can change scale – increase labour, capital, technology.
3. Suitable for studying Returns to Scale.

📘 1.2.0: Cobb-Douglas Production Function

🔷 7. Cobb-Douglas Production Function

1. Developed by Paul Douglas and C.W. Cobb.

2. Studied U.S. manufacturing industries.
3. Formula:
o Q = K × Lᵃ × C^(1–ᵃ)
 Q = Output
 L = Labour
 C = Capital
 K, a = Constants
4. Findings:
o Labour contributed around 75%, capital 25% to output growth.
5. Use:
o Despite simplifications, widely used in empirical research and economic
models.

📘 1.2.1: Law of Variable Proportions (Law of Diminishing Returns)

🔷 8. Meaning

1. Applicable in the short run, when one input is variable and others are fixed.
2. States that as more units of a variable input (e.g. labour) are added to fixed inputs
(e.g. capital), the marginal output from each additional input will eventually
decline.
🔷 9. Key Concepts

1. Total Product (TP):

o Total output from all units of input.
2. Average Product (AP):
o Output per unit of variable input.
o AP = TP / L
3. Marginal Product (MP):
o Additional output from one more unit of variable input.
o MP = ΔTP / ΔL or MPₙ = TPₙ – TPₙ₋₁

🔷 10. Relationship Between AP and MP

1. MP > AP → AP is rising
2. MP = AP → AP is at maximum
3. MP < AP → AP is falling

🔷 11. Assumptions of the Law of Variable Proportions

1. Fixed technology
2. At least one input is fixed
3. Inputs can be substituted to some extent
4. Focus is on physical output, not revenue or profit

🔷 12. Three Stages of Production

Stage I: Increasing Returns

1. TP increases at an increasing rate.

2. MP rises, reaches maximum, then begins to fall.
3. AP rises throughout the stage.
4. Ends when AP is maximum.
5. Reason:
o Under-utilised fixed resources
o Specialisation and better coordination

Stage II: Diminishing Returns

 1. TP increases at a diminishing rate.
2. MP and AP fall, but are positive.
3. Ends when MP = 0.
4. This is the rational stage for production.
5. Reason:
o Fixed input becomes constraint
o Too many variable inputs cause inefficiency

Stage III: Negative Returns

1. TP declines
2. MP is negative
3. AP continues to fall
4. Reason:
o Overcrowding
o Variable inputs interfere with each other

🔷 13. Producer's Rational Choice

1. Stage I: Not optimal – fixed factors underutilised

2. Stage III: Not optimal – negative marginal product
3. ✅ Stage II: Best stage for production – maximum efficiency
4. Decision on the exact point in Stage II depends on:
o Cost of input
o Revenue generated by additional output

🔵 1.2.2 RETURNS TO SCALE

✅ 1. Meaning and Definition

1. Returns to scale examine how output changes when all inputs (labour, capital, land,
etc.) are increased simultaneously and in the same proportion.
2. It refers to the long-run production process where no input is fixed, unlike in the
short run.
3. Focuses on the effect of scale expansion on output, as opposed to just changing
input proportions (as in the law of variable proportions).

✅ 2. Characteristics
 1. Applies only in the long run when all inputs are variable.
2. Describes technological outcomes of production, not decisions influenced by prices
or cost considerations.
3. Based on how efficiently inputs are combined as scale increases.

✅ 3. Three Types of Returns to Scale

🔹 A. Constant Returns to Scale (CRS)

1. Occurs when output increases in the same proportion as all inputs.

2. Example: If labour and capital are both doubled, and output also doubles, returns to
scale are constant.
3. Mathematically expressed as:
If
Q = f(K, L), then
kQ = f(kK, kL)
where k is any positive constant.
4. This kind of function is known as a linearly homogeneous production function.
5. In real life, firms experience CRS over a significant range of expansion.

🔹 B. Increasing Returns to Scale (IRS)

1. Occurs when output increases more than proportionately to the increase in all
inputs.
2. Example: Inputs are doubled, but output becomes more than double.
3. Causes:
o Economies of scale: Better utilisation of machinery, bulk buying, etc.
o Specialisation: Division of labour increases efficiency.
o Indivisibility of inputs: Some inputs (e.g., high-capacity machines) are more
efficient only when used at a large scale.
o Geometric Example:
A cube of 3 ft has 9x surface area but 27x volume compared to 1 ft cube.
4. Common in the early stages of production expansion.

🔹 C. Decreasing Returns to Scale (DRS)

1. Occurs when output increases less than proportionately to the increase in all inputs.
2. Example: Inputs are doubled, but output increases by only 50%.
3. Causes:
 o Managerial inefficiency due to large size
o Coordination problems
o Diseconomies of scale
o Overuse of resources and decline in communication
4. Typically seen in the later stages of business expansion.

✅ 4. Cobb-Douglas Production Function and Returns to Scale

1. A popular mathematical model used to study returns to scale.

2. General form:
Q = K × Lᵃ × Cᵇ
where Q = Output, L = Labour, C = Capital, a, b = output elasticities, K = constant.
3. Interpretation:
o a + b = 1 → Constant Returns to Scale
o a + b > 1 → Increasing Returns to Scale
o a + b < 1 → Decreasing Returns to Scale

🔵 1.3 PRODUCTION OPTIMISATION – Detailed, Point-Wise Explanation

✅ 1. Goal of Production Optimisation

1. Firms aim to minimise cost for producing a given output level, or

2. Maximise output for a given amount of spending (budget).
3. This is achieved by using:
o Isoquants (representing output levels)
o Isocost lines (representing spending or cost constraints)

✅ 2. Isoquants – Concept and Properties

🔹 A. Definition:

1. Isoquants are curves that show different combinations of two inputs (e.g., labour
and capital) that produce the same level of output.
2. Analogous to indifference curves in consumer theory.
3. Also called:
o Equal-product curves
o Iso-product curves
 o Production indifference curves

🔹 B. Characteristics:

1. Downward sloping (negative slope): More of one input means less of the other is
needed to maintain the same output.
2. Convex to the origin: Due to the diminishing marginal rate of technical
substitution (MRTS).
3. Non-intersecting: One isoquant cannot cross another because it represents a unique
output level.
4. Higher isoquants represent higher output:
o IQ3 > IQ2 > IQ1

🔹 C. Marginal Rate of Technical Substitution (MRTS)

1. MRTS = Rate at which one input (say Y) can be substituted for another (say X),
keeping output constant.
2. Formula:
MRTS = ΔY / ΔX
3. MRTS diminishes as more of one input is used in place of another.

🔹 D. Example Table (From Notes)

Combination Factor X Factor Y MRTS

A 1 12 –

B 2 8 4

C 3 5 3

D 4 3 2

E 5 2 1

✅ 3. Isocost Lines – Concept and Explanation

🔹 A. Definition:
 1. Isocost line shows combinations of inputs that can be purchased for a given total
cost.
2. Similar to budget line in consumer theory.

🔹 B. Formula:

 C = Px·X + Py·Y
Where:
C = total cost,
Px = price of input X,
Py = price of input Y.

🔹 C. Example:

1. Budget = ₹1,000
2. Price of X = ₹10 → Max X = 100 units
3. Price of Y = ₹20 → Max Y = 50 units
4. All combinations between (100, 0) and (0, 50) form the isocost line.

🔹 D. Graphical Representation:

1. X-axis = units of input X

2. Y-axis = units of input Y
3. Slope = -Px/Py
4. Different isocost lines show different budgets (higher lines = higher cost)

✅ 4. Least-Cost Combination (Producer’s Equilibrium)

🔹 A. Objective:

 To find the cheapest combination of inputs that produces a given level of output.

🔹 B. Condition for Optimum Combination:

1. Occurs where isoquant (for fixed output) is tangent to isocost line.

 2. At the point of tangency:
MRTS = Px / Py

🔹 C. Explanation:

1. Suppose the firm wants to produce 1000 units (isoquant = P).

2. Combinations A, B, C, D, E can all produce this output.
3. Point C (on diagram) is where isoquant P touches the lowest isocost line MM₁.
4. This point gives the minimum cost for producing 1000 units.
5. Any other point (e.g., A, B, D) lies on higher isocost lines, meaning higher cost.

🔹 D. Conclusion:

 At point C:
o Cost is minimised.
o Inputs are optimally allocated.
o Firm achieves production efficiency.