COURSE TITLE: ECONOMICS

CODE: ECO. 155

BIT 2ND SEMESTER

Presented by Hemanta Rai

Assistant Professor Economics
Patan Multiple Campus
Tribhuvan University
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UNIT 4: PRODUCTION
 Meaning of production and Production function
(Cobb-Douglas production function) production with one
variable inputs: law of diminishing marginal
productivity/returns; production with two variable inputs:
concept of Isoquant; properties of isoquant; right angled
(L shaped) and linear (straight line) Isoquants; concept
of Iso-cost curve (meaning, equation and slope);
producer’s equilibrium condition for optimum
employment of one, two and multi variable
inputs/factors of production;
Click to add text production in long run:
concept of returns to scale with possible causes of
each.
PRODUCTION:
 Production is an economic activity to create the utility in
goods and services
 Addition of utility on goods and services
 Those things which has the ability of capacity to satisfies
the human wants are known as goods and services.
 With change in the quantity, quality, size, shape, place,
time we can add utilities on goods and services.
 It is a process where we convert factor inputs/factors of
production into outputs.
 Factor inputs/factors of production/factors refers to the
land, labor, capital, entrepreneurship/organization
technology, raw material, fuel and others (land, labor,
capital and organization)
PRODUCTION FUNCTION:
 The functional, technical, mathematical
relationship between volume of production
(Output) and factors determinants of production.
 A production function is a description of the
quantitative relationship between the inputs
absorbed and the outputs emerging from a
particular production process.
 Q= f(N,L,K,T,O and others
 100kg= 10L+30K
 Q = f (N) Q =output N= inputs
SHORT-RUN (ONE VARIABLE INPUT)
PRODUCTION FUNCTION

 The short-run production function establishes a

functional relationship between the units of variable
inputs with constant units or capacity of fixed inputs
and the output.

 Q = f (Nvf ,K)
Q = output Nvf, = units of variable inputs
f =function K = constant units of fixed inputs.
Short-run refers to that time period in which producer can
not change all the factors of production but some factors
of production can be changed.
LONG-RUN (MULTIVARIABLE) PRODUCTION
FUNCTION
 Long run production function establishes a
functional relationship between all inputs and
output.
 Algebraically,

Multi-variable production function Q=f(W,L,K,M,T)

Or Two-variable production function Q=f(L,K)
Q=output, f=function, W=land, L=Labor,
M=management, T= Technology
COBB-DOUGLAS PRODUCTION FUNCTION
 Developed by C.W. Cobb American mathematician and
P.H. Douglas economist in 1928AD.
 It shows the multiplicative relationship between inputs
and output.
 It is a long run production function.
 This is known as the empirical production function.
 They modeled the growth of American economy during
the period 1899-1922.
Mathematically,
Q=AKβLα Q= 20K.5L.5
Where Q=output, L=Labor, K=capital
A= efficiency parameter positive constant
α and β are the positive constant parameters (elasticity of
output with respect to inputs)
 Properties of Cobb-Douglash
QUESTIONS FOR DISCUSSIONS
1. Differentiate production and production function.
2. What do you mean by Cobb-Doulash production
function? Explain its properties.
3. Given the production function Q= 20K.8L.4 then
answer the following
a) what is the factor intensity and returns to scale?
b) Calculate average and marginal productivities of
labour and capital.
c) Find the Marginal Rate of Technical substitution
(MRTSLK) and (MRTS KL).
d) Calculate output elasticity of inputs.
CONCEPT OF TOTAL, AVERAGE AND MARGINAL
PRODUCT

1. Total product (TP): It refers to the total volume of

goods and services produced by the firm by use of
factor inputs and technologies. In another words it
is the total amount of a commodity produced by the
combination of all inputs in a given period of time.
TP =AP *N or TP =∑MP TP=MP1+MP2+….+MP3
Where TP= total product, AP = Average product
MP=marginal product and N =total number of
inputs
TP initially increase at increasing rate, and then it
increases at decreasing rate and reaches at maximum
point when the value of MP is zero. Finally it starts to
fall beyond the maximum point to continuous increase
in labour unit.
 Contd..
2. Average product (AP): it is the outcome of total
product divided by total units of the input. In another
words it refers to the per unit output (productivity) of
input. AP=TP/N
Average product of labour APL= TP/L
Average product of capital APK=TP/K
In the beginning, increases, reaches at maximum point
and finally starts to decrease.
3. Marginal product (MP): it is the addition made to the
total product while one more unit of input is used. In
another words it is the ratio of change in total product
with the change in units of inputs
MP=∆TP/ ∆N
Firstly, MP increase faster than AP, reaches at
maximum point and starts to fall faster than average
product, and then become zero and negative.
LAW OF VARIABLE PROPORTION
 It was developed by famous economist Alfred
Marshall, Benham, Samuelson, and Robbins.
 It states and analyses the phenomenon of
short-run production.
 It examines the production relation with one
factor (i.e. labor) as a variable, keeping other
factors fixed.
 When the quantity of one factor is changed
keeping the quantities of other factors constant
the proportion between the variable factor and
fixed factor is changed therefore, it is known as
law of variable proportion.
Contd…

 According to this law, as the quantity of a

variable factor is increased by equal amount
keeping the quantities other factors constant,
initially total product increases at an increasing
rate, but after a point increases at a
diminishing rate, becomes maximum and start
to decline. AP increases to a certain point after
that it continuously decreases. MP also
increases as other product but it increases
faster then AP and start to decrease, when TP
reaches maximum it becomes zero and it may
be negative as well.
Assumptions of law of variable proportion.
1. States of technology is given and constant
2. Only one factor is variable and others are constant
3. This law is based on short-run production function.
The law of variable proportion schedule
Land (in Units of TP AP MP Stages
acre) labor
5 0 0 - - Stage 1st
5 1 10 10 10 Stage of increasing
returns
5 2 30 15 20
5 3 60 20 30
5 4 80 20 20
5 5 90 18 10 Stage 2nd
5 6 90 15 0 Stage of decreasing
returns
5 7 80 11.4 -10 3rd stage negative
returns
 Law of Variable Proportion
100

5, 90 6, 90
TP, MP, AP

80 4, 80 7, 80

60 3, 60

TP
stage 1st stage 2nd stage 3rd
40 Series2
Series3

2, 30 3, 30

20 2, 20 3, 20 4, 20
5, 18
2, 15 6, 15
1, 10 5, 10 7, 11.4

0 0, 0 6, 0
0 2 4 6 8

7, -10 Units of Labour

-20
 Law of variable proportion

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STAGES OF THE LAW: THE LAW OF VARIABLE
PROPORTION CAN BE DIVIDED INTO THREE STAGES.

Stage I (increasing Returns):

 Total product (TP): increases at an increasing rate to a
certain point and then rate of increasing switches from
increasing to diminishing.
 Average product (AP): increases throughout this stage
and reaches to maximum at point.
 Marginal product (MP): initially increases reaches
maximum point and start to decline. When AP and MP
touch and become equal this stage ends in our above
figure at 4 units of labour this stage ends.
Causes of increasing returns:
1. Increase in efficiency of fixed factors
2. Increase in the efficiency or productivity of variable
factor
Stage II (Decreasing returns):
 TP continues to increase at a diminishing
rate until it reaches it’s maximum point
where second stage ends
 In this stage both AP and MP are diminishes
but are positive at the end of this stage MP
is negative.
Causes of decreasing returns in second stage:
1. Scarcity of fixed factor
2. Indivisibility of fixed factor
3. Imperfect substitutability of the factors
Stage III (Negative Returns):
 TP start to decrease
 AP continuously decreases but never be zero
and negative
 MP decrease continuously so it becomes
negative
Causes of Negative Returns in the third stage:
1. Variable factors are too much as compare
to the fixed factors of production (too much
cooks spoil the broth)
2. Indivisibility and scarcity of fixed factors
Stage of operation:

 A rational producer never choose to produce in stage

III where the marginal product of variable factors is
negative even if variable factor is free.
 A rational producer also does not choose to produce
in stage I because the MP and AP of the variable
product is increasing there is the possibility of more
benefit when goods and services are produced more
and more
 Thus it is clear that a rational producer will produce
in stage II where TP is increasing and both MP and
AP of variable factors are diminishing so this law is
also called law of diminishing returns. At which
particular point in this stage, the producer will decide
to produce depends upon the prices of factors.
OPTIMAL EMPLOYMENT OF ONE VARIABLE INPUT

 It refers to the optimum amount of labor which produce

maximum output at a minimum cost.
 The level of variable input which gives the producer
maximum benefit at minimum cost.
 Level of variable input in which producer be in equilibrium.

The conditions for producer’s equilibrium (or Optimum

Employment of one variable input)
VMPL=MCL DL = SL
VMPL= Value of marginal productivity of labor
MCL = Marginal cost of labor
 Cont…
Assumptions
1. Only one commodity is produced by employing
only one variable input, i.e. labor.
2. The theory assumes that the goal of the firm is
profit maximization.
3. Production technology remains constant.
4. An economy is operating at full employment in
the long run
5. There is operation of law of diminishing
marginal returns in the productivity of labor.
6. There is existence of perfect competition in
both product and factor markets.
(VMPL) Value of marginal productivity of labor or demand for
labor (DL): demand for labor is the product of marginal
productivity of labor and per-unit price of output
 So VMPL or DL= Px*MPL OR MRPL = MPL*MR

 The marginal productivity of labor is the ratio of the change

in total productivity of labor with the change in units of labor
(i.e. MPL=△TP/△L)
 Due to the operation of law of diminishing returns in the
productivity of labor MPL decline continuously with an
increase in units of labor.
 Due to the perfectly competitive market price of the product
remains constant at any level of output of the firm.
 Hence VMPL or DL declines continuously with an increase
in units of labor VMPL curve slopes downwards to the right
Marginal cost of labor (MCL) supply of labour =W
 MCL or marginal wage is the wages paid to the each
additional units of labor.
 Due to the perfectly competitive market firm can not
influence on wage rate and then it has to hire any unit of
labor at given wage rate.
 Hence MCL curve slopes as a straight line to X-axis.

 The firm being a profit maximiser, will hire a factor where

MCL equals to value of marginal productivity of labor.
 It never pays a wage which is greater (or less) than the
marginal productivity of labor.
 Therefore, the firm will go on hiring more and more labor so
long as the addition made to the total productivity of
additional labor is greater than the wage rate.
 Questions
1. Let production function Q= 196L-6L2 price(P)=Rs40, wage
rate (w)= Rs 80, fixed cost (c)= Rs10,000
a. Discuss the law of variable proportion.
b. Determine profit maximizing unit of labor, maximum
output. What is the profit?
c. What will be maximum output and profit when wage rate
increase to Rs 120?
2. Let production function Q= 98L-3L2 price(P)=Rs200, wage
rate (w)= Rs400, fixed cost (c)= Rs100,000
a. Compute the profit maximizing unit of labor, maximum
output. What is the profit?
b. What will be maximum output and profit when wage rate
increase to Rs 520?
Group II
Situation Analysis 1

Kathmandu designers Pvt. Ltd. Is a firm among hundreds of firms providing services
of computer typing in both Nepali and English language. The firm starts its service
with three computers and one worker in one room. The worker type documents
deals with customers, keeps account and accomplishes other office work. The
worker types 100 pages per day. When demand increases, the firm hires one more
worker and assigns only the typing job for one person and all the other jobs to next
person. As a result, the worker types 240 pages per day. Similarly, the firm hires
third worker to meet more demand
Click toand
addassigns
text English typing for one person,
Nepali types for one person and all other jobs to another person. As a result they
type 390 pages per day. The firm hires fourth worker and assigns job: one person for
typing for Nepali, two persons for typing English and one person for all other jobs.
The firm produces 520 pages in a day. When the firm hires five workers and assigns
job as: two workers for typing Nepali, two workers for typing English one worker for
all other jobs. The firm produces 610 pages in a day. When firm hires sixth, seventh
and eighth worker its output is 660, 660 pages and 640 pages respectively.
Contd..

The sixth worker assigned for customer dealing separately.

Seventh worker is assigned as accountant separately. When
the firm employees 8 workers the job is divided as: two for
Nepali typing, two for English typing, one for customer dealing,
one for account keeping and two for office support.
In competitive factor market with homogeneous labour,
Kathmandu Designers Pvt. Ltd can hire at rate Rs. 1000 per
day. The service charge of the product is Rs. 20 per page.

a) Find the optimum units of labour for Kathmandu Designers

Pvt Ltd.
b) Find the level of profit for one month if the total cost (other
than labour charge) of one month of Kathmandu Designers
Pvt Ltd is Rs. 200000.
OPTIMAL EMPLOYMENT OF TWO VARIABLE
INPUTS
 Isoquant: an isoquant (or equal product curve
or product indifference curve) is a locus of
representing different combination of two
inputs (labor and capital) which yield the same
level of output to the producer.
 It slopes downwards to the right as rectangular
hyperbola.
 It is due to the operation of law of diminishing
marginal rate of technical substitution.
 It is also shows producers preference
 Q=f(L,K)
 combinations Capital labor MRTS output
ISOQUANT
A 1 15 - 200
B 2 11 1:4 200
C 3 8 1:3 200
D 4 6 1:2 200
Isoquant
E 5 5 1:1 200
16
1, 15
14

12
2, 11
10
Labor

8 3, 8

6 4, 6
5, 5
4

0
0 1 2 3 4 5 6
Capital
 Cont…
 Assumptions:

1. Only two inputs, labor and capital are assumed

to be variable
2. There is operation of law of diminishing
marginal rate of technical substitution
between two inputs
3. Production function is continuous, implying
that labor and capital are perfectly divisible
and can be substituted in any small quantity.
4. Producer must be rational.

5. Transitivity
LAW OF DIMINISHING MARGINAL RATE OF TECHNICAL
SUBSTITUTION (MRTS):
 MRTS is a rate at which units of two inputs are
substituted to each other to maintaining same level
of output to the producer.
 It is the ratio of the change in units of one input
(say labor) with the change in unit of another input
(say, capital)
 Q=f(L,K) ….(i) IQ production function
-△L MPL …(ii) when producer sacrifices some units of labor
total output will change
+△K MPK ….(iii) when he changes some unit of capital, total
output will change
-△L MPL = +△K MPK
-△L/△K =MPK/MPL ..... (iv)
PROPERTIES OR CHARACTERISTICS OF ISO-QUANT
 It has negative slopes. Or Isoquant always slopes
downwards from left to the right.
 It is convex to the origin.
 Isoquants never intersect to each other.
 Higher Isoquant represents higher output and
lower Isoquant lower quantity.
Labor
Labor

a
b
IQ2
IQ1
IQ c
0 Capital
0 Capital
LINEAR ISOQUANTS

Isoquant: perfectly substitutable

goods
Capital Labour quantity MRTS 30

0 25 10 - 25 0, 25

1 20 10 1:5
20 1, 20

2 15 10 1:5

labour
15 2, 15

3 10 10 1:5
10 3, 10

4 5 10 1:5
5 4, 5
5 0 10 1:5

0 5, 0
0 1 2 3 4 5 6
Capital
L-SHAPED ISOQUNAT

Capital Labour Quantity L-Shaped isoquant: complementary

between two factor inputs
4 1 10
4.5
3 1 10 4 1, 4
3.5
2 1 10
3 1, 3 Isoquant

Labour
1 1 10 2.5
2 1, 2
1 2 10
1.5
1 3 10
1 1, 1 2, 1 3, 1 4, 1
1 4 10 0.5
0
0 2 4 6
Capital
ISO-COST LINE:
 It is the locus of various combinations of inputs
along which a producer makes same level of
expenditure.
 It represents the budget constraint of the
producer
 It shows the various combinations of two factor
inputs that can be hired by the producer with
his/her given total investment expenditure.

C = wL + rK ……. i) Iso-cost line equation

where C = total cost/ investment expenditure

w= wage rate, L = unit of labor, r= rate of interest, K = unit
of capital
 Cont……
Let C = Rs100. w= Rs10, and r =Rs20 then Iso-cost line is drawn as
100=10L+20K
C=wL+rK
when L = 0, K= C/r = 100/20 = 5 a point of Iso-cost line
When K=0, L=C/w = 100/10= 10 another point of Iso-cost, then

Slope of iso-cost is labor

dK/dL= - w/r
10
C=wL+rK

0
5 capital
Cont…..
Causes of shift in Iso-cost line
a) Change in total cost/ total investment expenditure

I. When total cost increase it shift rightward

II. When total cost decrease it shift leftward

b) Change in input prices

i. If price of the inputs decreased it shift rightwards
ii. If price of the inputs increased it shift leftwards
LEAST COST COMBINATION OF TWO INPUTS OR OPTIMAL
COMBINATION OF TWO INPUTS OR PRODUCER’S EQUILIBRIUM

 It represents that units of labor and capital which yield

maximum output at minimum cost to the producer.
 It is also called the optimal combination of factor inputs
because there is no any other combinations of these two
factor inputs which gives maximum output at minimum cost
to the producer besides this combination.
 At this combination of factor inputs producer is able to
achieve their goal of to producer maximum output at
minimum cost so this is also called the producer’s
equilibrium point.
 There are two approaches to explains the producer’s
equilibrium. a. maximization of output at given total cost
outlay. b. minimization of cost at given production quota.
A. MAXIMISATION OF OUTPUT AT GIVEN TOTAL COST OUTLAY

Assumptions
1. Producer must have iso-quant map and iso-cost line
2. Producer must be rational.
3. Total cost outlay and prices of two inputs remain fixed
4. Producer has to maximise output by investing fixed total outlay
on two inputs (labor and capital) at minimum cost.
Conditions:
1. Necessary(1st order) condition: iso-cost line is tangent to iso-
quant(or the slope of iso-quant equals to the slope of iso-cost
line, (i.e. MRTSKL =MPK/MPL )= r/w
2. Sufficient (2nd order) condition: iso-quant must be convex to
the origin at tangent point
Producer’s equilibrium
labor

A
f

e
L

IQ3
g
IQ2
IQ1

0 K B capital
Expansion path:
labor
g

A P
e3 Expansion path
C

e2
L
e1
IQ3
IQ2
IQ1

0 K D B f capital
B. MINIMIZATION OF COST AT GIVEN PRODUCTION QUOTA

 If the entrepreneur has already decided about the level of output to

be produced.
Assumptions
1. Producer must have iso-quant and family of iso-cost line.
2. Producer must be rational.
3. Prices of two inputs remain fixed.
4. Producer has different level of investment capacity or total cost
outlay.
5. Producer has to produce given level of output at minimum cost.
Conditions:
1. Necessary(1st order) condition: iso-cost line is tangent to iso-
quant(or the slope of iso-quant equals to the slope of iso-cost line,
(i.e. MRTSKL =MPK/MPL )= r/w
2. Sufficient (2nd order) condition: iso-quant must be convex to the
origin at tangent point
Least cost combination of two factor inputs
labor
g

r
A

e
L
s

IQ2

0 K D B f capital
LAW OF RETURNS TO SCALE
 It is associated with long run production
function
 It examines the relationship between output
and the scale of inputs in the long run when all
the inputs are increased in the same
proportion.
 Firm increases its scale of production by using
more space, more machines and labourers (as
inputs)
 “Law of returns to scale refers to the
relationship between to the changes in output
and proportionate change in all factors of
production” Roger Miller
Assumptions
1. All factors are variable enterprise is fixed.

2. No change in state of technology

3. There is perfect competition

4. The product is measured in quantities.

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Stages of law of returns to scale
a. Increasing returns to scale (IRS)

b. Constant returns to scale (CRS)

c. Decreasing returns to scale (DRS)

a. Increasing returns to scale (IRS): if the output of a
firm increases more than in proportion to an equal
percentage increase in all inputs, the production is
said IRS. e.g. if amount of inputs are increased by
10% then output increases by more than 10% (say
15%)
b. Constant returns to scale (CRS): if output increases
at the same proportion as that of inputs, then it is
known as CRS. e.g. if factor inputs increase by 10%
then output also increase by same 10%
c. Decreasing returns to scale (DRS): if the output
increases at less proportion than the increase in
inputs then the production scale is said to be DRS.
e.g. if inputs increases by 10% then output
increases by less than 10%
Units of Units of Total units of Total units of result
labour capital inputs output

2L 2K 2L+2K 100 (IQ1) Increasing

returns to
4L 4K 4L+4K 300 (IQ2) scale
8L 8K 8L+8K 700(IQ3)

4L 4K 4L+4K 200(IQ2) Constant

returns to
8L 8K 8L+8K 400 (IQ3) scale

4L 4K 4L+4K 180 (IQ2) Decreasing

returns to
8L 8K 8L+8K 300(IQ3) scale
  Returns to scale
Causes of increasing
Increasing returns to scale
returns to scale:
OA>AB>BC Economies of scale
1. Technical and
managerial
indivisibles/economies
2. Higher degree of
Labour

C
specialization
B IQ3=300 3. Dimensional relations
4. Transportation
A IQ2=200 economies
IQ1=100
5. Advertising economies
O Cpital
  Returns to scale
Causes of constant
Constant returns to scale
returns to scale: There is
OA=AB=AC balance between internal
and external economies
of scale and
diseconomies of scale
Labour

B IQ3=300

A
IQ2=200
IQ1=100
O Captial
  Returns to scale
Causes of decreasing
Decreasing returns to scale
returns to scale:
OA<AB<BC Diseconomies of scale
1. Managerial
C diseconomies
2. Limitedness or
exhaustibility of the
Labour

IQ3=300
natural resources
B 3. Labour diseconomies
4. Pecuniary
A diseconomies
IQ2=200
IQ1=100
(discount and
concession)
O Capital