03. Theory of production.pdfsdfghbjn,kadsefghj

Chapter Three
-
Theory of production

Learning Objective
Define production, input, and output;
Distinguish the differences between short-run and long-run production period;
Define production function;
Explain the concepts of production function with one variable input;
Distinguish the difference between total, average, and marginal product;
Show the relationship between average product and marginal product;
Describe the law of diminishing marginal product;
Identify and analyze the steps of productions;
Explain the concepts of production function with two variable input;
Define Isoquant curve schedule and map;
State the basic characteristics of Isoquant;
Identify the economic region of production; and
Show the effects of technological change on production.

Definition of Production
Example
For example, when we get
wheat on a plot of land
with the help of inputs
like labor, capital and
seeds, it is termed as
production of wheat.
Similarly, when, in a cloth
mill, inputs like labor,
capital and threads are
transformed into cloth, it
is called the production of
cloth.
Similarly, in an economy,
services are also produced.

Factors of Production or
Inputs
1. Land: Refers to all natural
resources (land itself,
minerals, forests, water, oil,
and other natural assets)
 Limited in supply and Cannot be
produced by human effort
2. Labour: Represents human
effort, both physical and
mental, used in the production
process.
Includes all types of work
performed by individuals to
create goods and services.
3. Capital: Refers to man-made
resources used to produce goods
and services.
Includes machinery, tools,
4. Entrepreneurship: Involves the
ability to organize the other
factors of production effectively
to create goods and services.
Entrepreneurs take risks to
innovate, start businesses, and
manage resources.
Key Features:
• Combines land, labor, and
capital to produce goods or
services.
• The reward for
entrepreneurship is profit.
Example: Startup founders,
business owners.

Classification of Raw Materials: Land or working capital
• Examples of Raw Materials as Part of Land:
• Minerals and Ores: Iron ore, bauxite, gold, silver, and other natural mineral deposits.
• Forests: Trees that are part of a forest before they are cut down for wood or paper production.
• Soil and Agricultural Land: Fertile soil that supports farming activities or land used for growing crops.
• Water Bodies: Water in its natural state (e.g., rivers, lakes, or underground aquifers) before being processed
or transported.
• Oil and Natural Gas: Crude oil or natural gas in reservoirs beneath the Earth's surface.
• Fisheries and Marine Resources: Fish in the ocean or other aquatic resources before being harvested.
• Transition from Land to Working Capital:
• As Part of Land: While raw materials are still in their natural state (e.g., trees in a forest, oil underground),
they are considered part of land.
• As Part of Working Capital: Once these resources are extracted, harvested, or processed (e.g., logs from
trees, crude oil in barrels), they become part of the working capital used in production.

Production Function
• The production function is purely a technological
relationship that expresses the relationship between
the output of a good and the different combinations of
inputs used in its production.

Period of
Productio
n
• Short-Run: Short-run refers to the period over which the
amount of some inputs, called the ‘fixed inputs’, cannot be
changed.
• For example, the amount of plant and equipment is fixed in the
short run.
• The short-run periods of different firms have different durations.
• some firms can change the quantity of all their inputs within a
month while it take more than a year for other types of firms.
QX = f (L, ത
𝑘 )
• Long-Run: Long-run is defined as the time period during which
all factors of production can be varied. A firm can install a new
plant or raise a new factory building.
QX = f (L, K)

Production Function with One
Variable Input
QX = f (L, ത
𝑘 )
• The total product (TP) is the total output amount resulting
from different quantities of inputs. If we assume labour (L) as
the variable input assuming (capital, etc., held constant).
• Marginal product of labour (MPL) is defined as the change in
total product (TP) per unit change in variable input, say
labour (L), that is,
• MPL = ∆ TP /∆ L……. (2)
• Similarly, Average product of labour may be defined as
APL = TP / L……. (3)

Hypothetical Schedule of TP, MP and AP and
Diagram

Relationship Between Total Product,
Marginal Product, and Average Product
The relationship
between MP and
AP:
When MP > AP, this means that AP is rising,
When MP = AP, this means that AP is maximum,
When MP < AP, this means that AP is falling.
Graphically, the
relationships
between the MP
curve and AP
curve are as
follows (see
Figure 4.1):
So long as the MP curve lies above the AP curve, the AP curve is a
positively sloping curve, AP rises
When the MP curve intersects the AP curve, AP is at maximum,
When the MP curve lies below the AP curve, the AP curve slopes downward,
i.e., AP declines.
The relationship
between TP and
MP:
When TP increases at an increasing rate, marginal product increases,
While TP increases at a diminishing rate, MP declines,
When total product reaches its maximum, marginal product becomes zero,
When TP begins to decline, MP becomes negative.

The Law of
Diminishing
Marginal Returns
The law states that as
more and more of one-
factor input is employed,
assuming all other input
quantities held constant,
a point will eventually be
reached where additional
quantities of the varying
input will yield
diminishing marginal
contributions to total
product.

The Law of
Diminishing
Marginal Returns
Note that:
• The law operates only if
technology does not
change
• The law starts to operate
after the MP curve
reaches its maximum (see
Figure 4.1)
• The law is universal
because the tendency of
diminishing return is all
pervading, and so it
applies sooner or later
in every field of
production.

Long Run Analysis –Q=f(L,K)
Production process and iso-quant
• Technical Efficiency: Technical
efficiency happens when a firm
produces a given level of output
by using least number of inputs.
• Economic Efficiency: Economic
efficiency happens when a firm
produces a given level of output
at least cost. So economically
efficient method of production
depends on the relative costs of

Production Function with Two
Variable Inputs
A tabular
representation of the
various combinations of
two variable inputs
which give the same
level of output is
called an isoquant
schedule or equal
product schedule.

Isoquant curve
and Isoquant map
Isoquant: An isoquant is a curve
representing the various
combinations of two inputs that
produce the same amount of output.
An isoquant may, therefore, be
defined as a curve which shows the
different combinations of the two
inputs that produce a given level of
output.

Properties of
Isoquants
• An isoquant is downward-sloping to the
right, (i.e., negatively inclined),
implying that if more of one factor is
used, less of the other factor is
needed for producing the same level of
output.
• No two isoquants intersect or touch
each other. If two isoquants intersect
or touch each other it means that there
is a common point on the two curves
(point A in Figure 4.6). This common
point would imply that the same amount
of labour and capital can produce two
levels of outputs (example, 60 and 70
units, here), which is impossible.
• Isoquants are convex to the origin. The
property of convexity implies that the
slope of the isoquant diminishes from
left to right along the curve.
Convexity of an isoquant is the result
of the principle of diminishing
marginal rate of technical substitution
(MRTS) of one factor in place of the

Economic Region of
Production
A ridge line is the locus of points of isoquants
where marginal product of input is zero.
 the upper ridge line joins all such points
(for example, a, b, etc.) where marginal
product of capital (MPk ) is zero
 lower ridge line joins points where marginal
product of labour (MPL ) is zero (points c, d,
etc.).
 The production techniques are technically
efficient inside the ridge lines.
 Outside the ridge lines, the marginal products
of inputs are negative, i.e., more of both
inputs are required to produce a given level
of output.
 Obviously, no rational producer would like to
operate outside the ridge line. Thus, the
economic region of production is the region
bounded by the ridge lines.

Marginal Rate of Technical
Substitution (MRTS)
A marginal rate of technical
substitution is the rate at
which factors can be
substituted at the margin
without altering the level
of output.
More precisely, marginal
rate of technical
substitution of labour for
capital may be defined as
the number of units of
capital which can be
replaced by one unit of
labour, the level of output
remaining unchanged.

MRTS
Formula
• MRTS of labour for capital =
ΔK / ∆L
=Amount of capital given up /
Amount of labor used ……(4)
ΔK represents change in units
of capital and ∆L, change in
units of labour.
Note:
• MRTS at a point on an isoquant
= the slope of the isoquant at
that point.
• The property of diminishing
MRTS results in convexity of
the isoquant.

Returns to Scale (Production with all
Variable Inputs)
Returns to Scale (RTS): Returns to scale refers to the rate by which
output changes if all inputs are changed by the same proportion.
1. Increasing Returns to Scale. It occurs when output increases by
a greater proportion than the proportion of increase in all the
inputs.
2. Constant Returns to Scale. It happens when output increases by
the same proportion as of inputs increase.
3. Diminishing Returns to Scale. It occurs when output increases by
a smaller proportion than the proportion of in input increases.

hypothetical schedule and
diagram

Returns to Scale and Homogeneity of The
Production Function
Suppose we increase both factors of the function : X0 = f (L, K)
by the same proportion t, and we observe the resulting new level of output
X*: X* = f (tL, tK)
• If t can be factored out (that is, may be taken out of the brackets as a
common factor), then the new level of output X* can be expressed as a
function of t (to any power v) and the initial level of output
• X* = tv f (L, K) or X*= tv x0
• and the production function is called homogeneous. If t cannot be factored
out, the production function is non-homogeneous. Thus:
• A homogeneous function is a function such that if each of the inputs is
multiplied by t, then t can be completely factored out of the function. The
power v of t is called the degree of homogeneity of the function and is a
measure of the returns to scale:
1. If v = 1 CRTS . 2. If v < 1 ; DRTS. 3. If v > 1; IRTS

Some
example
Example of Non- homogeneous production
function
X0 = f (L, K) =L+K2
= tL+t2 K2
=t (L+tK2)
X* ≠ t X0
Homogeneous Production function
with constant returns to scale
Q =K 0.3 L0.7
= (tK) 0.3 (tL0.7)
=t0.3 K 0.3 t 0.7 L0.7
= t0.3 t 0.7 (K 0.3 L0.7)
=t1 (K 0.3 L0.7)
Q* =t1 Q
Q= K 0.3 L0.2 Q= K2 + L2 Q=2k2+L+KL Q=2k2+L2+KL Q=4k+4L2

Reasons for
Increasing and
Decreasing Returns
Reasons for operation of increasing returns
to scale are:
• Greater division of labour and
specialisation which increases
productivity.
• Use of more productive specialised
machinery.
•
Reasons for operation of diminishing returns
to scale are:
• The main reason for operation of
diminishing return to scale is difficulty
in management and coordination when scale
of operation becomes bigger and bigger.

Effect of Technological Change
on Production Function
• Technological change refers
to a change in the
underlying techniques of
production, as occurs when
a new process of production
is invented or an old
process is improved. In
such situations, the same
output is produced with
fewer inputs or more output
is produced with the same
inputs. These changes in
technology are called
technological progress or
innovation in processes.

Assignment on Technical and
economic Efficiency
Assignment Title: An economically efficient method of
production process is also technically efficient.
However, a technically efficient method of production
may not be an economically efficient one.
• Size: A4, Fonts: Time new Romans ; Line Space:
1.5

03. Theory of production.pdfsdfghbjn,kadsefghj

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