FMG 24: Theory of Production

Managerial Economics
Dr. Subhasis Bera

What to produce and how to produce?

Your mother makes delicious Puri and Sabji.
Your friends are mainly visit your house to
have Puri and Sabji. How your mother
manages kitchen when there are five
friends as guest and how does she changes
of doing things at kitchen when there are
twenty five of your friends are visiting your
house just to have Puri and Sabji?

How does she manages her resources ( raw material as well as labor help) to
prepare sufficient amount of Puri Sabji without wasting anything

What to produce and how to produce?

As a manager once you know the demand for a particular product which has utility,
next thing that you need to consider is how to create that utility.

This creation of utility is possible by any of three following way

i) by change in the form of goods
ii) Change in the temporal form of goods
iii) Increase in the quantity of goods

what to produce and how to produce?

Creation of utility is known as the production

From the demand analysis a manager can decide what to produce

A manager must know the volume of the factor inputs to be used to produce a
certain amount of output

Introduction
Production is a process of transforming the inputs into goods and services.
There are numbers of inputs required to produce a particular types of good or
services and therefore production function can be represented as

q f (L, K,T,E,O,....)
The production function refers to the physical relationship between the inputs
or resources of a firm and their output of goods and services at a given period of
time, ceteris paribus.

Here technology determines the type, quantity and proportion of inputs.

Technology(T) also determines the maximum limit of total output from a given
combinations of inputs. We need to remember that at a particular point of time T
is constant and therefore T is included only in the long run production functions.

Operational Time Period: Short Run and Long Run

The production function is dependent on different time frames. Firms can produce
for a brief or lengthy period of time.
Short run is a time period when at least one factor input remain constant.
In the long run all the factor inputs are variable.
Therefore SR production function is

q f (L, K)

From this production function we can calculate Average Product and Marginal
product of any factor input.
From the above we can get AP TP q
L

and

MPL

(TP) q

L
L

Short run Properties: Law of Variable Proportion

From the production function it is obvious that changes in the input will change the
volume of output. In SR changes in the output due to the change input follows law of
variable proportion. Law of variable proportion states that with increase in the
quantity of the variable factor, its marginal and average products will eventually
decline while other inputs remain unchanged. This law of variable proportion also
known as law of diminishing returns.
K

TP

You can think of you new mobile or

new laptop or tablet to understand
law of diminishing returns

Note: this law never say when it will start to take effect. It assumes that all
the inputs have the same productivity which is not true

Impact of Technology
In SR technology is fixed. Therefore change in technology have impact on the
production function in the long run.
Since LR is a sum total time of number of SR therefore a change in technology will
only shift the production function, ceteris Paribas.
TP

TP3

TP2

TP1

AP and MP of Short Run Production Function

Slope of Tangent at any
point measures MP of
variable factor input

Total Q

TP

Slope of the line joining

origin and the point
measures AP

Maximum MP
A

L1

L2

L3

A manager must keep this

relation in mind for future
Labor
reference

Three Stages of Production

TP

TPL

L1

AP,MP

L2

L3
Stage II
MP<AP
AP decreasing
MP still positive

Stage I
MP>AP
AP increasing

L
Stage III
MP<0
AP decreasing

APL
L1

L2

L3

L
MPL

Three Stages of Production

Stage I: from zero units of the variable input to where AP is maximized (where MP = AP)
Stage II: from the maximum AP to where MP = 0
Stage III: from where MP = 0
Increase in the volume of one factor input increases the efficiency of use of fixed factor
and therefore TP increases at increasing rate. This is known as first stage of production.
At this stage both AP and MP increase.
In the second stage, after the efficient use of fixed input, increase in variable input
increases the production at a decreasing rate because of the law of diminishing return.
At this stage MP is falling but still MP > AP.
In the third stage of production increase in the variable input reduces the volume of
production i.e., it gives the negative return and here both AP and MP fall and MP < AP.

It is obvious that none of the firm will operate at stage III.

None will operate at stage-I as they will continue increasing variable input as long
as AP and MP increase.

Short Run Equilibrium: Optimum level of Single Output

To determine the optimum level of factor inputs we need to know the MRP (marginal
revenue product ) and the cost of labour.
Where, MRPL=change in total revenue due to a change in the volume of labour input used
MRPL =

d (TR) d (TR) dQ
=
=MR. MPL

dL
dQ dL

And MLC= change in the total labor cost due to a unit change in the volume of labour
engaged in the production process.
Now if total labour cost = w. L, then MLC = w
Therefore from the profit maximizing condition (MRP = MLC) we can have that firm will
employ the variable factor input in such a way so that
MR.MPL w
MR w / MPL

Therefore in case of multiple variable factor input optimum level will be derived from the
condition

MP1 MP2 MPk

w1
w2
wk

Long Run Production Function

In LR all the factor inputs are Variable.
There are various combinations that yields the same level of output.
Locus of combinations of two factor inputs that yields same level of out is called
isoquant.
Properties of IQ

1) Downward slopping from left to right

2) Convex to origin

K1

3) Two IQ never intersect each other

C
K2
K3
B
L1

L2

L3

Q( L, K ) Q1
Q( L, K ) Q2

Marginal Rate of Technical Substitution (MRTS)

Its the amount of one factor input that must be substituted for 1 unit of another input
to maintain a constant level of output.
MPL
MRTS

Slope of Isoquant =
LK
MPK

MRTSLK diminishes as amount of substitution increases.

K per period

KA

B
KB

q = 20

LA

LB

L per period

Factor Input Substitutability

Depending on the factor input substitutability we can have various types of
isoquant.
1) Linear Isoquant
2) Right-Angle Isoquant or Input-Output Isoquant
3) Convex Isoquant

Linear Isoquant- In Linear Isoquants there is perfect substitutability of inputs.

e.g., In a power plant equipped to burn oil or Gas. Various amounts of electricity
could be produced by burning Gas, Oil or a combination. i.e., Oil and Gas are
perfect substitutes.
Input-Output Isoquant- in this case factor inputs are not substitute.
Convex isoquant- in this case factor input Substitutability are limited

Ridgelines: Economic Region

1. a firm will continue to employ a

factor input unless its MP
becomes negative. Therefore
threshold level for employing a
factor unit is MPx = 0

MPK =0

MPL =0
L

2. Ridgeline is the locus of points

on the isoquants where MPx is
zero.
3. Firm will substitute factor inputs
within the ridgeline.
4. the isoquant in between the
ridge line known as economic
region where input substitution
is economically viable.

Return to Scale
In Long Run if all the factors are changed in same proportion then new can say that
there is a change in the scale of production.
Changes the volume of output due to Proportional change in the input is known
Return to Scale (RTS).
Depending on the changes in the volume of output we can have IRS, DRS and CRS.

Return to Scale: IRS, DRS, CRS

Consider a 450 line which shows the factor input ratio remain same on the line.

Distance between a and b = that of b and c CRS

Distance between a and b < that of b and c DRS
Distance between a and b > that of b and c IRS

K per period

c
c
b
a

q=3

q=3
q=3
q=2
q=1

L per period

Return to Scale: Mathematical

Returns to scale can also be described using the following equation

hQ = f(kX, kY)
if h > k then IRS
if h = k then CRS
if h < k then DRS
Many production system exhibit first increasing, then constant and then decreasing
return to scale. The region of increasing returns is attributable to specialization. As
output increases, specialized labour can be used and efficient large-scale
machinery can be used in the production process.
Beyond some scale of operation, however further gains from specialization are
limited and coordination problems emerge.
When coordination expenses more than offset additional benefits of specialization,
decreasing returns to scale set in.

Isocost Line
Isocost lines shows the combination of two factor inputs that a producer can
purchase at given prices and income.
Equation of the isocost line is M= PL .L + PK .K
K
K2
K1

L2

L1

L3

Producers Equilibrium

Equilibrium condition is
Slope of Isoquant = Slope of Isocost Line

C
W1

K2
K1

Iq3
Iq2

Iq1

L2

L1

W2

W1

At equilibrium producer maximises its profit

Producers Equilibrium: Managers Problem

Now we assume that our production function is Q=f (L,K)

Isocost line is PL .L + PK . K = Y
Objective of a manager is to make maximum profit out of the production and there
to maximise the gap between income and expenditure.
There are two ways manager can maximise profiti) by maximising output keeping the cost constant
ii) by minimising cost keeping the output level fixed.

Producers Equilibrium: Output Maximization

In this case our problem is

Therefore from FOC we get

Max M= f ( L, K ) (Y PL L-PK K)

M f ( L, K )

PL 0..................(i)
L
L

and

M f ( L, K )

PK 0................(ii)
K
K

and

M
Y PL L PK K 0............(iii)

MPL MPK

Now solving (i) and (ii) we get

PL
PK

i.e., optimal input proportion require that the ratio of marginal product to price
must be equal for all input factors.

Producers Equilibrium: Cost Minimization

In this case our problem is

M PL L PK K [Q * f ( L, K )]

Therefore from FOC we get M PL . f ( L, K ) 0..................(i)

L

and

M
f ( L, K )
PK .
0................(ii)
K
K

and

M
Q* f ( L, K ) 0............(iii)

Now solving (i) and (ii) we get

MPL MPK

PL
PK

i.e., optimal input proportion require that the ratio of marginal product to price
must be equal for all input factors.

Various Types of Production Function

There are various types of production function.
i) Cubic form ,
Q a bL cL2 dL3
where a, b, c are coefficients
ii) Quadratic function Q a bL cL2

iii) Power function

Q aLb

A very widely used production function is Cobb-Douglas Production function and

represented as

Q aL K

Where, a = Total factor productivity

, are output elasticities.

Cobb-Doglus production Function: Properties

q aL K

01. For Q to be a positive number both the factor must exits i.e., if either of the factor vanishes
then so the output.
02. This production function exhibit increasing, decreasing and constant return to scale.
Originally CD assumes that returns to scales are constant.
(+ ) represents the return to scale .
If (+ ) > 1 the there is IRS
If (+ ) = 1 then there is CRS
And if (+ ) < 1 then there is DRS

03. This allows calculating MP of any factor input keeping other constant and there this is useful
for short run analysis also.
04. Parameters can be estimated using linear regression model.
05. A Theoretical production function assumes technology is constant. However the data fitted
by the managers may span a period over which technology has progressed. One of the
independent variables in the previous equation could represent technological change and thus
adjust the function to take technology into consideration.
06. it has attractive mathematical characteristics, such as diminishing marginal returns to either
factor of production.

Cobb-Doglus production Function: Limitation

q aL K

The Cobb-Douglas production function was not developed on the basis of any
knowledge of engineering, technology, or management of the production process.
Neither Cobb nor Douglas provided any theoretical reason why the coefcients and should be
constant over time or be the same between sectors of the economy. Remember that the nature of the
machinery and other capital goods (the K) differs between time-periods and according to what is
being produced. So do the skills of labor (the L).

This does not allow to calculate MP going through all three stages of production in
one specification ( a cubic function would be necessary to achieve this).

This can not show a firm or industry passing through, increasing, constant and
decreasing returns to scale.
There are also problem of specification of data to be used in empirical estimates.

Leontief Production Function

This is an extreme case of perfect complements of the factor inputs. This
production function has L shaped isoquant.
Production function represented as
L K
Q min ,

and if L K then Q K

and K is considered to be binding constraint in the production process.

CES Production Function

A special type of production function ( introduced by Arrow, Chenery, Minhas and
Solow and known as ACMS function) represented as

Q A K (1 ) L

Where A = efficiency parameter

= Distribution parameter that shows the relative factor shares
= substitution parameter which help us to derive elasticity of substitution
r = scale parameter which determine the degree of homogeneity

Estimation Production Function

After formulating the model, one can estimate the production function.

There are mainly three methods of estimating production function

Time series Analysis

Cross Sectional Analysis

Engineering Analysis
Now collect data from the Prowess Database and
estimate the production function for metal industry
for the period 2000-2015
This is an Assignment

Thank You!

She is also producing something as per the demand of her children. Short of
resources does not allow her to meet the demand and she is identified as poor one