CONCEPTS OF PRODUCTION
3 STAGES OF PRODUCTION
SHORT RUN vs LONG RUN
RETURNS TO SCALE
ISOQUANTS AND ISOCOSTS
• We will see how firms can organize their
production efficiently and how their costs
of production change as input prices and
the level of output changes. The physical
relationship that describes how inputs are
transformed into outputs are focused
• Production refers to conversion of input to
output. But in economics production
means creating utility.
• The relation between input and output of a firm is termed
as the “ production function”.
• Production function deals with the maximum output that
can be produced with a limited and given quantity of
inputs. For example, the production function of a steel firm
takes into consideration, various inputs like labor, raw
material, power consumption, cost of land, etc. It also takes
into account the quantity of output that is being
produced, using all the above fixed and variable inputs.
Thus, production function deals with input as well as
output. A production function can be expressed as an
equation, table, or a graph.
• If a firm uses inputs like labor (L) and capital (K), then the
production function can be formed as
Q = f (K, L)
• Production function is a simple numerical relationship
between inputs and outputs
Concepts of Product
• There are three types of product concepts that
are crucial to the production function. Total
product, marginal product and average product.
• Total product is the total physical product or the
total amount of output produced by all inputs put
• Marginal product is the additional output
generated by one additional unit of input.
• Average product is productivity per unit of input.
Total Product, Average Product and
No of Labour units
• Cassels suggested that there are three stages of production for any firm. In
the first stage, the average returns are increasing. Marginal product also
increases up to a certain point, thereafter it starts declining.
• It can be observed from the graph that in the first stage, the marginal
product is greater than average product. As there is increasing returns in this
stage of production, it is known as stage of increasing returns.
• In the second stage of production, both average product and marginal
product are decreasing. Though marginal product is decreasing, it remains
positive in this stage. In this stage there is less than proportionate increase
in the output, as a result of the change in the variable input. In this stage,
the entrepreneur would like to make maximum utilization of the fixed
assets. This stage is known as stage of decreasing returns.
• In the third stage of production, total product is diminishing, and the
marginal product shows negative growth. Therefore, this stage is known as
stage of negative returns. It can be observed from the graph that the third
stage is the mirror image of the first stage.
3 stages of production
No. of Labour
• Short Run and Long Run:
In the production process, there are various types of inputs that go into the
production process. In production process, two different time periods are
discussed, short run and long run. In short run a firm can change its variable inputs
like labor, raw material, etc. While in the long run, all factors of production
including capital can be changed to alter the production levels.
The difference between short run and the long run can be illustrated through
If a farmer wants to increase the productivity, he can hire additional labor, or can
increase the quantity of seeds and fertilizers. Changes in these variable inputs can
be made at any moment of time, and requires not much effort and resources. On
the contrary, if the farmer wishes to change the crop, it takes considerable time
and investment as well. This change cannot be made in the midst of a season. In
the given case the decision of the farmer to increase the variable inputs like labor
is a short run decision, and making change in the crop is a long run decision.
An automobile company has installed capacity of producing 100 cars per week,
and currently producing 70 cars per week. If the demand increases, it can increase
the production by increasing the labor and raw material. If the demand persists
and increases drastically, rising to 200 cars per week, then the firm cannot increase
the production overnight. If it wants to install an additional plant, it requires huge
investments and time as well. Therefore, in this case the decision to increase the
labor is a short run decision, whereas decision to install a new plant or relocate the
plant is a long run decision. Thus, in the long run all the factors are variable.
• Improvements in technology help increase in production and raises
standard of living. Technological change leads to
• Process innovation
• Product innovation
• Process innovation: When improvements in the technology results in
improvements in the production methods, it is known as process
• Example: The introduction of optical fiber technology has transformed the
whole telecommunication industry. This has resulted in minimization of
costs for the companies offering telecom services. As the benefits are
passed on to the customers, it is resulting in lower telecom tariffs.
• Product innovation: Product innovation takes place, when new and
improved products are introduced in the market. Electronic goods industry
is witnessing rapid changes in the products. Product innovation has helped
in raising the standard of living. Many organizations rely heavily on the
product innovation, and have made it as a part of the strategy. The
advantages of the product innovation are difficult to quantify.
• Example: Intel the computer processor manufacturer launches a new
improved processor after a given period of time.
Returns to Scale
Returns to scale show the responsiveness of total product when all the inputs are
increased proportionately. Returns to scale is a factor that is studied in the long
run. Returns to scale can be constant, increasing or decreasing.
Constant returns to scale:
In this case, the change in inputs results in proportional change in output.
For example, if a firm is using three factors of production, land, labor and
capital, and if it doubles all these inputs, output should also be doubled.
Increasing returns to scale:
When rise in inputs result in more than proportional increase in the output, it is
known as increasing returns to scale.
For example, if a plant is producing 100 units of the product using 10 units of labor
and 100 units of capital. If the labor is doubled to 20 units and capital is also
doubled to 200 units, and the output generated is 250 units, then the firm is
operating at increasing returns to scale level.
Decreasing returns to scale:
When increase in all the inputs result in less than proportional increase in
output, then it is known as decreasing returns to scale.
For example, if a firm increases all its inputs by 20 percent and the resulting
increase in the output is just 15 percent, then it is the case of decreasing returns to
Diminishing Marginal Returns
• There are two ways in which a firm can approach the optimal production
function. First, a firm can keep the input rate of one factor constant. In
the second approach both the inputs are allowed to vary. If any of the
input is fixed for a particular period of time, it is known as short run. In the
short run, atleast one input is fixed, whereas in the long run all the inputs
can be varied. A firm can add variable inputs in the short run to meet the
immediate requirements, but in the long run it needs to put in more
capital. Thus, it can be said that firms operate in the short run but plan in
the long run.
• According to the law of diminishing returns, we get less and less extra
output with the addition of an input, holding other inputs constant. It
means that the marginal product of each unit of input declines, as the
• The law of diminishing returns is not only applicable to industry, it is
equally applicable to agriculture as well. Suppose a farmer has a fixed area
of land, his marginal productivity will increase to a certain point, beyond
which the additional labor yields negative returns.
• It helps in allocating scarce resources. Suppose a firm feels that it has
surplus labor in any of the plant, it can divert those labors to any other
unit, or can make use of them for some other purpose. It also helps in
determining the input combination that yields maximum output.
Example for Diminishing marginal returns
• A firm producing readymade shirts has a limited shop floor
area and has 25 machines and 25 workers. Using these
resources, firm could produce 100 shirts per day. To
increase production, the firm hired 2 additional workers.
This resulted in marginal increase in the production. To
increase the production further, the firm hired three
additional workers. This has declined the production of
shirts to 90 shirts per day, instead of increase in production
of shirts. This happened because workers were not feeling
convenient while working because of lack of working space
and less number of machines. Though, the number of
workers was increased, but the area of shop floor remained
unchanged. This has resulted in deterioration of the
working conditions, leading to decline in production.
Hence, law of diminishing marginal returns was into play.
The Production Isoquant
• If a firm is having two variable inputs, the approach to
determine the optimal input rates is completely different.
In this scenario, the problem of efficient resource allocation
can be solved in two ways.
• Maximize the production, utilizing the available resources.
These two problems are known as constrained optimization
problems. The problem of resource allocation can also be
solved by producing the profit maximizing output.
• Isoquants also known as production-indifference curves,
represent the combinations of inputs that produce same
quantity of output. This can be explained with the help of
• It is assumed that the there are two factors
of production - labor and capital. In the
given example, the factor combination A
consists of 2 units of labor and 24 units of
capital producing the required output of
100 units. Various combinations of the
factors labor and capital for the isoquant
are shown in the figure. Each isoquant
curve represents the specified level of
Marginal Rate of Technical
• MRTS can be defined as the number of units of one input that can be
replaced by one unit of another input, keeping the level of output
constant. If labor and capital are two inputs, MRTS of labor would be the
number of units of capital that can be replaced by one unit of labor.
• In the given case, when we move from combination A to combination B, 4
units of capital are replaced by one unit of labor. The marginal rate of
technical substitution on a point on an isoquant is the slope of the
isoquant at that point.
• The following are the properties of isoquants:
• They slope downward towards right indicating that if the utilization of one
factor increases the utilization of another decrease.
• The higher isoquants represent higher output. If one factor is kept
constant, and the other factor is increased, the output level also increases.
• As there is no common point on the two isoquant curves, they cannot
• Isoquants are convex to the origin because it becomes more difficult to
substitute one factor of production by other as we move along isoquant
and increase the use of one factor to substitute the other factor.
• Isocost line provides various combinations of inputs that can
be employed at a given level of cost. Isocost lines give
information regarding costs. Suppose a firm is using two
inputs, labor and capital, isocost lines provide various
combinations of labor and capital that a firm can hire at a
given level of cost.
• Since isocost is concerned with the prices, they are also
known as price lines. Isocost helps in determining the
combination of inputs that gives maximum output. It helps a
firm to minimize the costs, and thereby increase the profits.
• The slope of the isocost line shows the ratio of the price of
labor to the price of capital or price of capital / price of labor.
Least Cost Combination
Any rationale firm would like to maximize its output with the least cost. In order to
attain this, a firm should have a least cost combination. Least cost combination is
attained at a point where the isoquant touches the isocost line. Thus, the least
cost input combination is that combination where the slope of the isoquant is
equal to the slope of the isocost. Thus, the least cost combination depends upon
both isoquants as well as isocost.
The least cost combination can be explained with the help of the given figure . It
can be seen that the Y axis of the curve represents capital and labor is represented
by X axis. In the given case, producer wants to produce 500 units of output.
Producer has the option of using various combinations of labor and capital on the
isoquant curve R, S, E, T, and J.
It can be observed from the figure that cost will be minimum at point E where the
isocost line CD is tangent to the isoquant Q, whereas all other points R, S, T, and J
on isoquant Q are on higher isocost lines when compare to CD. At these points,
higher costs are incurred in producing the given output. The factor combination E
is the optimum combination under the given conditions. Therefore, the tangency
point of an isoquant with an isocost line represents the least cost combination of
factors for producing a given output.
• Expansion path can be defined as the locus of different
equilibrium points where there is an increase in the
expenditure of the firm, with no change in the price of
the inputs. Expansion path reveals the change in the
factor combinations when output and expenditure
changes, with no change in the input prices.
• If there is an increase in the firm’s expenditure without
increase in the price of input, there will be a parallel
shift in isocost line. In this case, each isocost line gives
a new tangency point and new equilibrium point. It can
be observed in the given figure that after joining all
equilibrium points the expansion path (P) is arrived at.
Types of economies
• Internal economies
• External economies
• Internal – advantages that arise as a result of
the growth of the firm
– Risk Bearing
How do unit or average costs fall as the scale of
production increases? 1
• Technical economies – using large scale productive equipment. Whilst
this equipment is expensive the large output leads to reduced unit costs. To
acquire such equipment requires that the business has the finance and the
• Marketing economies – selling in bulk reduces admin / transport costs.
Also large scale selling can be supported with a marketing budget that does
not need to increase with the sales revenue generated. Eg a television advert
costing $1m can support $4m sales a day or $8m sales a day.
• Financial economies – larger businesses are simply less likely to go
bankrupt and they have sizable assets they can use as collateral. They can
negotiate the interest they pay on loans and even issue their own debt
How do unit or average costs fall as the scale of
production increases? 2
• Managerial economies – as businesses expand they employ specialist
managers. The boss with a eye on each business function becomes
departments staffed by specialists.
Whilst this increases the managerial salary bill these managers are experts.
Human resource managers now recruit better suited candidates who fit
with the organisation’s needs and culture. Employees stay longer, are more
motivated and more productive.
Production managers can re-arrange production so that it is more efficient
and they have better knowledge regarding what equipment to purchase.
• Purchasing economies – bulk buying discounts
• External economies are the advantages firms can gain as a
result of the growth of the industry – normally associated
with a particular area
• Supply of skilled labour
• Local knowledge and skills
• Training facilities
• These occur when an industry develops in a certain
• Pool of trained workers
• Ancillary services – marketing, accountancy to
• Co-operation between businesses eg on research
• Development of specialist suppliers of components
and raw materials
Diseconomies of Scale
• The disadvantages of large scale production that
can lead to increasing average costs
– Problems of management
– Maintaining effective communication
– Co-ordinating activities – often across
– De-motivation and alienation of staff
– Divorce of ownership and control
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