eco Unit 3: PRODUCTION

TECHNOLOGY:

It is the sum total of knowledge of the methods of producing goods and services.

It is the society’s knowledge about the industrial and agricultural arts.

It includes the methods of organisation and the techniques of production.

In economics, it is the current state of our knowledge of how to put resources together to produce
goods (& our knowledge of what can be produced)

INPUT:

It refers to any thing used by the firm in the process of production.

It includes every type of productive resource- land,

Labour, capital, time, human knowledge, etc.

They are usually complementary in nature-they are combined to transform into output.

Sometimes they may be substitutes to one another. In reality they are not perfectly substitutable
but they may have various degrees of substitutability.

Very specific inputs have zero or very low degree of substitutability.

SHORT-RUN ANALYSIS OF PRODUCTION:

The ‘short-run’ is defined as the period of time over which inputs of some factors cannot be varied.

That is, in the short-run, some factors of production are fixed and some are variable.

e.g. Size of the firm: machinery, equipments are generally fixed in the short-run.

In the short-run, output can be changed only by changing the variable factors combined with the
given set of fixed factor inputs.

That is, in the short-run, some factors of production are fixed and some are variable.

e.g. Size of the firm: machinery, equipments are generally fixed in the short-run.

In the short-run, output can be changed only by changing the variable factors combined with the
given set of fixed factor inputs.
LONG-RUN ANALYSIS OF PRODUCTION:

‘Long-run’ refers to a period of time long enough to permit changes in all the factors of production
employed by a firm.

This is therefore a time period over which all factors become variable.

There is no distinction between the fixed and variable factors in the long-run.

The scale of production can now be varied, as the size of plant (which remains fixed in the short run)
can now be changed.

There is full scope of adjustment between factors of production in the production process.

The production function is

In the short run

In the long run

Inputs Production Outputs

Function

MANAGERIAL USES OF PRODUCTION FUNCTION:

1. Determination of the least cost factor combination-minimise cost

2. Determination of optimum level of output
3. Determination of returns to scale

Further points-reference- Homework

THE LAW OF VARIABLE PROPORTIONS: SHORT RUN ANALYSIS

The law of variable proportions is the modern version of the law of diminishing marginal returns. It
can be stated as, “in the short run, under given technology, with other conditions remaining
unchanged, when more units of the variable factor are added to the fixed factors, the total product
initially increases at an increasing rate, then after a point it increases at a decreasing rate.”

Assumptions of the law of variable proportions:

The assumptions of the law of variable proportions are given as:
1. Only one factor is changed, all others remain constant;
2. The scale of production, size and efficiency of the firm remains constant;
3. The production technique does not change;
4. All units of the variable factor are homogeneous
Some concepts used in the Law:

1. Total Product (TP): it is the total number of units of output produced per unit of time by all the
factor inputs.

In the short run, the total output increases with an increase in the variable factor input.

2. Average Product (AP): it refers to the total product per unit of the given variable factor.

Average Product (AP) = total product

variable factor

3. Marginal Product (MP): it refers to the rate of measuring the change in total product with
respect to a unit change of the variable factor.

MPn = TPn – TPn-1

For e.g., when 14 workers are employed, the total product is 630 units. But when only 13 workers
are employed, it is 600 units, and the MP of the 14th worker will be:

MP14 = TP14 – TP14-1 = TP14 – TP13 = 630 – 600 =30 units

The following hypothetical production schedule of a firm helps explain this law further:

Units of variable Total Average Marginal Product (MP) Stages of

input – labour (n) Product Product MP = TP – TP the Law
n n n-1
(TP) (AP)

0 0 0 0 Stage I
1 10 10 10
2 24 12 14
3 39 13 15
4 52 13 13
5 60 12 8 Stage II
6 66 11 6
7 70 10 4
8 72 9 2
9 72 8 0
10 70 7 -2 Stage III
The above table shows the unit-wise increases of the variable factor, i.e., labour to the other fixed
factors; and the impact this has on the output produced.

Here the technology is kept unchanged.

From the table one can observe the following points:

1. The marginal product column clearly shows the working of the law of diminishing returns.

2. At first, with each unit increase of labour, the output increases at an increasing rate, i.e., the
marginal product keeps rising. The average product increases too. This is known as the
STAGE OF INCREASING RETURNS (STAGE I)

3. When it reaches at particular point, in the table this is when the fourth unit of labour is
employed, the marginal product begins decreasing. Here the total product increases at a
slower rate. This is the STAGE OF DIMINISHING RETURNS (STAGE II).

At the maximum level of average product, the marginal product is equal to the average

product. At the fourth unit of labour, AP =MP (13 units)

4. The marginal product continues decreasing, till it becomes zero and then negative. This is
STAGE III.

When the MP =0, the total product (TP) is maximum. In the table the highest TP is 72 units.

The MP=0 and nine units of labour are employed.

The MP then becomes negative, and the TP starts decreasing. The AP also decreases, but remains
positive.

These points are further explained with the following diagram:-

The law of variable proportions:

Explanation of the stages:

The law of variable proportions operates due to the following two characteristics of factors of
production: i) indivisibility of certain fixed factors; and ii) imperfect substitutability between factors.

Increasing returns: as more of the variable factor is added to the fixed factors, the combination gets
nearer and nearer to the optimum combination. This results in output rising in greater proportion
than the increase in the units of the variable factors getting employed.

The productive services of the indivisible factors such as manager and machines also get used more
efficiently.

Certain inputs particularly machinery, management etc. are available in large and lumpy units. Such
inputs cannot be divided into small sizes to suit the small scale of production.

For e.g. there cannot be half a machine, half a computer or half a manager. Such inputs have to be
employed fully even if the scale of production is small. Therefore, as the scale of production
increases, these indivisible factors are utilized better and more efficiently. This leads to increasing
returns to scale.

Decreasing (diminishing) returns: as more and more of the variable factor is added to the fixed
factors in order to increase the output, the firm tries to substitute fixed factors by variable factors.

Due to the imperfect substitutability between factors, when the fixed factors get over-utilised; the
marginal product decreases.

Negative returns: when the input of a variable factor is much more than the fixed factors in the
production function; their efficacy gets reduced.

Stages I and III are both are both irrational stages of production- In Stage I, the producer will realise
that there is under-utilisation of the factors, and there can still be an increase in the profits, with
higher employment of variable factor.

In Stage III, there is over-utilisation of the factors, and additional inputs would contribute to negative
marginal product.

THE LAWS OF RETURNS TO SCALE- LONG RUN ANALYSIS:

In the long run all factors can be adjusted; and are therefore variable.

When the factors are changed in the long-run, the changes in output are described as, “returns to
scale”. (In the short run, we have ‘returns to variable factor’)

The production function in the long run is shown as,

Q = f(a1, b1, c1, ....,n, T)

Where all the inputs are variable.

Statement of the law: Other things being equal, when all factors employed are increased in the long
run, the output first increases more than the increase in inputs, then both increase in the same
proportion, and finally the output increases less than proportionately.
Assumptions of the Law:

1. All units of the factors are homogenous,

2. The technique of production remains the same,

3. The returns are measured in physical terms

There are three phases of returns in the long-run:

1) The Law of Increasing Returns:

There are increasing returns to scale when a given proportionate change in inputs would result in
greater than proportionate change in the output.

This happens due to internal economies of scale like technical economies, managerial economies,
etc with expansion of the firm’s size.

The efficiency of labour and capital also increases with improvements in organisation.

Thus, improvements in large-scale operation, division of labour, use of better technology and
machinery, etc are the reasons behind the increasing returns.

2) The Law of Constant Returns:

As the firm continues to expand, the internal economies get exhausted, and the increasing returns
cannot keep on taking place forever. This then leads to the phase of constant returns.

Thus a given proportionate increase in inputs leads to an equally proportionate increase in the
outputs.

Here there is an exact balance between the economies and diseconomies of scale.

3) The Law of Decreasing Returns:

As the firm keeps growing, the diseconomies of scale become more powerful than the economies of
scale, and there is less than proportionate increase in the output than proportionate increase in the
inputs.

This is often due to reasons such as increased business risks associated with the large-scale firms; as
well as the fact that there are supervision and coordination problems in a large scale of production.

LABOUR LAND TOTAL PRODUCT (TP) MARGINAL PRODUCT (MP) RETURNS TO SCALE
in kg in kg

1 2 5 5 Increasing Returns to
scale
2 4 11 6 (Phase I)
3 6 18 7
4 8 26 8 Constant Returns to scale
(Phase II)
5 10 34 8
 6 12 41 7 Decreasing returns to
scale
7 14 47 6 (Phase III)
8 16 52 5

The above three phases can be explained in the following diagram:

The x axis shows different units of the factors of production, and the y axis shows the marginal
product. The graph ICDR shows the different phases of the Laws of Returns of Scale. The segment IC
shows the phase of increasing returns to scale, whereas segments CD and DR of the graph show the
constant and decreasing scale of returns to scale, respectively.