1. THEORY OF PRODUCTION
Meaning of production
Production is an economic activity that makes goods available for
consumption. Production at times is also defined as all economic activities
minus consumption. It is the process of creating goods or services using
various available resources.
Production function and Factors of production
Production function shows the relationship between the quantity of a
good/service produced (output) and the factors or resources (inputs)
used. The inputs used for producing these goods and services are called
factors of production.
Variable factor of Production: A variable factor of production is one
whose input level can be varied in the short run. Raw material inputs
are a variable factor and unskilled labour is usually thought of as a
variable factor.
Fixed factor of production: A fixed factor of production is one whose
input level cannot be varied in the short run. Capital is usually a fixed
factor. Capital refers to resources such as buildings and machinery etc.
Thus production generally represented as a function of capital and labour.
Q = F (K, L)

2. Production Possibilities frontier
Production possibilities frontier (PPF) curve represents all combinations of
goods and services that can be produced using the available goods and
resources.
The PPF curve is also called Transformation curve. This curve shows the
maximum quantity of goods/services that can be produced given the
availability of the factors of production.
As can be seen from the figure below point X lies beyond the PPF curve and
thus the output level of X can’t be reached. Similarly point A lies below the
PPF curve which means that the production is below the efficient
level. Points B, C and D are different combinations of quantity produced of
Good X and Good Y. At all these points the resources or inputs are efficiently
utilised

3. Isoquants
Isoquants are those combination of inputs or factors of production which
provides an equal or same quantity of output. Isoquant curves are also
called Equal product or isoproduct curve. For a production function which
denotes isoquant:
Q=F(L,K),
Q is fixed level of production
L = labour and K = Capital are variable
The table below shows different combinations of labour and capital required
to produce 100 shirts
Labour Capital Output
(L) (K) (Shirts)
10 90 100
20 60 100
30 40 100
40 30 100
50 20 100

4. Different resources/ inputs are required for production of goods. Same
number of outputs can be produced using different input combinations.
Isoquant is the combination of all such combination of inputs which produces
same output. Thus we have an isoquant curve for every level of output.
Since the quantity produced will remain unchanged on an isoquant, the
producer is indifferent for different input combinations.
In the figure below the producer will be indifferent on points A, B and C since
they are on the same isoquant. Also he cannot move to D without increasing
both the inputs and would not produce at E due to inefficiency
Similar to Indifference curve as one move to the right of the isoquant, one
reaches a higher level of production.
Returns to a factor
In the short run the output can be increased for a production function by
increasing the amount of the variable factor, usually taken to be labour.
Thus the responsive change in the output due to a change in the variable
input keeping all other things constant is called returns to a factor.
Law of variable proportions
In short run the output of goods and services is increased by introducing
additional variable factor to the production process to a said quantity of fixed
factors.
Law of variable proportions outlines the various possible output scenarios
due to the change in the proportions of fixed and variable factors used for
production. If we increase the number of a factor (labour) keeping all other
factors fixed (capital), then the proportion between the fixed and variable

5. factors is changed.
The law of variable proportions implies that as we keep on adding the
variable factor of production the marginal product of that factor keeps on
decreasing progressively. Thus after a point every additional unit of factor
added will result in a smaller increase in output.
The law of variable proportion is also known as law of diminishing marginal
returns or law of diminishing returns.
The law has several assumptions as below:
one input is variable while others are fixed in the short run
all units of the variable input are same and have equal efficiency
no change in production technology
factors of production like land and labour can be used in different
proportions
Take for instance, hiring additional employees (a variable resource) to work
at a factory will initially increase output but eventually it will become more
and more difficult to generate additional output from the fixed resources
(due to plant size and equipment limitations) and thus the total output will
increase at a decreasing rate and ultimately will start decreasing
To further understand this let us consider an example of production of shirts
in a factory
Refer to the table below:
Marginal product
Labour Total Product Average Product
(shirts per additional
(workers/day) (shirts per day) (shirts per worker)
worker)
1 2 - 2.00
2 5 3 2.50
3 9 4 3.00
4 12 3 3.00
5 14 2 2.80
6 15 1 2.50
7 15 0 2.14
8 14 -1 1.75
The numbers in the above table shows that as additional number of workers
are put on work the total production of shirts increases.
Total product is the maximum output that a given quantity of input can produce
Marginal product is the increase in total output due to an increase in a unit of input
(labour) with all other inputs remaining constant.
MP=∆TP/∆L or MPn=TPn-TPn-1
Average product is the average quantity of shirts produced by each worker. This tells us
how productive workers are on an average.
AP=TP/L

6. As we can see from the above table, marginal product at first increases and
then starts decreasing. Average product also similarly first increases and
then starts decreasing. The relationship between these 3 product concepts
and input can be further explained using the three product curves below

7. In the figure above the input (labour) is shown on x axis while the output
(shirts) are shown on the y axis. As we can see from the figure upto three
input units the production increases at increasing rate and thus marginal
product (MP) is highest. After this MP curve starts declining and intersects
average product (AP) curve. At this point AP is highest and after this AP also
starts to decline. At 7 input units the total product is maximum and MP is
zero. Thereafter TP starts decreasing leading to negative marginal product
The three stages of production as shown above in the figure above can be
summarised as follows:
Total Product(TP) Marginal Product (MP) Average product (AP)
Stages
Stage 1 Increase at increasing Initially increases and reaches Increases and reaches its
rate and than at the maximum point, thereafter maximum. At this stage
diminishing rate starts decreasing AP=MP
Stage 2 Continues to increase Continues to decrease and Starts to diminish. Remains
and reaches its reaches to zero above the MP curve
maximum
Stage 3 Starts decreasing Moves to negative territory Continues to decrease but
always remains above zero
Relationship between MP and TP
From the above table and figure we can identify the following relationship
between MP and TP
As long as MP is increasing, TP will increase at increasing rate
When MP starts diminishing, TP will increase but at a decreasing rate
When MP is zero, TP remains unchanged and is at its maximum. Thus
At MP=0, TP is maximum
When MP is negative, TP starts decreasing
Relationship between MP and AP
Similar to the relationship between MP and TP, we can also observe the
relationship between MP and AP from the table and figure discussed above
AP increases till MP>AP

8. AP decreases when MP<AP
AP is maximum when AP=MP
MP can be zero or negative, but AP continues to be positive always
Returns to scale
In the long run output of goods can be increased by increasing all the factors
(i.e. both labour and capital). In the long run all factors are variable, thus
the responsive change in the output due to proportional change in the size
or scale of inputs or factors of production is called returns to scale.
For instance, if the initial production function is as below:
P= f(K, L)
and the factors of production K and L are increased in same proportion, than
the new production function will be:
P1= f(aK,aL)
Constant returns to scale: When P1 increase in the same proportion
as the factors of production it is called constant returns to scale. Thus
in this case
P1/P = a
Decreasing returns to scale: When P1 increases less than the
proportionate increase in the factors it is called decreasing returns to
scale, i.e.
P1/P < a
Increasing returns to scale: if P1 increases more than the
proportionate increase in the factors of production it is called
increasing returns to scale, i.e.
P1/P > a
The three stages of returns to scale are also explained with the help of the
table below:
% increase in % increase in Returns to
Labour Capital Total Product
inputs total product scale
1 2 - 10 -
2 4 100% 30 200%Increasing
3 6 50% 60 100%Increasing
4 8 33% 80 33%Constant
5 10 25% 100 25%Constant
6 12 20% 110 10%Decreasing
7 14 17% 120 9%Decreasing

9. 8 16 14% 125 4%Decreasing
constant returns to scale if (for any constant a greater than or equal to 0)
F(aK, aL) = aF(K,L)
increasing returns to scale if (for any constant a greater than 1)
F(aK, aL) > aF(K,L)
decreasing returns to scale if (for any constant a greater than 1)
F(aK, aL) < aF(K,L)