MANAGERIAL ECONOMICS

SECTION 1

CHAPTER 4

PRODUCTION ANALYSIS
WEIGHTAGE IN FINAL EXAMS 5 TO 10 MARKS









 Ÿ Production:
Production is an activity that creates
utility or value. It includes any process that transforms inputs
into output since production refers creation of utility with
exchange value; it may take any of the forms like form utility,
place, time & service utility.
E.g.
1) Furniture made of wood Changing the shape.
2) Food grains are shifted from Farm to the city market by
grain merchants.
3) Storing and preserving certain goods over a period of
time.
Doctor, lawyers, Teachers, Bankers etc...Service utility.

x According to Prof. Nicholson:-

“Production is the creation or additional of those economic
utility which in general are the result of labour possesses
exchange value and are appropriate.”






 ¾
Production function:
Production function expresses a relationship between
output & input under condition of given technology. Thus,
given the technical conditions of production, the output of a
particular type of goods depends on the quantity of 2 or more
inputs.
Q = F [Labour, Land, Capital, Mgt, Technology]
Here Q is quality of output of output which can be
produced by combining inputs land, labour, capital; mgt. F is
function relationship between output and input.
Thus, above equation explain that the quantity of output
produced depends on the quantities of input produced
depends on the quantities of inputs which are used for
producing the commodity.
There are two types of production function.
1. Short run.
2. Long run.
Q – What is production? Explain factors of
Production.

Introduction:
Production consists of producing, storing and distributing
goods and services supply of a product refers to its quantity
which the seller is ready to offer at a given price once
demand for the product known it’s quantity supplied depends
on the factor like production conditions of the sellers which
include technology input supply managerial efficiency etc...

Meaning:
For a lay man, production means creation of new goods and
services, as if from now here. But in economics production
generally means transformation of inputs into output of
goods and services. This process of transformation can be
any one of the following 3 kinds.
i. Change in form e.g. milk into ice-cream
ii. Change in Place e.g. transportation
iii. Change in time e.g. storage.
Factors of production:
Whenever a commodity or a service is to be
produced, it requires input, also called factors of production.
In a broad sense inputs are classified into Land,
Labour, Capital, Organisation or management and
technology the inputs or factors of production that they yield
optimum output at minimum cost in the given situation. We
shell discuss each factor of production briefly as below:

Land:
It is one of the basic factors of production because
without land no production can take place. Land is a free gift
of nature its supply in absolute terms in perfectly inelastic, it
is immobile, it differs in quality in terms of fertility and location
both and finally the properties of land are indestructible.

Labour:
Like land, Labour also is a basic factor of production
because like land, without labour also nothing can be
produced. It includes mental and physical labour both in
other words any one offers his services in return for a
reward, called wages is to be included in the category of
labour.

Capital:
Capital is a man-made factor of production and is
defined as the produced goods of production. It includes not
only its financial component but also plants, machinery,
tools, raw-materials etc... With the help of which capital
goods can be purchased and more economic wealth is
created. In other words, when prudently used, it multiplies
itself. It is a man-made input in the sense that it is generated
form savings which is a residue of income after consumption
expenditure is incurred by the community, Symbolically y –
c= s, where y is the aggregate saving, provided that y > c ,
when savings are invested in take the form of capital. Capital
is a complementary factor of production. It is perishable and
mobile capital in each group identical

Organisation or management:
Like capital, organisation or management is also a
complementary factor of production. Production is a process
in which various factors of production are mobilised and
brought together. This activity is generally shouldered by an
entrepreneur who takes the risks and bears the uncertainties
associated with production.

Technology:
This is the most modern form of factors of production it
is prevalent these days. Technology implies the use of the
mechanical arts and applied sciences in the process of
production. The type of technology used in production
determines the rate of output as well as the quality of the
products. Technology depends upon research and
development as well as on innovations.
Q– Law of returns?
There are 3 laws of returns.
1. The law of diminishing returns.
2. The law of constant returns.
3. The law of increasing returns.

oWhen increase in output is equal to the proportionate

increase in factors of production we have constant
returns to scale.

oWhen the increase in output is more than the

proportionate increase in the factors of production,
we have increasing returns to scale.

oWhen the increase in output is less than

proportionate increase in the factor of production we
have diminishing or decreasing returns to scale.

x Increasing returns is known as decreasing cast

because per unit cost decreases.

x Constant returns is known a constant cost (if you more

forward with production then you will get decreasing
returns. It suggestions to stop your production)

x Decreasing returns is known an increasing cost

because the per unit cost increases.
 Law of diminishing returns
Description:
The law of diminishing returns is one of the most
fundamental law of economics and it is nothing but a
generalization drawn from the experience of farmers. A
Scottish farmer is said to have been the first to state this law.
All the farmers know that they can not raise on unlimited
amount of produce from 1 acre of land as he cultivates more
intensively by applying more and more units of labour and
capital. After a certain stage the produce does not increase
in the same proportion. In other words the returns from land
after a certain point do not increase in the same proportions
as compared to the expenditure incurred i.e. the returns
increase but at a diminishing rate.
Marshall has stated this law as follow “An increase in capital
and labour applied in the cultivation of land courses in
general less than proportionate increase in the amount of
produce raised, unless it happens to co-inside with an
improvement in the art of agriculture.
Explanation of the law:-
The law makes clear the following 2 points:
1) The phase “in general” is important. It emphasises the
point that in ordinary course of time this tendency
should operate but there are certain cases where the
successive units of capital and labour may give
proportionate increasing returns. But however the law
would not be wrong. The law states that beyond a
cultivation of land has been reached, every further
increase in the amount of labour and capital applied to
 its produces less than proportionate returns. In other
words, it is only after a certain stage that the successive
units of labour and capital give diminishing returns. The
law refers to the marginal produce and not to the total
produce i.e. it is not that the total returns from land
diminish but that the additional returns as a result of the
additional expenditure is less than proportionate to it.
2) The phase “unless it happens to co-inside with an
improvement in the area of agriculture is also important”
this means that if improvements are introduced in the
method of cultivation the tendency to diminishing
returns will not operate. But if all the things remain the
same and no improvements are introduced in the
method of cultivation. The law will hold good.
Units of
Total Average Marginal
capital &
production production production
labour
10
1 10 10
increasing
2 22 11 12
14
3 36 12
constant
4 50 12.5 14
11
5 61 12.2
diminishing
6 68 11.3 7
 Let us suppose that a farmer has a plot of land
worth. 10 acres it is interested in increasing the
production of his plot of land and he applies more and
more units of labour and capital on the same pot of
land.
In the diagram along OX axis we measure the
units of labour and capital and along the OY axis we
measure the marginal output the production first
increases at an increasing rate which is represented by
the line BC and ultimately the total production increases
at a diminishing rate which is represented by the line
CD. The law of diminishing returns operates after point
C. It should however be notes that the law of
diminishing returns do not state that the total produce
will diminish, the total produce increases but after a
certain point it increases at a diminishing rate.
 ¾
Assumptions of the law:
The law of diminishing returns is based on certain
assumptions. They are as follows:
1. The first assumption is that of the factors of
production is fixed or constant we have taken a
plot of acres of land and assume that the farmer
applies the successive unit of labour and capital on
this plot of land.
2. The second assumption is that all the different
units of a variable factor i.e. labour and capital are
homogenous.
3. The third assumption is that there is no
improvement in the art or methods of cultivation
production techniques remain the same. If
however improved methods improved seeds and
fertilizers are used the law may not operate.
4. The law assumes that it should be possible to
change the combination of the factors of
production by using a little less or more of one of
the factors. The law will not apply to cases where
the combination of the factors is fixed.
 Law of constant returns
It is a case in which output increases (or decreases)
exactly in the same proportion in which input or factors of
production are increased (or decreased). In such a situation
the casts also do not change and that is why this law is
known as the law of constant returns. This law represents
the phase of transition between the tow laws, the law of
diminishing return and the law of increasing returns. In other
words, the law of constant returns establishes a relationship
that exists between the other tow laws.
Prof. Stigler has defined the law of constant returns as
“when all the productive services are increased in a given
proportion the product is increased in the same production”.
Thus this law does not make any distinction between fixed
factor and variable factor. The important point of take
increased (or decreased) in the same proportion so as to
lead an equivalent result in output e.g. if all the input are
doubled the output would also be doubled. If all the inputs
are halved in units, output would also be halved.
This law is based on two main assumptions.
1) It is possible for the firm to increase or decrease input
exactly in the same proportion.
2) Factors of production or inputs employed by the firm are
perfectly.
Economist like Joan Robinson, Kaldor, K.f.Knight, and lerner
subscribe to the view that it is possible to change inputs in
the same proportion so that constant returns is possible
although Prof. Chamberlin does not agree with their view.
According to him there is greater possibility specialisation
and technological up gradation in the firm. Never the less,
the law of constant returns reflects an optimum combination
of inputs in a firm at a given moment of time. If the firm
increases its output beyond that point the law of diminishing
returns would operate.

Law of increasing returns

Increasing return stipulate that output increases in a
greater proportion than the increase in inputs. It is a case
where output increases in a larger proportion than the
proportion in which costs increase assuming that the supply
of input or productive factors is elastic, an expansion of a
manufacturing firm. Up to a point, is accompanied by a more
than proportionate increase in returns what is stated by this
law is that total output may increase at an increasing rate at
every new stage of production which implies that when the
law operates the marginal return goes an increasing. In the
words of Prof. Marshall “An increase of labour and capital
leads generally to improved organisation, which increases
the efficiency of the work of labour and capital therefore, in
those industries which are not engaged in raising raw
produce, an increase of labour and capital generally gives an
increased return more than in proportion”
Prof. Chapman has stated the law thus, “the expansion
of an industry, provided that there is no dearth of suitable
agents of production, tends to be accompanied, other things
being equal by increasing returns”.
Conclusions:
1) The cause of increasing returns is to be traced to
expansion of the firm leading to an improvement in its
organisational set up. Increasing returns thus are
associated with the change in the scale of production.
2) The law is conditional in the sense that it will operate
only if there is no dearth of suitable agents of
production. This means that the law operate in all
spheres of production activity wherever this condition is
fulfilled.
3) Unlike the law of diminishing returns, this law is not
certain to operate. It may or may not.
4) The law will operate only when the factors of production
are combined in appropriate proportions with each
other.

Illustration:
Let us suppose that a firm wants to maximise its profit
by producing more and more units of its product by using
more and more units of capital and labour. Given this
situation the following table shows the tendency of increasing
return in the firm–
Marginal
Units of capital Total output (in Average output
output (in
& labour unite) (in unit)
units)
1 500 500 500
2 1200 600 700
3 2100 700 900
4 3200 800 1100
5 4700 900 1500
 In the diagram, we have measured units of capital and
labour on the horizontal axis OX and marginal output on the
vertical axis OY. The diagram is based on the table given
above. The upward moving MP curve shows that with every
successive unit of capital and labour there is more than
proportionate increase in the output. The MP curve itself
depicts the movement of the trend called increasing returns.
 Law of variable proportions
The law of variable proportions is based on certain
assumption.
1. We assume that one input or one factor of production is
fixed, and others are variable.
2. All the units of variable inputs are identical or
homogenous in respect of their productivity.
3. The technique of production remains the same.
4. Only physical inputs and outputs are considered and
not the economic profitability.
5. The behaviour of an entrepreneur is rational.
6. The proportions are cariable i.e. there are no fixed
proportions in which output are combined

The law of variable proportions presents relationship

between the change in variable factors and the change in
output. The fixed factor i.e. land remains constant. But the
variable factor i.e. labour and capital changes, and there is a
change in the output. Initially the output rises more than
proportionately than it rises at a constant rate. But after a
point it rises less than proportionately. These 3 phases are
explained as the law of increasing returns, law of constant
returns and law of diminishing returns.
When the units of one factor are changed, keeping all
other inputs constant the proportion between the fixed inputs
are variable inputs undergoing a change. The effect on
output clue to variations in factor proportions is called the law
of variable proportions. The law states “if one input is held
constant and if another facto is varied, the total output will
increased at an increasing rate in the first instance and then
at a diminishing rate.
The law can be explained with reference to 3 stages of
proportion:

Stage-1:-
In the first the total output average output and up to a
certain extent marginal output are increasing in this stage the
marginal output increases at an increasing rate initially,
reaches maximum and then starts increasing at decreasing
rate. The average output reaches its maximum point at the
end of the first stage. There fore, initially there are increasing
returns and then there are diminishing returns point K shows
maximum average output.

Stage-2:-
In the second stage both the average output and
marginal output are falling when the number of units of
labour and capital reaches point N, the marginal output is
zero. At this point total output is maximum which is
represented by point P in the diagram marginal output is
falling falter than the average output the point P shows
maximum output.

Stage-3:-
In the third stage, the marginal output is less than zero
and is still falling from this point onwards the total output is
also falling. In the third stage all the three. .i.e. marginal
output, average output and total output are falling.

Conclusion:
It may be concluded that economic efficiency rises
during stage more and more output is attained per unit of
land which is the fixed factor, and labour and capital which
are the variable factors. Therefore the firm will cross the first
stag and week in the second stage. The three i.e. marginal
average and total output are declining.
Q/- Explain ISO-quant or equal product
curve and its characteristics with
relevant diagram?
Introduction:-
Production of any good or commodity depends on the
combination and changes in proportion of factors of
production when all the factors are increased simultaneously.
Then there is increases in the output Prof. Cobb and
Douglas assumed that the production function has only 2
factors i.e. capital & labour.

Meaning:
According to Prof. Kerrptead equal product curve
represents all possible combinations of 2 factors that will give
equal level of output per unit of time. In the word of Cobb and
Douglas, an equal product curve is a curve along which the
maximum rate of production remains constant.

Illustration:

No. Of Mt Rs.
Factor ‘X’ Factor ‘Y’
combinatio Total output (labour &
Capital Labour
n capital)
1 1 10 100 ---
2 2+1 7-3 100 1:3
3 3+1 5-2 100 1:2
4 4+1 4-1 100 1:1
 From the table that is above, it is seen that, the unit of
factor ‘X’ i.e. capital is increasing at the cost of factor ‘Y’ i.e.
labour. The marginal rate of substitution is decreasing as
more units of labour are substituted for capital

The ISO quant is downward sloping form left to right. It

is a line or a curve joining all points representing different
combinations of inputs producing equal level of output.

Characteristics of ISO-quant:
1. Equal product curve stop downwards form left to
right:-
 The ISO-quant has a negative slope because it
indicates the decrease in marginal rate of
substitution. If the slope of the curve is moving
upwards to the right it indicates that as both the
factors of production are increasing, the output
also increases. If the curve is a horizontal straight
line then the units of capital are increasing with
constant units of labour resulting into more
production. There fare, this curve slopes
downward from left to right.
2. Equal product curve is convex to the origin:
This implies that the marginal significance of one
factor in terms of another diminishes along an
equal product curve the marginal significance of ‘X’
i.e. capital in terms of ‘Y’ i.e. labour, is the quantity
of labour which can be given off for one more unit
of capital. It means that the marginal significance
of ‘X’ in terms of ‘Y’ diminishes along an equal
product curve. There fore it is convex to the origin.
3. Equal product curve lying to the right represents a
larger output:
An equal product curve lying to the right indicating
a larger output means that they are parallel to
each other

In the diagram point P indicates a point on IQ.

Whereas point p1 is on TQ2, P1 indicates more
units of capital and same units of labour.
Therefore, due to increase in capital with labour
gives a higher amount of output.
4. Equal product curve never intersects cut each
other:-
The 2 ISO-quant can never intersect each other.
For E.g. If they intersect at point P it can be shown
in the following diagram:
 In this diagram, two ISO-quant curves are
intersecting at point P which gives equal output on
both the curves, IQ1 and IQ2. If we take IQ1 the
output at point P and point A are equal. In the
same way on IQ2 the output is equal on point P
and B. In both the curves the combinations of
capital and labour are equal at point P, but are not
equal at point A and B. A and B are on different
ISO-quant giving different production. Therefore,
we can say that the 2 ISO-quant can never
intersect or cut each other.
5. Units of output shown on equal product curve is
arbitrary (imaginary) :-
Various units of output such as 10, 20, 30 etc. On
equal product curve map are purely imaginary or
arbitrary.
6. In between two ISO-quants, there can be a number
of ISO-quants:
Different ISO-quants show different levels of
output which the combination of two factors can
 yield. Therefore, there are many ISO-quants which
can be drawn in between each other.
7. No ISO-quant can touch either of the axis:
If an ISO-quant touches either X-axis or Y-axis, it
shows that the product is being produced with the
keep of either labour or capital alone. This is not
possible.

8. ISO-quant and optimum factor combination:

The equal product curves show different
combination of two factors of production which will
give the same output the firm has to pay the prices
as rewards to the factors of production. The cost
line indicates the budget line of the firm. Different
combinations of payment paid to the factors of
production will give the total cost of production. A
rational entrepreneur would choose only that
combination which cost him the least in a given
situation. Ultimately the firm will look to the cost
curve and the production curve on the basis of the
 equilibrium i.e. the tendency between the ISO-
quant and the ISO cost line.

Situation. Ultimately the firm will look to the cost

curve and the production curve on the basis of the
equilibrium i.e. the tendency between the ISO-
quant and the ISO cost line.

In the diagram represents least cost input

combination or optimum factor combination. The
firm is in equilibrium at point & where ISO-quant
IQ2 is tangent to ISO cost line PP1.
9. The equal product curve help to determine the
boundary lines for the economic region of
production:
The equal product curve IQ helps the firm to
decide the boundary line for the economic region
of production. An equal product curve is convex to
the origin with a positive slope at both the ends.
This can be show by the following
diagram:

As shown in the diagram there are 3 ISO

quants IQ1, IQ2, IQ3 points a and d are on IQ1
similarly, point B and E and points C and F are on
IQ2 and IQ3 respectively. By joining the points a, b,
c we get OQ curve. In the same way we obtain the
curve OR by joining the points d, e and f. These
lines/curves are known as ridge line or boundary
lines. They represent the boundary for the
economic region of production. In other words only
that portion of the equal product curve which lies
between the ridge lines, the production is carried
out.
Q/- Expansion Path?
An expansion path of firm indicates the best way
various inputs can be obtained at a given time in which
inputs can be freely varied, subject to the condition that input
prices and technology are constant. It shows the locus of the
least cost input combinations for obtaining different levels of
output

Expansion path is an expansion of a situation in which the

resources available with a firm expands which means that it
can hire more and more units of the inputs so as to attain
higher and higher ISO-quants.
In the diagram, units of capital are measured on the
vertical axis OY. IQ1 to IQ6 are the different levels of ISO-
quants while the lines from K1L1 to K6L6 are the different ISO-
quants and ISO-cost lines at different levels of output
indicating the availability of resources and efficiency of the
firm. By joining the different points of equilibria. We get the
expansion path of the firm when its recourses go on
expanding so that at each new stage it hires more units of
capital and labour both.
Q:- Marginal rate of technical substitution
(M R T S)
This is one of the important concepts associated with
production function MRTS is the rate at which two inputs are
substituted for rate of substitution between such inputs which are
imperfect substitutes and therefore the unit of one input can be
replaced by units of the other. As stated earlier, capital and
labour are imperfect substitutes and there fore when a firm wants
to reduce the cost of production output remaining the same, it
would substitute a costlier input by a cheaper input MRTS will
indicate the number of units of input K (capital) that can be
replaced by one unit of L (labour). Quantity of output remaining
unchanged. It is an intermediate position in which the inputs are
neither perfect complements nor are they perfect substitutes.

Illustration:
The following table and the subsequent diagram indicate
the MRTS between two imperfect substitutes like capital &
labour.

K L MRTS
24 + 2 2:8 or 1:4
16 + 4 2:6 or 1:3
6 + 6 2:4 or 1:2
4 + 10 2:2 or 1:1
 Kit
book
No. Question
Page
No.
1) Meaning of Production function 6.25

2) Determinents of Production function 6.28

3) Types of Production function 6.29

4) Iso-Cost Line 6.38

5) Equiliberium of the firm 6.44

6) Uses of production function 6.48