Chapter- 3.

Production Function
and Analysis

What is Production?

Production Creation of utilities.

Consumption Destruction of utilities.

Concerned with the way in which resources (inputs) are employed

to produce a firm’s products (outputs).

1
 Inputs FIRM
Outputs
(Processing)
Production process

•Production does not refer to just the physical

transformation of resources.

• Production process includes acquisition of

capital resources, efficient employment of
resources, besides the normal process of
converting raw materials into finished goods.
3

Production Function

À Expresses the technological or engineering

relationship between outputs and inputs
used in the production.
À Q = f (La, Lb, K, M, T)
À The dependent variable, output Q is a
positive function of the independent
variables, i.e., factors of production.
À Where
Q = output in physical units
4

2
 La = Land units employed in the prod. of Q
Lb = Labor units employed in the prod. of Q
K = Capital units employed in the prod. of
Q
M = Managerial units employed in the prod.
Q
T = Technology employed in the prod. of Q

Characteristics of a Production
Function
À Shows physical relationship between inputs
and the level of output.
5

À Depicts the maximum output that can be

produced from a given amount of various
inputs.
or
À minimum quantity of inputs necessary to
produce a given level of output.
À It assumes that output is an increasing
function of all inputs but if an input is
excessively applied in relation to other
inputs, an increase in it, other inputs held
constant, might lead to decrease in output.

3
À The production is not possible without using
at least one of the inputs.
À The inputs and outputs are perfectly
divisible.
Analysis
À For analytical simplicity, if the two inputs
considered are labor and capital, the
production function can be rewritten as:
Q = f ( L, K )
which means Q depends on L and K.

Short-run Production
Function
À Short-run is defined as a situation in which
the firm has at least one fixed factor of
production.
À During SR, production could be increased or
decreased by changes in other (variable)
inputs.
À Assuming capital as the fixed input and labor
as the variable input, the SR production
function can be written as Q = f (L, K ).
8

4
 Long-run Production
Function
À During LR all the factors of production are
variable.
À During LR, production could be increased
through a change in any one or more of the
inputs.
À Short-run is a time concept and not a time
period.
À These time horizons (SR and LR) do not
correspond to any definite periods of
calendar time as the nature of the
production process differs.
9

Fixed and Variable Inputs

À Factor inputs whose quantity does not vary

with output are known as fixed factors.
À Factor inputs whose quantity may vary with
output are known as variable factors
(Labor, raw material etc.).
À In SR at least one factor does not vary with
output.
À In LR all factors may vary.
À In LR the distinction between fixed and
variable factors disappears as in the LR all
factors can vary.
10

5
 Production Function in Managerial
Economics
À Input-output relations where some inputs are
fixed while quantities of other inputs vary –
SR production function. Two situations are:
À One input is variable, all other inputs are
fixed.
À Two inputs are variable, all other inputs are
fixed.
À Input-output relations where all the inputs
are variable – LR production function.
11

À Total Product (TP): Refers to the total

output of the firm per period of time.
À Average Product (AP): Total product
divided by the amount of the variable input
used to produce this output (AP = TP/L).
À Marginal Product (MP): Addition to TP due
to the addition of one unit of the variable
input to the production process, fixed input
remaining the same.
(MP = ∆ TP/ ∆ L ).

12

6
 SR Production Function
(Fixed Factors + One Variable Input)
À Assuming capital as the fixed input (K) and
Labor (L) as the variable input, expressed as
Q = f (L, K ).

À When quantity of variable factor increase,

quantity of fixed factors remain unchanged,
the proportions between fixed and variable
factors keep on changing – ‘Variable
Proportions’.
13

À As per the Law of Variable Returns (Law of

Diminishing Returns), as more and more
units of the variable input are employed in
the production, fixed inputs remaining
unaltered, production first increases at an
increasing rate and then at a diminishing
rate, leading to a decline in total production
eventually.
À MP increases over a certain range of input
up to a point, after which it decreases and
eventually becomes negative.

14

7
À Simply, when increasing amounts of the
variable input are combined with a fixed
level of another input, a point will be
reached where the marginal product of the
variable input will decline (Law of
Diminishing Marginal Returns).
Assumptions:
À The state of technology is given.
À One input must always be kept constant.
À Factor inputs must be divisible.

15

16
Rate of Labor Total, Average and Marginal Product of levels
input
(L) TPL APL MPL

0 0 _ _

1 20 20 20

2 50 25 30

3 90 30 40

4 120 30 30

5 140 28 20

6 150 25 10

7 155 22 5

8 150 19 -5

8
 Stage II Stage III
Stage I

TPL

a a

Rate of Labor
L1 L3
Average Product,
Marginal Product
Input ( L )

IMR DMR NMR

AP L
Rate of Labor
Input ( L )
L1 L2 L3
MP L 17

À Initially, TP increases at an increasing rate

over the range 0 to L1, and then increases at
a decreasing rate.
À Beyond L3, TP declines.
À Initially, the input proportions are inefficient,
i.e., there is too much of the fixed factor,
capital.
À As the L increased from 0 to L1, output rises
more than in proportion to the increase in L,
i.e., MP per unit of L increases as a better
balance of L and K inputs is achieved.

18

9
À As the L is increased beyond L1, diminishing
marginal returns set in and thus MP declines
as the L finds the fixed factor inadequate.
À When the labor input has increased to L3, TP
reaches a maximum.
À Beyond L3, the amount of labor has become
excessive with the result that TP actually
declines.
Relationships among TP,
AP & MP functions
À MP reaches a maximum at L1, indicating an
inflection point (a) on the TP function.
19

À At inflection point, the TP function changes

from an increasing at an increasing rate to
increasing at a decreasing rate.
À MP curve intersects AP curve at its
maximum point, i.e., at L2.
À Whenever MP is above AP, the average is
rising.
À When MP is below AP, the average is
falling.
À MP becomes negative at L3, which
corresponds to the point where TP curve
reaches a maximum.

20

10
À Production over the range 0 to L2, is
defined as stage 1, in which the MPL is
positive, but the MPK is negative.
À In this range, there is not enough Labor to
efficiently use the Capital stock.
À In stage 1, fixed input is underutilized, AP
increases when additional variable input is
used.
À Beyond L3 (stage 3), the MPL is negative as
too much of labor is combined with the
capital stock, thus variable input causes
output to fall.
21

À The firm will not operate in either stage 1 or

3 as the MP of either L or K is negative.
À Production will occur only in stage 2,
as the MP of both L and K is positive.
À In stage 2, greater output is the result of
specialization and teamwork and fixed input
is being properly utilized.
À In stage 1 the firm would be underutilizing
its fixed inputs, and in stage 3, it would be
over utilizing its fixed inputs.

22

11
 Assignment 1
K L TP AP MP
1 0 0 _ _

1 1 2 2 _
1
1 2 5 _ 3

1 3 _ 3 4

1 4 12 3 _

1 5 14 _ _

1 6 _ 2.5 1

1 7 15 2.5 _

1 8 14 _ _

1 9 _ 1.1/3 -2

23

Optimal Employment of a
Factor of Production

À Additional units of the variable input should

be hired until marginal revenue product
(MRP) of the last unit employed = to the
cost of the input.
À MRP is equal to the MR multiplied by MP,
MRPL = MR x MPL
À MR = ∆ TR/ ∆ Q, and MPL= ∆ Q/ ∆ L,
À Hence MRPL = ∆ TR/ ∆ Q. ∆ Q/ ∆ L
= ∆ TR/ ∆ L
24

12
À Marginal revenue product can be the
change in total revenue per one unit change
in the rate of Labor input.
À MRP = MLC rule guides the firm in deciding
the units of variable inputs to be employed
relative to its fixed input.
À The firm should employ an input up to the
point at which the revenue contribution of
the additional input is equal to the cost
incurred by the firm to employ that input.
À The Labor is hired until MRPL = W.

25

13