CHAPTER 5 PRODUCTION FUNCTION

Production is an activity of creating utility by converting inputs into outputs. Inputs are land, labour, capital,
entrepreneurship etc.

Production Function: It refers to a mathematical relationship between inputs (factors of production) &
output under a given state of technology. It shows what quantity of each input is required to produce a given
amount of output. The production function specifies either the maximum output that can be produced with
the given inputs or the minimum quantity of inputs needed to produce a given level of output.
Ox= F(i1, i2, i3….) where Ox = Output of a commodity produced
F= functional relationship
i1, i2, i3 = Different Inputs

❖ Factors of Production

Factors of Production

Fixed factors Variable Factors

➢ Fixed Factors: It refers to those factors of production which cannot be changed easily during a short
period of time. For eg: Land, Building, machinery etc.
• These factors are difficult to install & they are not easily available.
• They do not vary with the change in the level of output.
• They are there in the firm even if the level of output is zero.

➢ Variable Factors: It refers to those factors of production which can be varied or changed during a short
period. For eg: raw materials, labour etc.
• They are easily available.
• They vary directly with the level of output.
• They are not required in case of zero output.

❖ Time Period

Time Period

Short Run Long Run

➢ Short Run: It is that time period in which a firm carries out its production activity with certain factors of
production which are variable in nature & some are fixed factors. A producer can increase the production
of a good by increasing the quantity of variable factor only but till the extent of capacity of fixed factors.

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 ➢ Long Run: It is that time period in which a firm can change all the factors of production & therefore all
are variable factors. To increase the production, a producer can increase the quantity of all factors
simultaneously.

Basis Short Run Long Run

Meaning Short run refers to a time period in Long run refers to a period in which
which output can be changed by output can be changed by changing all
changing only variable factors. factors of production.
Classification Factors are classified as variable & All factors are variable in the long run.
fixed factor in the short run.
Price In the short run, demand is more In the long run, both demand & supply
Determination active in price determination as supply play an equal role in price determination
cannot be increased immediately with as both can be increased.
increase in demand.

❖ PRODUCT
Product/ Output refers to the volume of goods produced by a firm or an industry during a specified period
of time.
1. Total Product/ Total Physical Product: It refers to the total output of a commodity produced by a
firm with given inputs during a specified period of time. It is calculated as:
TP= ∑MP
TP= AP × Units of variable factor.

2. Average Product/ Average Physical Product: It refers to output per unit of variable input.
TP
AP= Units of Variable Factor

3. Marginal Product/ Marginal Physical Product: It refers to the addition to the total product when
one additional unit of a variable factor is employed.
MPn= TPn – TPn-1
∆TP
MP= ∆Units of Variable Factor

❖ LAW OF VARIABLE PROPORTION

It states that as a firm employees more & more units of a variable factor along with the fixed factor then
TP initially rises at an increasing rate (rise in MP) then rises at a diminishing rate (fall in MP) & finally falls
down (MP becomes negative).

Assumptions:
1. It operates in short run, as factors are classified as variable & fixed factor.
2. The law applies to all fixed factors including land.
3. Under law of variable proportions, different units of variable factor can be combined with fixed factor.
4. The state of technology is assumed to be constant during the operation of this law.
5. It is assumed that all variable factors are equally efficient.
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 6. It is assumed that factors of production become imperfect substitutes of each other beyond certain
limit.

Units of fixed Units of TP MP AP

factor variable factor
1 1 2 2 2
1 2 5 3 2.5
1 3 9 4 3
1 4 12 3 3
1 5 14 2 2.8
1 6 15 1 2.5
1 7 15 0 2.1
1 8 14 -1 1.7
1 9 12 -2 1.3

The law operates in 3 phases:

PHASE 1 PHASE OF INCREASING RETURNS

This phase begins when a firm starts its production by
employing variable factors along with the fixed factors. In this
phase every additional variable factor adds more & more to
total output. MP of the additional variable factor increases
which makes total product to increase at an increasing rate. This
is because the firm moves towards the optimum combination of
factors. This phase continues (from unit 1 to 3) till MP becomes
maximum as shown by point B in the diagram i.e. point of
inflexion.

PHASE 2 PHASE OF DIMINISHING RETURNS

This phase begins when MP is maximum (i.e. point B). In this
phase every additional variable factor adds lesser & lesser to the
total output. Since there is a over utilization of fixed factor for
the variable factor, therefore, when more units of variable
factor are employed then MP starts falling down but remain positive. This makes TP to increase at a
diminishing rate. This phase comes to an end when MP becomes zero (point E).

PHASE 3 PHASE OF NEGATIVE RETURNS

This phase begins when MP is zero (point E). In this phase, since there is fall in per unit availability of fixed
factor for variable factor therefore, when additional units of variable factor are employed then MP starts
becoming negative.

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 A rational producer will operate in phase 2 because although TP is increasing at a diminishing rate but
the employment of additional variable factor brings an increase in TP.

• In phase 1, employment of every additional unit of variable factor gives more & more output i.e.
marginal product increases. It means, there is scope for more profits, if production is increased
with more units of variable factor.
• In phase 3, marginal product of each variable factor is negative. So, this phase is ruled out on the
ground of technical inefficiency & a rational producer will never operate in this phase.

CAUSES OF THE OPERATION OF LAW

➢ Causes of Increasing returns
1. Better co-ordination between factors: For every fixed factor there are different combinations of
variable factor. Among the various combinations there is one optimum combination which gives good
production with given resources. So initially when the firm increase its variable factor, there is better
coordination among variable factors & thus increasing returns appear.=’
2. Increased efficiency of variable factor: When a firm increases its variable factor along with the fixed
factor then it brings in specialization. Division of work among the variable factors enables increasing
returns to appear as each factor gets a suitable job for him which makes the marginal product to
increase. Variable factor is utilized in a more efficient manner due to division of work.
3. Full/Better utilization of factors: Initially when a firm increases its variable factor then the
underutilized fixed factor gets better utilized. The factor proportion becomes more suitable to increase
the production at a faster rate.

➢ Causes of Diminishing Returns

1. Use beyond optimum/full capacity: The phase of diminishing returns appears in a firm when a firm
employs additional variable factor with constant fixed factor even after achieving optimum
combination because the fixed factor gets over-utilized & will bring less than proportionate returns. As
a result, MP of variable factor tends to decline.
2. Poor Co-ordination: Increased application of variable factor with a fixed factor beyond a point crosses
the ideal factor ratio. If the ideal combination is disturbed, MP will fall.
3. Imperfect substitutes: Factors of production are not the perfect substitutes of each other. It implies
that in order to increase the production, variable factor can be increased but the optimum proportion
shall not be disturbed. Beyond a certain point the factors become imperfect substitutes leading to
diminishing returns.

➢ Causes of Negative Returns

1. Fall in per unit availability of fixed factor/ Fixity of Fixed factor: The fixed factors & the variable
factors both are required to carry out the production activity. With the employment of variable factors
keeping fixed factors constant, the per unit availability of fixed factors falls down. The fixed factors
become too small to be effectively worked upon by the variable factor. As a result, MP turns negative.
2. Defective factor ratio: With fixity of fixed factor & over crowding of variable factor, factor proportions
become less & less suitable for the production & MP becomes negative.

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 3. Decrease in efficiency of variable factor: With continuous increase in variable factor, the advantages
of specialization & division of labour start diminishing. It results in inefficiencies of variable factor,
which is another reason for the negative returns to eventually set in.

❖ LAW OF DIMINISHING RETURNS

Law of diminishing returns states that when more and more units of a variable factor are employed with a
fixed factor, then marginal product of the variable factor must fall. This law is also known as “Law of
Diminishing Marginal Product”.
Fixed Variable TP MP
Factor Factor
1 1 12 12
1 2 22 10
1 3 30 8
1 4 36 6
1 5 40 4

❖ RELATIONSHIP BETWEEN MP & AP

1. Initially when the firm starts production, marginal

product increases. Average product will also rise till
the value of MP is greater than the value of AP. This
can be seen from 1st to 3rd unit of variable factor.

2. When the value of MP becomes equal to AP, AP

reaches its maximum point. This can be seen at 4th
unit of variable factor employed.

3. When the value of MP becomes less than AP, then AP falls i.e. from 4th to 9th unit of variable factor
employed.
4. Thereafter, both MP and AP fall down but MP becomes negative whereas AP remains positive. MP
falls at a faster rate than AP.

*MP can be positive, zero & negative but AP is always positive.