Production Concepts Production Concepts &&

Law of Diminishing Law of Diminishing ReturnsReturns

Meaning of ProductionMeaning of Production

• In Economics the term production means a In Economics the term production means a process by which resources are process by which resources are transformed into a different more useful transformed into a different more useful commodity or service. In general, commodity or service. In general, production means transforming inputs into production means transforming inputs into an output. an output.

• In the economic sense production process In the economic sense production process may take a variety of forms other than may take a variety of forms other than manufacturing. For example transferring a manufacturing. For example transferring a commodity from one place to another commodity from one place to another where it can be used in the process of where it can be used in the process of production is productionproduction is production

Input and Output Input and Output

• An input is a good or service that An input is a good or service that goes into the process of production. goes into the process of production. In the words of Baumol, “An input is In the words of Baumol, “An input is simply any thing that the firm buys simply any thing that the firm buys for its use in production or other for its use in production or other processes.processes.

• An output is any good or service that An output is any good or service that comes out of the production process.comes out of the production process.

Fixed and variable inputsFixed and variable inputs

• In the economic sense, A fixed input is one In the economic sense, A fixed input is one whose supply is inelastic in the short run. In whose supply is inelastic in the short run. In the technical sense, a fixed factor is one the technical sense, a fixed factor is one that remains constant for a certain level of that remains constant for a certain level of output.output.

• A variable input is one whose supply in the A variable input is one whose supply in the short run is inelastic. All users of such short run is inelastic. All users of such factors can employ a larger quantity in the factors can employ a larger quantity in the short run. Technically, a variable input is short run. Technically, a variable input is that changes with the change in output. In that changes with the change in output. In the long run all inputs are variable.the long run all inputs are variable.

Short run and long runShort run and long run

• The reference to time period involved in The reference to time period involved in production process is another important production process is another important concept used in production analysis.concept used in production analysis.

• Short run refers to a period of time in which Short run refers to a period of time in which the supply of certain inputs is fixed or is the supply of certain inputs is fixed or is inelasticinelastic

• The long run refers to a period of time in The long run refers to a period of time in which the supply of all inputs is elastic, but which the supply of all inputs is elastic, but not enough to permit a change in technology. not enough to permit a change in technology.

Production FunctionProduction Function

• Production function is a tool of analysis used Production function is a tool of analysis used to explain the input-output relationship. A to explain the input-output relationship. A production function describes the production function describes the technological relationship between inputs technological relationship between inputs and output in physical terms. In its general, and output in physical terms. In its general, it tells that production of a commodity it tells that production of a commodity depends on certain specific inputs. In its depends on certain specific inputs. In its specific form, it represents the quantitative specific form, it represents the quantitative relationship between inputs and outputs. relationship between inputs and outputs.

Accordingly there are 2 kinds of Accordingly there are 2 kinds of production functionsproduction functions

1.1. Short run production functionShort run production function

2.2. Long run production functionLong run production function

Production function Production function assumptionsassumptions• Perfect divisibility of both inputs and Perfect divisibility of both inputs and

outputsoutputs

• There are two factors of production – labor There are two factors of production – labor and capitaland capital

• Limited substitution of one factor for the Limited substitution of one factor for the otherother

• A given technologyA given technology

• Inelastic supply of fixed factors in the short Inelastic supply of fixed factors in the short runrun

The Laws of productionThe Laws of production

• The traditional theory of production The traditional theory of production studies the marginal input-output studies the marginal input-output relationships underrelationships under

1.1. Short run conditionsShort run conditions

2.2. Long run ConditionsLong run Conditions

Short term Laws of Short term Laws of productionproduction• The Law of returns to variable input: the Law of The Law of returns to variable input: the Law of

diminishing returnsdiminishing returns• The law of diminishing returns states that when The law of diminishing returns states that when

more units of a variable input are applied to a more units of a variable input are applied to a given quantity of fixed inputs, the total output given quantity of fixed inputs, the total output may initially increase at an increasing rate and the may initially increase at an increasing rate and the at a constant rate but it will eventually increase at a constant rate but it will eventually increase at diminishing ratesat diminishing rates

• Assumptions:Assumptions:1.1. The state of technology is givenThe state of technology is given2.2. Labor is homogeneousLabor is homogeneous3.3. Input prices are givenInput prices are given

Three stages of productionThree stages of production

No. of workersNo. of workers Total ProductTotal Product Marginal Marginal productproduct

Average Average productproduct

Stages of Stages of productionproduction

11

22

33

44

55

66

2424

7272

138138

216216

300300

384384

2424

4848

6666

7878

8484

8484

2424

3636

4646

5454

6060

6464

II

INCREASING INCREASING RETURNSRETURNS

77

88

99

1010

462462

528528

576576

600600

7878

6666

4848

2424

6666

6666

6464

6060

IIII

DIMINISHING DIMINISHING RETURNSRETURNS

1111

1212594594

552552-6-6

-42-425454

4646IIIIII

NEGATIVE NEGATIVE RETURNSRETURNS

Factors behind Laws of Factors behind Laws of returnreturn

• Indivisibility of fixed factorIndivisibility of fixed factor

• Division of laborDivision of labor

Application of the law of Application of the law of diminishing returns diminishing returns

• The law cannot be applied The law cannot be applied universally. It may operate quickly in universally. It may operate quickly in some and slow in others and there some and slow in others and there may be cases where this may not may be cases where this may not appear at all. It has been found to appear at all. It has been found to operate in agriculture more than in operate in agriculture more than in industriesindustries

The law of Diminishing returns The law of Diminishing returns and business decisionsand business decisions

• The law of diminishing returns as The law of diminishing returns as presented graphically has a presented graphically has a relevance to the business decisions. relevance to the business decisions. The graph can help in identifying the The graph can help in identifying the rational and irrational stages of rational and irrational stages of operations.operations.