Production Function CA Foundation Notes | EduRev

Business Economics for CA Foundation

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CA Foundation : Production Function CA Foundation Notes | EduRev

The document Production Function CA Foundation Notes | EduRev is a part of the CA Foundation Course Business Economics for CA Foundation.
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PRODUCTION FUNCTION
The production function is a statement of the relationship between a firm’s scarce resources (i.e. its inputs) and the output that results from the use of these resources. More specically, it states technological relationship between inputs and output. The production function can be algebraically expressed in the form of an equation in which the output is the dependent variable and inputs are the independent variables. The equation can be expressed as:
Q = f (a, b, c, d …….n)
Where ‘Q’ stands for the rate of output of given commodity and a, b, c, d…….n, are the different factors (inputs) and services used per unit of time.
Assumptions of Production Function: There are three main assumptions underlying any production function.
First we assume that the relationship between inputs and outputs exists for a specific period of time. In other words, Q is not a measure of accumulated output over time.
Second, it is assumed that there is a given “state-of-the-art” in the production technology. Any innovation would cause change in the relationship between the given inputs and their output. For example, use of robotics in manufacturing or a more efficient software package for financial analysis would change the input-output relationship.
Third assumption is that whatever input combinations are included in a particular function, the output resulting from their utilization is at the maximum level.
The production function can be defined as:
The relationship between the maximum amount of output that can be produced and the input required to make that output. It is defined for a given state of technology i.e., the maximum amount of output that can be produced with given quantities of inputs under a given state of technical knowledge. (Samuelson) 
It can also be defined as the minimum quantities of various inputs that are required to yield a given quantity of output.
The output takes the form of volume of goods or services and the inputs are the different factors of production i.e., land, labour, capital and enterprise. To illustrate, for a company which produces beverages, the inputs could be fixed assets such as plant and machinery; raw materials such as carbonated water, sweeteners and favourings and labour such as assembly line workers, support-staff and supervisory personnel.
For the purpose of analysis, the whole array of inputs in the production function can be reduced to two; L and K. Restating the equation given above, we get:
Q = f (L, K).
Where Q = Output
L= Labour
K= Capital 

Short-Run Vs Long-Run Production Function 
The production function of a firm can be studied in the context of short period or long period. It is to be noted that in economic analysis, the distinction between short-run and long-run is not related to any particular measurement of time (e.g. days, months, or years). In fact, it refers to the extent to which a firm can vary the amounts of the inputs in the production process. A period will be considered short-run period if the amount of at least one of the inputs used remains unchanged during that period. Thus, short-run production function shows the maximum amount of a good or service that can be produced by a set of inputs, assuming that the amount of at least one of the inputs used remains unchanged. Generally, it has been observed that during the short period or in the short run, a firm cannot install a new capital equipment to increase production. It implies that capital is a fixed factor in the short run. Thus, in the short-run, the production function is studied by holding the quantities of capital fixed, while varying the amount of other factors (labour, raw material etc.) This is done when the law of variable proportion is studied.
The production function can also be studied in the long run. The long run is a period of time (or planning horizon) in which all factors of production are variable. It is a time period when the firm will be able to install new machines and capital equipments apart from increasing the variable factors of production. A longrun production function shows the maximum quantity of a good or service that can be produced by a set of inputs, assuming that the firm is free to vary the amount of all the inputs being used. The behaviour of production when all factors are varied is the subject matter of the law of returns to scale.
Cobb-Douglas Production Function 
A famous statistical production function is Cobb-Douglas production function. Paul H. Douglas and C.W. Cobb of the U.S.A. studied the production function of the American manufacturing industries. In its original form, this production function applies not to an individual firm but to the whole of manufacturing in the United States. In this case, output is manufacturing production and inputs used are labour and capital. Cobb-Douglas production function is stated as:
Q = KLa C(1-a)
where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital. ‘K’ and ‘a’ are positive constants. The conclusion drawn from this famous statistical study is that labour contributed about 3/4th and capital about 1/4th of the increase in the manufacturing production. Although, the Cobb-Douglas production function suffers from many shortcomings, it is extensively used in Economics as an approximation.

The Law of Variable Proportions or The Law of Diminishing Returns:
In the short run, the input output relations are studied with one variable input (labour) with all other inputs held constant. The laws of production under these conditions are known under various names as the law of variable proportions (as the behaviour of output is studied by changing the proportion in which inputs are combined) the law of returns to a variable input (as any change in output is taken as resulting from the additional variable input) or the law of diminishing returns (as returns eventually diminish).
The law states that as we increase the quantity of one input which is combined with other fixed inputs, the marginal physical productivity of the variable input must eventually decline. In other words, an increase in some inputs relative to other fixed inputs will, in a given state of technology, cause output to increase; but after a point, the extra output resulting from the same addition of extra input will become less and less.
Before discussing this law, if would be appropriate to understand the meaning of total product, average product and marginal product.
Total Product (TP): Total product is the total output resulting from the efforts of all the factors of production combined together at any time. If the inputs of all but one factor are held constant, the total product will vary with the quantity used of the variable factor. Column (1) of Table 1 presents the quantity of variable factor (labour) used along with the factors whose quantity is held constant and column (2) represent the total product at various levels of use of the variable input.
Table 1: Product Schedule

Quantity of labourTotal Product (TP)Average Product (AP)Marginal Product (MP
(1)(2)(3)(4)
1100100.0100
2210105.0110
3330110.0120
4440110.0110
5520104.080
6600100.080
767095.770
872090.050
975083.330
1075075.00
1174067.3-10

We find that when one unit of labour is employed along with other factors of production, the total product is 100 units. When two units of labour are employed, the total product rises to 210 units. The total product goes on rising as more and more units of labour are employed. With 10 units of labour, the total product rises to 750 units. When 11 units of labour are employed, total product falls to 740 units due to negative returns from the 11 th unit of labour.
Average Product (AP): Average product is the total product per unit of the variable factor
Production Function CA Foundation Notes | EduRev
It is shown as a schedule in column (3) of Table 1. When one unit of labour is employed, average product is 100, when two units of labour are employed, average product rises to 105. This goes on, as shown in Table 1.
Marginal Product (MP): Marginal product is the change in total product per unit change in the quantity of variable factor. In other words, it is the addition made to the total production by an additional unit of input.
Symbolically,
MPn = TPn – TPn-1
The computed value of the marginal product appears in the last column of Table 1. For example, the MP corresponding to 4 units is given as 110 units. This reflects the fact that an increase in labour from 3 to 4 units, has increased output from 330 to 440 units.

Relationship between Average Product and Marginal Product: Both average product and marginal product are derived from the total product. Average product is obtained by dividing total product by the number of units of the variable factor and marginal product is the change in total product resulting from a unit increase in the quantity of variable factor. The relationship between average product and marginal product can be summed up as follows:
(i) when average product rises as a result of an increase in the quantity of variable input, marginal product is more than the average product.
(ii) when average product is maximum, marginal product is equal to average product. In other words, the marginal product curve cuts the average product curve at its maximum.(iii) when average product falls, marginal product is less than the average product.
Table 1 and Figure 1 confirm the above relationship.
The Law of Variable Proportions or the Law of Diminishing Returns examines the production function with one factor variable, keeping quantities of other factors fixed. In other words, it refers to input-output relationship, when the output is increased by varying the quantity of one input. This law operates in the short run ‘when all factors of production cannot be increased or decreased simultaneously (for example, we cannot build a plant or dismantle a plant in the short run).
The law operates under certain assumptions which are as follows:
1. The state of technology is assumed to be given and unchanged. If there is any improvement in technology, then marginal product and average product may rise instead of falling.
2. There must be some inputs whose quantity is kept fixed. This law does not apply to cases when all factors are proportionately varied. When all the factors are proportionately varied, laws of returns to scale are applicable.
3. The law does not apply to those cases where the factors must be used in fixed proportions to yield output. When the various factors are required to be used in fixed proportions, an increase in one factor would not lead to any increase in output i.e., marginal product of the variable factor will then be zero and not diminishing.
4. We consider only physical inputs and outputs and not economic profitability in monetary terms.
The behaviour of output when the varying quantity of one factor is combined with a fixed quantity of the others can be divided into three distinct stages or laws. In order to understand these three stages or laws, we may graphically illustrate the production function with one variable factor. This is done in Figure 1.
In this figure, the quantity of variable factor is depicted on the X axis and the Total Product (TP), Average Product (AP) and Marginal Product (MP) are shown on the Y-axis. As the figure shows, the TP curve goes on increasing upto to a point and after that it starts declining. AP and MP curves first rise and then decline; MP curve starts declining earlier than the AP curve.
The behaviour of these Total, Average and Marginal Products of the variable factor consequent on the increase in its amount is generally divided into three stages (laws) which are explained below.
Production Function CA Foundation Notes | EduRev
Stage 1: The Stage of Increasing Returns: In this stage, the total product increases at an increasing rate upto a point (in figure upto point F), marginal product also rises and is maximum at the point corresponding to the point of inflexion and average product goes on rising. From point F onwards during the stage one, the total product goes on rising but at a diminishing rate. Marginal product falls but is positive. The stage 1 ends where the AP curve reaches its highest point.
Thus in the first stage, the AP curve rises throughout whereas the marginal product curve first rises and then starts falling after reaching its maximum. It is to be noted that the marginal product although starts declining, remains greater than the average product throughout the stage so that average product continues to rise.
Explanation of law of increasing returns: The law of increasing returns operates becausein the beginning, the quantity of fixed factors is abundant relative to the quantity of the variable factor. As more units of the variable factor are added to the constant quantity of the fixed factors, the fixed factors are more intensively and effectively utilised i.e., the efficiency of the fixed factors increases as additional units of the variable factors are added to them. This causes the production to increase at a rapid rate. For example, if a machine can be efficiently operated when four persons are working on it and if in the beginning we are operating it only with three persons, production is bound to increase if the fourth person is also put to work on the machine since the machine will be effectively utilised to its optimum. This happens because, in the beginning some amount of fixed factor remained unutilised and, therefore, when the variable factor is increased, fuller utilisation of the fixed factor becomes possible and it results in increasing returns. A question arises as to why the fixed factor is not initially taken in a quantity which suits the available quantity of the variable factor. The answer is that, generally, those factors which are indivisible are taken as fixed. Indivisibility of a factor means that due to technological requirements, a minimum amount of that factor must be employed whatever be the level of output. Thus, as more units of the variable factor are employed to work with an indivisible fixed factor, output greatly increases due to fuller utilisation of the latter. The second reason why we get increasing returns at the initial stage is that as more units of the variable factor are employed, the efficiency of the variable factor increases. This is because introduction of division of labour and specialisation becomes possible with sufficient quantity of the variable factor and these results in higher productivity.
Stage 2: Stage of Diminishing Returns: In stage 2, the total product continues to increase at a diminishing rate until it reaches its maximum at point H, where the second stage ends. In this stage, both marginal product and average product of the variable factor are diminishing but are positive. At the end of this stage i.e., at point M (corresponding to the highest point H of the total product curve), the marginal product of the variable factor is zero. Stage 2, is known as the stage of diminishing returns because both the average and marginal products of the variable factors continuously fall during this stage. This stage is very important because the firm will seek to produce within its range.
Explanation of law of diminishing returns: The question arises as to why we get diminishing returns after a certain amount of the variable factor has been added to the fixed quantity of that factor. As explained above, increasing returns occur primarily because of more efficient use of fixed factors as more units of the variable factor are combined to work with it. Once the point is reached at which the amount of variable factor is suficient to ensure efficient utilisation of the fixed factor, any further increases in the variable factor will cause marginal and average product to decline because the fixed factor then becomes inadequate relative to the quantity of the variable factor. Continuing the above example, when four men were put to work on one machine, the optimum combination was achieved. Now, if the fifth person is put on the machine, his contribution will be nil. In other words, the marginal productivity will start diminishing.
The phenomenon of diminishing returns, like that of increasing returns, rests upon the indivisibility of the fixed factor. Just as the average product of the variable factor increases in the first stage when better utilisation of the fixed indivisible factor is being made, so the average product of the variable factor diminishes in the second stage when the fixed indivisible factor is being worked too hard. Another reason offered for the operation of the law of diminishing returns is the imperfect substitutability of one factor for another. Had the perfect substitute of the scarce fixed factor been available, then the paucity of the scarce fixed factor during the second stage would have been made up by increasing the supply of its perfect substitute with the result that output could be expanded without diminishing returns.
Stage 3: Stage of Negative Returns: In Stage 3, total product declines, MP is negative, average product is diminishing. This stage is called the stage of negative returns since the marginal product of the variable factor is negative during this stage.
Explanation the law of negative returns: As the amount of the variable factor continues to be increased to a constant quantity of the other, a stage is reached when the total product declines and marginal product becomes negative. This is due to the fact that the quantity of the variable factor becomes too excessive relative to the fixed factor so that they get in each other’s ways with the result that the total output falls instead of rising. In such a situation, a reduction in the units of the variable factor will increase the total output.
A rational producer will also not produce in stage 1 as he will not be making the best use of the fixed factors and he will not be utilising fully the opportunities of increasing production by increasing the quantity of the variable factor whose average product continues to rise throughout stage 1. Even if the fixed factor is free of cost in this stage, a rational entrepreneur will continue adding more variable factors.
It is thus clear that a rational producer will never produce in stage 1 and stage 3. These stages are called stages of ‘economic absurdity’ or ‘economic non-sense’.
A rational producer will always produce in stage 2 where both the marginal product and average product of the variable factors are diminishing. At which particular point in this stage, the producer will decide to produce depends upon the prices of factors. The optimum level of employment of the variable factor (here labour) will be determined by applying the principle of marginalism in such a way that the marginal revenue product of labour is equal to the marginal wages. (The principle of marginalism is explained in detail in the chapter discussing equilibrium in different types of markets.)
Returns to Scale:
We shall now study about changes in output when all factors of production in a particular production function are increased together. In other words, we shall study the behaviour of output in response to a change in the scale. A change in scale means that all factors of production are increased or decreased in the same proportion. Change in scale is different from changes in factor proportions. Changes in output as a result of the variation in factor proportions, as seen before, form the subject matter of the law of variable proportions. On the other hand, the study of changes in output as a consequence of changes in scale forms the subject matter of returns to scale which is discussed below. It should be kept in mind that the returns to scale faced by a firm are solely technologically determined and are not influenced by economic decisions taken by the firm or by market conditions.
Returns to scale may be constant, increasing or decreasing. If we increase all factors i.e., scale in a given proportion and output increases in the same proportion, returns to scale are said to be constant. Thus, if doubling or trebling of all factors causes a doubling or trebling of output, then returns to scale are constant.
But, if the increase in all factors leads to more than proportionate increase in output, returns to scale are said to be increasing. Thus, if all factors are doubled and output increases more than double, then the returns to scale are said to be increasing. On the other hand, if the increase in all factors leads to less than proportionate increase in output, returns to scale are decreasing. It is needless to say that this law operates in the long run when all the factors can be changed in the same proportion simultaneously.
It should be remembered that increasing returns to scale is not the same as increasing marginal returns. Increasing returns to scale applies to ‘long run’ in which all inputs can be changed. Increasing marginal returns refers to the short run in which at least one input is fixed. The existence of fixed inputs in the short run gives rise to increasing and later to diminishing marginal returns.
Constant Returns to Scale: As stated above, constant returns to scale means that with the increase in the scale in some proportion, output increases in the same proportion. Constant returns to scale, otherwise called as “Linear Homogeneous Production Function”, may be expressed as follows:
kQx = f( kK, kL)
= k (K, L)
If all the inputs are increased by a certain amount (say k) output increases in the same proportion (k). It has been found that an individual firm passes through a long phase of constant returns to scale in its lifetime.
Increasing Returns to Scale: As stated earlier, increasing returns to scale means that output increases in a greater proportion than the increase in inputs. When a firm expands, increasing returns to scale are obtained in the beginning. For example, a wooden box of 3 ft. cube contains 9 times greater wood than the wooden box of 1 foot-cube. But the capacity of the 3 foot- cube box is 27 times greater than that of the one foot cube. Many such examples are found in the real world. Another reason for increasing returns to scale is the indivisibility of factors. Some factors are available in large and lumpy units and can, therefore, be utilised with utmost efficiency at a large output. If all the factors are perfectly divisible, increasing returns may not occur. Returns to scale may also increase because of greater possibilities of specialisation of land and machinery.
Decreasing Returns to Scale: When output increases in a smaller proportion with an increase in all inputs, decreasing returns to scale are said to prevail. When a firm goes on expanding by increasing all inputs, decreasing returns to scale set in. Decreasing returns to scale eventually occur because of increasing difficulties of management, coordination and control. When the firm has expanded to a very large size, it is difficult to manage it with the same efficiency as before.
The Cobb-Douglas production function, explained earlier is used to explain “returns to scale” in production. Originally, Cobb and Douglas assumed that returns to scale are constant. The function was constructed in such a way that the exponents summed to a+1-a=1. However, later they relaxed the requirement and rewrote the equation as follows:

Q = K La C b

Where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital, ‘K’ and ‘a’ and ‘b’ are positive constants.
If a + b > 1 Increasing returns to scale result i.e. increase in output is more than the proportionate increase in the use of factors (labour and capital).
a + b = 1 Constant returns to scale result i.e. the output increases in the same proportion in which factors are increased.
a + b < 1 decreasing returns to scale result i.e. the output increases less than the proportionate increase in the labour and capital. 

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