1. Unit 6
Production
Objectives:
After going through this unit, you will be able to explain:
Concept of production and production process
Factors of production
Production functions and its various types
Optimal level of output for a given level of inputs
Why firms grow large in size
Economies of scale and scope
Structure:
1.1 Introduction
1.2 Concept of production
1.3 Factors of production
1.4 Production function
1.5 Production function with one variable input – Returns to factor
1.6 Law of variable proportions and returns to factor
1.7 Production function with two variable inputs - Isocosts, Isoquants and
producer’s equilibrium
1.8 Production function when all inputs are variable - Returns to scale
1.9 Economies and Diseconomies of Scale
1.10 Economies of Scope
1.11 Summary
1.12 Key words
1.13 Self-assessment questions

2. 1.1 Introduction
In our earlier units we have discussed about the economic tools that help sellers
understand the consumer better. In this unit we shall explore those economic tools which
concern with marketers ability to supply in the market. Production decisions concentrate
on levels of output and processes and systems used for optimizing the mix of resource
inputs. In other words, the tools discussed in this unit will help sellers in efficient
utilization of resources for effectiveness in achieving production goals. The production
skill can be combined with effective consumer and market information to determine the
optimum quantity of goods and services to manufacture and the appropriate price to
charge.
1.2 Concept of Production
Production is simply the conversion of inputs into output. It is an economic process that
uses resources to create a commodity that is suitable for trade and fulfills customer
expectations. Production can include multifarious activities – resource planning,
manufacturing, packaging, and logistics. In economics all activities other than the
consumption of goods and services involve some or the other production activity and is
hence, referred to as production.
Production should really be viewed as a process that occurs over a period of time. There
are three aspects to production processes:
a) Inputs
b) Process
c) Final output
Consider the following figure:

3. P R O D U C T I O N
INPUT PROCESS OUTPUT
In this entire production process as described in the above diagram there are multiple
decisions involved. Let us begin understanding these decisions with the first link – the
inputs, which are also called factors of production.
1.3 Factors of production
The inputs or resources used in the production process also called as factors of production
are numerous in number. In economics they are usually grouped into four categories.
These factors are:
a) Land
b) Labour
c) Capital
d) Enterprise
a) Land is the natural resources available for production. By convention,
economists include in the category land both,
(i) The “original and indestructible powers of the soil” and
(ii) Natural resources, such as coal, oil, and metallic ores.
b) Labour is the human input into the production process. Labor uses capital on
land to produce wealth. It covers both physical and mental effort - e.g.
stacking shelves in a supermarket, or calculating the final accounts of a
company.
c) Capital includes the manufactured resources used to manufacture or produce
other goods and services. Common examples of capital are the factories,
buildings, trucks, tools, machinery, and equipment used by businesses in their

4. productive pursuits. Capital’s primary role in the economy is to improve the
productivity of labor as it transforms the natural resources of land into wants-
and-needs-satisfying goods. Capital can be understood as fixed or working,
(i) Fixed capital includes long-term capital such as machinery, plant
and equipment, new technology, factories and buildings.
(ii) Working capital includes inventories of finished and semi-
finished goods and other inputs that will be either consumed or
converted into finished goods.
d) Entrepreneurs are people who organize other productive resources to make
goods and services. They are factor responsible for acquiring and utilizing all
the other factors. The success and/or failure of a business often depend
critically on the entrepreneurial skill and effort.
1.4 Production Function
We have seen that production is really the process o converting inputs into output. Then it
can be drawn out that there should be a relationship between output and inputs. This
relationship requires us to understand the concept of production function.
A production function expresses the relationship between an organization’s inputs and its
output. It indicates, in mathematical or graphical form, what output can be obtained from
various amounts and combinations of factor inputs. In particular it shows the maximum
possible amount of output that can be produced per unit of time with all combinations of
factor inputs, given current factor endowments and the state of available technology.
The relationship is non-monetary, that is, a production function relates physical inputs to
physical outputs. Prices and costs are not considered. In simple words, the production
function relates the output of a firm to the amount of inputs.

5. We can express the production function summarizing the process of conversion of factors
into a commodity, let’s say ‘y’ in the form of a general equation as follows,
y = f(n1,n2,……nx),
which relates a single output y to a series of factors of production n1, n2, ..., nx.
In this sense then, production functions explain the dependency of output on factor inputs
and the response of output when inputs change. Using the above equation unique
production functions can be constructed for every production technology.
The following section analyses this relationship in three different ways,
a) Production function when one input is variable
b) Production function when two inputs are variable
c) Production function when all inputs are variable
It is important to understand at this point what we mean by a variable input. All
businesses operate in a short and a long run. The short run is characterized myriad
constraints. One of the constraints is the availability of factor inputs. While in the long
run these constraints may not prevail. It is on this basis that we can define fixed and
variable inputs:
a) Fixed inputs are those whose quantities cannot be changed over the time period
in consideration.
b) Variable inputs are those whose quantities can be altered over the time period in
consideration
We are now ready to understand production function when factor inputs can be fixed or
variable.
1.5 Production function when one input is variable – Returns to factor
We begin studying the relationship between output and inputs by first keeping one input
variable and the other inputs constant. When this is done the Law of Variable Proportions
operates. We know that variable input is an input whose quantity can be changed in the

6. time period under consideration. The most common example of a variable input is labor.
A variable input provides the extra inputs that a firm needs to expand short-run
production. In contrast, a fixed input, like capital, provides the capacity constraint in
production. When inputs are used in this fashion there is production of a certain level of
output. There are three aspects of this output that we need to understand:
a) Total output or total physical product (TPP)
b) Average output or average physical product (APP)
c) Marginal output or marginal physical product (MPP)
a) The total physical product identifies what output is possible using various levels of
the variable input. This can be displayed in either a chart that lists the output level
corresponding to various levels of input, or a graph that summarizes the data into a “total
product curve”. Consider the following table and the diagram that show a TPP data and
TPP curve.
Units of Total Physical
variable input Product
1 10
2 30
3 90
4 120
5 130
6 120

7. Output
A
Inputs
In this example, output increases as more inputs are employed up until point A.
The average physical product is the total product divided by the number of units of
variable input employed. It is the output of each unit of input. It can be calculated using
the following equation:
APP = TPP
Quantity of inputs
Where APP = average physical product and TPP = total physical product.
For example, if there are 10 employees working on a production process that
manufactures 50 units per day, then using the above equation the average product of
labour input can be calculated to be 5 units per day.
The average product typically varies as more of the input is employed, so this
relationship can also be expresses as a chart or as a graph.

8. The marginal physical product is the change in total output due to a one unit change in
the input or alternatively the rate of change in total output due to change in the variable
input. It can be calculated using the following equation:
MPP = ΔTPP
ΔQuantity of inputs
Where MPP = marginal physical product and TPP = total physical product
The following table and figure show the APP and MPP that have been derived form TPP
using the formulae mentioned.
Units of
Input TPP MPP APP
1 10 10 10
2 30 20 15
3 90 60 30
4 120 30 30
5 130 10 26
6 120 -10 20
Output
APP
MP
Inputs

9. Because the marginal product drives changes in the average product, we know that when
the average physical product is falling, the marginal physical product must be less than
the average. Likewise, when the average physical product is rising, it must be due to a
marginal physical product greater than the average. For this reason, the marginal physical
product curve must intersect the maximum point on the average physical product curve.
Based on the basic concept we can now discuss the Law of Variable Proportions which
describes the response of total output when one input is variable while others are kept
constant.
1.6 Law of Variable Proportions
According to the Law of variable proportions that as we add more and more of a variable
input, we will reach a point beyond which increase in output starts to diminish. When one
of the inputs is variable and the others are kept constant, the output initially increases at
an increasing rate, thereafter the rate of increase diminishes, and after this point if more
units of the variable input are added the TPP actually declines. Consider the following
diagram,
Output
Stage II Stage III
Stage I
TPP
APP
Inputs
MPP

10. To simplify the interpretation of this production function with on variable input, we can
divide the response of output into 3 stages. Consider the following table:
Stages in production Response of TPP Response of APP Response of MPP
function
Stage I – Increasing Increases at an Increases at an Increases at an
returns to factor increasing rate increasing rate increasing rate
Stage II – Increases at an Declines Declines
Diminishing returns diminishing rate
to factor
Stage II –Decreasing Declines Declines Becomes negative
returns to factor
In stage I the variable input is being used with increasing efficiency and the response of
TPP, APP, and MPP is very positive. This is why a firm will try to operate beyond this
stage. This happens because, perhaps, the fixed inputs are underutilized.
In Stage 2, TPP increases at a decreasing rate, and the average and marginal physical
product is declining. In this stage, the employment of additional variable inputs increase
the efficiency of fixed inputs but decrease the efficiency of variable inputs. The optimum
input/output combination will be in stage 2. Maximum production efficiency must fall
somewhere in this stage.
If firms continue to Stage 3, too much variable input is being used relative to the
available fixed inputs. Both the efficiency of variable inputs and the efficiency of fixed
inputs decline through out this stage. The result is that TPP and APP decline and MPP
becomes negative.
1.7 Production Function when two inputs are variable - Isocosts, Isoquants and
producer’s equilibrium

11. In this section we will study the response of output when two inputs are variable while
other are fixed. To understand how the output responds and the consequent equilibrium
situation of the producer requires us to understand the concept of,
a) Isoquants, and
b) Isocosts
An isoquant, in the case of two variable input, is a curve that shows all the ways of
combining two inputs so as to produce a given level of output. Iso is Latin for equal and
quant is short for quantity. Isoquants can be identified with the following characteristics:
(i) Movement along an isoquant depicts a constant rate of output, but a
changing input ratio.
(ii) A unique isoquant can be constructed for every level of output, and a family
of isoquants can be created to represent various output levels.
(iii) Isoquants further from the origin represent greater amounts of output.
(iv) Isoquants are usually considered to be everywhere dense, meaning an
infinite number of them could be plotted in any two input space.
(v) The “downward to the right” slope of the economic region of an isoquant is
due to the possibility of substituting one input for another in the production
process while keeping the level of output constant.
(vi) Isoquants are typically convex to the origin reflecting the fact that the two
factors are substitutable for each other at varying rates. This rate of
substitutability is called the “marginal rate of technical substitution”
(MRTS) or occasionally the “marginal rate of substitution in production”. It
measures the reduction in one input per unit increase in the other input that
is just sufficient to maintain a constant level of production. For example, the
marginal rate of substitution of labour for capital gives the amount of capital
that can be replaced by one unit of labour while keeping output unchanged.
Consider the following figure,

12. Input A
I4
I3
I2
I1
0
Input B
In the above figure the two variable inputs are B and A. When taken on x and y axis
respectively, there can several convex-shaped, downward sloping isoquants be plotted,
each representing various combinations of inputs for a given level of output. Isoquants
represent possibilities of variable input combinations or various levels of output.
Isoquants, infact, can be understood as a producer’s indifference curve where on the same
isoquant producer is indifferent between various combinations of inputs because they
produce the same level of output.
However, the specific input combination that is chosen by the producer also depends on
one more factor that is his affordability of the inputs. This can be found out through the
producer’s budget line. The producer’s affordability is reflected through an Isocost. An
Input A
isocost defines the producer’s budget or his maximum expenditure on the two variable
inputs. Consider the following figure,
A
Isocost
Input B
0
B

13. In the above figure, AB is the isocost. It is derived after defining the maximum amount of
both the inputs that the producer can purchase given his budget constraints.
Producer’s equilibrium or purchase decision is derived using both the Isoquants and the
Isocost as shown in the following figure,
Input A
e I3
A’
I2
I1
0
B’ Input B

14. In the above figure, the producer buys that combination of the two inputs which is
defined by point ‘e’. At e OA’ and OB’ of input B are used to produce the level of output
defined by isoquant I2. All points below this point do not maximize output and all points
beyond it are not affordable for the producer. The equilibrium point is, hence, e where the
producer’s isocost is tangent to the highest isoquant.
1.8 Production Function when all inputs are variable - Returns to scale
When all the inputs in the production process are altered an economic concept that comes
into play is called as Returns to Scale.
Returns to Scale refers to a technical property of production that explains what happens
to output if we increase the quantity of all input factors by some amount.
The returns to scale exhibiting the response of output to a change in all inputs can be any
one of the following,
a) Increasing
b) Diminishing
c) Constant
d) Variable
Consider the following diagrams,

15. Output Output
b
a
Inputs Inputs
Output Output
d
c
Inputs Inputs
The above diagrams showing for possible returns to scale are described in the following
table,
Diagram Response of Description
No. output
a) Increasing Output increases by an amount that is more than the

16. returns to scale quantity of inputs.
b) Diminishing Output increases by an amount that is less than the
returns to scale quantity of inputs.
c) Constant returns Output increases by an amount that is same as the
to scale quantity of inputs.
d) Variable returns Output first increases by an amount that is more than the
to scale quantity of inputs and after a certain point increases by an
amount that is less than the quantity of inputs.
The production facilities showing increasing returns to scale are high growth, while
matured and stable growth production facilities show diminishing and constant returns to
scale. However, empirical studies show that over the lifetime production facilities mostly
exhibit variable returns to scale, i.e., increasing returns to scale in the initial years and
diminishing returns to scale after a certain point of time. This happens because of what
we call in economics Economies of Scale. The following section explains the concept and
how it causes variable returns to scale.
1.9 Economies and Diseconomies of Scale
Economies and diseconomies of scale refer to that aspect of production which evaluates
what happens to cost if we increase the quantity of all input factors by some amount. If
costs increase proportionately, there are no economies of scale, if costs increase by a
greater amount, there are diseconomies of scale, if costs increase by a lesser amount, and
there are (positive) economies of scale. Economies of scale are thus reduction in average
cost of production as firms grow large in size or increase the scale of production When
combined, economies of scale and diseconomies of scale lead to ideal firm size theory,
which states that per-unit costs decrease until they reach a certain minimum, then
increase as the firm size increases further.
Economies of scale tend to occur in industries with high capital costs in which those costs
can be distributed across a large number of units of production. The exploitation of
economies of scale helps explain why companies grow large in some industries. It is also
a justification for free trade policies, since some economies of scale may require a larger

17. market than is possible within a particular country. Typically, because there are fixed
costs of production, economies of scale are initially increasing, and as volume of
production increases, eventually diminishing, which produces the standard U-shaped cost
curve of economic theory. In some economic theory (e.g. perfect competition) there is an
assumption of constant returns to scale.
There are two main types of economies of scale:
a) Internal
b) External.
a) Internal economies of scale: Internal economies of scale relate to the lower unit
costs a single firm can obtain by growing in size itself. There are five main types of
internal economies of scale.
(i) Managerial economies: As a firm grows, there is greater potential for
managers to specialize in particular tasks e.g. marketing, human resource
management, finance. Specialist managers are likely to be more efficient as
they possess a high level of expertise, experience and qualifications
compared to one person in a smaller firm trying to perform all of these roles.
(ii) Financial economies: Many small businesses find it hard to obtain finance
and when they do obtain it, the cost of the finance is often quite high. This is
because small businesses are perceived as being riskier than larger
businesses that have developed a good track record. Larger firms therefore
find it easier to find potential lenders and to raise money at lower interest
rates.
(iii) Economies of bulk purchases: As businesses grow they need to order
larger quantities of production inputs. For example, they will order more
raw materials. As the order value increases, a business obtains more

18. bargaining power with suppliers. It may be able to obtain discounts and
lower prices for the raw materials.
(iv) Economies of risk-spreading: As firms grow in size they are more capable
of spreading risks across products and markets. A simple rule of economics
and finance is that not all markets go bad in a day. Working on this
principle, for minimization of risks, is possible for firms when they grow in
size and begin to expand and diversify.
(v) Marketing economies: Every part of marketing has a cost – particularly
promotional methods such as advertising and running a sales force. Many of
these marketing costs are fixed costs and so as a business gets larger, it is
able to spread the cost of marketing over a wider range of products and sales
– cutting the average marketing cost per unit.
(vi) Technical economies: Businesses with large-scale production can use more
advanced machinery or use existing machinery more efficiently. This may
include using mass production techniques, which are a more efficient form
of production. A larger firm can also afford to invest more in research and
development
b) External economies of scale: External economies of scale occur when a firm benefits
from lower unit costs as a result of the whole industry growing in size. The main types
are:
(i) Improvement in communication and transport infrastructure: As an
industry establishes itself and grows in a particular region, it is likely that
the government will provide better transport and communication links to
improve accessibility to the region. This will lower transport costs for firms
in the area as journey times are reduced and also attract more potential
customers

19. (ii) Development of skilled human resource: Training and education becomes
more focused on the industry. Universities and colleges will offer more
courses suitable for a career in the industry which has become dominant in a
region or nationally
(iii) Growth of support industries: Other industries grow to support this
industry. A network of suppliers or support industries may grow in size
and/or locate close to the main industry. This means a firm has a greater
chance of finding a high quality yet affordable supplier close to their site.
Out of internal and external economies of scale the internal economies have a greater
potential impact on the costs and profitability of a business. This is because they are
internal to the firm and relatively more in favor, while external economies are external
and therefore would be dependent on exogenous variables.
Consider the following diagram to understand economies scale.
Costs
Economies of
scale Diseconomies
of scale LRAC
c
c’
q q’ Output
In the above figure increase in output from q to q’ causes a decrease in the average cost
of each unit from c to c’. Beyond q’ level of output the average cost curve starts rising
indicating the appearance of diseconomies of scale.

20. Diseconomies of scale are the forces that cause larger firms to produce goods and
services at increased per-unit costs. Diseconomies of scale result in increase in average
cost of production as firms grow large in size or increase the scale of production beyond
the optimum firm size.The primary causes underlying diseconomies arise out of
managerial and administrative inefficiencies. Some of the forces which cause a
diseconomy of scale are listed below.
(i) Problems of Communication and Control: Ideally, all employees of a
firm would have one-on-one communication with each other so they know
exactly what the other workers are doing. As firm grows in size the one-on-
one channels of communication grow more rapidly than the number of
workers, thus increasing the time, and therefore cost, of communication.
(ii) Duplication of effort: When firms grow to thousands of workers, it is
inevitable that someone, or even a team, will take on a project that is already
being handled by another person or team.
(iii) Top-heavy companies: The more employees a firm has, the larger
percentage of the workforce will be “management” and lower percentage of
“line workers”. Managers are necessary to manage a large, complex
company, but should be considered a “necessary evil” as they also reduce
overall productivity.
(iv) Interpersonal behavioral issues: This will be defined as management
behavior which that manager knows is counter to the best interest of the
company, but is in their personal best interest The more levels, the more
opportunity for this.
(v) Isolation of employees from decisions: An individual employee at a huge
company may not be linked be with a lot of decisions and issues happening

21. in the company which may affect the company as a whole as well him as an
employee also.
1.10 Economies of scope
Another advantage that firms enjoy is Economies of scope which refers to benefits
derived out of exploiting efficiencies associated with increasing or decreasing the span of
marketing and distribution by bringing about changes in the number of different types of
products manufactured and sold. The benefits that are drawn out to of economies of
scope include the following:
(i) Spreading advertising and promotion costs: As the number of products
promoted is increased and broader media used, more people can be reached
at the same cost
(ii) Spreading the cost of skilled workforce: A sales force is selling several
products can often be more efficient than a sales force selling only one
product. The cost of their travel time is distributed over a greater revenue
base, so cost efficiency improves.
(iii) Benefits from product range synergies: There can also be synergies
between products such that offering a complete range of products gives the
consumer a more desirable product offering than a single product would.
(iv) Distribution synergies: Economies of scope can also operate through
distribution efficiencies. It can be more efficient to ship a range of products
to any given location than to ship a single type of product to that location.
(v) Making use of by-products: Further economies of scope occur when there
is cost-savings arising from by-products in the production process. For
example juice manufacturers can use the by product fruit pulp for making of
jams.

22. 1.11 Summary
In this unit we have studied that production decisions concentrate on levels of output and
processes and systems used for optimizing the mix of resource inputs. Production should
really be viewed as a process that occurs over a period of time. The inputs or resources
used in the production process also called as factors of production are numerous in
number. In economics they are usually grouped into four categories. A production
function expresses the relationship between an organization’s inputs and its output.
Empirical studies show that over the lifetime production facilities mostly exhibit variable
returns to scale, i.e., increasing returns to scale in the initial years and diminishing returns
to scale after a certain point of time. This happens because of what we call in economics
Economies of Scale. Economies and diseconomies of scale refer to that aspect of
production which evaluates what happens to cost if we increase the quantity of all input
factors by some amount. Firms also enjoy economies of scope when they diversify into
similar or different products.
1.12 Key words:
a) Production: The process of conversion of inputs into output.
b) Factors of production: The inputs or resources used in the production process.
c) Production function: Expresses the relationship between an organization’s
inputs and its output.
d) Fixed inputs: Inputs whose quantities cannot be changed over the time period in
consideration.
e) Variable inputs: Inputs whose quantities can be altered over the time period in
consideration
f) Returns to factor: Response of output when one input is variable.
g) Total physical product: Total output as result of using various levels of input.
h) Average physical product: The total product divided by the number of units of
variable input employed.

23. i) Marginal physical product: The change in total output due to a one unit change
in the input.
j) Law of variable proportions: As we add more and more of a variable input, we
will reach a point beyond which increase in output starts to diminish.
k) Isoquant : A curve that shows all the ways of combining two inputs so as to
produce a given level of output.
l) Isocost: The producer’s budget or his maximum expenditure on the two variable
inputs.
m) Returns to Scale: A technical property of production that explains what happens
to output if we increase the quantity of all input factors by some amount.
n) Economies of Scale: Reduction in average cost of production as firms grow large
in size or increase the scale of production.
o) Diseconomies of Scale: Increase in average cost of production as firms grow
large in size or increase the scale of production beyond the optimum firm size.
p) Internal economies of scale: Lower unit costs a single firm can obtain by
growing in size itself.
q) External economies of scale: Benefits for an individual firm from lower unit
costs as a result of the whole industry growing in size.
r) Economies of scope: Benefits derived out of exploiting efficiencies associated
with increasing or decreasing the span of marketing and distribution by bringing
about changes in the number of different types of products manufactured and
sold.
1.13 Self-assessment questions
1) Explain the concept of production and production function
2) Discuss, in detail, the Law of Variable Proportions
3) Distinguish between
a) Isocosts and Isoquants
b) Fixed and Variable inputs
c) Returns to factor and returns to scale
d) Economies and diseconomies of scale

24. e) Economies of scale and scope
4) Explain production function when all inputs are variable
5) Write a brief note on Internal and external economies of scale
6) The process of conversion of inputs into output is called,
a) Consumption
b) Distribution
c) Production
d) None of the above
7) Production function expresses the relationship between an organization’s
a) Inputs and output
b) Inputs and economies
c) Economy and output
d) All of the above
8) The inputs or resources used in the production process, in economic, are called as
a) Factors of consumption
b) Factors of distribution
c) Factors of production
d) None of the above
9) Inputs whose quantities cannot be changed over the time period in consideration
are called,
a) Fixed
b) Variable
c) Constant
d) Moving
10) Inputs whose quantities can be changed over the time period in
consideration.
a) Fixed
b) Variable
c) Constant
d) Moving
11) Fill in the blanks:

25. a) __________________________ is the response of output
when one input is variable.
b) __________________________ is the total output as result
of using various levels of input.
c) __________________________ is the total product divided
by the number of units of variable input employed.
d) __________________________ is the change in total
output due to a one unit change in the input.
e) __________________________ says that as we add more
and more of a variable input, we will reach a point beyond which increase
in output starts to diminish.
f) __________________________ is the curve that shows all
the ways of combining two inputs so as to produce a given level of output.
g) __________________________ is the producer’s budget or
his maximum expenditure on the two variable inputs.
h) __________________________ is the technical property of
production that explains what happens to output if we increase the
quantity of all input factors by some amount.
i) __________________________ is the reduction in average
cost of production as firms grow large in size or increase the scale of
production.
j) __________________________ is the increase in average
cost of production as firms grow large in size or increase the scale of
production beyond the optimum firm size.
k) __________________________ is the benefits of lower
unit costs a single firm can obtain by growing in size itself.
l) __________________________ is the benefits for an
individual firm from lower unit costs as a result of the whole industry
growing in size.