Last Updated on: 18th September 2024, 12:53 pm

Production Theory

Production

In this Part, we discuss about Production and related topics like :

• Production
• Land
• Labour
• Capital
• Capital Formation
• Entrepreneur
• Factors of Production
• Laws of Return
• Economies of Scale
• Production Function
• Iso Product curves
• Isoquant
• Iso Cost Line

Production

In common term, Production means the creation of a physical product (such as wheat, rice, camera, computer etc.). According to modern economists, man can neither produce a physical product, nor can destruct it. Man can only alter the form of a physical product to derive utility.

• Creation of utilities: Production implies creation of utilities. Any activity that makes a product more useful, is called production.
• Satisfaction of want: Production includes any activity and the provision of any service, which satisfies or is expected to satisfy a want.

Factors of Production

All goods and services, involved in the process of production (like Land, Labour, Capital, Entrepreneur etc.), are called factors of production.

Land

In common term, land means the upper surface of earth only. In economics, Land consists of all economic wealth and resources supplied by nature (i.e free gifts of nature, like mountains, hills, water resources, mines, air, light etc.), in their original state.

Features of Land

• Free gift of nature:  The supply of land comes from the nature. No human efforts or sacrifice is needed to produce land.
• Diminishing Returns: The constant and continuous cultivation of the land with more application of labour and capital, results in reducing  yield from the land.
• Immobile: Land cannot be shifted from one place to another. So, natural conditions typical to one area cannot be transferred to some other place.
• Heterogeneous: Land, like the other factors of production, differs from one another in nature, fertility and productivity. David Ricardo classifies land as intra-marginal, sub-marginal and marginal lands.
• Limited Supply: The quantity of land is limited. Its supply can neither be increased nor decreased by any human effort. Hence, as per economists, land has no supply price.

Labour

Labour refers to all those physical or mental work done to earn money. For example,if a woman cooks in a party for money, her effort will be called labour, but if the same woman cooks voluntarily (not for money), her effort will not be called labour.

Features of Labour

• Inseparable: Labour cannot be separated from labourer. Labourer has to deliver labour in person being physically present at the production place.
• Destroyable:  The labour power exists as long as the labourer exists. It disappears when the labourer has to sell his labour immediately, irrespective of the price. If labour power is not utilised in proper time, labour is lost.
• Efficiency: Labour efficiency depends upon physical strength, education, skill and motivation to work. On the basis of labour power, labourer may be segregated as skilled, semi-skilled and unskilled. Through motivation, high wage, job security, proper training, proper division of labour, labour efficiency can be enhanced.
• Bargaining power:Labourer usually have no reserve, and are compelled to accept available wages. Labourer are not well organized to bargain for higher wages due to their poor economical background, and maldistribution of labour power.

Division of Labour

Division of labour is the specialization of activities. Division of labour involves splitting up the production process into its component  parts, as per specialized factors on each sub division, and combining them.

Benefits of division of labour

• Productivity: On specialization & division of work,worker achieves more proficiency. Productivity and quality rises.
• Efficiency: The job is divided as per the ability and skill of workers. The right person is placed on the right job. Repetition on the task helps the workers gain efficiency in his job.
• Time & Cost : Specialization gradually decreases the time taken to produce the goods. This causes decrease in cost of production.
• Production Scale: Large-scale production becomes easier through division of labour. This, in turn, leads to decrease in cost of production per unit.

Disadvantages of division of labour

• Inter Dependence: Division of labour leads to inter dependence of labour, as one type of worker depends on the other.
• Job Monotony: When the worker performs a particular work over and over again, he feels tired and loses interest in his job due to monotony of work. For this reason, some companies adopt job rotation among the workers to reduce boredom.
• Risk of Unemployment: Since workers become expert in only one type of work, there is greater risk of unemployment if they lose their present job. Working in the same line, they lose skill in diversified job necessary for getting new jobs.

Labour Mobility

Labour Mobility means the willingness of labourers to move from one place to another place or from one job to another job.

• Territorial Mobility: A labourer moves from one firm or place to another firm or place, in search of better job.
• Occupational mobility: A worker moves from one post to another post (vertical mobility) or from one industry to another (horizontal mobility)

Reasons of Labour mobility

• Social Reasons: Workers change their place of work due to attachment to a particular area. A worker would always prefer to work near his native place.
• Job Promotion:  Workers change their occupation to get better designation
• Economic reasons: Workers change their place of work to get better salary and benefits.
• Working environment:A worker would change his job to get better working environment.
• Job security:  A worker would change job to get more secured job.
• Future Prospects: If a worker finds better future prospects in a particular job, he would be interested to get it and change his job.

Capital

Capital is the part of wealth, which yields or aids in generating income. Capital is used in the process of producing further wealth. 

Characteristics of Capital

• Productive: Labour with the aid of capital can produce more than it can without it. As capital is productive, people demand it and are willing to pay money for it.
• Prospective: People look forward to getting an income by accumulating capital. This feature explains the supply side by capital.
• Result of labour: Tools, machinery, and materials, which are now utilised for producing goods, which were once the immediate products of labour working on natural resources. According to John Stuart Mill capital is the “accumulated product of past labour used for the production of future wealth”.
• Result of saving: Production of capital goods implies creation of goods which cannot be consumed immediately. The reward of such labour (in the form of final goods) comes at a later time. So capital is considered as “a single coherent mass of saved-up labour accumulated over time”.
• Non-permanent: Capital has to be reproduced and replenished from time to time.

Types of Capital

• Real Capital: Real capital refers to the capital in physical form, which we can see, and touch (called material capital). Real capital is directly utilised in production process (like land, building, machinery etc.)
• Human capital: Human capital refers to the qualities of labour force, like intelligence ability, efficiency, character, education, training etc. (also known as personal capital).
• Social Capital: Social Capital refers to capital owned by a society or a country as a whole, like Roads, rivers, bridges, dams, etc. (also known as public capital).
• Fixed Capital: Fixed Capital refers to the capital continued to be utilised in process of manufacture, for a long time (like building, machines, plant, furniture, office equipments etc).
• Circulating capital: Circulating capital refers to  capital, which is used in the process of production, like raw materials etc. (also known as working capital).
• Productive capital: Productive refers to capital used directly in production process, like raw materials, machinery, fuel and power etc.
• Consumption capital: Consumption capital means the capital, which is indirectly utilised in production process like office, staff, canteen, building.

Capital Formation

Capital formation means increasing the stock of real capital, by raising the level of production of goods and services. Capital formation involves diversion of a part of society’s currently available resources, for raising the stock of capital goods for expansion of consumable output in future.

Capital Formation Stages

• Savings: Capital is formed on saving of Income. Saving depends on the income of people. If the income of people is more, they can also save high. However, there must be necessary intention to save.
• Mobilization of Saving: Capital is formed on mobilization of savings. Savings of people need to be mobilised through banks, post-offices, insurance companies and other financial institutions to attract large number of people to save.
• Investment: Investment is final stage of capital formation. Banks and other financial institutions provide the mobilized saving of the public to the entrepreneurs for production process. This is the stage when the saving changes into capital goods.

Entrepreneur

In modern industry, the job of organization of resources is undertaken by a specific class of individuals, called entrepreneurs. The function of the enterprise/ entrepreneur is to expand productive capacity to uplift standard of living of the people. Entrepreneur works to increase production by bringing together land, labour and capital.

Functions of an Entrepreneur

• Planning and Initiation : The entrepreneur formulates proper plan and start the business.
• Risk :The entrepreneur takes risk of business in his personal stride.
• Organisation :After starting the business, the entrepreneur organises the various factors of production like Land, labour, capital etc. and co-ordinate all the resources.  

Factors of Production

To produce goods and services for sale, and generate revenue and profits, a firm must purchase or hire scarce inputs, called Factors of Production. These factors may be classified as  fixed or variable.

Fixed factor inputs : Fixed factors are those that do not change as output is increased or decreased. For example, offices and factories, capital equipment such as machinery and computer systems.

Variable factor inputs : Variable factors are those that do change with output. So, more of such input factors are employed when production increases (and less when production decreases). For example, labour, energy, and raw materials directly used in production.

Production of a commodity is the outcome of combined efforts of various factors to production.

Laws of Return

To enhance production, quantity of the factors of production will have to be increased. Rise in production in respect to a given rise in factors of production is not always same. Such behaviour is explained by Law of Return, as proposed by Prof. Marshall

• Law of Increasing Return : In this stage, increase of output leads to a reduction in the cost of production.
• Law of diminishing Return :  In this stage, when a firm tries to increase output by applying additional variable inputs to a fixed factor, the additional output or returns from each additional marginal unit of  variable factor, diminishes .
• Law of constant Return : In some industries, expansion of output produces no economies or diseconomies (or the economies in one area is balanced by diseconomy in another area)
• Law of Negative Return :  In some situation, total product begins to fall and marginal product becomes negative.

Law of Increasing Returns

The law of increasing returns is said to operate, when increase of output leads to a reduction in the cost of production. It occurs in situation of :

• Economies of scale : In large industries (e.g. steel production) normally increase in the scale of production brings to various economies, external and internal, and the cost of production falls.
• Availability of factors :  If all necessary factors of production are easily available and can be used in suitable proportions, output may increase more than in proportion. The cost of production naturally falls. 

Law of Diminishing Returns

The law of diminishing returns comes into play whenever a firm tries to increase output by applying additional variable inputs to a fixed factor. Both fixed and variable factors are used to create an output. If firms increases the number of variable factors, such as labour, while keeping one factor fixed, such as machinery, the extra output or returns from each additional, marginal unit of the variable factor eventually diminishes.

As per Alfred  Marshal, the law of Diminishing Returns is applied to all fields of production.

 The law of diminishing returns was propounded by Ricardo.

Principle of Variable Proportions :  Diminishing marginal returns forms part of a larger principle, called the principle of variable proportions, which states that, assuming one factor is fixed, the marginal returns generated from adding new variable factors will not be constant.

In fact, returns will rise at first, reach a turning point, and then eventually diminish. The law of diminishing marginal returns simply refers to the last phase of this wider principle.

Marginal Return

The additional output obtained from the use of the last increment of an input is called the Marginal Return.

The example shows that the marginal returns are reducing as the inputs of labour are increasing. The same results will follow if, instead of labour, any other input is increased under similar circumstances. This is called the Law of Diminishing Returns.

Man years of labour	Total output (Total Returns in kilograms)	Extra output added  by the additional unit of labour (Marginal Returns in kilograms)
1	30	30
2	55	25
3	75	20
4	90	15

The Law of Diminishing Returns states that if the input and the factors of production are increased, the total returns increase but the marginal returns diminish.

• Scarcity of Resources: If there is a factor of production, the quantity of which cannot be enhanced easily, the firm will have to do with the limited quantity of that scarce factor. This will decrease the productivity of other factors of production. As a result, the law of diminishing returns will be applicable.
• Change in factors of production: If the quantity of only one factor of production is increased and the quantity of other factors remain fixed, increased quantity of variable factor will have to work with less quantity of fixed factors. It will decrease the productivity of variable factors and law of diminishing return will follow.
• Combination of factors of production: When the quantity of only one factor of production is altered keeping the quantity of all other factors constant, an optimum combination of factors of production is attained. If the quantity of variable factor is further increased, the law of diminishing return will be applicable.

Law of Negative Returns

Law of Negative Return describes the situation in which total product begins to fall and marginal product becomes negative. In such situation, producer would stop to increase the quantity of variable factors of production. This situation begins only after attaining the point of maximum total product. This situation can be improved by decreasing the quantity of variable factors of production.

Law of Constant Returns

In some industries, expansion of output produces no economies or diseconomies, and the cost of production remains the same. Such industries are said to be governed by the law of constant returns.

Sometimes, expansion of output leads to economics in certain matters and diseconomies in others.

If the economies and diseconomies exactly balance, we get constant returns.

In industries, where new firms can come in easily, and the technical structure of all firms is similar, increase of output will occur by increase in the number of firms rather than by expansion of individual firms.

The total output will be produced by a large number of firms of optimum size operating at constant cost.

Time periods of Firm

The fundamental principles of production relate closely to the time periods in question

• Short Run : A firm is said to be in its short run when it can increase its output by using more variable factors, such as by hiring more workers, but not by increasing its fixed factors. In the short run, firms do not use extra fixed factors, such as moving to new premises, to increase output. Therefore, in the short run, at least one factor of production is fixed.

• Long Run : A firm enters its long run when it increases its scale of operations. Increasing scale means that no factor of production is fixed, and all are variable. Typically, this means that a firm expands by building or renting larger premises, purchasing or leasing new machinery and employing more workers.

Returns to a factor during Short-run

Distinction between Short  & Long run Production Function

Short-run Period	Long-run Period
Time Period : Short-run Period is the time period to bring about changes in fixed factors.	Long run Period is the time period in which all factors of production can be changed.
Change in Output : In Short-run Period, Output can be increased by changing variable factors.	In Long run Period, Output can be changed by changing both fixed & variable factors.
Factors of production : In Short-run Period, Factors of production can be categorised as Fixed & Variable.	In Long run Period, distinction of Fixed & Variable factors disappears.
Price Determination : In Short-run Period, Demand plays a dominant role in determination of price of a commodity.	In Long run Period, supply can be adjusted according to change in demand. So demand & supply play equal role in price determination.

Economies of Scale

Economies of scale are the cost advantages that enterprises obtain due to size, output, or scale of operation, with cost per unit of output generally decreasing with increasing scale, as fixed costs are spread over more units of output.

Internal Economies of Scale: When an organization reduces cost by increasing its production, Internal economies of Scale is achieved. Internal economy of scale operates within the orgnisation

• Labour Economies: Large-scale production leads to specialization, which saves time, leads to automation and helps in achieving “cumulative volume” economies.
• Technical economies: Such economies are related with the ‘fixed capital’, which includes all types of machinery and other equipment. The technical economies arise due to specialization, set up cost, reserve capacity requirement etc.
• Marketing economies: When scale of production increases, the marketing cost per unit declines as normally marketing cost is almost of fixed in nature.
• Managerial Economies: These arise in the form of decentralization, teamwork, mechanization and adoption of time saving managerial techniques.

Internal Diseconomies of Scale : On the other hand, Internal diseconomies may also occur due various reasons, within the organisation.

• Production diseconomies: When inferior or inefficient factors of production are used, the cost starts rising again.
• Managerial Diseconomies: It operates when the organisation finds it difficult to control and co-ordinate the activities of all the departments, as the scale of operation crosses a threshold.
• Marketing Diseconomies: It operates when marketing overheads rise more than proportionately with the increment in output.
• Financial Diseconomies: It starts to operate when the financial cost rises more than proportionate output after the optimum scale, due to more dependence on external finance.

External Economies of Scale : When an Industry’s scope of operation expands due to better economic environment, infrastructure & government policies, External Economies of scale is achieved. External economy of scale benefits all the firms of the Industry.

• Technological Economies:  When the whole industry expands, the demand for improvement in the technology used in that industry increases. Improvement of existing technology lead to the improvement of new technology. This technical development causes decrease in the cost of production.
• Raw Material and Capital Equipment: When an industry expands, the demand for the material and capital equipment required by it also increases. Consequently, the suppliers of the material and capital equipment attempt to give at lower cost, which decreases the cost of production.
• Labour Economies: Due to expansion of industry in a particular area, labour of that area becomes accustomed to do the various production process of that industry. Consequently, the firms of that industry do not have to go anywhere to find out efficient labourer. More the skilled labour, wastage of material as well as the cost of production decreases.
• Economies of By-products: The expansion of an industry would help the firms to decrease their cost of production through better usage of wastage material. The waste material of one firms may be useable as raw materials in other firms, thereby enabling to decrease their cost of production.
• Infrastructure Facilities: The expansion of an industry may lead to improvement of the network of infrastructure facilities, such as transportation, banking, roads, insurance, finance, etc. The development of infrastructural facilities decreases the cost of product.

Production Function

Production Function states the relationship between inputs and output i.e. the amount of output that can be produced with given quantities of inputs under a given state of technical knowledge. The inputs are the different factors of production (i.e. land, labour, capital and enterprise), and the  output is obtained in the form of goods or services  produced.

Production function can be expressed as the minimum quantities of various inputs required to yield a given quantity of output. Cost function is associated with production function.

Q = f (x₁, x₂, x₃ ……x_n)

Where Q is the quantity produced during a given period of time and  (x₁, x₂, x₃ ……x_n) are the quantities of various inputs used in production.

Analysis of Production Function

• The production function of a firm can be studied by holding the quantities of some factors fixed, while varying the amount of other factors, through the law of variable proportion.
• The production function can also be studied by varying the amounts of all factors.
• The behaviour of production when all factors are varied is the subject matter of the laws of returns to scale. The theory of production or production analysis is also concerned with explaining which combination of inputs a firm will choose so as to minimize its cost of production.

Production optimization

Every manufacturer wants to achieve maximum production at minimum cost, by setting up an optimum combination of the factors of production (called product optimization). Product optimization phenomenon may be demonstrated through certain graphic representations.

• Iso product curves :  Represents the best combination of several alternative cost methods open to him, to produce a given output out at lowest cost
• Isoquants or Equal Product Curve : An isoquant is the line drawn through the set of points at which the same quantity of output is produced while changing the quantities of two or more inputs.
• Iso cost lines :  The iso cost line is combined with the isoquant map to determine the optimal production point at any given level of output

Cobb-Douglas Production function

One of the famous empirically analysed production functions is the Cobb-Douglas Production Function, which in its original form is applied to the whole of the manufacturing industry.

Cobb-Douglas Production function proposes two inputs, labour and capital. It says that about 75 per cent of the increase in production is due to labour and 25 per cent is due to capital.

The mathematical form of the Cobb-Douglas production function is

Q = KL^a xC^1-a _, where Q is the output, L is the quantity of labour, C is the quantity of capital and ‘K’ and ‘a’ are positive constants (a < 1).

The Cobb-Douglas production function exhibits Returns to Scale.

Returns to Production Factor

• Total product: It indicates the amount of a particular product produced by any firm using both fixed & variable factors of production during any particular time period. For example, a firm may produce 30 units of a product per day by using one unit of capital (K) & 3 units of Labour (L). Since the fixed factor (K) remains unchanged during the short-run, we may call it the total product of a variable factor. [TP_L = Q]
• Average Product: It refers to variable factor of output per unit. If total product = 30 units & three workers are employed to produce that output, then AP = 30/3, or AP_L = Q/L.
• Marginal Product: It is the rate of change in total product or change in total product due to one additional change in variable factor.

Iso Product curves

Iso-product curve represents all the possible combination of two factors of production, which produce equal amounts of production. A producer is indifferent to all these combinations.

Example

A given output can be achieved by employing different combinations of factors of production. Let us assume that a firm can produce 10 units of a commodity by employing any of the following alternative combinations of two factors ‘x’ and ‘y’.

Combination	Units Factor ‘x’	Units Factor y’	Output Units
M	9	5	9x+5y=10
N	7	7	7x+7y=10
O	5	10	5x+10y=10
P	3	15	3x+15y=10
Q	2	19	2x+19y=10

Properties of ISO-Product Curve : ISO-Product Curves slope downwards to the right. ISO-Product Curves are convex to the origin. ISO-Product Curves cannot intersect each other. An ISO-Product curve lying to the right represents larger output.

Isoquant  or  Equal-Product Curves

The Isoquant Curve (also known as equal product curve) shows all combinations of inputs yielding the same level of output.

Combination of input	Input E	Input F	Output
M	2	16	14
N	3	12	14
O	4	8	14
P	6	4	14

All the form of combinations M, N, O and P give the same level of output.

Characteristics of Isoquant

• Isoquant is also known as production indifference curve. 
• An isoquant slopes downward to the right because a decrease in the quantity of one factor of production must be associated with an increase in the quantity of another factor of production so that the same level of production may be maintained.
• At equilibrium point a specific isoquant is tangent to an isocost line.
• Usually isoquants are covex to the origin.

Iso Cost Line

An Isocost line shows all combinations of inputs which cost the same total amount. The point of tangency between isoquant and isocost line gives the lowest-cost combination of inputs that can produce the level of output associated with that isoquant.

Iso Cost Line-dVidya.com

The use of the isocost line pertains to cost-minimization in production, as opposed to utility-maximization.

The equation of the isocost line is :

rK+wL=C, where w & r represents the rate of the production factors,  K & L represent respective quantity of the factor employed (e.g. w represents the wage rate of labour, r represents the rental rate of capital, K is the amount of capital used, L is the amount of labour used), and C is the total cost of acquiring those quantities of the two inputs.

The absolute value of the slope of the isocost line, with capital plotted vertically and labour plotted horizontally, equals the ratio of unit costs of labour and capital. The slope is -w/r.

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MCQ related to Production

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