Production analysis and concept of marginality 3.

1
PRODUCTION ANALYSIS (THEORY OF FIRM)

The theory of the firm consists of a number of economic theories, which describe the nature
of the firm (company or corporation), including its behavioural aspects and its relationship
with the market.

In the theory of production, we leargely discuss the relation between inputs and outputs.

The inputs are what a firm buys (i.e. productive resource) and outputs (i.e. goods and
services produced) what it sells. The firm can be defined as base of the production or as the
smallest unit of production in an economy.

The theory of production is the study of:

 factor of production and their organization,
 law of production,
 theories of population (in relation with an important and special factor of production
- labour),
 production function,
 law of return to scale,
 Cost concepts and least- cost combination of factors,

Production theory describes physical (technical & technological) conditions under which
production take place, it brings out the relationship between output and inputs, i.e. various
combination of inputs, and also explain how the least cost combination is arrived at. From
the perception of business administration, the theories also look at the economic
consequences of the different incentives influencing individuals working within companies,
tackling issues such as pay, agency costs and corporate governance structures.

FIRMS

The ‘Firm’ generally term for a commercial organization, such as, business, company,
concern, corporation, enterprise, partnership, proprietorship etc those are engage with
producing any sort of good or service. In economic analysis, firm is considered as the ‘unit
of production’ and used to describe a collection of individuals grouped together for
economic gain.

For many years, economists had little interest in what happened inside firms, preferring
instead to examine the workings of the different sorts of industries in which firms operate,
ranging from perfect competition to monopoly. Since the 1960s, however, sophisticated
economic theories of how firms work have been developed. These have examined why firms
grow at different rates and tried to model the normal life cycle of a company, from fast-
growing start-up to lumbering mature business. The aim is to explain when it pays to
conduct an activity within a firm and when it pays to externalise it through short- or long-
term arrangements with outsiders.

PRODUCTION

Production is one of the three major economic activities that is done in the human society.
Production in an economy is generally understood as the process of transforming inputs
into outputs. It can also be defined as the process of creating utility, more precisely, the
creation of want satisfying goods and services in a planned manner by using natural
resources. In defining ‘Production’ economic gives similar importance on ‘value creation’ as
‘creation of utility’. For instance, cooking food for family members is definitely an activity
for addition of utility, but cannot be recognized as economic production. Production,
therefore, should be defined as not as only creation of utility, but creation (or addition) of
value also.

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 Production analysis and concept of marginality 3.1

PRODUCTION FUNCTION

The production function relates the amount of output of a firm to the amount of
inputs, typically capital and labor, required to produce the output.

The production function is the relationship between the maximum amounts of output that
can be produced by a firm (a unit of production) and the inputs required to make the
output. It is defined for a given state of technological knowledge.

It is important to keep in mind that the production function describes technology, not
economic behavior. A firm may maximize its profits given its production function, but
generally takes the production function as a given element of that problem. (In specialized
long-run models, the firm may choose its capital investments to choose among production
technologies.)

Q= f (K, L) is an example of typical production function.

Where, Q = Amounts of total output,
K = capital and L = labour.

‘ f ’ is the (algebraic) expression of the functional relationship between inputs (K=capital

and L=labour) and output.

The following three production concepts are very familiar in the production theory of
economics.

(i) Total Product:

Total production (TP) is the amount of total ‘physical product’. It designates the total
amount of output produced in physical units (ton, barrel, etc.)

(ii) Average Product:

Average product (AP) measures the total output divided by total units of input. It is a
statistical measurement of output.

(iii) Marginal Product:

The marginal product (MP) of an input is the extra product or output added by 1 extra unit
of that input while other inputs are held constant, i.e., the marginal product is the output
produced by one more unit of a given input.

LAW OF DIMINISHING MARGINAL RETURN:

The law of diminishing marginal returns is a production-principle propounded by David

Ricardo (1772-1823). The economic law states that if one input used in the manufacture of
a product is increased while all other inputs remain fixed, a point will eventually be reached
at which the input yields progressively
smaller increases in output. For example, a Unit of Total Marginal Average
labour Production Production Production
farmer will find that a certain number of 0 0
farm labourers will yield the maximum 2,000
output per worker. If that number is 1 2,000 2,000
1,000
exceeded, the output per worker will fall. 2 3,000 1,500
500
In common usage, the “point of diminishing 3 3,500 1,167
returns” is a supposed point at which 300
4 3,800 950
additional effort or investment in a given 100
endeavor will not yield correspondingly 5 3,900 780

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 Production analysis and concept of marginality 3.1
increasing results.

The above table and the figures below show the mathematical and graphical example of
diminishing marginal return of labour in a small agricultural firm.
Marginal Product Curve
Production Curve (Total Product)

2500
5000

Marginal Product
2000
Total Product

4000
3000 1500

2000 1000
1000 500
0
0
0 1 2 3 4 5
0 1 2 3 4 5
Unit of Input (Labour)
Unit of Input (Labour)

SHORT RUN AND LONG RUN

There is no fixed time that can be marked on the calendar to separate the short run from
the long run, because, long run and the short run do not refer to a specific period of time
such as 3 months or 5 years. The difference between the short run and the long run
is the flexibility decision makers have. The short run is a period of time in which the
quantity of at least one input is fixed and the quantities of the other inputs can be varied.
The long run is a period of time in which the quantities of all inputs can be varied.
The short run and long run distinction varies from one industry to another. An example of
toothbrush manufacturing firm as well as industry can be considered here. A company in
this industry will need the following inputs to manufacture toothbrushes:
 Raw materials (such as plastic)
 Labor
 Machinery
 A (new) factory

In Short Run, Some inputs are variable and some are fixed. New firms do not enter the
industry, and existing firms do not exit. On the other hand, in long Run, all inputs are
variable; firms can enter and exit the market (in the industry).

FACTOR PRODUCTIVITY AND RETURN TO SCALE:

In economics, productivity is the amount of output created (in terms of goods produced or
services rendered) per unit input used. For instance, labour productivity is typically
measured as output per worker or output per labour-hour. With respect to land, the "yield"
is equivalent to "land productivity". Thus, the factor productivity refers to productivity of
individual factor, such as labour or land.

Labour productivity is generally speaking held to be the same as the "average product of
labour" (average output per worker or per worker-hour, an output which could be measured
in physical terms or in price terms).It is not the same as the marginal product of labour,
which refers to the increase in output that results from a corresponding increase in labour
input.
Some economists write of "capital productivity" (output per unit of capital goods
employed), the inverse of the capital/output ratio. "Total factor productivity," sometimes

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 Production analysis and concept of marginality 3.1
called multifactor productivity, also includes both labor and capital goods in the
denominator (weighted by their incomes).
Unlike labor productivity, the calculation of both capital productivity and total factor
productivity is dependent on a number of doubtful assumptions and is subject to the
Cambridge critique. Even measures of land and labor productivity should be used only when
conscious of the role of the heterogeneity of these inputs to the production process

Returns to scale refers to a technical property of production that predicts what happens to
output if the quantity of all input factors is increased by some amount/ percentage. If
output increases by that same amount, it is called constant returns to scale (CRTS),
sometimes referred to simply as returns to scale. If output increases by less than that
amount, it is decreasing returns to scale. If output increases by more than that amount, it
is increasing returns to scale.

ECONOMY OF SCALE AND DISECONOMY OF SCALE

Ecomony of scale (ES) describes- ‘as the volume of production increases, the cost of
producing each unit decreases’. Therefore, building a large factory will be more efficient
than a small factory because the large factory will be able to produce more units at a lower
cost per unit than the smaller factory.
When more units of a good or a service can be produced on a larger scale, yet with (on
average) less input costs, economies of scale (ES) are said to be achieved. Alternatively,
this means that as a company grows and production units increase, a company will have a
better chance to decrease its costs.
Just opposite to the economies of scale, diseconomies of scale (DS) also exist. This
occurs when production is less than in proportion to inputs. What this means is that there
are inefficiencies within the firm or industry resulting in rising average costs.

ECONOMY OF SCOPE

An economic theory stating that the average total cost of production decreases as a result
of increasing the number of different goods produced.
For example, McDonalds can produce both hamburgers and French fries at a lower average
cost than what it would cost two separate firms to produce the same goods. This is because
McDonalds hamburgers and French fries share the use of food storage, preparation
facilities, and so forth duringdproduction.

Another example is a company such as Proctor & Gamble, which produces hundreds of
products from razors to toothpaste. They can afford to hire expensive graphic designers
and marketing experts who will use their skills across the product lines. Because the costs
are spread out, this lowers the average total cost of production for each product.

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