MODULE NAME: BUSINESS

ECONOMICS
TOPIC 2: PRODUCTION
 1. INTRODUCTION:

1.1 Definition
Production is the satisfaction of wants. It can be defined as the creation of wealth which, in
turn, adds to society’s welfare. It is the process of converting inputs into outputs; the output
produced should create utilities. (i.e. to satisfy the human needs).
The process of production is incomplete until a commodity reaches a consumer. Therefore, the
services of distribution such as wholesale traders and retailers, transport, banking and
insurance are part of production.

We can distinguish between direct and indirect production.

• Direct production means the production of goods and services by an individual for
personal use and at times it is referred to as subsistence production.
• Indirect production means the production of goods and services for sale.

Levels of Production
• Primary production is the first stage of production and includes farming, fishing,
forestry, mining, hunting and the like. At times, these are known as extractive
industries.
The production at this stage is raw material, which is used as input for the production
of final goods. Agricultural products like sugarcane and cotton are used to produce
sugar and cloth.

• Secondary production is the transformation of raw materials into finished products.

Generally, the output of primary production is used for the secondary production.
For instance, sugarcane is the primary production used to produce sugar. At times, the
primary products are converted into semi-finished products and then set to other
manufacturing units to produce final goods.
Construction is also part of the secondary production. The materials used in the
construction industry are obtained from primary production.

• Tertiary production: Include the processes which increase the value or utility of
commodities. Tertiary production starts after producing the final product.

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 The movement of goods to the final consumer involves different services which are
referred to as tertiary services. These are distinguished into commercial services and
direct services.
Commercial services; refer to the services that enable trade to take place efficiently.
They create place and time utility. These include retailing, wholesaling, banking,
insurance, transport and the like.
Direct services; refer to the services offered by individuals directly to consumers.
Example: Teaching, Medical services, Legal services, Hair cutting & dressing, and the like.

1.2 Factors of Production:

Is an economic term that describes the resources or inputs required in the production of a
commodity to make an economic profit. Production is made possible by combining certain
resources.
There are mainly four (4) factors of production.
Production = f (land, labour, capital, entrepreneurship)

i. Land as a factor:
Land, whose payment is rent, can take various forms as a factor of production, from
agricultural land to commercial real estate to the resources available from a particular piece of
land. Thus it denotes all natural resources-land, minerals, rivers, seas, forests, etc.
It gives a site where production can take place. Land is fixed in supply, and therefore, its supply
is perfectly inelastic. Reclamation of land from sea should not be regarded as an increase in
land supply because the sea is also regarded as land. Land is not homogeneous. It is not of the
same value. Land situated near the urban, industrial, and market areas is of greater value than
that in the rural areas.

ii. Labor as a factor:

Labor, which is paid a wage, is the human effort that contributes towards the production of
goods and services. We can distinguish between productive labour and unproductive labour.
o Productive labour is the labour that is engaged in producing goods and services (labor
exchanged against capital), and it is paid a wage. Example, cooks and waiters, since
they make capital for their proprietor.
o Unproductive labour is the labour that does not produce goods or services (labor
exchanged against revenue) and therefore it receives no wage. Example, domestic
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 servants since they do not make capital out of their services but rather spend revenue
on them.
Labour efficiency is affected by the following: Education; Health conditions; Nutrition;
Capital; Technology; Housing facilities; Incentives offered to Labour; Climate conditions, etc.

• Specialization (The Division Of Labor)

Division of labour is an important characteristic of modern production. When the making of an
article is split up into several processes and each process is entrusted to a separate set of
workers, this is referred to as division of labour.

Advantages of division of labour:

There are several advantages of division of labour some of which include:
• Specialization leads to increased production
• Division of labour results in workers acquiring greater skill at the jobs.
• There is a saving of time in the training of operatives. A person trained very quickly for
the performance of a single operation.
• It makes possible a much greater use of machinery.
• Division of labour involves production on a large-scale.
• Division of labour saves on the use of tools. For instance, a wood has to perform just
part of the operation and that workers need no supplied with a complete set of tools for
making the entire article.

Disadvantages of the division of labour:

• Monotony. A worker who performs the same task each day is, sooner or later, going to
find the work monotonous.
• Loss of craftsmanship. It is said that with the extensive use of machinery the workman
ceases to be a craftsman and becomes a tender of machine. One tends to be dull.
• Greater risk of unemployment. Specialisation means that workers do not have the
wide industrial training which would make them adaptable to changes in the technique
of production. If he happens to lose his job, he may not easily find another job in a
rapidly changing world.

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 iii. Capital:
Capital, whose payment is interest, is any physical asset capable of creating further goods or
services. Capital can be distinguished into real capital and money capital.
o Real capital is the stock of physical assets capable of producing goods and services. It
is not for satisfying wants directly but is used in production. It increases volume of
goods and services. Examples are roads, railways, machines, factories, buildings, etc.

o Money capital is the paper notes and coins, and it is used as a method of payment for
capital goods. It is not directly productive to a lay person; it is money capital that
matters while to an economist, it is real capital that matters.
Capital is very important in the process of development. Capital accumulation enlarges the
country’s capacity to produce goods and services and leads to an increase in real goods and
services. It introduces more machines, and hence economic growth.

iv. Entrepreneurship:
The payment to an entrepreneur is profit. An entrepreneur is a person who assumes the
responsibilities of organisation, management and risk during the course of production,
combining factors of production, locating the firm, and innovation.

1.3 Implication of Factors of Production

i) It is used in the theory of production
Various combinations of factors of production help in producing output when a firm operates
under increasing or decreasing costs in the short-run (stage I & II), and when the returns to
scale increase or decrease in the long-run.

ii) Explains the theory of cost of production

Helps to know, how can the least-cost combination of factors are obtained by a firm. The theory
depends upon the combinations of factors employed in business and the prices that are paid to
them. From the point of view of the theory of costs of production, factors of production are
divided as fixed factors and variable factors. Fixed factors are those whose costs do not change
with the change in output, such as machinery, tube well, etc.
Variable factors are those whose quantities and costs change with the change in output. Larger
outputs require larger quantities of labour, raw materials, power, etc.

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So long as a firm covers the costs of production of the variable factors it employs, it will
continue to produce even if it fails to cover the costs of production of the hired factors, and
incurs a loss. But this is only possible in the short-run.
In the long-run, it must cover the costs of production of both the fixed and variable factors.
Thus the distinction between fixed and variable factors is of much importance for the theory of
firm.

iii) Explaining the concept of economies of scale

Factors of production are also divided into divisible and indivisible factors. Factors are
divisible when their inputs can be adjusted to the output. Labour is said to be divisible when
the number of labourers may be reduced in keeping with the output of the firm. Divisible factors
lead to the economies of scale for a firm by adjusting the number of factors to the output of the
firm.
Indivisible factors are those which are available in minimum sizes, and are lumpy, such as
machines, entrepreneur, etc. They also lead to economies of scale, but at a faster pace. When a
firm expands, the returns to scale increase because the indivisible factors are employed to their
maximum capacity. More output can be had by using the existing machines up to their full
productive capacity.

iv) The concept of factor of production is used in explaining the theory of factor-pricing.
For this purpose, factors of production are divided into specific and non-specific. A factor of
production which is specific in use earns a higher reward than a non-specific factor. This also
solves the problem of distribution of income to the various resource-owners.

1.4 Time Frames:

To study the relationship between a firm’s output decision and its costs, we distinguish three
decision time frames; short-run, long-run and very long-run.

i. Short-run:
It is a time period so short that the firm is unable to vary all its resources. OR Is the time
period in which at least one of the factors of production is fixed. In the short run, some
factors are fixed while others are variable.
The more efficient firm has a shorter short-run period while the inefficient firm has a longer
short-run period. To increase output in the short run, a firm must increase the quantity of
variable inputs it uses.
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 ii. Long-run:
run is a period in which the firm can change its plant. However, the basic technology of
production does not change.
The major importance of the long-run in production theory is that it corresponds to the situation
facing the firm when it is planning to start operating, or expanding or contracting the scale of
its operations. Long-run decisions are not easily reversed. The long-run period also varies from
firm to firm.

iii. Very long-run:

It is period when there are technological improvements that lead to new and better quality
products. Larger quantities of output are produced than before.

1.5 Factors That Affect Capital Accumulation (Formation):

Capital accumulation;
is a process where a country directs part of the current productive activity to the formation
of capital goods – machines, plants, equipment, transport facilities and other forms of real
capital.
The basic essence of the capital formation process is the diversion of a part of society’s
currently available resources to the purpose of increasing the stock of capital goods so as to
make possible and expansion of consumable output in the future.
The process of capital accumulation involves three aspects: increase the volume of real savings,
mobilisation of saving through a financial system, and the act of investment itself. Savings
must be invested productively.

1.5.1 Factors Determining The Level Of Capital Formation:

a) The level of savings: Resource mobilisation through increased savings drives a
country’s capital accumulation and vice versa.

b) Institutional framework:
Ø Culture of the society, its habits and customs: Society’s perception about
capital formation is vital. A society with a vision to create more wealth and self-
driven entrepreneurship abilities are most certain to increase its levels of capital
accumulation needed in the development process.
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 Ø Extended family system: One reason why developed countries have managed
to foster faster capital formation than developing countries is the nature of
family nuclear. With small family obligations, savings can be possible unlike
with extended family obligations where consumption turns out to be a top
priority.
Ø Level of financial sector development: The financial sector includes banking
institutions, insurance companies, capital markets, etc. A well-developed
financial sector facilitates the accumulation of capital through increased savings
mobilisation and investment.
Ø Government and security: Capital formation is a function of good governance
and management of the country’s resources. A politically stable environment
ensures investors’ confidence in the economy, which in turn influence the
capital formation process.

c) The profit level: When profit levels are high and more so re-invested, then the
likelihood for increased capital formation is high and vice versa.

d) Labour productivity. A trained and facilitated labour force opens up opportunities for
increased efficiency and quality products. Thus, higher capital formation is a positive
function of higher output.

e) Technology: Improved technologies increase a country’s opportunities for increased

efficiency and quality products and vice versa.

f) Capital stock: The level of capital stock is vital in explaining investment in an

economy. A higher capital stock facilities foster capital formation than low capital
formation.
g) The wage rate and remuneration. What a worker earns is important in explaining a
firm’s output levels and subsequently the profit levels. Similarly, capital formation is
highly a firm’s profitability.
h) The number of workers: With large active labour participation, it is possible to
increase the productive capacity of a country and vice versa.

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 1.6 Mobility of The Factors of Production:
There are two aspects of mobility: occupational and geographical.
• Occupational mobility concerns the movement of a factor of production from one
occupation to another.
• Geographical mobility describes the movement of a factor from one location to
another. This is an important matter when new industries establish themselves in
locations different from those in which older industries were established.

2. PRODUCTION FUNCTION:
Function is the mathematical relationship between independent variables (Xs) and dependent
variables (Ys).
Production function: is the technical relationship between inputs and output. It shows the
technical relationship between various quantities of inputs how combined so as to produce
the maximum possible level of output given the technological efficiency and point of time.

Production function can be described in different ways such as:-

a) It may take the form of a table/schedule such as the one below:
Land in Use (acres)
Labour (Units) 1 2 3 4
Bags of Maize Produced
1 10 22 34 44
2 15 31 38 58
3 20 48 42 69
4 32 59 54 78
5 50 61 66 92

b) It may be in a form of an equation

Q = Q (L, K) ……………………………….. (i)

Q = a + bL ……………………………….. (ii)

Where: Q = Output
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 K = Capital
L = Labour ‘a’ and ‘b’ = constants

• The first equation is an implicit function that shows that output produced depends on
labour and capital inputs.
• The second equation is a linear function and shows that output depends only on labour
input.
c) It may also take the form of a curve or a graph.

The standard economic assumption which affects the shape of the production function is the
law of diminishing marginal returns, which states that, “as more and more of a variable input

x is employed on a fixed factor, total output increases first at an increasing rate and later at a
decreasing rate until a point is reached where additional quantities of input x will yield
diminishing marginal returns assuming all other factors are kept constant.

2.1 Inputs:
Is the amount of factors of productions, agents of production, and ingredients of production.
They are the resources needed in production, e.g. labour, land, capital, raw materials.
Inputs are combined with level of technology to produce a given level of output. As output is
expanded requires much more quantities of inputs.
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 • Fixed inputs: Are inputs which quantities are not changing as the output is expanded/
changing under a given period of time.
They are the inputs whose quantities do not vary with output. Output expands (increase)
fixed inputs do not change, e.g. land, machines. That is fixed inputs are not the function
of output. FI ¹ f (Q).
• Variable inputs: Are inputs whose quantities are changing as the output is expanded
under a given period of time, e.g. raw materials and labour can be increased or reduced.
They are inputs which vary with output.

2.2 An empirical production function: It is generally very complex. It includes a wide range
of inputs, (i) land (ii) labour (iii) capital (iv) raw materials (v) time and (vi) technology. All
these variables enter the actual production function of a firm. Thus, the long-run production
function is generally expressed as:
Q = f (Ld, L, K, M, T, t…)
Where;
Ld = land and building,
L = labour,
K = capital,
M = materials,
T = technology and
t = time.
Economists have however reduced the number of variables used in a production function to
only two viz., capital (K) and labour (L), for the sake of convenience and simplicity in the
analysis of input-output relations and production function is expressed as:
Q = f (L, K)

The reasons for ignoring other inputs are as follows; land and building (Ld), as inputs, are
constant for the economy as a whole, and hence it does not enter into the aggregate production
function.
However, land and building are not a constant variable for an individual firm or industry. In
case of individual firms, land and building are lumped with ‘capital’.

In case of ‘raw materials’ it has been observed that this input ‘bears a constant relation to output
at all levels of production’.

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For example, cloth bears a constant relation to the number of garments. Similarly, in car
manufacturing of a particular brand or size, the quantity of steel number of the engine, and
number of tyres and are fixed per car.

This constancy of input-output relations leaves the methods of production unaffected. So is the
case generally, with time and space. That is why in most production functions only two inputs
– labour and capital are included. Technology, time and managerial are also assumed to be
given in the short run.

Algebraically, the general form of production function may be expressed as;

Q = f (K, L).
Where, Q = the quantity of output produced per time unit
K = Capital, and
L = Labour

It implies that Q is the maximum quantity of the product that can be produce given the total
volume of capital, (K) and the total number of workers, (L) employed to produce coal.
Increasing production will require increase in K and L. whether the firm can increase both
K and L or only L depends on the time period it takes into account for increasing production,
i.e. whether the firm considers the short run or the long run.

In the short run, the firm can employ one of capital or labour; in the long-run, however, the
firm can employ more of both capital and labour.
Therefore, the firm would have two types of production functions:
(i) Short-run production function; and
(ii) Long-run production function.

The short run production function or what may also be termed as Single variable production
function; i.e. Q = f (L). or Q = f (K).

In the long run production function, both K and L are included and the function takes the form
of: Q = f (K, L).

2.3 Assumptions for the production functions:

The production functions are based on certain assumptions:
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 i) Perfect divisibility of both inputs and output
ii) Limited substitution of one factor for another
iii) Constant technology; and
iv) Inelastic supply of fixed factors in the short-run.
Note: If there is a change in these assumptions the production function will have to be modified
accordingly.

2.2 Concepts Of Production :

i) Total Product:
Is the amount of total output produced by a given amount of the variable factor, other
factor held constant.

ii) Average Product:

Is the total output produced per unit of the factor employed.
Thus; Average Product = Total Product
Number of units of a factor employed.

AP = Q
L

iii) Marginal Product

Marginal Product of a factor is the addition to the total production by the employment
of an extra unit of a factor

Mathematically:
If employment of labour increases by ∆L units which yield an increase in total output
by ∆Q units, the marginal physical product of labour is given by:

∆Q
∆L

That is; MPL = ∆Q

∆L

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3 THE LAW OF VARIABLE PROPORTIONS:

Law of variable proportions occupies an important place in economic theory. This law
examines the production function with one factor variable, keeping the quantities of other
factors fixed. In other words, it refers to the input-output relation when output is increased by
varying the quantity of one input.
When the quantity of one factor is varied, keeping the quantity of other factors constant, the
proportion between the variable factor and the fixed factor is altered; the ratio of employment
of the variable factor to that of the fixed factor goes on increasing as the quantity of the variable
factor is increased.
Since under this law we study the effects on output of variation in factor proportions this is also
known as the law of variable proportions. Thus law of variable proportions is the new name
for the famous “Law of Diminishing Returns” of classical economics.
This law has played a vital role in the history of economic thought and occupies an equally
important place in modern economic theory. It has been supported by the empirical evidence
about the real world.
The law of variable proportions or diminishing returns has been stated by various economists
in the following manner.
“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 inputs will become less”. (Paul A. Samuelson).

Marshall discussed the law of diminishing returns in relation to agriculture. He defines the law
as follows: “An increase in the capital and labour applied in the cultivation of land causes
in general a less than proportionate increase in the amount of product raised unless it
happens to coincide with an improvement in the arts of agriculture.” (Alfred Marshall).

Therefore, it is obvious from the above definitions of the law of variable proportions (or the
law of diminishing returns) that it refers to the behavior of output as the quantity of one factor
is increased, keeping the quality of other factors fixed and further it states that, the marginal
product, and average product will eventually decline.

3.1 Assumptions Of The Law Of Variable Proportions Or Diminishing Returns:

The law of variable proportions or diminishing returns holds good under the following
conditions:
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 i. The state of technology is assumed to be given and unchanged. If there is
improvement in the technology, then MP and APs may rise unsteady of diminishing.
ii. There must be some inputs whose quantity is kept fixed. The law does not apply in
case all factors are proportionately varied. When all inputs (factors) are varied then it
is “Returns to Scale”.
iii. All units of the variable input are homogeneous.
iv. The proportions in which factor input are combined can be varied.
The law does not apply to those cases where the factors must be used in fixed proportion
to yield a product.
When the various factors are required to be used in rigidly fixed proportions, then the
increase is one factor would not lead to any increase in output i.e. the MP of the factor
will then be zero and not diminishing.

3.2 Illustration of the Law of Variable Proportions:

Suppose there is a given amount of land in which more and more labour (variable factor) is
used to produce Maize, the labor – output relationship is given by the following production
function:

Q = -L3 + 10L2 + 20L1

Given the production function above, we may substitute numerical values for L in the function
and workout a series of Q; i.e. the quantity of output that can be produced with different number
of workers.
E.g. Q = -L3 +10L2 +20L1
No. of FC TPL MPL (tons) APL (tons) Stage of
works Production
1 10 29 29 29
2 10 72 43 36
3 10 123 51 41 I
4 10 176 53 44
5 10 225 49 45
6 10 264 39 44
7 10 287 23 41 II
8 10 288 1 36
9 10 261 -27 29
10 10 200 -61 20 III
Table 4.1: Total product, Marginal product and Average product.

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From Table 3.1, Total Product, Average Produce and Marginal Product curves can be:

Fig 3.1 Three stages of the law of variable proportions.

2.2 Three Stages Of The Law Of Variable Proportions:

The behavior of output when the varying quantity of one factor is combined with a fixed
quantity of the other can be divided into three distinct stages:

I. Stage I: Increasing Returns

In this stage, total product curve TP increases at an increasing rate up to a point of inflection,
point F, from the origin to the point F, slope of the total product curve TP is increasing; i.e. up
to the point F, the total product increases at an increasing rate (the total product curve TP is
concave upward up to the point H),

From point F onwards, the total product curve goes on rising but its slope is declining which
mean that TP increases at diminishing rate (the total product curve is concave downward); i.e.
marginal product falls but is positive. At the point of inflection, F; MP is maximum after which
it starts to diminish.

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This stage is called the stage of increasing returns because the average product (AP) is of the
variable factor is also increases throughout the stage.
The first stage ends where the Average product curve AP reaches its highest point, i.e. point S
on AP curve and where it equals MP.

During stage I when MP of the variable factor is falling it still exceed its AP and so continue
to cause the AP curve to rise. Thus, during stage I, where as MP curve of a variable factor rises
in a part and then falls, the AP curve rises throughout.
The quantity of the fixed factor is too much relative to the variable factor so that if some of the
fixed factor is withdrawn, the total product will increase.

II. Stage II: Decreasing Returns

In stage II, the Total Output (TP) continues to increase at a diminishing rate until it reaches its
maximum point H, where the second stage ends. This is because the fixed factor becomes
inadequate relative to the quantity of the variable factor. In this stage both MP and the AP
of the variable factor are diminishing but remain positive. At the end of the second stage, i.e.
at point M, marginal product of the variable factor is zero (corresponding to the highest point
H of the TP curve).
This is a crucial stage as the firm will seek to produce in its range.

III. Stage III: Negative Returns

With the increase in the variable factor, TP declines and therefore the total product curve slopes
downward. As a result, MP of the variable factor is negative and the MP curve goes below the
x-axis, hence the name Stage of Negative Returns. In this stage the variable factor is too much
relative to the fixed factor;

The Stage Of Operation:

Therefore, a rational producer will always seek to produce in Stage II here both the Marginal
Product and Average Product of the variable factor are diminishing; but remaining positive.

3.3 Causes Of Initial Increasing Marginal Returns To A Factor:

In the beginning, the quantity of the fixed factor is abundant relative to the quantity of the
variable factor.

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 i) Therefore, when more and more units of a variable factor (labor) are added to the
constant quantity of the fixed factor, the fixed factor is more intensively and effectively
utilized. Thus, it is the indivisibility of some factors which causes increasing returns
to the variable factor in the beginning.

ii) As more units of the variable factor are employed the efficiency of the variable factor
itself increases. That is, because when there is sufficient quantity of the variable factor
it becomes possible to introduce specialization or division of labour which results in
higher productivity.
The greater the quantity of the variable factor, the greater the scope of specialization
and hence the greater will be the level of its productivity or efficiency.

NB: The law of diminishing returns is important to planners in that it makes possible for the
producer to determine the optimum amount of the variable factors which if combined with the
fixed factor can yield maximum output.

3.4 Causes Of Diminishing Marginal Returns To A Factor:

(i) Because further increase in the variable factor will cause Marginal Product (MP)
and Average Products (AP) of a variable factor to decline because the fixed factor
then becomes inadequate relative to the quantity of the variable factor.
That is; the contributions to the production made by the variable factor after a point
becomes less and less because the additional units of the variable factor have less
and less of the fixed factor to work with.

(ii) The indivisibility of the fixed factor:

The diminishing return will happen when the variable factor has increased to such
an amount that the fixed indivisible factor is being used in the ‘best or optimum
proportion’ with the variable factor.
Once the optimum proportion is disturbed by further increases in the variable factor,
returns to a variable factor (i.e. MP and AP) will diminish primarily because the
indivisible factor is being used too intensively; or in other words the fixed factor is
being used in non – optimal proportion with the variable factor.
Note: If the fixed factor was perfectly divisible, neither the increasing nor the
diminishing returns to a variable factor would have occurred.

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 3.5 Relationship Between Average Product And Marginal Product.
The result that both the average and marginal products of labour eventually declined as more
and more units of labour are added to a fixed amount of other factors is an illustration of the
law of diminishing returns.
The relationship between average product and marginal product can either be shown
graphically.
Notice from the graphs that MP reaches a maximum before AP, and MP begins to fall before
AP does. MP is equal to AP when AP is at maximum (figure 3.4).
When AP is increasing, MP is greater than AP and, where AP is falling, MP is less than AP.
It is MP that controls AP.

Figure 3.2 Average product and Marginal product

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EXERCISES

1. What is a production function? How does a long run production function differ from
a short run production function? Why is the marginal product of labor likely to increase
and decline in the short run.

2. The marginal product of labor is known to be greater than the average product of
labor at a given level of employment, is the average product increasing or decreasing?
Explain

3. Consider the short run production function below; only labour input is varied.

Labour input/day Output/day

0 0
1 35
2 80
3 122
4 156
5 177
6 180

(a) Calculate the marginal product of labour and average product of labor
(b) Using graph paper, plot the MPL and APL
(c) At approximately what level of labour input do diminishing set in?
(d) At approximately what level of labour input does the MPL cut the APL?
(e) How would you expect the MPL curve to be affected by the change in the level
of capital input?

4. Fill spaces in the following table.

Amount Total labour APL MPL
0 0 - -
1 75 - -
2 - 100 -
3 - 100 -
4 - - -

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