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Production
In common parlance production means the creation of utilities. Utility refers to the
want satisfying capacity of a product. Thus, production is the process of creation of
products that can satisfy human wants. There are four factors of production. They are
land, labour, capital and organization. These are also called production inputs. In
order to produce anything that can satisfy human wants, these inputs are to be used.
Production in a broader sense means the transformation of inputs into want satisfying
outputs (products) which have exchange value.
According to J.R. Hicks "production is any activity whether physical or mental, which
is directed to the satisfaction of other people's wants through exchange". This
definition highlights the following three essential components of production.
1. Production means some activity; either physical or mental. Thus, a doctor who
performs mental activity is a producer. A farmer who performs physical
activity to produce agricultural crops is a producer.
2. The activity aims at satisfying other people's wants. It means that an activity
for self consumption is not treated as production.
3. The wants of other people should be satisfied through the process of exchange.
It means that the activity that can satisfy human wants should have exchange
value. So, anything given free of cost cannot be regarded as production.
Production Theory
The main objective of a business concern is to make maximum profit. There are two
ways through which profit can be maximized. One way is by increasing selling price
and the other is by reducing cost of production. Now a days most of the markets are
highly competitive and the selling price is determined by the forces of demand and
supply. Therefore, a producer has very little control over the selling price. So, the only
way available for a producer is to reduce the cost of production. In order to reduce the
cost firms should make use of the available inputs in a most economical manner.
Production theory provides tools to make use of the available inputs in a most efficient
and economical way. Production theory studies the relationship between various
possible combinations of input and output. In other words, production theory tells
how factors of production are combined to produce the outputs.
Production Function
Production is the process of transforming physical inputs into physical outputs.
Physical inputs are the factors of production such as land, labour, capital and
organization. Physical outputs are the quantity of goods produced. The output is thus
a function of factors called inputs. Production function may be defined as the
functional relationship between physical inputs and physical outputs. Production
function can be expressed algebraically as
Q = f (a, b, c,......)
Where Q = The output of a commodity per unit time
f = function of or depends on
a, b, c,... are the quantities of various inputs like land, labour, capital etc..
It is clear from the above equation that the quantity of output of a commodity depends
upon the quantities of inputs used. "A production function summarizes the
relationship between labour, capital and land inputs and the maximum output these
inputs can produce. It tells how much output can be produced from a given
combination of inputs and tells by how much output will increase if one (or all) input
(s) increase (s)".
A firm has two types of production function. Short run production function and long
run production function. Depending up on the time required to change input levels
Economists distinguish between short run and long run. "The short run is a period of
time so short that the existing plant and equipment cannot be varied; such inputs are
fixed in supply. Additional outputs can be produced only by expanding the variable
inputs of labour and raw-materials. The long run is a period long enough to vary all
inputs".
Assumptions of Production Function
Production function is based on the following assumptions.
1. It has reference to a particular time period- Production function expresses the
relation between inputs and outputs over a period of time. As the time period
changes production function also changes. The same inputs can produce
different outputs both in the short run and long run. In the long run a producer
has more choices than in the short run because all the inputs can be varied in
the long run.
2. State of technology does not change- The state of technical knowledge is
assumed to be constant for specifying a production function. If the technology
advances production function also changes because now it is possible to
produce more output from a given set of inputs with the advanced technology
or lesser quantities of inputs can be used for producing a given quantity of
output. For example, if labourers are given more education and training labour
productivity will improve. Similarly technological advancement leads to
increased productivity of machines.
Concepts of Product
There are three concepts of product (1) Total product (2) Average product (3) Marginal
product
Total product
Total product of a particular quantity of input is the amount of total output produced
by a given amount of input, keeping the level of all other inputs unchanged. If 5
workers can produce 15 tables a day, the total product of labour input (5 workers) is
15 tables.
Average product
Average product of a particular input is the amount of output produced by that input
divided by the quantity of that input used. Thus, the average product of labour input
is calculated as,
APL = Q /L
Where APL Average product of labour
Q = Total product produced by labour input
L = Quantity of labour input
For example, in a bakery if 20 workers can make 200 cakes per day, the average
product of 20 workers is 10 cakes per day.
Marginal product
Marginal product of any factor of production is the addition to total product as a result
of employment of an extra unit of a factor. It can be defined as the addition made to
the total output by the application of one more unit of variable input. Assume that 5
workers can produce 15 tables per day. If another worker joins them and the number
of tables increases to 19, then the marginal product of 6th worker is 4 tables.
Laws of Production
There are two types of production function. Production function in the short-run and
production function in the long run. In the short run inputs like land, machinery,
equipment’s etc. are fixed at certain quantities and it cannot be varied within a short
span of time. However, inputs like labour can be varied at any point of time and hence
it is a variable input. Increase in output in the short run is possible only by adding
more variable inputs but in the long run all inputs are variable and output can be
increased by increasing both fixed as well as variable inputs.
Laws of production deal with both production function in the short run and long run.
The law that deals with production function in the short-run is called Law of
diminishing returns or Law of variable proportions. The law that deals with
production function in the long run is called Law of returns to scale.
Law of Diminishing Returns or Law of Variable Proportions
Law of diminishing returns examines the input output relation when the output is
increased by varying one variable input. As per the law of diminishing returns if the
quantity of a variable input is increased continuously, keeping the quantity of other
inputs constant, the output will first increase but after a stage the output will decline.
In the words of Stigler "As equal increments of one input are added; the inputs of other
productive services being held constant, beyond a certain point the resulting
increments of product will decrease, i.e., the marginal products will diminish".
The law of diminishing returns is explained with the help of an example. Suppose a
farmer has 10 hectares of land, buildings, implements etc. These are his fixed inputs.
His variable input is his workers (labour). The details of productivity of his labourers
are given in the below table. With these details he can easily fix the production
function.
The above table shows that with a fixed quantity of land and capital, as the farmer
increases the number of workers from 1 to 7, the total product increases from 30 tons
to 189 tons. If he increases the number of workers beyond 8, the total product begins
to decline.
There are 3 stages of the law of diminishing returns. The first stage is the stage of
increasing returns. At this stage total product increases at an increasing rate. From
table 3.1 it is clear that up to the use of 3 workers total product increases at an
increasing rate. The marginal product of workers (contribution from each additional
worker) also increases at this stage. As the total product increases the average product
also increases at this stage.
The second stage is the stage of diminishing returns. From the table it is clear that
from the employment of 4th worker to the employment of 8th worker, the total
product continues to increase but at a diminishing rate. This stage ends until the total
product reaches its maximum (189 tons). At this stage both average product and
marginal product of variable input diminishes but marginal product remains positive
with zero marginal product at the end of this stage.
The third stage is the stage of negative returns. From the table it is clear that both the
total product and average product declines and the marginal product turns negative.
Nobody would like to operate in the third stage.
The law of diminishing returns and its 3 stages are diagrammatically shown as
follows:
X axis represents the variable input (labour) and O axis represents the product (Total
product, Average product, Marginal product), TP is the total product curve, AP is the
average product curve and MP is the Marginal product curve. In stage one TP, AP and
MP curves show an increasing trend. In the second stage TP is still increasing with a
lesser speed but MP and AP decline. In the third stage all product curves diminishes
and MP goes below the X axis showing negative figure.
Point of inflexion
Point of inflexion is the point where the slope of Total product (TP) curve reaches the
maximum ad starts decreasing. At this point, Marginal Product (MP) is maximum.
Law of returns to scale has 3 phases depending upon the magnitude of effect on
output due to simultaneous change in all the inputs. If the increase in output is more
than proportionate to the increase in inputs it is increasing returns to scale. If the
increase in output is proportionate to increase in inputs it is constant returns to sale.
If the increase in output is less than proportionate to increase in inputs it is
diminishing returns to scale.
In the above table, when the farmer employs one worker on 2 acres of land, the total
product is 4 quintals. As he doubled the inputs, the increase in output is more than
double, i.e, 150%. Again, when the farmer increased the inputs by 50%, the increase in
output is 80%. It is more than proportionate to increase in input. Increasing returns to
scale leads to increase in marginal product. The following are the reasons for
increasing returns to scale.
(a) Indivisibility of fixed inputs- As fixed inputs are indivisible there is greater scope
for full and efficient use of fixed inputs at the initial stages. This leads to increase in
output.
(b) Increased division of labour- As the input combinations are increased, there is
more scope for division of labour and specialization. When there is one worker
working on 2 acres of land there is no scope for division of labour. When there are two
workers working on 4 acres of land there is increased scope for division of labour and
output increases more than proportionate to increase in inputs.
When the farmer increases both labour and capital inputs by 20% (labour increased
from 5 to 6 and capital increased from 10 to 12) the increase in total product is less
than proportionate to increase in input i.e, 16.67%. Again, when the farmer increased
the inputs by 16.67% the increase in output is only 11.43%. The marginal product
declines from 5 quintals to 4 quintals. This is because the input combinations are
increased to such an extent that the scope for division of labour is reduced.
The three stages of law of returns to scale is diagrammatically represented as follows
Economies of Scale
When a business firm grows in size or increase the scale of operations it can derive
production advantages from market and firm size in terms of low average cost of
production. Such production advantages due to large scale operations are known as
economies of scale. "Economies of scale are present when an increase in output causes
long run average cost to fall". The fall in average cost of production is because of
increased productivity resulting from specialization in areas like production,
marketing, research and development, management etc. The division of labour can
become much more specialized in large firms as compared to small firms. The
economies of large-scale operations may be classified into internal economies and
external economies.
Internal Economies
Internal economies are those economies which accrue to a single firm due to its
increase in scale of operations. The source of internal economies to a large firm is from
the use of more efficient production methods and efficient management of resources.
According to Alfred Marshall "the chief advantage of production on a large scale are
economy of skill, economy of machinery and economy of materials". Internal
economies may be of the following kinds;
1. Technical economies- Technical economies arise out of the use of most modern
production technology which can reduce the cost of production per unit. A
large firm, as it increases production can make use of the optimum utilization
of plant and machinery. A large firm can afford to make use of the most modern
technologies while a small firm must satisfy with the primitive technologies.
2. Economy of labour- In a large firm division of labour is much more specialised
than small firms. Division of labour and specialization increases efficiency of a
firm. Since the output of a large firm is higher it can employ large number of
employees with specialised skills so that they can concentrate on specified
tasks. As the number of employees are less in a small firm, an employee has to
perform many tasks and it makes him jack of all trades but master of none.
Moreover, he losses much of his time in moving from one task to another.
3. Managerial economies - When production is carried on a large scale it is
profitable to group the activities of a business enterprise into production,
marketing, finance, human resources etc. Each group is headed by well
qualified and experienced professionals who can direct their subordinates to
perform their tasks in the most efficient way.
4. Commercial economies- A large firm can have economy in buying and selling
of goods. The economies occurring from buying and selling is called
commercial economies. It is also called economy in transport and storage.
Economy buying arises from bulk buying, bargaining advantages, better credit
terms from suppliers, prompt delivery of raw materials etc. Bulk buying
enables a firm to reduce ordering cost and transportation cost. Economy in
buying helps a firm to sell its products at a reduced rate. A large firm can afford
to have a wide network of retail outlets in important areas where sales potential
is more. It can also satisfy its customers by providing after-sale services and
establishing customer care centres depending upon the nature of the product.
5. Economy of capital-A large firm can satisfy its fixed capital and working
capital requirements without much difficulty. It can borrow money from banks
and financial institutions on more favourable terms. It can accept deposits from
the public and issue shares and debentures for raising capital. Therefore, the
cost of capital of a large firm will be lower than that of a small firm.
6. Risk bearing economies- A large firm is healthier enough to bear the risks
associated with business. Through diversification of business activities, a firm
can compensate the risk from one product with the profit from another
product. A large firm can withstand in the market even while there is a
temporary fall in the market demand in times of economic depression.
External Economies
External economies are those economies that accrue to the whole of an industry arising
from the localisation of industry. When most of the firms in an industry set up their
factories in one particular area it is called localisation of industry. External economies
may be grouped under the following two leads.
1. Economies of concentration- These are the benefits derived by all the firms in
an industry because of the localisation of industry. They are;
a) Development of transport and communication facilities
b) Availability of credit facilities due to development of banking system
in the area
c) Establishment of raw-material suppliers, marketing and advertising
agencies, waste treatment plants etc in the immediate vicinity of the
industry.
d) Support from government and governmental agencies in the form of
infrastructure development, power generation etc.
Diseconomies of Scale
Though firms can enjoy economies of scale by expanding the scale of operations, there
is a limit for expanding the size of a firm. Beyond a certain limit diseconomy of scale
appears. "Diseconomies of scale are present when an increase in output causes long
run average costs to increase". Therefore, it is profitable for a firm to maintain an
optimum size. An optimum firm is a firm whose scale of operations are expanded to
such a level that the cost of production is at the minimum. There would be no motive
for further expansion once a firm reaches its optimum size. If a firm expands beyond
the optimum size the long run average cost begins to increase.
Isoquant
Isoquant represents various combinations of two inputs that can produce the same
output. The two inputs are capital and labour. 'Iso' means same and 'quant' means
quantity. So, Isoquant means same quantity. Isoquant curve is a curve which shows
all possible combinations of capital and labour inputs that can produce the same
quantity of output.
Since Isoquant curve shows all those combinations that yield the same output, the
producer would be indifferent between them and hence it is called product-
indifference curve. It is also known as Iso product curve or equal product curve. The
concept of Isoquant is shown in the following table.
Input Combinations Capital Labour Output
A 1 12 50
B 2 8 50
C 3 5 50
D 4 3 50
E 5 2 50
As shown in the above table, two factor inputs labour and capital are used for the
production of product. Each input combinations A, B, C, D, E can produce an output
of 50 units.
In this figure all these input combinations are plotted and by joining all these
combinations we get an Isoquant curve for the production of 50 units. Capital input is
represented in OX axis and labour input is represented in OY axis. Points ABCD and
E show different combinations of labour and capital that can produce 50 units.
Isoquant map
It is a set of isoquant curves that show efficient combinations of inputs that can
produce different levels of output. It is also called Equal product map. Higher the
isoquant curve in the isoquant map indicates higher level of output.
Properties of Isoquants
The following are the main characteristics of Isoquant.
1. Isoquants slope downward from left to right- Isoproduct curves slope
downward from left to right (negative slope). It means that if the quantity of
one input is decreased, the quantity of another input must be increased so as to
maintain the same quantity of output. As shown in the above table, when the
number of units of labour is decreased from 12 to 8 units, the number of units
of capital is increased from 1 to 2 units. It means that four units of labour is
replaced by one unit of capital. The rate at which one factor is substituted for
another factor in order to get the same output is called Marginal Rate of
Technical Substitution. Thus, Marginal rate of technical substitution of capital
for labour is ∆L/∆K = 4/1=4
2. Isoquants are convex to the origin-Isoquants are convex to the origin because
of the diminishing marginal rate of technical substitution. The diminishing
marginal rate of technical substitution illustrated in the below table.
Input Combinations Capital Labour Marginal rate of technical
substitution (∆L/∆K)
A 1 12 ---
B 2 8 4:1
C 3 5 3:1
D 4 3 2:1
E 5 2 1:1
3. Two isoquants never intersect- Two Isoquants cannot out each other. It means
that an input combination that can produce a particular quantity of output
cannot produce another quantity of output in a given state of technology. If two
Isoquants, one representing 50 units of output and the other representing 60
units of output intersect each other, it means that the same input combination
that can produce 50 units can also produce 60 units. This cannot happen when
the technique of production remains the same.
4. Higher the isoquant curve indicates higher level of output
Iso cost line shows all the combinations of labour and capital that a firm can buy with
a given amount of money. Suppose a firm wants to spend ₹600 on labour and capital
inputs. One unit of labour cost is ₹6 per labour hour and one unit of capital is ₹10 per
machine hour. With an amount of ₹600 the firm can buy 100 units of labour or 60 units
of capital. In the above figure, Let OR represents 100 units of labour and OM
represents 60 units of capital. If we join together the points R and M through a straight
line, we get all possible combinations of labour and capital that can be purchased for
₹ 600. The line MR is called the Iso cost line. The Iso cost line is also called the price
line or outlay line. If the firm decides to spend a higher amount, say ₹700, it can buy
more quantities of labour and capital and therefore the Iso cost curve will shift
upwards to R1M1. This Iso cost line shows all possible combinations of labour that
can be purchased for ₹ 700.