Lecture : 13 and 14

Theory of Production : Definition of

Production, Factors of Production,
Land and Capital, Production Function,
The Law of Variable Returns or
Proportion or Three Stages of
production, Short – run and long – run,
Returns to scale.

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 Definition of Production : Production is sometimes defined as the
creation of utility or the creation of want- satisfying goods and
services. It is not correct definition. To produce a thing which has
utility but not value is not production in the economic sense. One
may spread the cult of yoga and promote the physical and spiritual
well-being of one’s friends - a thing of great utility but unless one
makes it one’s profession, his activity will not come under
production.

Production, therefore, should be defined, not as creation of utility,

but creation of value.

Utilities are created in three forms, i.e., Form of utility; Time utility;
and Place utility. Production essentially means transformation of
one set of goods into another. A good may be transformed by being
physically changed (form utility), being transported to the place of
use (place utility) and being kept in store till required (time utility).

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 Factors of Production : Productive resources
required to produce a given product are called
factors of production. Generally factors of
production as a group or class of original
productive resources. The term ‘factors’ is used
for a class of productive elements the individual
members of which are known as units or inputs
of the factor. The factors of production have
been traditionally classified as Land, Labour,
Capital and Organization. Now we shall briefly
deal with them one by one.

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 Land: The term ‘land’ has been given a special
meaning in economics. It does not mean soil as
in the ordinary speech, but it is used in a much
wider sense. In the words of Marshall, land
means the materials and the forces which nature
gives freely for man’s aid, in land and water, in
air and light and heat. Land stands for all natural
resources which yield an income or which have
exchange value. It represents those natural
resources which are useful and scarce, actually
or potentially.

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 Peculiarities of Land :
In contrast of the other factors of production, land
presents certain well-marked peculiarities, such as,
• Land is nature’s gift to man;
• Land is fixed in quantity. It is said that land has no supply
price, i.e., price of land prevailing in the market cannot
affect its supply, the price may high or low, its supply
remains the same;
• Land is permanent;
• Land provides infinite variation of degree of fertility and
situation so that no two prices of land are exactly alike.
This peculiarity explains the concept of margin of
cultivation.

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 Labour : In the ordinary speech, the term
‘labour’ means a mass of unskilled labour. But in
economics it is used in a wider sense. Any work,
whether manual or mental, which is undertaken
for a monetary consideration, is called labour in
economics. In Marshall’s words, “ Any exertion
of mind or body undergone partly or wholly with
a view to some good other than the pleasure
derived directly from the work, is called labour.”

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 Peculiarities of Labour :
Labour is not only a means of production but also an end
of production. There are certain characteristics which
distinguish labour from the rest of the factors of
production:
• Labour is inseparable from the labourer himself;
• Labour has to sell his labour in person;
• Labour does not last. It is perishable;
• There can be no rapid adjustment of the supply of labour
to demand for it, because supply cannot be increased
quickly, nor can it be reduced.

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 Capital : Capital refers to that part of a man’s wealth which is
used in producing further wealth or which yields an income.
The term ‘capital’ is generally used in economics for capital
goods, e.g., plant and machinery, tools and accessories,
stocks of raw materials, goods in process and fuel.

Importance of Capital :
Capital plays a vital role in the modern productive system.
Production without capital is hard for us even to imagine.
Capital occupies a central position in the process of economic
development. Capital formation is the very core of economic
development. Capital formation is the creation of employment
opportunities in the country.

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 Enterprise : The fourth factor of production is enterprise
which is supplied by the entrepreneur.
Role of entrepreneur :
The role that the entrepreneur plays consists in co-
ordinating and correlating the other factors of production.
He starts the work, organizes and supervises it. He
undertakes to remunerate all the factors of production.
Thus he takes the final responsibility of the business.
The entrepreneur is the innovator. It may mean the
introduction of a new method of production or an
improvement in the old method.

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Is land capital :
Land is not regarded as capital because

i) Land is a free gift of nature but capital is

man-made;
ii) Capital is perishable, whereas land is
permanent;
iii) The amount of capital can be increased
but the quantity of land is fixed and limited; and
iv) Income from capital is uniform whereas
rent of land varies.
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 Production function : Production function may be defined as the
functional relationship between physical inputs, i.e., factors of
production and physical outputs, i.e., the quantity of goods
produced. It shows the maximum amount of output that can be
produced from a given set of inputs in the existing state of
technology. In real life, a manufacturer wants to know how much of
the various factors or inputs, viz., land (i.e., natural resources),
labour and capital will be required to produce a unit or given quantity
of a commodity during a given period of time. Production function is
concerned with physical aspects of production, it is more a concern
of an engineer or technician than of an economist. Only a technician
can say what specific quantity of a good can be produced by the
use of the various productive resources and their combinations.
Production function can be expressed as under :
X = f (a, b ,c, d, -----)
Here, X is the output of a commodity per unit of time and a, b, c, d,
------ are the various productive resources which into the making of
the quantity of the commodity, f is function.
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 Total, Average and Marginal Product : We begin by
computing the total product, which designates the total
amount of output produced in physical units, such as;
bushels of wheat or number of telephone calls produced.
The average product, which is equals total output divided
by total units of inputs.
The marginal product of an input is the extra unit of that
input while other inputs are held constant.

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 The Law of Diminishing Returns
Introduction : There are three laws of returns known to
economists, i.e., the laws of diminishing, increasing and constant
return. As we shall explain below, these three laws are only three
aspects of one law, viz., the Law of Variable Proportions.
Statement of the law : The law of diminishing returns was
supposed to have a special application to agriculture. It is the
practical experience of every farmer that “successive applications
of labour and capital to a given area of land must ultimately, other
things remaining the same, yield a less than proportionate
increase in produce.” According to Marshall, “An increase in
capital and labour applied in the cultivation of land causes in
general less than proportionate increase in the amount of
produce raised, unless it happens to coincide with an
improvement in the arts of agriculture.”

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 Assumptions: To analyze the Law of Diminishing Returns
we assume the following assumptions;

i) The state of technology remains unaltered;

ii) Various inputs employed in production are constant.

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 No. of Total Marginal Average
Analysis of Workers Returns Returns Returns
the law of 1 80 ------ 80
diminishing 2 170 90 85
returns, we 3 270 100 90
need to a
schedule. 4 368 98 92
The
following is 5 430 62 86
the given 6 480 50 80
below : 7 504 24 72

8 504 0 63
9 495 -9 55
10 440 - 55 44
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 From the table, it appears that there are three
different aspects of the Law of Diminishing
Returns. These are –

Law of Total Diminishing Return : Column two

shows the total return, the returns begin to
diminish from the 9th worker. Every successive
worker employed does make some addition to the
total output. But the 8th adds nothing and 9th and
10th are a positive nuisance. As worker cannot be
had gratis, no prudent farmer will employ more
than seven workers in the conditions represented
by this table.

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• Law of Diminishing Marginal Return : Column 3 represent the
marginal return. Marginal return goes on increasing up to 3rd worker
and goes on falling from 3rd man onwards till it drops down to zero at
the 8th man. The 9th and 10th men are merely a cause of obstruction
to the others and are responsible in making the marginal return
negative. It can be seen that the total output is at its maximum when
marginal output is zero.
• Law of Diminishing Average Return : Column 4 represent the
average return. The average return reaches the maximum at the 4th
worker, i.e., one step later than the marginal return reaches the
maximum. Then the marginal return falls more sharply. The two
equalize somewhere between the 4th and 5th, i.e., when the 5th
worker works part-time. But we do not employ men in fractions in
real life. Therefore, it is not always possible to equalize the marginal
and the average returns. It is also clear that it is possible for the
average output to increase while the marginal output falls and the
marginal return negative but average return always positive.

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 Diagrammatic Representation: The law can be
diagrammatically represented as in the following figure.
There are three stages of production. The total production
goes on increasing till it reaches maximum where the third
stage starts. The marginal return reaches the maximum
the earliest and starts diminishing the first stages. The
average return starts diminishing where the second stage
begins. No sensible entrepreneur will operate in the third
stage where the marginal product is zero, unless, of
course, the variable factor is free. Economically, the
second stage is the significant region where the average
product is greater than the marginal product which is still
positive. It can be seen that the total output curve is
steepest where the marginal output is the largest.

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 Product

Second
Stage Third TP
First Stage Stage

AP
0
No. of Workers
MP

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 Economic Implications :
In the first stage, as more and more labour is used, the average
product of labour increases which reflects the increasing efficiency
of labour. In this stage, the total product increases also for this unit
of land which shows that the efficiency of land too is increasing.
Hence, this stage shows that both land and labour are being
efficiently utilized.
In the second stage, the average and marginal product is
decreasing. But since the total output goes on increasing, the
marginal product is positive. This stage shows the decreasing
efficiency of labour. But the efficiency of land continues to increase
because the total return continues to increase.
In the third stage, the average product decreases still further.
Also, the marginal product becomes negative and the total product
is decreasing. Hence, in this stage, both labour and land have
been used inefficiently.

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  Limitations of Law :
i) Improved methods of cultivation;
ii) New soil;
iii) Insufficient capital.

Conclusion : The combination of land and labour attained

maximum efficiency of labour at the boundary line between stage
one and stage two and maximum efficiency of land at the
boundary line between stage two and stage three. Stages one
and three are ruled out. Stage one is ruled out because
throughout this stage average product of both land and labour
are still increasing and stage three is ruled out because the
average product of both factors is decreasing. Finally, stage two
represents higher efficiency of land-labour ratio than that of the
other two stages.

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 Short-run and long-run : We define the short-run as a
period in which firms can adjust production by changing
variable factors, such as; materials and labour but cannot
change fixed factors, such as; capital. The long-run is a
period sufficiently long so that all factors including capital can
be adjusted.

Returns to scale: The returns to scale reflects the

responsiveness of total product when all the inputs are
increased proportionately. Three important cases should be
distinguished:
Constant returns to scale : Constant returns to scale
denote a case where a change in all inputs leads to a
proportional change in output. For example, if labour, land,
capital and other inputs are doubled, then under constant
returns to scale output would also double.
 
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 Increasing returns to scale : Increasing returns to scale
arise when an increase in all inputs lead to a more than
proportional increase in the level of output. For example, an
engineer planning a small-scale chemical plant would generally
find that increasing the inputs of labour, capital and materials
by 10 percent will increase the total output by more than 10
percent.
 
Decreasing returns to scale : Decreasing returns to scale
occur when a balanced increase of all inputs leads to a less
than proportional increase in total output. One case has
occurred in electricity generation, where firms found that when
plants grew too large, risks of plant failure grew too large. Many
productive activities involving natural resources such as
growing wine grapes or providing clean drinking water to a city,
show decreasing returns to scale.
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 Factor Intensity : In comparing methods of
production, it is common to describe some as
capital-intensive and others as labour- intensive.
When a relatively little labour, it is capital-intensive.
When there is heavy use of labour and little use of
capital, the production method is labour-intensive.
The following table illustrates the factor intensity.

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Technique Capital Labour Rental Wage Capital Labour Total
Input Input Rate Per Rate Cost Cost Cost
Machine $/ $/week $/week $/
$/week week week

A 4 4 320 300 1280 1200 2480

B 2 6 320 300 640 1800 2440

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 We can say that technique A is more capital- intensive
than technique B. In technique A, the ratio of capital to
labour is 1 to 1, i.e., 4 units of capital to 4 units of labour.
In technique B, the ratio of capital to labour is 1 to 3, i.e.,
2 units of capital to 6 units of labour. Thus the first
production method is more capital-intensive than the
second. Conversely, the second production method is
more labour-intensive than the first.

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