Chapter 4: Theory & Laws of Production

Meaning of production

Production may be defined as any activity, whether physical or mental, which is directed to the satisfaction of other peoples wants through exchange. Prof J R Hicks In modern context production is related to the value creation and may be defined as follows: production is the process of transformation which leads to creation or addition of value in a good or a factor

Production process Input transformation transformation output

Since production is transformation, it can be done through the following changes:

Change of shape Change of appearance or form Change of place Change of time Other methods

Factors of production
Land Labour Capital entrepreneurship

Characteristics of factors of production

Complementarity Substitutability Specificity Mobility

The output can change under two conditions:

Only one factor of production is changed, while others are kept constant (law of variable proportions) All factors are changed in given proportion (Returns to scale)

LAW OF INCREASING RETURNS

According to Marshall an industry is subject to increasing returns if an extra investment in industry is followed by more than proportionate returns i.e. if marginal productincreases. As the proportion of one factor in a combination of factors is increased, up to a point, marginal product of factor will increase. The reason for increasing returns is because of Division of Labor and specialization by industry. This law is also called Law of Decreasing Cost, as marginal product keeps on increasing and marginal cost keeps on decreasing.

CONDITIONS OF THE LAW 1-----Factors of production should not be in short supply. 2-----Optimum level of production has not reached so far.

Now suppose expenses involved on per unit of labor and capital are Rs.1000 and output are Socks. Marginal cost is calculated by dividing Rs.1000 with marginal product of socks, Rs.1000/50 socks=Rs.20 per sock.

LAW OF DIMINISHING RETURNS

According to Alfred Marshall an increase in labour and capital applied in the cultivation of land causes in general a less than proportionate increase in the amount of produce raised, unless it happens to co-inside with an improvement in arts of agriculture. With the continuous use of land its fertility goes on diminishing therefore output goes on diminishing. This law is particularly applicable to agriculture, but it is also applicable in those sectors of economy where nature plays a dominating role such as fishery and mining. The law operates when mining operations are extended to inferior, or on deeper mines and when fishing operations are concentrated on specific place. This law is also called Law of Increasing Cost because as marginal product diminishes marginal cost increases. CONDITIONS OF THE LAW
1-----Quality of factors of production (land & labor) should be of same standard.

2-----Cultivation should be carried on continuous on the same plot of land.

3-----Cultivation/production methods should not change.

Now suppose that expenses involved on per unit of labor and capital are Rs.1000/- and output of wheat is in mounds. Marginal cost is calculated by dividing Rs.1000 with marginal product of wheat (Rs.1000/50)=Rs.20 per mound.

LAW OF CONSTANT RETURNS

Marshall said that an industry is subject to constant returns when whatever the output, cost per unit remains unaltered or increased investment of labor and capital results in a proportionate increase in output. The reason for constant returns is that an industry, which is involved in production process might also be engaged in cultivation of raw material for its industrial unit, for example a blanket industry might also be engaged in rearing of sheep for its wool requirement. In sheep rearing or wool production law of diminishing returns will operate and in blanket manufacturing law of increasing returns will operate. Another example may be of sugar cane production and manufacturing of sugar by same business unit or fruit farming and fruit canning and processing factory by same owners. This law is also called Law of Constant cost because marginal product remains unchanged and marginal cost also remains same.

CONDITIONS OF THE LAW Both agricultural sector and industrial unit should be under ownership and operation by same owners so that the loss on one side is balanced from the profit of the other side of business.

Now suppose that expenses involved on per unit of labor and capital are Rs.1000 and output is sugar. Marginal cost is calculated by dividing Rs.1000 with marginal product of sugar i.e. Rs.1000/50 kgs = Rs.20 per kg.

Law of variable proportions

if we keep other factors as constant and increase only one

factor of production, the Total Physical Product (TPP) will first increase at an increasing rate, then at a constant rate and
finally at a diminishing rate.

Assumptions of the law:

Only one factor is increased while others are kept constant. The various units of the variable factor are homogenous. Conditions of production like production method, technique, climatic conditions etc. are constant. This law is applicable only for physical output and not for its value.

In the table below up to third labor marginal product keeps on increasing from 80 to 100
units but the 4th and 5th labors marginal product decreases by 98 and 62 units respectively. This production behavior is divided into three stages, therefore this law is also known as Stages of Production.

Returns to scale

It refers to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).
If output increases by that same proportional change then there are constant returns to scale (CRS). If output increases by less than that proportional change, there are decreasing returns to scale (DRS). If output increases by more than that proportional change, there are increasing returns to scale (IRS).

Thus the returns to scale faced by a firm are purely technologically imposed and are not influenced by economic decisions or by market conditions.

Example:

When all inputs increase by a factor of 2, new values for output will be:

Twice the previous output if there are constant returns to scale (CRS)
Less than twice the previous output if there are decreasing returns to scale (DRS) More than twice the previous output if there are increasing returns to scale (IRS)

Increasing returns to scale

Decreasing returns to scale

Constant returns to scale

Economies of large scale

Internal economies of scale

Labour economies Purchase economies Marketing economies Financial economies Technological economies Managerial economies

Internal diseconomies of scale

There is always an optimum size beyond which a firm can get more disadvantages than advantages; therefore a firm cannot expand its size in an unlimited manner. A firm may experience financial diseconomies in the form of increased proportionate financial cost. When a firm having a very big size uses all possible division of labor and specialized machines, a further increase in its size will result in dis-economies because of lack of proper control/management hence cost will start increasing. If firm continues unlimited diversification it would result in a greater risk and would increase the economic fluctuations rather than covering these risks.

External economies of scale

Economies of concentration

Economies of information
Economies of research and development Economies of negotiation

External Diseconomies
When the industry is localized in a particular area, there is a huge demand of skilled labor therefore, wages and price of land increases hence the cost of production increases.
Firms compete themselves for hiring transport, hence freight charges increase. Prices of raw material (especially of those which are in short supply) increase, due to excessive demand by all firms of same industry of that area. Due to concentration and localization of large factories of the same nature congestion and pollution creates a lot of social/health problems.

Production function: Basic Concepts Production function is a relationship between maximum physical output and
the quantity of labor and capital used in the production process. It is a technological relationship between inputs and outputs and depends on the available technology. Those firms which are less efficient will obtain less output than the ones which are efficient.

Technical efficiency : achieved when maximum amount of output is achieved with a given combination of inputs. Economic efficiency: achieved when a firm is producing a given output at the lowest possible total cost. Inputs: Fixed inputs and variable inputs. Short Run: At least one input is fixed. All changes in output achieved by changing usage of variable inputs. Long Run : All inputs are variable. Output changed by varying usage of all inputs.

Short run production

In the short run, capital is fixed. Only changes in the variable labor input can change the level of output.

Q = f(L, K) = f(L)

FIXED PROPORTIONS PRODUCTION FUNCTION

VARIABLE PROPORTIONS PRODUCTION FUNCTION

ISO-PRODUCT CURVE

An Iso-product curve is also known as Iso-quant curve or Equal-Product curve. Isoquants means equal quantities. It shows various combinations of two inputs required for production of the same output. In this situation the producer becomes indifferent as to which combination of factors of production he should choose. It is similar to indifference curve when different combinations of two goods x and y provide the same level of satisfaction.

In graph Iso- product curve (IP) represents all those combinations of X & Y inputs i.e. labor and capital, which can produce 100 pens. In the above situation producer has become indifferent as to which combination of labor and capital (X & Y) he should use for the production of 100 pens.

HIGHER THE ISO-PRODUCT CURVE HIGHER THE PRODUCT

MARGINAL RATE OF TECHNICAL SUBSTITUTION

M.R.T.S. means that the rate at which one unit of factor of production is substituted for other units of factor of production while maintaining a constant level of output. MRTS = MPL/MPK (As the labour is substituted by capital, MPL declines and MPK increases , thus diminishing the MRTS) In the first instance in order to increase one unit of X input, 3 units of Y are substituted or released therefore MRTS is 1:3. As more and more of X is used MRTS goes on diminishing and in the last for one additional X only one Y is substituted or released, because some thing of Y is needed along with X input to produce Pens. It means MRTS goes on diminishing for additional units of X.

EQUILIBRIUM OF A FIRM

LEAST COST COMBINATION OF A FIRM Or ISO-COST LINE Main objective of a firm is to maximize profit. If a firm wants to spend Rs.100 for production of any good (pens), it will be in equilibrium position when the firm utilizes that combination of inputs X & Y, (capital and labor), where Iso-product curve is tangent to Iso-cost line.

PRODUCTION POSSIBILITIES CURVE

Production Possibilities Curve indicates various combinations of two goods that can be produced by an economy when all of its resources are fully and efficiently utilized. It represents graphically alternative production possibilities facing an economy. With limited resources an economy has limited possibilities for production of goods and services. If govt. increases military goods then the consumer goods production will decrease. For an economy to be well off it is necessary that all resources are fully employed in a Technologically Efficient manner. To have more consumer goods in future, we must accept fewer consumer goods today. In other words, here an opportunity cost is involved. Every time we make a choice for more goods today, we incur an opportunity cost of fewer goods tomorrow. Production possibility curve is also called Transformation Curve because in moving from one point to another point on curve, one good is transformed into another, not physically but by transferring resources from one use to another use.

1. Rate at which one product is transformed into another is called marginal rate of transformation. 2. MRT between missile and wheat is the amount of wheat, which has to be sacrificed/given up for production of missile.

1. Point R inside curve represents inefficient use of resources and Point S outside the curve cannot be attained with current level of resources and technology of economy.