Hum 2229

Lecture 3
Production
 Theory of production

• Theory of production deals with the question of ‘How to produce?’ It

discusses the supply side of the pricing of products. Supply of a
product depends on the cost of production. Cost of production, in turn
depends on-
• Physical relationship between inputs and output
• Prices of inputs.
How a firm choose the optimum factor combination either,
• To minimize the cost of production for given level of output or
• To maximize the level of output for a given cost/set of input
 What is Production?
• Production may be defined as a process through which a firm transforms inputs
into output.
• It is the process of creating goods and services with the help of factors of
production or inputs for satisfaction of human wants. In other words,
‘transformation of inputs into output’ whereby value is added, is broadly called
production.
• For example, in the production of wheat, the use of land, seed, fertilizer water,
pesticides, tractors, labour etc. are inputs and wheat is output.
 Production function
The functional relationship between inputs and output is called the ‘Production
Function’.
Production function is an equation that expresses the relationship between the
quantities of factor employed and the amount of product obtained. It signifies a
technical relationship between the physical input and physical output of the firm for
a given state of technology. The relationship can be written as –

Y =  ( X 1, X 2 ..........X n )
Here Y= quantity of output, X= different inputs
 Factors of Production
1. Land: It refers to all natural resources which are free gifts of nature. Land, therefore,
includes all gifts of nature available to mankind—both on the surface and under the
surface, e.g., soil, rivers, waters, forests, mountains, mines, deserts, seas, climate,
rains, air, sun, etc.
2. Labor: Human efforts done mentally or physically with the aim of earning income is
known as Labor. The compensation given to laborers in return for their productive
work is called wages (or compensation of employees).
3. Capital: All man-made goods which are used for further production of wealth are
included in capital. Thus, it is a man-made material source of production. Examples
are—machines, tools, buildings, roads, bridges, raw material, trucks, factories, etc. An
increase in the capital of an economy means an increase in the productive capacity of
the economy.
4. Entrepreneur/Organization: An entrepreneur is a person who organizes the other
factors and undertakes the risks and uncertainties involved in the production. He hires
the other three factors, brings them together, organizes and coordinates them so as to
earn maximum profit.
Types of factors: Fixed Factor and Variable Factor

Fixed Factor: Fixed factor of production is one whose quantity cannot readily be
changed in response to desired changes in output. Its quantity remains same
whatever the level of output is more or less or zero.
• Example- Building, land, machinery

Variable Factor: Variable factor of production is one whose quantity may be

changed in response to changes in output. Such factor are required more when
output is more and vice versa
• Example- Labor, fuel
 Short run Production Function
• The period of time in which quantities of one or more factors of production cannot
be changed. This implies that in the short-run there are two categories of inputs:
• • Fixed inputs • Variable inputs,
• As such there are two types of costs: fixed cost and variable cost.
• So, Short-run production function
q = f ( L, K )
Here,
q = quantity of output
L = quantity of labour input. It is variable factor,
K = quantity of capital input – fixed factor
Here at least one of the factor of production will be fixed
 Long-run production Function

• The period of time in which quantities of all factors of production can

be varied. In the long-run production, all factors are variable factors.
However, the production technology further remains unchanged.
q = f ( L, K )
 Types of Product

• Total product (TP): It refers to total volume of goods and services produced by a
firm with the given input during a specified period of time.
TP= P*Q

• Average product (AP): It is per unit product of variable factors. It is calculated

by dividing the total Product by the units of variable factor.
Average Product=Total Product/Unit of Variable Factor

• Marginal Product (MP): It is an addition to the total product when an additional

unit of a variable factor is employed.
MP=Change in output /Change in input =Δq/ΔL
 Short run production curve
Explanation of the three stages of Production at a Glance
• Based on the relationship
between TP, AP, and MP of the Stages TP MP AP
variable factor, three stages of Stage I Increases at an First increases Increases through
production can be defined as MP>AP increasing rate and reaches and reaches its
shown in the graph below: and later at a the maximum maximum point. At
decreasing rate. point and then the endpoint of the
start to stage AP=MP.
decline.
Stage II It increases at a Decreases After reaching its
MP<AP diminishing rate gradually and maximum
and reaches become zero the point begins to
its maximum at point decrease.
point.

Stage III It begins to fall. Becomes Continues to

MP<0 negative. decline but
remains positive.
 The best stage of Production

• A rational producer will not operate in stages 1 and 3.

• In this stage I, the marginal product increases with an increase in the variable
factor. Therefore, the producer can employ more units of the variable to efficiently
utilize the fixed factors. Hence, the producer would prefer to not stop in Stage I
but will try to expand further.
• Producers do not like to operate in Stage III either. In this stage, there is a decline
in total product and the marginal product becomes negative. In order to increase
the output, producers reduce the amount of variable factor. However, in Stage III,
he incurs higher costs and also gets lesser revenue thereby getting reduced profits.
• The only stage where the production can take place is stage 2, where both
marginal and average products are declining, but, they are positive.
 Economics of Scale

• Economies of scale are the cost advantage a business obtains due to expansion. It
exist when long run average total cost decreases as output increases.
• Economies of scale refer to these reduced costs per unit arising due to an increase in
the total output.
• As a result of increased production fixed cost get spread over more output than
before.
• Extended scale of production increases the efficiency of production process.
 Internal Economics of scale

• Internal economies are caused by factors within a single company. It is the advantage
gained by the individual firm by increasing its size like having larger or more plant.
• It is the lower long run average cost resulting from a firm growing in size.
• Example: A firm may hold a patent over a mass production machine, which allows it to
lower its average cost of production more than other firms in the industry.
 Different kinds of Internal economies
1. Technical economies of scale: When the output increases, the firm will invest
more in efficient equipment and optimize operation based on experience. Efficient
machinery result in producing output at lower cost.
2. Managerial economies of scale: The employment of specialized workforce
result in managerial economies of scale. In addition, the firm efficiency is increased
by employing specialist, accountants, human resource, etc which will result in
reducing the cost of production and increase revenue.
3. Marketing economies of scale: Marketing economies of scale is the ability to
spread advertising and marketing budget over an increasing output. Thus, Better
advertisement result in reaching larger audience and increase the sale of the firm.
4. Financial economies of scale: Access of financial and capital market result in
financial economies of scale. Hence large firms find easier and cheaper to raise
funds.
5. Commercial economies of scale: Reduction in price due to discounts or
bargaining power result in commercial economies of scale. Larger firms can buy
goods and services in larger quantities. Thus they get larger discount and can
bargain to negotiate lower prices.
6. Network economies of scale: When the marginal costs of adding additional
customers are extremely low result in network economies of scale. Hence this
means larger firm can support large numbers of new customers with their existing
infrastructure can substantially increase profitability as they grow.
 External Economics of Scale
• External economics of scale is the lower long run average costs resulting from an
industry growing in size.
• This scale occurs outside the firm but within the same industry. It is associated with an
increase in the industry.
• It benefits all the firms in the industry. Here, the cost depends on the size of the industry
and not on the firm.
• Example: suppose the government wants to increase steel production. In order to do so,
the government announces that all steel producers who employ more than 10,000
workers will be given a 20% tax break.
 Different kinds of External Economics of Scale

• Economies of Concentration: It is the advantage of a firm due to its

concentration. Many other factors such as skilled labour, better
transport facilities etc. also help in the economy of the organization.
• Economies of Information: A firm needs continuous information
from the industry like the cost of the inputs, products, policies, and
other services are required by the organization.When an industry
provides the firms with this, it provides economics to the firm.
• Research and Development: The industry can have an R&D
department. Running such a department reduces costs by developing
more efficient methods and techniques.
 Diseconomies of Scale

• Diseconomies of scale occur when long run average total cost increases as output
increases
• It is the disadvantage of being too large.

Internal diseconomies of scale:

A firm that increases its scale of operation to a point where it encounters rising long run
average cost is said to be experiencing internal diseconomies of scale.
External diseconomies of scale:
External diseconomies of scale occur when an industry growing in size causes negative
externalities and rising long-run average costs. For example, if an industry grows rapidly
in size, it may cause traffic congestion.
 Productivity

• Productivity is a common measure of how well resources are being used or a

measure of the effective use of resources usually expressed as the ratio of output
to input
• Productivity =Output /Input
Productivity measures are useful for tracking an operating unit’s performance over
time. Judging the performance of entire industry or country.
Productivity is mainly of two types -
• Partial factor productivity
• Total productivity
A) Partial Factor Productivity
• This is considered a ratio of outcome (output) to partial or single input which is consumed
in the production.

Types of Partial Factor Productivity

Partial factor productivity is further categorized into below categories:
a) Labor Productivity
In simple terms, per person output ratio or actual financial yield based on per hour of work
is termed as labor productivity. It is used to measure a worker’s efficiency in producing a
higher value product.
b) Capital Productivity
This is the relation between total output in terms of goods or services and the input in terms
of physical capital. Different assets of an organization such as machines, building, land,
tools, manpower, etc. are essential in a production set-up, and to meet these, capital is
required.

c) Material Productivity
This consists of the ratio between total output and total material input. The material under
input includes both direct and indirect raw material which is used to produce the final
product. The technique of material productivity is utilized in measuring the productivity in
form of material cost.
Material Productivity= Total output/ Material input
B) Multifactor or Total Productivity
Partial factor productivity includes one single input i.e. labor or capital or material
wherein, the multifactor productivity includes the relation of total output with total
inputs such as labor, capital, material, etc.
In other words, Multifactor productivity is defined as the ratio among total output and
total input used to produce the total output units.