THEORIES OF PRODUCTION, RETURN TO SCALE, THEORIES OF COST

Production is the process of making wealth; it is defined as an activity that results in the

creation of goods and services for the satisfaction of human wants.

 Production combines factors of production (labour, capital, land) by firms to create goods

and services which consumers are prepared to pay in order to satisfy human wants.

 The production process is not completed until the goods and services are in hands of final

consumer.

 In economics we are only concerned with the production of economic goods.

 These goods which are scarce and consumption of them involves opportunity cost

i.e. something has been given up in order to satisfy the wants for the goods.

 Economic goods are classified into two types such as producer goods (capital/investment

goods) and consumer goods which are used directly to satisfy human wants.

 Consumer goods again are classified as durable and non durable goods.

Durable goods are those which have a long life and give satisfaction over a long

period of time, for example cars, TVs set ets while

Non durable goods are goods which are consumes and gives satisfaction for

only a short period of time e.g. foodstuffs and drinks.

Direct vs indirect production

Direct production means the production of goods and services by an individual for his own use

or consumption. It is also known as subsistence production.

Indirect production means the production of those goods in order to sell. Those persons who

use the goods are not the one who produced them, this type of production is known as indirect

production.

Levels of production

Levels of production means stages of production.

Primary production: this is the first stage of production and includes activities like hunting,

fishing, mining, farming, forestry etc. these are also known as extractive industries.

 The outputs of these production activities are raw materials which are useful

inputs for other production processes.

Secondary production: under secondary production raw materials from primary production are

converted to semi-finished goods and then it is sent to other manufacturing units for further

production of finished goods/final products.

 For example different parts of cars can be produced from different factories and are

assembled in specific factories, while in another area of secondary production is the

construction of roads, buildings bridges, textile manufacturers etc, raw materials from

primary production were used to final consumption.

Tertiary production: the process of production may be still incomplete after the second stage of

production.

 Production includes all those processes which increase value of commodities

 The tertiary production starts after the completion of goods.

  A factory in Iringa produces goods which are used all over in East Africa.

 The movement of goods from factory to the consumer involves different services.

 These services may further be classified as commercial and personal services.

Commercial services refer to the services of wholeseller, retailers, banks insurance,

transport etc.

 Personal services refer to the services of doctors, advocates, teachers etc.

Basic concept

Fixed and variable inputs:

Fixed and variable inputs are defined in economic sense and also in technical sense.

 In economic sense a fixed input is the one whose supply is inelastic in short run.

Therefore all the users cannot buy more of it in the short run.

 In the technical sense, a fixed input is the one that remain fixed/constant for a certain

level of production.

 Variable inputs are those whose supply in the short run is elastic, all the users of that

factor can employ a larger quantity of it in the short run as well as in the long run.

Technically, variable inputs are those which change with the level of output. In long run

all inputs are variable.

Short run and long run

The reference of time period involved in production process is another important factor/concept

used in production analysis. The two reference periods are short run and long run.
Short run: short run refer to the period of time in which the supply of certain inputs (e.g. plant

machinery, building etc) is fixed or inelastic.

 In the short run therefore production of a commodity can be changed by altering the size

of variable inputs like labour.

 It is important to note that short run and long run are economist’s jargon. They do not

refer to a certain specific period of time. While in some firms/ industries short run may

be a matter of few weeks, or few months, while in other firms/industries may mean three

or more years.

Long run:

 Long run refers to a period of time in which the supply of all inputs is elastic, but not

enough to permit a change in technology.

 That is, in the long run all inputs are variable.

 Therefore, in the long run, production of a commodity can be increased by employing

more of both variable and fixed inputs.

 The economist also uses another terminology i.e. ‘very long run’ which refers to a

period in which the technology of production is also subjected to a change or can be

improved.

 In the very long run the production function can also change.

Production function

Apart from a quantitative presentation of various production possibilities faced by a firm, a

production function also represent a mathematical presentation of input-output relationship.

  A production function states a technological relationship between inputs and outputs in a

form of equation, graph or a table.

In real life production function is generally complicated. It includes a wide range of inputs e.g.

land and building(LB), Labour(L), Capital (K), Raw materials (M), Time (T), and technology (t).

When all of these factors are entered in the actual production function of firm then a long run

production function will generally expressed as

Q = f (LB, L, K, M, T, t)

For the sake of convenience and simplicity in the analysis of the input-output relations, we can

reduce to two factors

Q = f (L, K)………………………………………(01)

The production function (01) implies that quantity of Q produced depends on the quantity of K

and L employed to produce Q.

 Increasing Q production will require increasing K and L.

 Whether a firm can increase both K and L or only L depends on the time period it takes

into account for increasing production, whether a firm considers a short run or long run.

Short run production function

 In the short run therefore, a firm can increase Q production by increasing only L since in

the short run K is inelastic.

 The short production function is what also may be referred to as “single variable input

production function” and can be presented as

Q = f ( K , L) Where k is constant……………………………………………(02)

A production function can therefore be expressed as

Q = bL, where b = ΔQ/ΔL which give a constant return to labour.

Long run production function

In the long term production function, both K and L are included in the function and takes the

following form

Q = f (K, L) ……………………………………………..(03)

Consider a cob-Douglas function

Q = AKaLb

 Where, K capital, L labour, A, a and b are parameters which their numerical values may

be determined by using actual factory data on production.

 Suppose numerical values of parameters are estimated as A=50, a and b = 0.5

Then the production function can be expressed as follow

Q = 50K 0.5 L 0.5

This production function can be used to obtain the maximum quantity Q that can be produced by

using different combinations of K and L as follows

Q = 50 √ LK

Suppose K=2 and L= 5, then

 Q = 50√ 2*5 = 158

Short run laws of production: Production with one variable input

In short run, input-output relationship is studied with one variable input (labour), other inputs

held constant. The laws of production under these conditions are referred as “laws of variable

proportions” or “laws of returns to variable inputs”.

The law of Diminishing Returns: the law of diminishing return states that when more and more

units of variable inputs are used with a given quantity of fixed inputs, the total output may

initially increase at increasing rate and then at a constant rate, but it will eventually increase at

diminishing rates.

Assumptions: the law of diminishing returns is based on the following assumptions

I. Labour is the only variable inputs, capital remain constant

II. Labour is homogenous

III. The state of technology is given

IV. Inputs prices are given

To illustrate the law of diminishing return, let assume that,(i) a firm of coal mining has set of

machinery as its capital (K), Fixed in the short run.(ii) a firm can employ more of the mining

workers to increase coal production. Thus, the short run production function will be as

Qc = f (L), K Constant

Let assume that the labour-output relationship in coal production is given by the hypothetical

production function of the following form

 Qc = - L3+15L2+10L…………………………………… 04

For example if L = 5

Then from our hypothetical production function the value of output (Q) will be 300 unit.

What we need now is to work out marginal productivity of labour, (MPL) and the Avarage

Productivity of labour (APL).

Marginal productivity of Labour (MPL): from the hypothetical production function 04 we can

obtain the MPL by differentiating the production function as follows,

MPL = ɗQ/ɗL = -3L2+30L+10………………………………..05

by substituting numerical values for labour, (L) in eqn 05, MP L can be obtained at different

levels of labour employment. However, this method can be used only where labour is

perfectly divisible and ɗL 0

Suppose L= 5

-3L2+30L+10=0

-3(5)2+30(5) +10 =0

=-3x25+30x5+10

=-75+150+10

then MPL = 85 units

Avarage Productivity of labour (APL): This can be obtained by dividing the hypothetical

production function 04 as follows

 APL = -L3+15L2+10L = - L2+15L+10……………………06
L
Now APL can be obtained by substituting the numerical values for L in eq 06

Suppose L=5 Then APL = 60 units

Note: Average product (AP) is defined as the total product divided by the number of units of

inputs used (labour). While Total Product (TP) is the amount of output the firm can produce

given the factor inputs and level of technology. Marginal product is addition to total product

resulting from one additional unit of input (labour ) used.

GROUP EXERCISE

1(a) present a diagram explaining the three stages of production, observe and explain

the trend of the MPP throughout your diagram

b) Observe the following factory data, calculate the MP L and AP L for each row and

hence based on the trend of MP L group your data according to three stage of

production

No of workers TPPL(tonnes) MPL APL Stages of

production based
on MPL
1 24
2 72
3 138
4 216
5 300
6 384
7 462
8 528
9 576
10 600
11 594
12 552