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Theory of-production

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  • 1. THEORY OF PRODUCTIONMeaning of productionProduction is an economic activity that makes goods available forconsumption. Production at times is also defined as all economic activitiesminus consumption. It is the process of creating goods or services usingvarious available resources.Production function and Factors of productionProduction function shows the relationship between the quantity of agood/service produced (output) and the factors or resources (inputs)used. The inputs used for producing these goods and services are calledfactors of production. Variable factor of Production: A variable factor of production is one whose input level can be varied in the short run. Raw material inputs are a variable factor and unskilled labour is usually thought of as a variable factor. Fixed factor of production: A fixed factor of production is one whose input level cannot be varied in the short run. Capital is usually a fixed factor. Capital refers to resources such as buildings and machinery etc.Thus production generally represented as a function of capital and labour. Q = F (K, L)
  • 2. Production Possibilities frontierProduction possibilities frontier (PPF) curve represents all combinations ofgoods and services that can be produced using the available goods andresources.The PPF curve is also called Transformation curve. This curve shows themaximum quantity of goods/services that can be produced given theavailability of the factors of production.As can be seen from the figure below point X lies beyond the PPF curve andthus the output level of X can’t be reached. Similarly point A lies below thePPF curve which means that the production is below the efficientlevel. Points B, C and D are different combinations of quantity produced ofGood X and Good Y. At all these points the resources or inputs are efficientlyutilised
  • 3. IsoquantsIsoquants are those combination of inputs or factors of production whichprovides an equal or same quantity of output. Isoquant curves are alsocalled Equal product or isoproduct curve. For a production function whichdenotes isoquant:Q=F(L,K),Q is fixed level of productionL = labour and K = Capital are variableThe table below shows different combinations of labour and capital requiredto produce 100 shirtsLabour Capital Output(L) (K) (Shirts) 10 90 100 20 60 100 30 40 100 40 30 100 50 20 100
  • 4. Different resources/ inputs are required for production of goods. Samenumber of outputs can be produced using different input combinations.Isoquant is the combination of all such combination of inputs which producessame output. Thus we have an isoquant curve for every level of output.Since the quantity produced will remain unchanged on an isoquant, theproducer is indifferent for different input combinations.In the figure below the producer will be indifferent on points A, B and C sincethey are on the same isoquant. Also he cannot move to D without increasingboth the inputs and would not produce at E due to inefficiencySimilar to Indifference curve as one move to the right of the isoquant, onereaches a higher level of production.Returns to a factorIn the short run the output can be increased for a production function byincreasing the amount of the variable factor, usually taken to be labour.Thus the responsive change in the output due to a change in the variableinput keeping all other things constant is called returns to a factor.Law of variable proportionsIn short run the output of goods and services is increased by introducingadditional variable factor to the production process to a said quantity of fixedfactors.Law of variable proportions outlines the various possible output scenariosdue to the change in the proportions of fixed and variable factors used forproduction. If we increase the number of a factor (labour) keeping all otherfactors fixed (capital), then the proportion between the fixed and variable
  • 5. factors is changed.The law of variable proportions implies that as we keep on adding thevariable factor of production the marginal product of that factor keeps ondecreasing progressively. Thus after a point every additional unit of factoradded will result in a smaller increase in output.The law of variable proportion is also known as law of diminishing marginalreturns or law of diminishing returns.The law has several assumptions as below: one input is variable while others are fixed in the short run all units of the variable input are same and have equal efficiency no change in production technology factors of production like land and labour can be used in different proportionsTake for instance, hiring additional employees (a variable resource) to workat a factory will initially increase output but eventually it will become moreand more difficult to generate additional output from the fixed resources(due to plant size and equipment limitations) and thus the total output willincrease at a decreasing rate and ultimately will start decreasingTo further understand this let us consider an example of production of shirtsin a factoryRefer to the table below: Marginal product Labour Total Product Average Product (shirts per additional (workers/day) (shirts per day) (shirts per worker) worker) 1 2 - 2.00 2 5 3 2.50 3 9 4 3.00 4 12 3 3.00 5 14 2 2.80 6 15 1 2.50 7 15 0 2.14 8 14 -1 1.75The numbers in the above table shows that as additional number of workersare put on work the total production of shirts increases.Total product is the maximum output that a given quantity of input can produceMarginal product is the increase in total output due to an increase in a unit of input(labour) with all other inputs remaining constant.MP=∆TP/∆L or MPn=TPn-TPn-1Average product is the average quantity of shirts produced by each worker. This tells ushow productive workers are on an average. AP=TP/L
  • 6. As we can see from the above table, marginal product at first increases andthen starts decreasing. Average product also similarly first increases andthen starts decreasing. The relationship between these 3 product conceptsand input can be further explained using the three product curves below
  • 7. In the figure above the input (labour) is shown on x axis while the output(shirts) are shown on the y axis. As we can see from the figure upto threeinput units the production increases at increasing rate and thus marginalproduct (MP) is highest. After this MP curve starts declining and intersectsaverage product (AP) curve. At this point AP is highest and after this AP alsostarts to decline. At 7 input units the total product is maximum and MP iszero. Thereafter TP starts decreasing leading to negative marginal productThe three stages of production as shown above in the figure above can besummarised as follows: Total Product(TP) Marginal Product (MP) Average product (AP)StagesStage 1 Increase at increasing Initially increases and reaches Increases and reaches its rate and than at the maximum point, thereafter maximum. At this stage diminishing rate starts decreasing AP=MPStage 2 Continues to increase Continues to decrease and Starts to diminish. Remains and reaches its reaches to zero above the MP curve maximumStage 3 Starts decreasing Moves to negative territory Continues to decrease but always remains above zeroRelationship between MP and TPFrom the above table and figure we can identify the following relationshipbetween MP and TP As long as MP is increasing, TP will increase at increasing rate When MP starts diminishing, TP will increase but at a decreasing rate When MP is zero, TP remains unchanged and is at its maximum. ThusAt MP=0, TP is maximum When MP is negative, TP starts decreasingRelationship between MP and APSimilar to the relationship between MP and TP, we can also observe therelationship between MP and AP from the table and figure discussed above AP increases till MP>AP
  • 8. AP decreases when MP<AP AP is maximum when AP=MP MP can be zero or negative, but AP continues to be positive alwaysReturns to scaleIn the long run output of goods can be increased by increasing all the factors(i.e. both labour and capital). In the long run all factors are variable, thusthe responsive change in the output due to proportional change in the sizeor scale of inputs or factors of production is called returns to scale.For instance, if the initial production function is as below: P= f(K, L)and the factors of production K and L are increased in same proportion, thanthe new production function will be: P1= f(aK,aL) Constant returns to scale: When P1 increase in the same proportion as the factors of production it is called constant returns to scale. Thus in this case P1/P = a Decreasing returns to scale: When P1 increases less than the proportionate increase in the factors it is called decreasing returns to scale, i.e. P1/P < a Increasing returns to scale: if P1 increases more than the proportionate increase in the factors of production it is called increasing returns to scale, i.e. P1/P > aThe three stages of returns to scale are also explained with the help of thetable below: % increase in % increase in Returns toLabour Capital Total Product inputs total product scale 1 2 - 10 - 2 4 100% 30 200%Increasing 3 6 50% 60 100%Increasing 4 8 33% 80 33%Constant 5 10 25% 100 25%Constant 6 12 20% 110 10%Decreasing 7 14 17% 120 9%Decreasing
  • 9. 8 16 14% 125 4%Decreasing constant returns to scale if (for any constant a greater than or equal to 0) F(aK, aL) = aF(K,L) increasing returns to scale if (for any constant a greater than 1) F(aK, aL) > aF(K,L) decreasing returns to scale if (for any constant a greater than 1) F(aK, aL) < aF(K,L)