Unit 6 ProductionObjectives:After going through this unit, you will be able to explain:Concept of production and production processFactors of productionProduction functions and its various typesOptimal level of output for a given level of inputsWhy firms grow large in sizeEconomies of scale and scopeStructure:1.1 Introduction1.2 Concept of production1.3 Factors of production1.4 Production function1.5 Production function with one variable input – Returns to factor1.6 Law of variable proportions and returns to factor1.7 Production function with two variable inputs - Isocosts, Isoquants and producer’s equilibrium1.8 Production function when all inputs are variable - Returns to scale1.9 Economies and Diseconomies of Scale1.10 Economies of Scope1.11 Summary1.12 Key words1.13 Self-assessment questions
1.1 IntroductionIn our earlier units we have discussed about the economic tools that help sellersunderstand the consumer better. In this unit we shall explore those economic tools whichconcern with marketers ability to supply in the market. Production decisions concentrateon levels of output and processes and systems used for optimizing the mix of resourceinputs. In other words, the tools discussed in this unit will help sellers in efficientutilization of resources for effectiveness in achieving production goals. The productionskill can be combined with effective consumer and market information to determine theoptimum quantity of goods and services to manufacture and the appropriate price tocharge.1.2 Concept of ProductionProduction is simply the conversion of inputs into output. It is an economic process thatuses resources to create a commodity that is suitable for trade and fulfills customerexpectations. Production can include multifarious activities – resource planning,manufacturing, packaging, and logistics. In economics all activities other than theconsumption of goods and services involve some or the other production activity and ishence, referred to as production.Production should really be viewed as a process that occurs over a period of time. Thereare three aspects to production processes: a) Inputs b) Process c) Final outputConsider the following figure:
P R O D U C T I O N INPUT PROCESS OUTPUTIn this entire production process as described in the above diagram there are multipledecisions involved. Let us begin understanding these decisions with the first link – theinputs, which are also called factors of production.1.3 Factors of productionThe inputs or resources used in the production process also called as factors of productionare numerous in number. In economics they are usually grouped into four categories.These factors are: a) Land b) Labour c) Capital d) Enterprise a) Land is the natural resources available for production. By convention, economists include in the category land both, (i) The “original and indestructible powers of the soil” and (ii) Natural resources, such as coal, oil, and metallic ores. b) Labour is the human input into the production process. Labor uses capital on land to produce wealth. It covers both physical and mental effort - e.g. stacking shelves in a supermarket, or calculating the final accounts of a company. c) Capital includes the manufactured resources used to manufacture or produce other goods and services. Common examples of capital are the factories, buildings, trucks, tools, machinery, and equipment used by businesses in their
productive pursuits. Capital’s primary role in the economy is to improve the productivity of labor as it transforms the natural resources of land into wants- and-needs-satisfying goods. Capital can be understood as fixed or working, (i) Fixed capital includes long-term capital such as machinery, plant and equipment, new technology, factories and buildings. (ii) Working capital includes inventories of finished and semi- finished goods and other inputs that will be either consumed or converted into finished goods. d) Entrepreneurs are people who organize other productive resources to make goods and services. They are factor responsible for acquiring and utilizing all the other factors. The success and/or failure of a business often depend critically on the entrepreneurial skill and effort.1.4 Production FunctionWe have seen that production is really the process o converting inputs into output. Then itcan be drawn out that there should be a relationship between output and inputs. Thisrelationship requires us to understand the concept of production function.A production function expresses the relationship between an organization’s inputs and itsoutput. It indicates, in mathematical or graphical form, what output can be obtained fromvarious amounts and combinations of factor inputs. In particular it shows the maximumpossible amount of output that can be produced per unit of time with all combinations offactor inputs, given current factor endowments and the state of available technology.The relationship is non-monetary, that is, a production function relates physical inputs tophysical outputs. Prices and costs are not considered. In simple words, the productionfunction relates the output of a firm to the amount of inputs.
We can express the production function summarizing the process of conversion of factorsinto a commodity, let’s say ‘y’ in the form of a general equation as follows,y = f(n1,n2,……nx),which relates a single output y to a series of factors of production n1, n2, ..., nx.In this sense then, production functions explain the dependency of output on factor inputsand the response of output when inputs change. Using the above equation uniqueproduction functions can be constructed for every production technology.The following section analyses this relationship in three different ways, a) Production function when one input is variable b) Production function when two inputs are variable c) Production function when all inputs are variableIt is important to understand at this point what we mean by a variable input. Allbusinesses operate in a short and a long run. The short run is characterized myriadconstraints. One of the constraints is the availability of factor inputs. While in the longrun these constraints may not prevail. It is on this basis that we can define fixed andvariable inputs: a) Fixed inputs are those whose quantities cannot be changed over the time period in consideration. b) Variable inputs are those whose quantities can be altered over the time period in considerationWe are now ready to understand production function when factor inputs can be fixed orvariable.1.5 Production function when one input is variable – Returns to factorWe begin studying the relationship between output and inputs by first keeping one inputvariable and the other inputs constant. When this is done the Law of Variable Proportionsoperates. We know that variable input is an input whose quantity can be changed in the
time period under consideration. The most common example of a variable input is labor.A variable input provides the extra inputs that a firm needs to expand short-runproduction. In contrast, a fixed input, like capital, provides the capacity constraint inproduction. When inputs are used in this fashion there is production of a certain level ofoutput. There are three aspects of this output that we need to understand: a) Total output or total physical product (TPP) b) Average output or average physical product (APP) c) Marginal output or marginal physical product (MPP)a) The total physical product identifies what output is possible using various levels ofthe variable input. This can be displayed in either a chart that lists the output levelcorresponding to various levels of input, or a graph that summarizes the data into a “totalproduct curve”. Consider the following table and the diagram that show a TPP data andTPP curve. Units of Total Physicalvariable input Product 1 10 2 30 3 90 4 120 5 130 6 120
Output A InputsIn this example, output increases as more inputs are employed up until point A.The average physical product is the total product divided by the number of units ofvariable input employed. It is the output of each unit of input. It can be calculated usingthe following equation: APP = TPP Quantity of inputsWhere APP = average physical product and TPP = total physical product.For example, if there are 10 employees working on a production process thatmanufactures 50 units per day, then using the above equation the average product oflabour input can be calculated to be 5 units per day.The average product typically varies as more of the input is employed, so thisrelationship can also be expresses as a chart or as a graph.
The marginal physical product is the change in total output due to a one unit change inthe input or alternatively the rate of change in total output due to change in the variableinput. It can be calculated using the following equation: MPP = ΔTPP ΔQuantity of inputsWhere MPP = marginal physical product and TPP = total physical productThe following table and figure show the APP and MPP that have been derived form TPPusing the formulae mentioned.Units of Input TPP MPP APP 1 10 10 10 2 30 20 15 3 90 60 30 4 120 30 30 5 130 10 26 6 120 -10 20 Output APP MP Inputs
Because the marginal product drives changes in the average product, we know that whenthe average physical product is falling, the marginal physical product must be less thanthe average. Likewise, when the average physical product is rising, it must be due to amarginal physical product greater than the average. For this reason, the marginal physicalproduct curve must intersect the maximum point on the average physical product curve.Based on the basic concept we can now discuss the Law of Variable Proportions whichdescribes the response of total output when one input is variable while others are keptconstant.1.6 Law of Variable ProportionsAccording to the Law of variable proportions that as we add more and more of a variableinput, we will reach a point beyond which increase in output starts to diminish. When oneof the inputs is variable and the others are kept constant, the output initially increases atan increasing rate, thereafter the rate of increase diminishes, and after this point if moreunits of the variable input are added the TPP actually declines. Consider the followingdiagram, Output Stage II Stage III Stage I TPP APP Inputs MPP
To simplify the interpretation of this production function with on variable input, we candivide the response of output into 3 stages. Consider the following table:Stages in production Response of TPP Response of APP Response of MPPfunctionStage I – Increasing Increases at an Increases at an Increases at anreturns to factor increasing rate increasing rate increasing rateStage II – Increases at an Declines DeclinesDiminishing returns diminishing rateto factorStage II –Decreasing Declines Declines Becomes negativereturns to factorIn stage I the variable input is being used with increasing efficiency and the response ofTPP, APP, and MPP is very positive. This is why a firm will try to operate beyond thisstage. This happens because, perhaps, the fixed inputs are underutilized.In Stage 2, TPP increases at a decreasing rate, and the average and marginal physicalproduct is declining. In this stage, the employment of additional variable inputs increasethe efficiency of fixed inputs but decrease the efficiency of variable inputs. The optimuminput/output combination will be in stage 2. Maximum production efficiency must fallsomewhere in this stage.If firms continue to Stage 3, too much variable input is being used relative to theavailable fixed inputs. Both the efficiency of variable inputs and the efficiency of fixedinputs decline through out this stage. The result is that TPP and APP decline and MPPbecomes negative.1.7 Production Function when two inputs are variable - Isocosts, Isoquants andproducer’s equilibrium
In this section we will study the response of output when two inputs are variable whileother are fixed. To understand how the output responds and the consequent equilibriumsituation of the producer requires us to understand the concept of, a) Isoquants, and b) IsocostsAn isoquant, in the case of two variable input, is a curve that shows all the ways ofcombining two inputs so as to produce a given level of output. Iso is Latin for equal andquant is short for quantity. Isoquants can be identified with the following characteristics: (i) Movement along an isoquant depicts a constant rate of output, but a changing input ratio. (ii) A unique isoquant can be constructed for every level of output, and a family of isoquants can be created to represent various output levels. (iii) Isoquants further from the origin represent greater amounts of output. (iv) Isoquants are usually considered to be everywhere dense, meaning an infinite number of them could be plotted in any two input space. (v) The “downward to the right” slope of the economic region of an isoquant is due to the possibility of substituting one input for another in the production process while keeping the level of output constant. (vi) Isoquants are typically convex to the origin reflecting the fact that the two factors are substitutable for each other at varying rates. This rate of substitutability is called the “marginal rate of technical substitution” (MRTS) or occasionally the “marginal rate of substitution in production”. It measures the reduction in one input per unit increase in the other input that is just sufficient to maintain a constant level of production. For example, the marginal rate of substitution of labour for capital gives the amount of capital that can be replaced by one unit of labour while keeping output unchanged.Consider the following figure,
Input A I4 I3 I2 I1 0 Input BIn the above figure the two variable inputs are B and A. When taken on x and y axisrespectively, there can several convex-shaped, downward sloping isoquants be plotted,each representing various combinations of inputs for a given level of output. Isoquantsrepresent possibilities of variable input combinations or various levels of output.Isoquants, infact, can be understood as a producer’s indifference curve where on the sameisoquant producer is indifferent between various combinations of inputs because theyproduce the same level of output.However, the specific input combination that is chosen by the producer also depends onone more factor that is his affordability of the inputs. This can be found out through theproducer’s budget line. The producer’s affordability is reflected through an Isocost. An Input Aisocost defines the producer’s budget or his maximum expenditure on the two variableinputs. Consider the following figure, A Isocost Input B 0 B
In the above figure, AB is the isocost. It is derived after defining the maximum amount ofboth the inputs that the producer can purchase given his budget constraints.Producer’s equilibrium or purchase decision is derived using both the Isoquants and theIsocost as shown in the following figure, Input A e I3 A’ I2 I1 0 B’ Input B
In the above figure, the producer buys that combination of the two inputs which isdefined by point ‘e’. At e OA’ and OB’ of input B are used to produce the level of outputdefined by isoquant I2. All points below this point do not maximize output and all pointsbeyond it are not affordable for the producer. The equilibrium point is, hence, e where theproducer’s isocost is tangent to the highest isoquant.1.8 Production Function when all inputs are variable - Returns to scaleWhen all the inputs in the production process are altered an economic concept that comesinto play is called as Returns to Scale.Returns to Scale refers to a technical property of production that explains what happensto output if we increase the quantity of all input factors by some amount.The returns to scale exhibiting the response of output to a change in all inputs can be anyone of the following, a) Increasing b) Diminishing c) Constant d) VariableConsider the following diagrams,
Output Output b a Inputs Inputs Output Output d c Inputs InputsThe above diagrams showing for possible returns to scale are described in the followingtable,Diagram Response of Description No. output a) Increasing Output increases by an amount that is more than the
returns to scale quantity of inputs. b) Diminishing Output increases by an amount that is less than the returns to scale quantity of inputs. c) Constant returns Output increases by an amount that is same as the to scale quantity of inputs. d) Variable returns Output first increases by an amount that is more than the to scale quantity of inputs and after a certain point increases by an amount that is less than the quantity of inputs.The production facilities showing increasing returns to scale are high growth, whilematured and stable growth production facilities show diminishing and constant returns toscale. However, empirical studies show that over the lifetime production facilities mostlyexhibit variable returns to scale, i.e., increasing returns to scale in the initial years anddiminishing returns to scale after a certain point of time. This happens because of whatwe call in economics Economies of Scale. The following section explains the concept andhow it causes variable returns to scale.1.9 Economies and Diseconomies of ScaleEconomies and diseconomies of scale refer to that aspect of production which evaluateswhat happens to cost if we increase the quantity of all input factors by some amount. Ifcosts increase proportionately, there are no economies of scale, if costs increase by agreater amount, there are diseconomies of scale, if costs increase by a lesser amount, andthere are (positive) economies of scale. Economies of scale are thus reduction in averagecost of production as firms grow large in size or increase the scale of production Whencombined, economies of scale and diseconomies of scale lead to ideal firm size theory,which states that per-unit costs decrease until they reach a certain minimum, thenincrease as the firm size increases further.Economies of scale tend to occur in industries with high capital costs in which those costscan be distributed across a large number of units of production. The exploitation ofeconomies of scale helps explain why companies grow large in some industries. It is alsoa justification for free trade policies, since some economies of scale may require a larger
market than is possible within a particular country. Typically, because there are fixedcosts of production, economies of scale are initially increasing, and as volume ofproduction increases, eventually diminishing, which produces the standard U-shaped costcurve of economic theory. In some economic theory (e.g. perfect competition) there is anassumption of constant returns to scale.There are two main types of economies of scale: a) Internal b) External.a) Internal economies of scale: Internal economies of scale relate to the lower unit costs a single firm can obtain by growing in size itself. There are five main types of internal economies of scale. (i) Managerial economies: As a firm grows, there is greater potential for managers to specialize in particular tasks e.g. marketing, human resource management, finance. Specialist managers are likely to be more efficient as they possess a high level of expertise, experience and qualifications compared to one person in a smaller firm trying to perform all of these roles. (ii) Financial economies: Many small businesses find it hard to obtain finance and when they do obtain it, the cost of the finance is often quite high. This is because small businesses are perceived as being riskier than larger businesses that have developed a good track record. Larger firms therefore find it easier to find potential lenders and to raise money at lower interest rates. (iii) Economies of bulk purchases: As businesses grow they need to order larger quantities of production inputs. For example, they will order more raw materials. As the order value increases, a business obtains more
bargaining power with suppliers. It may be able to obtain discounts and lower prices for the raw materials. (iv) Economies of risk-spreading: As firms grow in size they are more capable of spreading risks across products and markets. A simple rule of economics and finance is that not all markets go bad in a day. Working on this principle, for minimization of risks, is possible for firms when they grow in size and begin to expand and diversify. (v) Marketing economies: Every part of marketing has a cost – particularly promotional methods such as advertising and running a sales force. Many of these marketing costs are fixed costs and so as a business gets larger, it is able to spread the cost of marketing over a wider range of products and sales – cutting the average marketing cost per unit. (vi) Technical economies: Businesses with large-scale production can use more advanced machinery or use existing machinery more efficiently. This may include using mass production techniques, which are a more efficient form of production. A larger firm can also afford to invest more in research and developmentb) External economies of scale: External economies of scale occur when a firm benefitsfrom lower unit costs as a result of the whole industry growing in size. The main typesare: (i) Improvement in communication and transport infrastructure: As an industry establishes itself and grows in a particular region, it is likely that the government will provide better transport and communication links to improve accessibility to the region. This will lower transport costs for firms in the area as journey times are reduced and also attract more potential customers
(ii) Development of skilled human resource: Training and education becomes more focused on the industry. Universities and colleges will offer more courses suitable for a career in the industry which has become dominant in a region or nationally (iii) Growth of support industries: Other industries grow to support this industry. A network of suppliers or support industries may grow in size and/or locate close to the main industry. This means a firm has a greater chance of finding a high quality yet affordable supplier close to their site.Out of internal and external economies of scale the internal economies have a greaterpotential impact on the costs and profitability of a business. This is because they areinternal to the firm and relatively more in favor, while external economies are externaland therefore would be dependent on exogenous variables.Consider the following diagram to understand economies scale. Costs Economies of scale Diseconomies of scale LRAC c c’ q q’ OutputIn the above figure increase in output from q to q’ causes a decrease in the average costof each unit from c to c’. Beyond q’ level of output the average cost curve starts risingindicating the appearance of diseconomies of scale.
Diseconomies of scale are the forces that cause larger firms to produce goods andservices at increased per-unit costs. Diseconomies of scale result in increase in averagecost of production as firms grow large in size or increase the scale of production beyondthe optimum firm size.The primary causes underlying diseconomies arise out ofmanagerial and administrative inefficiencies. Some of the forces which cause adiseconomy of scale are listed below. (i) Problems of Communication and Control: Ideally, all employees of a firm would have one-on-one communication with each other so they know exactly what the other workers are doing. As firm grows in size the one-on- one channels of communication grow more rapidly than the number of workers, thus increasing the time, and therefore cost, of communication. (ii) Duplication of effort: When firms grow to thousands of workers, it is inevitable that someone, or even a team, will take on a project that is already being handled by another person or team. (iii) Top-heavy companies: The more employees a firm has, the larger percentage of the workforce will be “management” and lower percentage of “line workers”. Managers are necessary to manage a large, complex company, but should be considered a “necessary evil” as they also reduce overall productivity. (iv) Interpersonal behavioral issues: This will be defined as management behavior which that manager knows is counter to the best interest of the company, but is in their personal best interest The more levels, the more opportunity for this. (v) Isolation of employees from decisions: An individual employee at a huge company may not be linked be with a lot of decisions and issues happening
in the company which may affect the company as a whole as well him as an employee also.1.10 Economies of scopeAnother advantage that firms enjoy is Economies of scope which refers to benefitsderived out of exploiting efficiencies associated with increasing or decreasing the span ofmarketing and distribution by bringing about changes in the number of different types ofproducts manufactured and sold. The benefits that are drawn out to of economies ofscope include the following: (i) Spreading advertising and promotion costs: As the number of products promoted is increased and broader media used, more people can be reached at the same cost (ii) Spreading the cost of skilled workforce: A sales force is selling several products can often be more efficient than a sales force selling only one product. The cost of their travel time is distributed over a greater revenue base, so cost efficiency improves. (iii) Benefits from product range synergies: There can also be synergies between products such that offering a complete range of products gives the consumer a more desirable product offering than a single product would. (iv) Distribution synergies: Economies of scope can also operate through distribution efficiencies. It can be more efficient to ship a range of products to any given location than to ship a single type of product to that location. (v) Making use of by-products: Further economies of scope occur when there is cost-savings arising from by-products in the production process. For example juice manufacturers can use the by product fruit pulp for making of jams.
1.11 SummaryIn this unit we have studied that production decisions concentrate on levels of output andprocesses and systems used for optimizing the mix of resource inputs. Production shouldreally be viewed as a process that occurs over a period of time. The inputs or resourcesused in the production process also called as factors of production are numerous innumber. In economics they are usually grouped into four categories. A productionfunction expresses the relationship between an organization’s inputs and its output.Empirical studies show that over the lifetime production facilities mostly exhibit variablereturns to scale, i.e., increasing returns to scale in the initial years and diminishing returnsto scale after a certain point of time. This happens because of what we call in economicsEconomies of Scale. Economies and diseconomies of scale refer to that aspect ofproduction which evaluates what happens to cost if we increase the quantity of all inputfactors by some amount. Firms also enjoy economies of scope when they diversify intosimilar or different products.1.12 Key words: a) Production: The process of conversion of inputs into output. b) Factors of production: The inputs or resources used in the production process. c) Production function: Expresses the relationship between an organization’s inputs and its output. d) Fixed inputs: Inputs whose quantities cannot be changed over the time period in consideration. e) Variable inputs: Inputs whose quantities can be altered over the time period in consideration f) Returns to factor: Response of output when one input is variable. g) Total physical product: Total output as result of using various levels of input. h) Average physical product: The total product divided by the number of units of variable input employed.
i) Marginal physical product: The change in total output due to a one unit change in the input. j) Law of variable proportions: As we add more and more of a variable input, we will reach a point beyond which increase in output starts to diminish. k) Isoquant : A curve that shows all the ways of combining two inputs so as to produce a given level of output. l) Isocost: The producer’s budget or his maximum expenditure on the two variable inputs. m) Returns to Scale: A technical property of production that explains what happens to output if we increase the quantity of all input factors by some amount. n) Economies of Scale: Reduction in average cost of production as firms grow large in size or increase the scale of production. o) Diseconomies of Scale: Increase in average cost of production as firms grow large in size or increase the scale of production beyond the optimum firm size. p) Internal economies of scale: Lower unit costs a single firm can obtain by growing in size itself. q) External economies of scale: Benefits for an individual firm from lower unit costs as a result of the whole industry growing in size. r) Economies of scope: Benefits derived out of exploiting efficiencies associated with increasing or decreasing the span of marketing and distribution by bringing about changes in the number of different types of products manufactured and sold.1.13 Self-assessment questions 1) Explain the concept of production and production function 2) Discuss, in detail, the Law of Variable Proportions 3) Distinguish between a) Isocosts and Isoquants b) Fixed and Variable inputs c) Returns to factor and returns to scale d) Economies and diseconomies of scale
e) Economies of scale and scope4) Explain production function when all inputs are variable5) Write a brief note on Internal and external economies of scale6) The process of conversion of inputs into output is called, a) Consumption b) Distribution c) Production d) None of the above7) Production function expresses the relationship between an organization’s a) Inputs and output b) Inputs and economies c) Economy and output d) All of the above8) The inputs or resources used in the production process, in economic, are called as a) Factors of consumption b) Factors of distribution c) Factors of production d) None of the above9) Inputs whose quantities cannot be changed over the time period in consideration are called, a) Fixed b) Variable c) Constant d) Moving10) Inputs whose quantities can be changed over the time period in consideration. a) Fixed b) Variable c) Constant d) Moving11) Fill in the blanks:
a) __________________________ is the response of output when one input is variable.b) __________________________ is the total output as result of using various levels of input.c) __________________________ is the total product divided by the number of units of variable input employed.d) __________________________ is the change in total output due to a one unit change in the input.e) __________________________ says that as we add more and more of a variable input, we will reach a point beyond which increase in output starts to diminish.f) __________________________ is the curve that shows all the ways of combining two inputs so as to produce a given level of output.g) __________________________ is the producer’s budget or his maximum expenditure on the two variable inputs.h) __________________________ is the technical property of production that explains what happens to output if we increase the quantity of all input factors by some amount.i) __________________________ is the reduction in average cost of production as firms grow large in size or increase the scale of production.j) __________________________ is the increase in average cost of production as firms grow large in size or increase the scale of production beyond the optimum firm size.k) __________________________ is the benefits of lower unit costs a single firm can obtain by growing in size itself.l) __________________________ is the benefits for an individual firm from lower unit costs as a result of the whole industry growing in size.