Theory Of Production
Production: term refers to the processes during which some material thing is physically converted into something more useful – which can be consumed as a final product or used for processing of other products.
Generally, production is the transformation of resources or commodities into goods that will finally be used by consumers. In economics production includes manufacturing, mining, and farming. It converts some resources or commodities (‘inputs’), into new goods and services (‘outputs’) as a flow over some period of time.
Production cannot be done without technology. The higher the level of the technology the more efficient the producer firm is likely to transform materials into quality finished products. Poor technology is more costly to the firm in terms of inefficiencies and delays in processing, the number
produced per round, and the quality of the product produced.
The process of production
The process of production involves the following:
- Changing the form: raw materials are processed into finished goods.
- Change of place (and transportation) of commodities. movement of commodities and flow of information (logistic management).
- Change of ownership: the exchange of goods and services.
- It also involves provision of direct services.
The production decisions of the Firm
Mainly three production decisions of a firm:
- Production technology: A firm has, in a practical way, to describe how inputs (such as labour, capital, and raw materials) can be converted into outputs (radios, cars, mobile phones, televisions).
- Cost constraints: Costs influence the technology and quantities of inputs and outputs. Firms must carefully take into account the prices of labour, capital and other inputs before embarking on production. Some inputs might be so expensive during some periods while other will be relatively cheap. The firm has to consider the overall cost, and the cost of each input, against the projected revenue from the sale of the outputs.
- Input choices: When technology to use has been considered, the firm has to make decisions about the quantities (in numbers) of inputs, their cost, and the expected outputs (in numbers too). This is not about guess work. It is the work of experts who have to calculate inputs and outputs expected.
Factors of Production
The basic factors of production: land; labour; capital; and entrepreneurship
Reward for factors of production: The price for land is referred to as rent; for labour is wages (for low grade employees) and salaries (for upper grade staff); and for capital is interest.
Capital accumulation, technology and economic growth: They key ingredients of economic growth are labour, capital and technology. Technology enhances productivity of labour. Capital is very important in growth and development of an economy.
Technology can be defined as the application of knowledge to solve problems or invent useful tools. During the Stone Age era the early applications of knowledge to create technology can be seen in the development of simple tools from wood or shards of rock. It continued to develop to a stage where metal was used to make stronger tools. In the current era we talk of computers and the internet. In future we may talk of ‘teleporting’ a human being from one location to another.
COST OF PRODUCTION
Economic Costs
- Economic Cost versus Accounting Cost: Accounting costs refer to the costs of a project presented in terms of monetary outflows alone. Economic Costs are the costs of a project including opportunity costs. Economic costs are obtained by adding accounting costs and opportunity costs
- Transaction Costs: These are the costs of arranging economic activities – gathering information (research), paying executives to make needed decisions, lawyers to help in contract preparation, process of hiring workers(advertising, interviewing, etc.), dinners and lunch when firm is negotiating deals, etc.
- Internal and External Costs: Internal costs – The costs of a project from the perspective of the economic actor making the production decisions. External costs: The costs of a project that are borne by persons or entities (such as the environment) that is not among the economic actors directly responsible for the activity. Some of the external costs are actually external diseconomies to society (e.g. pollution)
Costs of tomato farming
Opportunity Cost: cost associated with opportunities that are forgone when the firm does not put its resources to their best alternative use. A firm that has office space and uses it as an office – without paying for it? It could rent this space out and get rent out of it.
Sunk Cost: expenditure that has been made and cannot be recovered. It is usually the expenditure that is undertaken before the project is funded – and includes costs of preparing the project proposal, among other activities.
Fixed Cost and Variable Costs: Total costs of production (TC) – also ‘thetotal economic costs of production’ can be divided into fixed costs and variable costs. The distinction between FV and VC is based on the period of time that is being considered. Over a very short period of time – for
example a few months – most of the firm’s costs are fixed.
Firm’s Costs in the Short Run
Marginal Cost (MC)
MC, sometimes called incremental cost, is the increase in cost that results from producing one extra unit of output. We should not that fixed cost does not change as the firm’s level of output changes. Therefore, because fixed cost does not change as the firm’s level of output changes, MC is equal to the increase in VC. We can also say that MC is equal to the increase in total cost (TC) that results from an extra unit of output.
When computing MC, we ignore the fixed costs because we assume that fixed costs have to be met or not any variable input was used. We are, therefore, only interested in the cost of additional, or last, or marginal unit of production.
The firm can experience constant, increasing or decreasing marginal cost of production. Constant marginal cost: Each unit of the variable input (with a variable cost), which has a constant price, adds exactly the same amount to the total output – and therefore the cost for each additional unit is the same.
Economies and Diseconomies of Scale
Economies of scale can be looked at as:
Real economies of scale: Those are the economies of scale that are associated with efficient production processes and methods. They include a reduction in raw materials used, labour and capital savings.
Pecuniary economies of scale refer to the advantages of large scale production due to paying lower prices for the factors of production which are used in the production and distribution of the product.
Internal economies of scale: these are the advantages of large scale production enjoyed by a single firm due to specialization in production of certain products.
External economies of scale: These are the economies of scale enjoyed by the entire industry. They can be in form of reduced average costs of production resulting from the expansion of the industry as a whole. They arise from the concentration of the firm doing related work in one area. Silicon Valley is one example in USA. Most IT companies are based in this valley. Service providers such ISPs can charge a lower rate because there are many users.
Internal economies of scale
- Managerial economies: A large firm can afford to have management put under separate departments: production, marketing and sales, logistics, procurement, finance and administration, R&D. It can also afford to hire specialists and consultants .
- Technical economies: These arise due to use of better machines in the production process. There is specialization and specialists use the machines for which they are more skilled at using. The firm can afford to buy specialized machines (such as tractors, milking machines, packing machines, etc.) which will lead to an increase in output; and reduced average cost.
- Research (R&D) economies: A large firm can afford the cost of research on product quality, branding and new technology which is efficient and effective. A small firm can not.
- Marketing economies: A large firm can afford to buy in bulk and enjoy discounts of bulk purchasing. This will enable the firm to sell at competitive prices the final product on the market. The purchasing discount can now be reflected in reduced prices of its products.
- Financial economies: It is hard for a small firm without collateral securities to obtain a loan from the financial institutions. Financial institutions tend to trust large firms. These firms can even obtain loans at cheap rates. These firms have got a large pool of assets, collateral securities and good reputation. They have a name and in business a name matters.
- Risk bearing economies: These are two main ways for a large firm to reduce risk. It can afford to purchase a comprehensive insurance policy. Secondly it can produce a variety of products or product versions and sell to different markets (diversification of markets). This will help spread and reduce the risk.
- Transport economies: It is possible for a large firm to transport in bulk and negotiate transportation concessions. A small firm does not enjoy such advantages.
- Storage economies: When materials are stored in bulk, storage costs per unit output reduces. A storage facility whose storage capacity is 1000 units will charge a firm same amount whether it keeps there 1000 units or 600 units.
- Welfare economies: These can also be referred to as social economies. A large firm can afford to negotiate a better rate and provide its workers with medical insurance, better housing, and education for the children of workers etc. A small firm cannot afford to provide welfare facilities to the staff.
Diseconomies of scale
Internal diseconomies:
- Technical diseconomies: As the firm over-expands, also the wear and tear of machines increases resulting from their intense use.
- Managerial diseconomies: At times over-expansion creates problems for management. It becomes difficult to access the last person on the shop floor. The firm can not easily get to know the problems facing workers. Supervision of workers becomes hard. Coordination between management and workers suffers. Effective monitoring and supervision declines and the result is inefficiency and increased cost per unit output.
- Financial diseconomies: To produce at full capacity by large firms, requires more finances. These finances may not be internally available. This may result in the firm over borrowing. This cost of borrowing is reflected in interest payments. Such a firm may be making more money but saving little due to interest payments.
- Marketing diseconomies: The firm that has over expanded may soon fail to get ample quantities of raw materials. This may affect the level of production. It may also fail to meet the demand that it had created. Some customer may switch to other brands and this will affect profitability.
External diseconomies:
Over expansion of the industry as a whole can result in diseconomies.
Land rent may go up because of high competition, accommodation and generally cost of living may go up; pollution may rise due to too much production in factories; transport costs may increase because there now more vehicles causing congestion on the roads in the area where the industry is
located.
Law of Diminishing Marginal Returns
The law of diminishing marginal returns states that as the use of an input increases in equal increments with other inputs fixed, a point will eventually be reached at which the resulting additions to output decrease. Let us use labour as a variable factor to explain this. When the amount of labour input is small – and capital is fixed – extra units of labour add considerably to output, usually because workers are allowed to devote themselves to specialized tasks. When the firm buys too many units of labour (too many workers), some of the workers become ineffective and the marginal product of labour falls. This law applies in the short–run.
Assumptions of the law of diminishing marginal returns:
- It applies to the short run when at least one input is fixed.
- It applies to a given production technology.
- It assumes that all labour units are of equal quality
- Diminishing marginal returns results from the limitations on the use of other fixed inputs (e.g. poor use of machinery) not from the declines in the worker quality
Labour Demand and the production Function
What does a firm consider when making decisions on how many workers to employ?
Let us talk about the Marginal Product of Labour (MPL). What is it? Why should we discuss it here?
MPL is the key feature of the production function of any labour market. MPL refers to the amount of extra output that one more worker can produce keeping fixed the stock of capital and the level of technology. Graphically, it is assumed shown to be decreasing with the level of employment – this is to say that ‘too many cooks spoil the broth’. When a firm considers how many workers to employ, mainly in the developed economies, then the MPL plays a key role.
Marginal Product of Labour (MPL)
Each additional worker should produce extra output equal to the MPL.
- If the firm can sell this output for a price (P), then hiring one more worker yields additional revenue of P x MPL.
- Every additional worker hired increases the firm’s costs – recruitment and training costs, he firm has to pay wages, employment taxes (e.g. mandatory contribution by the firm to the Personal Income Tax (PIN) for every work (this Pay As You Earn (PAYE), office costs (furniture, equipment), and so forth. The wage costs can be summarized as W. If P x MPL exceeds W, then hiring extra worker leads to an increase in profits, while if P x MPL is less than W, profits fall.
- Alternatively, we can say if MPL>W/P (real wage), the firm should hire workers, and if MPL<W/P, the firm should reduce its workforce. (The term W/P is the real wage and reflects how much the firm has to pay its workforce relative to the price of its output.
