Production Analysis… Production Function… Laws Of Returns › Economics Basics
Basic Principles of Economics, Market Structures and Cost Analysis
Basic Principles of Economics:
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Production Analysis
In the ordinary language, the term "production" means rising of crops or making of a physical goods in factories. For example, if you make ice cream, you will say that you have produced ice- cream (goods). But from the point of view of Economics, you have not produced any new thing in the form of ice-cream; rather, you have changed the form of milk, sugar, cream, etc, and thus, have created the utility. Marshall is right to say, "Man does not produce physical (material) goods; but when it is said that he produces material goods, in fact, he only creates the utility. Even the scientists also agree that "Matter can neither be created nor destroyed." Thus, in Economics, the word "production” is used to imply creation or increasing the utility of a good so that its value is increased.Definitions
"Production may be defined as the creation of utilities. Anatol Murad"Production is the process that creates utility in goods. A.H. Smith
"Production is the creation of economic utility "- Ely
"Production means an increase in the value of a commodity."- Nicholson
"Production is any activity which adds to the value of a nation's supply of goods and services.” -M.J.UImer
"Production may be defined as the process by which inputs may be transformed into output" - Robert Awh
Difference between Consumption and Production
Generally, production and consumption are considered to be altogether contrary and different activities.Consumption is the use of utility whereas production is creation of utility. In fact, their difference is not so fundamental. Both these are two different aspects of the same activity. For example, when a carpenter makes a chair, he performs an act of production by increasing the utility of log of wood. But at the same time, he has also consumed the log of wood by using its utility.
Thus, two aspects of the same activity are production and consumption. According to Prof. Mehta., "When the utility of a good is used for the direct satisfaction of want, it is called consumption, and its use for the indirect satisfactions of want is called production."
Methods of Creation of Utility
Production or creation of utility can be made by the following methods:1) Form Utility: If by changing the form of a good, capacity to satisfy wants is created in it, it is called the form utility. Changing of wheat in the form of biscuit, changing of wood into furniture are the examples of the form utility. Dalmia Biscuit Company or Godrej Steel Furniture Company or factories changing the raw materials into goods create the form utility.
2) Place Utility: Utility is also created by changing the place of goods. It is called place utility. Collecting of the sand from the river-bank and transporting it to the construction site or transporting the coal to different parts of the country from the coal-mines are the examples of place utility. A transporter, railways, shipping companies, and airways create place utility. So, the function of transporting companies is called production.
3) Time Utility: If by an act of storage of a good for some time its utility increases, it is called time utility. Storing oranges, apples and other fruits in the cold storages until their crop season is over and their prices increase, is the example of time utility. Thus the activities of traders, who make the stock of a commodity, can also be called production.
4) Service Utility: If the service of a man satisfies our want, it is called service utility. A professor's teaching in a class, a lawyer's pleading a case, a tailor's stitching a shirt, are the examples of the creation of service utility. Therefore, a professor, lawyer or a tailor are also the producers.
5) Possession Utility: If the change of possession of a good increases its utility, it is called the possession utility. The utility of a sewing machine is not so great for a dealer in sewing machines as it is for a tailor. The utility of the machine increases by this change of possession. It will be called possession utility. Since traders or retailers are the creators of this utility, their activity is also called production.
6) Knowledge Utility: When the utility of a good increase by increasing people's knowledge about that goods, it is called knowledge utility. For example, we come to know about the qualities of LG washing machine, Lux soap or Forhans tooth paste through advertisements. We make greater demand for these goods. Thus, advertisers also help production by creating knowledge utility.
Thus, in order to know whether a man is a producer or not, it is to ensure whether an increase in utility or value is made by the work done by that man or not. It is essential that the work-done by anyone must create or increase utility.
Factors of Production
You want to produce wheat. For the production of wheat, you require land, workers, tractor, tube well, seeds, pesticides, favourable climatic conditions and fertilizer, etc. All these are called the means of production or inputs. With the help of these, we get the output or production."The sources of services which enter into the process of production are called factors of production. The factors are broadly classified as land, labour, capital, organisation and enterprise .M.J. Ulmer
According to Dr. Marshall, "In a sense, only nature and man are the two sources of production-" Benham has rightly remarked, "Factors of production are neither two nor four but millions." But according to modem economists and for the sake of simplicity, there are four factors of production namely: (i) land (ii) labour (iii) capital (iv) organisation and enterprise. Modem economists call all these factors as Input or resources, as under;
1. Land: Land is that factor of production which is freely available from nature. In it, not only on the surface of soil is included, but also all other free gifts of the nature below the surface and above the surface are included; for example, forests, minerals, fertility of soil, water, etc. According to Marshall, "Land means the material and the forces which nature gives freely for man's aid, in land and water, in air, light and heat." Land is also called a natural resource.
2. Labour: Labour is a human factor of production. In it all those mental and physical activities of man are included which are performed in order to earn money. The services of a carpenter, black-smith, weaver, teacher, lawyer and doctor, etc., are called labour.
3. Capital: Capital is that man-made factor of production which is used for more production. Factors like machines, tools, raw materials, buildings, railways, factories, etc., are called capital. The saving of a man when invested to earn will also be called capital.
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Production Function
When most people think of fundamental tasks of a firm, they think first of production. Economists describe this task with the production function, an abstract way of discussing how the firm gets output from its inputs. It describes, in mathematical terms, the technology available to the firm.The technological relationship between inputs and output of a firm is generally referred to as the production function. The production function shows the functional relationship between the physical inputs and the physical output of a firm in the process of production. To quote Samuelson, "The production function is the Technical relationship telling the maximum amount of output capable of being produced by each and every set of specified inputs. It is defined for a given set of technical knowledge."
According to Stigler, "the production function is the name given to the relationship between the rates of input of productive services and the rate of output of product. It is the economist's summary of technical knowledge.
Production is the transformation of inputs into outputs. Inputs are the factors of production -- land, labor, and capital -- plus raw materials and business services.
The transformation of inputs into outputs is determined by the technology in use. Limited quantities of inputs will yield only limited quantities of outputs. The relationship between the quantities of inputs and the maximum quantities of outputs produced is called the "production function."
But how do these outputs change when the input quantities vary? Let's take a look at an example of a production function.
In general, we would allow for varying amounts of land, labor and capital. However, in this example, labor will be the only input, for the sake of simplicity.
The main theme of production function is to get the maximum production with the present given set of variable.
Eg: a firm can use the more labour and less machines OR it can use less labour and more machines to get maximum production. Here which is suited best and how to find the best alternative choice is the main aim of production function.
Q=output/quantity
• LB = Land & Buildings.
• L = Labour.
• K = capital.
• M = raw material.
• t= time.
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Laws Of Returns
1. Production function with one variable input /Law of variable proportions./ Law of diminishing marginal productivity.When there is increase in the production, we normally increase the labour rather than the machinery. The more labour employed in the production process, there will be raise in the production. But continues increase in the labour may lead to decrease in the production after certain point. Here comes the question. How many employees should be employed to get maximum production? Law of variable proportion answer the question of the employment of labour for optimum production.
DEFINITION
— According to Leftwitch, The law of variable proportions states that if the input of one resource is increased by equal increments per unit of time while the inputs of other resources are held constant, total output will increase, but beyond some point the resulting output increases will become smaller and smaller."— Eminent Economist Samuelson says, “The law states that an increase in some inputs relative to other fixed input will, in a given state of technology, cause total output to increase; but after a point the extra output resulting from the same addition of extra inputs is likely to become less and less.”
ASSUMPTIONS
The law has following main assumptions:(1) One of the factors is variable while all other factors are fixed.
(2) All units of the variable factor are homogeneous.
(3) There is no change in the technique of production.
This law of variable proportion shows the input and output relationship with one variable factor. e.g. labour.
Illustration:
From the above given data, we should find out the average production and the marginal production.
Points to remember:
1. point out the maximum value in the marginal production Colum.2. point out the maximum value relating to the marginal production value in the average production Colum.
3. At this intersection point indicates best number of employees employed to have the maximum production
3 stages of the production with Graph analysis:
(Stage 1): The maximum value of the marginal product is at 4 and maximum value of the average product relating to the marginal product Colum is 3. This is intersection point where the maximum 6 units of production can be done by employing 2 labours. Up to this point it is called as increasing returns stage.(Stage 2): when we employee more than 2 labours ie. 3 labours total production is raising but the marginal production is falling down from 4 to 3 and average product is nearly same. So this stage is stated as decreasing returns to the production.
(Stage 3): at 6 labours employed the marginal production is -1 units and the curve is cutting the X axis and moving down to the negative position. Hence this stage is stated as the negative returns in the production.
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Constant Returns to Scale
Law of Constant Returns to Scale When the scope for division of labour gets re¬stricted, the rate of increase in the total output remains constant, the law of constant returns to scale is said to operate. This law states that the rate of increase/decrease in volume of output is same to that of rate of increase/decrease in inputs.
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Increasing Returns To Scale
Law of Increasing Returns to Scale
This law states that the volume of output keeps on increasing with every increase in the inputs. Where a given increase in inputs leads to a more than proportionate increase in the output, the law of increasing returns to scale is said to operate. We can introduce division of labour and other technological means to increase production. Hence, the total prod¬uct increases at an increasing rate.DEFINITION
— In the words of Marshall, "An increase of labour and capital leads generally to improved organisation which increases the efficiency of the work of labour and capital. Therefore, an increase of labour and capital generally gives a return which increases more than in proportion."— According to Benham, "As the proportion of one factor in a combination of factors is increased, upto a point, the marginal productivity of the factor will increase."
— In the words of Mrs. Joan Robinson, "Increasing Returns to a factor states that when an increasing amount of a factor of production is employed it generally brings about an improvement in organisation. As a result of it, units of the factor concerned become more efficient and to increase production it will not be necessary to increase the physical quantity of the factor in the same proportion."
If the proportional increase in output (production) is larger than that of the inputs, then we have increasing returns to scale.
Facts
When robots replace people at the workplace
As machines move deeper and deeper into the work place, what are the humans left to do? Machine layout is made more efficient, and the new machines require fewer people to operate. This is considered progress, and has been going on from time immemorial. The economists celebrate this with their term ‘labour productivity' — if we employ fewer people for the same output, labour productivity goes up.
During 2000-2007, productivity in the non-farm business sector in the US went up by 2.5 per cent a year and slowed slightly to 1.9 per cent a year during 2007-2011. Productivity can help boost living standards since firms can now increase wages, but alternatively, when demand is sluggish, firms can slow down hiring and show greater profits. And in spite of a sluggish economy, firms have been showing healthy profits and unemployment remains high.
At some level, we welcome the substitution of people with equipment and machines. These would include jobs that are hazardous; where the use of a machine would make human lives safer. Or the job may be routine — that it frees the human to make better use of his or her brain.
The coming of computing and information technologies has speeded up this process in significant ways. Think about the services now facilitated by technology which previously required human interaction. At the ATM, money is available when you want it, while you had to previously stand in a line at the bank teller. You get your statement online and fewer tellers are now needed. You do your banking online, and send fewer cheques. Many grocery stores have added self-check-out counters and fewer sales staff are needed. Online purchases have reduced the need for brick-and-mortar stores in some areas, most notably, book stores.
Sure, there are more people needed in the new industries, for managing logistics, in shipping companies, and so on. But on the balance, the deal seems skewed in favour of technology.
Technology has also created a world where a few smart and savvy individuals have started companies, and created products and services that has brought them enormous wealth while the jobs and services that employ people who spend their money on these products and services has been shrinking.
More leisure, less money
Meanwhile, the people, with less to do, are producing more babies. We hit 7 billion recently. What do we have for them to do? The International Labour Organisation warns that we need to create 600 million jobs over the next decade.
It reminded me of the apocryphal story about the head of a car manufacturing company who was touring the production area with the head of the union. Looking at the robots doing the welding, the executive tells the union president, ‘I don't think those robots will be joining your union and paying dues.' The union leader replies, ‘I hope you pay those robots well so they will be able to buy your cars.'
I think if we are not careful about the substitution between labour and technology, we will rapidly be in a situation where we have plenty of leisure from lack of work, and less money in the pockets.
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Decreasing Returns to Scale
Law of Decreasing Returns to Scale Where the proportionate increase in the inputs does not lead to equivalent increase in output, the output increases at a decreasing rate, the law of decreas¬ing returns to scale is said to operate. This results in higher average cost per unit.If the output (production) increases than the proportionality with input increases, we have decreasing returns to scale
Definition
— In the word of Boulding, "As we increase the quantity for any one input which is combined with fixed quantity of other inputs, the marginal physical productivity of the variable input must eventually decline."— Prof. Benham states, "As the proportion of one factor in a combination of factors is increased after a point, the marginal and average product of that factor will diminish."
— Mr. Joan Robinson, defines it in these words. The law of Diminishing Returns states that with a fixed amount of any one factor of production successive increase in other factor will after a point yield a diminishing increment of output"
All factors of production (land, labor and capital) have been doubled. There is 100 percent increase in the factors of production whereas output has increased from 10 units to 15 units, which is less than double. There is an increase in output by 50%. It means increase in all inputs leads to a less than proportional increase in the output of the firm. Here diminishing returns to scale are operating. Diminishing returns to scale is achieved in those activities involving natural resources such as growing agricultural products.
These laws can be illustrated with an example of agricultural land. Take one acre of land. If you till the land well with adequate bags of fertilizers and sow good quality seeds, the volume of output increases. The following table illustrates further:
Capital (in units) labour (in units) Percentage of Increase in both both inputs Output (in units) Percentage of Increase in output Laws applicable
1 3 ----- -------- ------
2 6 100 120 140 Law of increasing returns to scale
4 12 100 240 100 Law of constant returns to scale
8 24 100 360 Law of decreasing returns lo scale
From the above table, it is clear that with 1 unit of capital and 3 units of labour, the firm produces 50 units of output. When the inputs are doubled two units of capital and six units of labour, the output has gone up to 120 units. (From 50 units to 120 units). Thus, when inputs are increased by 100 percent, the output has increased by 140 percent. That is, output has increased by more than double. This is governed by Law of Increasing Returns to Scale.
When the inputs are further doubled that is to 4 units of capital and 12 units of labour, the output has gone up to 240 units, (from 120 units to 240 units). Thus, when inputs arc increased by 100 per cent, the output has increased by 100 per cent. That is, output also has doubled. This is governed by Law of Constant Returns to Scale.
When the inputs are further doubled, that is, to 8 units of capital and 24 units of labour, the output has gone up to 360 units, (from 240 units to 360 units). Thus, when input are increased by 100 per cent, the has increased only by 50 per cent. This is governed by Law of Decreasing Returns to Scale.
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Returns To Factors
Returns to factors are also called factor productivities. Productivity is the ratio of output to the input. Factor productivity refers to the short-run relationship of input and output. The productivity of one unit of a factor of production will be equal to the output it can generate. The productivity of a particular factor is measured with the assumption that the other factors are not changed or remain unchanged. Only that particular factor under study is changed.Returns to factors refer to the output or return generated as a result of change in one or more factors, keeping the other factors unchanged. Given a percentage of increase or decrease in a particular factor such as labour, is it yielding proportionate increase or decrease in production? This is analysed in 'returns to factors.'
The change in productivity can be measured in terms of
(a) Total productivity The total output generated at varied levels of input of a particular factor (while other factors remain constant), is called total physical product.
(b) Average productivity The total physical product divided by the number units of that particular factor used yields average productivity.
(c) Marginal productivity The marginal physical product is the additional output generated by adding an additional unit of the factor under study, keeping the other factors constant.
The total physical product increases along with an increase in the inputs. However, the rate of increase is varied, not constant. The total physical product at first increases at an increasing rate because of the law of increasing return to scale, and later its rate of increase declines because of the law of decreasing returns to scale.
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isoquants
Production function with 2 variable inputs
Production function using 2 variable inputs is explained with the help of the Isoquants. Details about isoquants are explained belowIn economics, an isoquant (derived from quantity and the Greek word iso (equal) and Latin word qunatus meaning ‘quantity’. The isoquant therefore called as the “Equal Product Curve” or can be named as the “indifference curve”
As isoquant curve can be defined as the locus of points representing various combinations of two inputs___ capital and labour__ yielding the same output.
In economics, an isoquant is a contour line drawn through the set of points at which the same quantity of output is produced while changing the quantities of two or more inputs.
DEFINITION
— According to Ferguson, "An isoquant is a curve showing all possible combinations of inputs physically capable of producing a given level of output"— In the words of Peterson, "An isoquant curve may be defined as a curve showing the possible combinations of two variable factors that can be used to produce the same total product"
The term Isoquant or Iso-product is composed of 'iso' implying equal and 'quant' implying quantity or product or output. Thus it means equal quantity or equal output. Different factors are needed to produce goods. These factors may be substituted for one another. For example 100 watches may be produced with 90 units of capital and 10 units of labour. The same number of watches (100 units) may also be produced with such combinations as 60 units of capital and 20 units of labour or with 40 units of capital and 30 units of labour. If different combinations of two factors yielding equal amount of total output are diagrammatically presented in the form of a curve, then such a curve is called on Isoquant or Iso-product curve. Thus isoquant curve is that curve which shows the different possible combinations of two factor inputs yielding the same amount of output. Isoquant curves are also known as Equal product or Iso-product or Production Indifference Curves. Isoquant curve is called production indifference curve since it is an extension of indifference curve analysis from the theory of consumption to the theory of production.An isoquant shows that if the firm have ability to substitute between the two different inputs (labour and machines) in order to produce the same level of output
If the distance between isoquants increases (curve shifting upward) output increases. Example q 1000 to q 1500 shift in the curve shows increase in the quantity produced where q = quantity produced.
Eg: for producing 1000 goods we can use 60 machines and 20 labours. OR we can use 20 machines and 60 labours for same production.
Linear isoquants
This liner isoquant is drawn if there is a perfect substitutability in the inputs of production. For examplePower plant equipped to burn either oil or gas, various amounts of electric power can be produced by burning gas only or oil only. Gas and oil are perfect substitutes here. Hence isoquants are straight lines.
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Economies of Scale
Economies of scale arise when the cost per unit falls as output increases. Economies of scale are the main advantage of increasing the scale of production and becoming ‘big’.When we produce in large quantities generally the production cost reduces. It is the general principle everybody knows. Reduction in the cost of production, when output (production) is increased is called as economies of scale. Large scale of production is economical than small scale of production. Increase in returns to scale (reduction of cost by producing more goods) are caused by real economies, which are classified under
Economies of scale is classified as
Internal economies:
This happens when better use is made in factors of production within the firm and by increasing output the factors in the internal economies are as follows.1. labour economies:
Increase in the scale of production of a firm results into many economies of labour, like specialization. Enlarged scale of production allows division of labour and specialization with the result of an improvement in the skills. Specialisation means to perform just one task repeatedly which makes the labour highly efficient in its performance. This adds to the productivity and efficiency of the labour. Adam Smith illustrated this point with an example. A labourer, all alone can make just 20 pins in a day. But when he divides the work of pin-making into different parts and each part is entrusted to a different labourer then 2400 pins are made in a day. This is the marvel of division of labour which apart from increasing the skills of labour force, results in (i) Time Saving which is lost in shifting the worker from one job to another (ii) Promotion of New Inventions and (iii) Automation of Production Process. All these increase the productivity of labour and reduces costs.
2. Technical economies:
a) Economies of superior technique
If firm is big it can use high technology (automated machinery) and it can produce high quality goods and cost can be also reduced. Normally small firm cannot use high technology.
b) Economies of increased dimensions:
This is purely mechanical advantage
• A big ship is more economical then small ship for transportation
• Double Decker is more economical than single Decker for traveling.
• A big or small lorry needs single driver, it better to choose big lorry transportation to reduce cost rather than choosing two small Lorries With two drivers.
c) Economies of linked process:
Arranging production process in a correct sequence/order can lead to make Production continuous. Complete production process should be at one place only.
d) Economies of Power:
Uses of Large Machines are more economical than using small machines.
Eg: 10 small machines produce 10,000 units. Whereas one big machinery produces 10,000 units. Here choosing one big machinery is economical than choosing 10 small machines, because power consumed by 10 small machines is more than one big machinery.
e) Economies of continuation:
Production process should be continuous so that the usage of Raw material and other input can be utilized in properly and in efficient manner. Wastage can be reduced.
3. Managerial Economies:
As a firm grows, there is greater potential for managers to specialise 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.
4. Marketing Economies:
If a firm purchase high volume of raw material from the suppliers it cost less, than purchasing small volumes. Employing purchasing expert in the firm to purchase required raw material for the production prevents wastage of excess raw material and it also reduces cost.
5. 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.
Big firm has good advantage in financial matters like
1. Money borrowing (Recognized firms can get money easily from money lenders)
2. Low rate of interest
3. Can easily raise capital (by issuing shares)
6. Risk minimizing Economies:
Producing different types of products by one company has good scope in market rather than producing single variety. Eg: HLL Company produces different types of soaps.
External economies:
DefinitionIn the words of Cairn cross, "External economies are those which are shared in by a number of firms or industries when the scale of production in any industry or group of industries increases. They are not monopolised by a single firm when it grows in size, but are conferred on it when some other firms grow larger.'
External economies of scale occur when a firm benefits from lower unit costs as a result of the whole industry growing in size. The main types are:
These Economies related to external factors
1. Economies of localization : All firms should be localized to have economies. Different production department should be located at one place. This gives advantage in transportation and in timely labour utilization in production.
2. Economies of information and technical market intelligence : Industry enjoys research advantage, when Management can get whatever the information they want with in short time when firms allocated at one place.
3. Economies of vertical integration: Some industries rather than producing spare parts by themselves, they are purchasing from outside companies. This happens when company feels that buying of parts is cheaper than they produce by themselves.
(Make or Buy decision)
• E.g.: TATA Company purchased gear box for cars from kinetic Company
• E.g.: Mahindra cars purchasing engine from Renault Company.
4. Economies of Bi products: The firm using one raw material for manufacturing different other products can give more returns (profits) to the firm.
Eg: Amul India , Company producing different food products from milk.
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Dis-economies of Scale
Increasing the size of a business or production does not always result in lower costs per unit. Sometimes a business can get increase in cost of production or loss to the organisation, it is called as diseconomies of scaleDiseconomies of scale occur when a business grows so large that the costs per unit increase.
Diseconomies of scale occur because of several reasons; this situation is the result of the difficulties of managing a larger Workforce.
Internal diseconomies of scale
Internal diseconomies occur as the output of the firm is rising.Interdependency:
Large firms with many and different departments have the problem with interdependency with each other. A machine failure in the packaging department may result in stopping the whole production line.
Coordination and communication:
As the business expands communicating between different departments and along the chain of command becomes more difficult. There are more layers in the hierarchy that can distort a message and wider spans of control for managers. This may result in workers having less clear instructions from management about what they are supposed to do when.
3. Mismanagement:
One of the main causes of diseconomies of scale or internal diseconomies is the difficulties of large-scale management. As a firm expands, difficulties of management go on multiplying. In a big firm, it becomes pretty difficult to co-ordinate the work of different sections. It becomes a tough problem to supervise the work spread all over. It adversely affects operational efficiency of the firm. In the words of Mc Connell, "The main factors causing diseconomies of scale have to do with certain management problems which physically arise as a firm becomes a large-scale producer."
Industrial relations:
Because of the lack of contact between senior management and the work force, the workers may not feel commitment to work. Industrial disputes may arise and production may suffer.
Lack of motivation:
Workers can often feel more isolated and less appreciated in a larger business and so their loyalty and motivation may decrease. It is harder for managers to stay in day-to-day contact with workers and build up a good team environment and sense of belonging. The main result of poor employee motivation is fall in productivity levels and an increase in average labour costs per unit.
6. Lack of control:
When there is a large number of workers it is easier to escape with not working very hard because it is more difficult for managers to notice shirking.
External diseconomies of scale
External factors beyond the control of a company increases its total costs, as output in the rest of the industry increases. The increase in costs can be associated with market prices increasing for some or all of the factors of production.For example, as a business increases its output, more pressure might be put on its labor supplies, which would then raise the price of additional output. The availability of raw materials also might cause the cost of production to rise. A mining firm, for example, might first extract minerals that are easy to access. After it is necessary to mine deeper seams to produce more ore, the cost of additional output will rise.
As output increases in an industry, each of the factors of production, land, labour, capital and enterprise, become scarcer. As they become scarce (unavailability), their prices increase.