Theory of Production and Cost

UNIT -1: THEORY OF PRODUCTION

At the end of this Unit, you should be able to:

1. Define Production and Describe Production Function.

2. Describe the Characteristics of various Factors of Production.

3. Distinguish between Short run and Long run Production Functions.

4. Illustrate the Law of Diminishing Returns and Returns to Scale.

5. Describe Production Optimisation using Isoquants and Iso -cost curves.

SUMMARY

1. Production is the outcome of the combined activity of the four factors of production viz, land, labour, capital and organization. In simple terms production, means ‘creation of utility’. i.e. Utility of form, utility of place, utility of time and personal utility.

2. Production does not include work done out of love and affection, voluntary services and goods produced for self-consumption. Intention to exchange in the market is an essential component of production.

3. Land includes all those free natural resources whose supply for the economy as a whole is fixed.

4. Labour is all human efforts of body or of mind undergone partly or wholly with a view to secure an income apart from the pleasure derived directly from the work.

5 Capital is that part of wealth of an individual or community which is used for further production of wealth. Capital, a stock concept, refers to produced means of production and it comprises of manmade machines and materials which are used for further production.

6. Capital formation, also known as investment, means a sustained increase in the stock of real capital in a country. There are mainly three stages of capital formation viz. Savings which depends on ability to save and willingness to save; Mobilisation of savings which depends on availability of financial institutions and products; and Investment i.e. the process whereby the real savings get converted into real capital assets.

7. Entrepreneur is the person who organises business; initiates production, remunerates other factors of production, introduces innovations and bears the risk and uncertainties of business.

8. The objectives of an enterprise may be broadly categorised under the following heads. (i) Organic objectives (ii) Economic objectives (iii) Social objectives (iv) Human objectives (v) National objectives.

9. An enterprise faces a number of problems from its inception, through its life time and till its closure. These may relate to objectives, location, size, physical facilities, finance, organization structure, marketing, legal formalities and industrial relations.

10. Factors of production can be divided into two categories – Fixed factors are those factors whose quantity remains unchanged with changes in output within a capacity and variable factors are those the quantity of which change with a change in the level of output.

11. Production function is the technical relationship between inputs and output. Samuelson describes production function as the relationship between the maximum amount of output that can be produced and the input required to make that output. It is defined for a given state of technology.

12. The law of variable proportion or the law of diminishing returns is relevant when some factors are kept fixed and others are varied. It is applicable to the short-run.

13. There are three stages of the law of variable proportion – where law of increasing returns, law of diminishing returns and law of negative returns operate.

14. Total product is the total output resulting from the efforts of all the factors of production combined together at any time.

15. Marginal product is the change in total product per unit change in the quantity of variable factor.

16. Average product is the total product per unit of the variable factor.

17. The Law of returns to scale describes the relationship between inputs and output in the long run when all inputs are changed in the same proportion. Returns to scale may be constant, increasing and decreasing.

18. Constant returns to scale occur when the inputs increase by some proportion and the output also increases by the same proportion. It is also called linear homogeneous production function.

19. Increasing returns to scale occur when the inputs increase by some proportion and the output increases more than proportionately.

20. Decreasing returns to scale occur when the inputs increase by some proportion and the output increases less than proportionately.

21. Isoquants or product indifference curves show all those combinations of different factors of production which give the same output to the producer.

22. Iso-cost lines show various combinations of two factors which the firm can buy with given expenditure or outlay.

23. By combining Isoquants and iso-cost lines, a producer can find out the combination of factors of production which is optimum i.e. the combination of factors of production which would minimise his cost of production.

24. For producing a given output, the tangency point of the relevant isoquant (representing the output) with an iso-cost line represents the least cost combination of factors.