THE THEORY OF PRODUCTION NOTES
Definition
Production comprises all activities that provide goods and services
which people want and for which they are prepared to pay a price. The
composition of the total output can be classified into consumer goods
and produce goods and services. Consumer goods are commodities that
satisfy human needs directly .They can be:
- Durable consumers’ goods provide a steady stream of satisfaction and
their value diminishes slowly through age and usage. - Non- durable consumer good are consumed and destroyed in the very
act of being used e.g. Food, juice, cigarettes.
Producer goods are commodities that do not directly satisfied wants but
they are used for the contribution they make to the production of other
goods. Example: factories, buildings etc. Services are intangible
economic goods e.g. banking, transport, tourism and administration.
Services are non transferable i.e. they can not be purchased and then
resold at a different price.
Production can be categorized into three:
Extractive industries
examples are farming, fishing and forestry. Primary products result from
such industries
Manufacturing industries these include engineering, vehicle manufacture,
chemical and food processing.
Distribution industries; these incorporate the activities of wholesaling
and retailing.
4.2 Factors of Production
This refers to the inputs or resources from the society that are used in
the process of production .They include land, labour, capital and
entrepreneurship Land It refers to all natural recourses over which
people have power of disposal and which may be used to yield income. It
includes farming land, forest, river, lakes, building land, and mineral
deposit. The total supply of land in the world is limited although the
supply of land for some particular use is not fixed. Thus for example,
more maize can be planted at the expense of potatoes. Alternatively,
more land can be allocated to buildings at the expense of farming land,
drainage, irrigation and fertilizers can increase the area of
agricultural land.
Labour refers to the exercise of human mental and physical effort in the
production of goods and services. The supply of labour in an economy is
measured by the number of hours of work which is offered at a given wage
rate at a given period of time. Capital is a manmade input. It can be
classified as working capital or circulating capital referring to stocks
or raw materials, partly finished goods and goods held by producers.
Alternatively, capital can be classified as fixed capital which consists
of equipment used in production such as machinery and buildings. The
value of total output required for replacement of won out producer goods
every year is referred to as depreciation. The total output of producer
goods is referred to as the gross investment and any addition to capital
stock is referred to as the net investment.
This implies that: Gross investment – Depreciation = Net investment
Note that in economics, the concept of depreciation is distinct from the
concept of depreciation in accounting. Depreciation is considered to be
the period allocation of the cost of a fixed asset
Entrepreneurship the organizational of the factors of production with a
view to make a profit It involves hiring and combining other production
factors making decision on what to produce how and what and where to
produce. It in involves risk taking which arises because most production
is undertaken in expectation of demand and in most cases the future is
uncertain. Entrepreneurs make payments to cover their costs without any
certainty that the cost will be covered by revenue.
Mobility of Factors of Production has two main aspects
- Occupational mobility refers to the ease of movement of factors of
production from one job or task to another. - Geographical mobility refers to the movement factors of production
from one location to another.
Individual mobility of factors of production
Land is not mobile geographically but has a high degree of occupation
mobility i.e. land can be put into different uses of farming building
roads etc Capital is mobile in both cases e.g. a vehicle and tools are
geographical and occupational mobile. Some capital are immobile e.g.
railways. Other form of capital has occupational mobility e.g. a
building Labour is mobile both geographical and occupation. However
there are barriers to geographical and occupation mobility.
Barriers to Mobility of Labour
1) Reluctance of the family to move
2) Cost involves in labour mobility
3) Language barriers
4) Adverse climatic condition
5) Insecurity and political instability
6) Ignorance of job opportunities
4.3 Specialization
This refers to the concentration of activity in those lines of
production where the individual, firm or country has natural or acquired
an advantage. Adam Smith drew attention to the importance of division of
labour in his book, the wealth of nations. He was fundamentally
concerned with division of labour of a particular industry where the
manufacture of products was broken down into many specialized
activities. Adam Smith observed that the making of pins required 18
distinct operations, estimating that the production per day in the
factory was about 5,000 pins per person employed. If however the whole
operation was undertaken from first to finish by each employee, Smith
estimated that he would have been able to make only a few dozen pins per
day. Apart from specialization in particular industries the following
other forms of specialization can be identified:
- International specialization – refers to the concentrating of a
country of its resources on a specific area of production for
example, the concentration by Kenya in the production of coffee and
tea or the production of copper by Zambia. - Regional specialization within a country where factor endowments and
economic history have led industries to concentrate in certain areas
because it is difficult for competitive plants to be established
elsewhere. Thus for example, in Kenya the production of tea is
concentrated in the highlands. - Specialization between Industries since each economy includes many
industries an example; it is possible to speak of the motor
manufacturing industry, the steel industry and so on. - Specializations between firms- since industries are composed of
firms that can be regarded as units of production. Thus for example
different firms can specialize in the
manufacture of different components of a product. Thus for example,
in the car industry certain firms specialize in the provision of
spare parts. - Specialization within factories which arises because one firm will
often control a number of factories, and these are usually referred
to as plants and are units of production. For example, a
manufacturer might find it economical to build engines in one plant,
axles in another, car bodies in a third and so on, and subsequently
transport all the parts of another plant for final assembly. - Specialization within plants can be of two types:
- A particular plant may produce more than one item and plant may thus
be regarded as two working side by side. - Within every plant there is a considerable specialization of labour.
In a typical manufacturing firm, some employees will be receiving
and storing raw materials and components whereas the majority will
be engaged in the manufacturing process, while others will be
checking and packing finished product.
The advantages of specialization
- The fundamental advantage of division of labour is the increased
output arising from division of labour. - Specialization may lead to boredom or monotony as some workers
perform the same operation hundred of times. This monotonous repetion
may lead to a greater incidence of accidents and greater absenteeism as
a result of low morale. In addition, labour relations between senior
management and production workers may deteriorate as communication
becomes more difficult. - Specialization may be accompanied by decline in craftsmanship as
skills are transferred from the hands of the workers
to a machine that controls the
design, quantity and quality of a given product. It should however be
noted that mechanization has produced many craftsmen in occupations that
require a high degree of skills. - Specialization is associated with an increased risk of unemployment
as specialized workers do not have a wide industrial training that would
make them adaptable to changes in techniques of production. In the short
term such workers are susceptible to unemployment although in the long
run the simplification of tasks implied by specialization would mean
that jobs in different industries are fairly similar and retraining is
relatively easily achieved. - Specialization is economically limited by the extend of the market in
that methods of production using expensive capital equipment are only
worthwhile if there is a potential demand for the mass produced product
that keeps the capital equipment fully employed. This mass market may
not always exist because of low income levels in a particular country. - Specialization especially in cases involving mass production is
inevitably associated with standardization of products. This is because
of the heavy development costs incurred in launching mass commodities
that leave little possibility for the accommodation of tastes and
preferences of individual consumer‟s sovereignty is, to some extend,
limited by this narrow regard for individual preferences.
4.4 Production Function
This is a technical relationship between the output of good and the
input required to make these goods. The function may take the form of an
equation, a table or a graph. The relationship between an input and output is a technological relationship which may be the
short run or long run.
Q = f (K, L) where Q-output; K-capital; L – Labour
Short run refers to a period of time in which only some variables
change. It is an economic process during which supply of certain factors
of production e.g. land are fixed and cannot be varied. Long run refers
to a period of time in which all variables are able to settle at their
equilibrium and all economic processes have time to work in full.
Average product (AP) is the output per unit of the variable factors and
it’s given by:
Fixed Costs – are costs that do not change as output varies. They are
associated with fixed factors of production and include; rent rates,
insurance, interest on loans and depreciation. Fixed costs remain the
same whether output is one unit or output is 1,000 units. Fixed costs
are also referred to as overhead costs or unavoidable costs.
Depreciation, especially in capital intensive industries usually
constitute a major item in fixed costs since the life of capital tends
to be measured in economic rather than technical terms and machinery,
for example, depreciates even when not in use.
Variable Costs- are costs that are related directly to output and
include the wages of labour, the costs of raw materials, fuel and power.
Variable costs are alternatively known as direct or prime costs.
Total Costs represent the sum of fixed costs (FC) and variable costs (VC).
TC = FC+VC
When output is equal to zero, total costs will be equal fixed costs
since variable costs will be zero. When production begins to increase
total costs will continue to rise as variable costs increase since
output expands.
Law of Diminishing Marginal Returns/Law of Variable Proportions
It states that holding other factors constant as additional unit of a
variable factor are added to a given quantity of a fixed factors, the
total product and the marginal product will initially increase at an
increasing rate but beyond a certain level of output it will
increase at a decreasing rate and eventually fall.
Stage 1
There is increasing returns to the variable factors. In this stage the
total product is increasing at an increasing rate while the marginal
product and average product are also rising with marginal product higher
than average product at any given point. This is an indication of
increasing efficiency of the proportion in which the factors are
combined since the fixed factors are still under utilized and there is
greater scope of specialization.
Stage 2
It represents a decreasing return to the variable factors in that the
total product is increasing at a decreasing rate. The marginal product
and the average product are positive but they are falling at this stage.
The average product is higher than the marginal product and only
national production takes place.
Stage 3
This represents a stage of negative return of the variable factors. At
this stage the marginal product is negative and as a result the total
output is reducing. It represents a stage of extreme inefficiency when
factors of production are probably getting into each other‟s way
(conflicting). At this stage the producer will not operate even with
free labour, since he could also raise the total output by using less
labour. The law of diminishing marginal returns is explained by the use
of the schedule in Table 4.1
The average product curve raises at first, reaches the maximum and then
falls. It remains a positive as long as the total product is positive.
The marginal product rises and reaches the maximum before the average
product and then declines. The marginal product becomes zero when the
total product starts to decline. Therefore the falling portion of
marginal product curve illustrates the law of diminishing returns.
Assumptions
1) The state of technology remains unchanged.
2) Successive units of the variable factors are assumed to be equally
efficient
3) Production take place in the short run where at least one factor of
production is fixed.
4) There is one variable factor of production under consideration.
4.5 Long Run Changes in Production
In the long run all factors of production can be varied and thus the
firm will chose the input combination which optimize output and at the
same time minimize their cost. This is illustrated by the use isoquant
and isocost.
Isoquant shows all the difference combination of labour and capital with
which a firm can produce a specific quantity of output.
Assumption of Isoquant
1) There are only two factors of production i.e. labour and capital
2) It is possible to substitute labour for capital and vise versa
continuously in the production process
A higher isoquant shows a greater level of output (Q3) while a lower
isoquant shows lower level of output (Q1). A series of isoquant gives
isoquant map series
Properties of Isoquants
1) They are convex to the origin
2) Do not intersect
3) They have a negative slope
Isocost shows all different combination of labour and capital that a
firm can purchase given the total outlay (ability) of the firm and
factor prices.
Assumptions
1) The firm takes the input prices as given by the market
2) There are two inputs; there are the labour and the capital.
4.6 The Theory of Cost
It helps in understanding the concept of cost. The following are
necessary: Opportunity Cost Assuming full resources allocation and
employment in production of good and services increasing the production
of any one product involves the sacrifice of an alternation product. The
cost of producing a certain product is taken to refer to the forgone
value of the alternative product
Private cost and social cost (negative externalities) private cost
refers to these costs which relates to an individual producer. They
include both explicit and implicit. While social cost refer to these
costs which occur to the third party in the production process.
Implicitly cost The explicit costs refer to the money paid out made by
the firm. This includes payment for resources bought or hired e.g.
wages, cost of raw materials, rent etc.
Implicit cost includes the resources owned and used by the firm’s the
owner. When the profits are calculated on the bases of explicit and
implicit cost we obtain economic profit. When calculated only on basis
of explicit cost we obtain financial profit.
Assumptions
- The firms take prices or input as determined by the market forces.
- Firms aim at minimizing the production cost.
Short Run Cost Function
In the short run input levels will depend on output level that the firm
wants to achieve. In short run not all factors will be varied. At least
one must be fixed and therefore the cost incurred on it will be fixed
cost. The total fixed cost will be constant regardless of the
output level e.g. rent for factory building, salaries of office staff etc.
Variable costs are incurred by the firm for its variable input. A firm
wishing to increase its out put will require large variable input thus
higher variable cost. The variable costs of a firm will increase as the
output levels increase e.g. cost of raw materials, cost of direct
labour and other direct running expenses.
The relationship between average cost and marginal cost In most of case
the marginal cost the average cost from below. The average cost must be
failing as compared to marginal cost a) Mathematically it can be shown
that, if the slope of average cost is less than zero, then the marginal
cost will be less than average cost AC<0; MC0 ;MC>AC Since the average
cost curve is U- shaped the slope of average cost becomes zero to its
minimum and hence marginal cost is equal to costs at this point.
The relationship between average total costs, average fixed cost,
average variable cost and marginal cost is shown in Table 4.2.
4.8 Optimum Seize of a Firm
This is the level of output at which total profit is at maximum. It is
the best or the most efficient size of a firm when the long run average
cost of a firm is at minimum. At this point there will be no motive for
further expansion since at any other size large or smaller
the firm will be less efficient. This is also attained when the firm
cost of production is at its minimum level as illustrated in Figure 4.9
Below OL total cost exceeds total revenue and hence the firm is making
loss. At the point EL neither profit nor loss are being made and hence
its break even point (BEP) when total revenue is equal to the total
cost. The same case applies to the point EN. Maximum profit lies where
revenue and total cost difference total in the greater i.e. the point
where the vertical distance between the total revenue and the total cost
is greatest. In Figure 4.9 the maximum profit is at point M where AA is
the largest vertical distance.
N/B: For profit maximization the following two conditions must be met
- The necessary conduction – according to this conduction profit are
maximized at the levels of output where marginal revenues is equal to
marginal cost. To maximize profits profit is symbolized by pie ( ∏ - The sufficient condition states that the slope of marginal revenue
curve must be less than the slope of marginal cost curve at the point
where they meet. Meaning that the marginal cost curve cuts the marginal
revenue curve from below as shown in Figure 4.10
N/B: Total profit function is maximized as follows
- Taking the first derivative and setting it equal to zero to obtain
the critical values. - Taking the second derivative and evaluating it at the critical
values to ascertain if the function is at the relative minimum or
maximum.
4.9 Economies of Scale
In the long run, all the input into production processes are variable so
the problems associated with diminishing returns to the variable factors
do not arise. The law of diminishing returns therefore only applies to
short run costs and not on long run costs.
This implies that whereas short term decisions are concerned with
diminishing returns given fixed factors of production, long run output
decisions are concerned with economies of scale which are based on
assumptions that all factor inputs are variable.
Economies of scale are aspects of increasing size which lead to falling
long run average costs. Economies of scale assist in explanation of
trend towards large production units in some industries. Economies of
scale can be classified into internal and external economies of scale.
They are the advantages that arise due to expansion in scale of are two
categories:
- Internal economies of scale
- External economies of scale
Internal economic of scale are factors which bring to reduction in
average cost as the scale of production of individual firm rise.
Internal economies of scale are those factors which bring out a
reduction in average costs as the scale of production of individual firm
arises, depending on what is happening to other firms. This is
attributed to the activities within the firm hence the economics are
brought about by various source which include:
- Marketing economies of scale consists of all the advantages a firm
acquires as they approach the market such as
Buying advantage– large firms enjoy buying advantage since they
purchase goods in bulk hence receive heavy bulk discounts that reduce
cost of production.
Packaging advantage It is easier to package goods in bulk than in
small unit with reference to packaging costs.
Transportation advantage due to transporting many units at the same
time which reduces transportation cost to a large scale producer
compared to a small scale producer.
Selling advantage in terms of advertising whereby the large scale
producer will benefit more as he will sell more as compared to a small
scale producer due to mass advertisement
- Technical economic of scale consists of:
Factor indivisibility e.g., certain capital equipment must be of a
specific minimum scale or capacity of justify manufactures ability. A
small firm will not utilize its equipments in full due to idle capacity
arising from the small production capacity. Large scale producer will be
advantaged since he will optimally utilize the equipments.
Increased specialization The larger the scale of production the
greater the scope of specialization of both labour and machinery leading
to high productivity.
Principle of multiples If the production process involves use of
different stages and type of machinery the large firms will benefit due
to high productivity while smaller ones will be disadvantaged since they
produce fewer units.
Research and developments A large firm may be able to support its
research and development programs which could result in cost reducing
innovations - Financial economies Large firms can easily obtain financial resources
at lower rates than small firms. Large firms can also produce more
security for loans and investments - Risk becoming economies a large firm that has diversified into
several markets is usually better placed to withstand adverse trading
conditions. - Managerial and administrative economies Managers and administrators
are highly qualified in managements of large firms. This creates
division of labour which improves efficiency.
External economies of scale
These are advantages that arise from the growth of industry resulting
from simultaneous interaction of a number of industries in the same or
various industries as well as the community at large. External economies
of scale are those advantages in the form of lower average costs that a
firm gains from the growth of the industry. External economies are
available to all firms in the industry no matter their size.
These advantages include:
- Employment Due to growth of industries employment opportunities are
created to the communities that will help to improve the standard of
living. - Specialization Different firms within the industry will decide to
specialize in one area of production which will reduce cost of
production and improves quality of the product and reduce prices.
The repeated performance of the same actions means that labour can
become very skilled. The breaking of the production process into
many stages signifies that machines can be designed specifically for
each stage. An example is in the motor assemble plant where many of
the different stages in the assembly are completed using computer
controlled machines. - Growth of complimentary service Whenever a business is expanding its
output, there are some complimentary services that arise e.g.
schools medical facilities financial institutions, better roads,
etc. that benefit the society. - Increased co-operation Many firms within the industry can co-operate
with one another in terms of research and development hence improve
the quality of a product, new techniques in production which lowers
the cost of production and
reduction in prices.
Internal Diseconomies of scale
Increasing the size of a firm beyond a certain scale can lead to rising
average costs. This is because of management difficulties and rising
prices of inputs. Management problems arise because:
- As the size of departments in an organization increase, the task of
coordination becomes more difficult. - Despite the existence hierarchy of authority in large firms, the
task of control, that is, of ensuring implementation is extremely
difficult in practice. - In the firms of large sized communication may be problematic in that
it is difficult to ensure an effective vertical and lateral line of
communication. Communication network are generally more complex in
large organization with associated greater likelihood of
communication breakdown. - The maintenance of morale is more difficult in large organizations
because individual workers in large organizations may feel
unimportant the firm and often do not identify with the firm‟s
objectives. - An additional source of internal diseconomies of scale is increase
in price of inputs since as the scale of production increases, the
firm will increase the demand for inputs likelihood and transport
and this may lead to the bidding up of prices of prices of certain
inputs.
External Diseconomies of Scale
May arise because of a shortage of various inputs used in the industry
may arise leading to an increase in the cost of those inputs. For
example, an increased demand for raw materials may bid up the prices of
raw materials and cause their prices to rise. Heavy
localizations of industry may make land for expansion scarce and
therefore more expensive to rent and purchase. Increased congestion
could also lead to higher transport costs. Others costs include:
- Over production Increase in growth of a firm will lead to
overproduction leading to wastage due to lack of a market - Negative externalities e.g. pollution, poor working condition this
will be experienced as many firms expand their output. - Maintenance of morale Individual workers feel unimportant to the
firm and may not identify with the firm objectives - Government interference Whenever there is increase in output due to
increase in growth it‟s led to increase in profit. The government
then imposes tax which is a disadvantage to the firm
4.10 Mergers and Acquisitions
Mergers occur where two firms agree mutually to joint their operations
together. While an acquisition occurs when a firm called a predator
decides to take over another firm referred to as a prey either
forcefully of willings. Mergers and acquisitions are driven by
different motives. The following are major types of mergers and
acquisitions.
- Vertical integration occurs when merger takes place between firms
engaged in different stages of the production process. Thus for
example, a tyre manufacturer can acquire rubber plantations.
Backward integration is said to take place when the movement is
towards the market outlets as, for example in the case of large
oil companies taking control of petrol stations. - Horizontal integration occurs when firms engage in the production of
the same kind of good or service brought under unified control. An
example would be an amalgamation of several motor manufacturers. - Diversification occurs when firms that produce goods that are not
directly related to each other combine. An example would be the
merger of a firm producing fertilizers with a manufacturer of paint.
The main aim of diversification or conglomerates is to reduce the
risk of trading.
The survival of small firms
Small firms continue to survive for the following reasons:
- Demand for variety that cannot be met by mass production especially
in industries like clothing and footwear. - Many owners of small firms have no ambition to grow large because
they do not want to sacrifice their independence and control. - A personal contact with customers is important in many industries
like accountancy and architecture. - The size of the firm may be limited by the extend of the market
since a firm can only grow in size if this is permitted by the
market. The market for luxury items for example is limited by income
and wealth. - Firms may want to avoid the rising costs that arise from
diseconomies of scale - There is a tendency for mass production industries to disintegrate
into a large number of specialist firms.
Find Other Topics On Micro-Economics Here
INTRODUCTION TO ECONOMICS
DEMAND AND SUPPLY-Micro Economics
THEORY OF CONSUMER
THEORY OF PRODUCTION
TYPES OF MARKET STRUCTURES
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