3.1 production analysis and concept of marginality

8/6/2019 3.1 Production Analysis and Concept of Marginality

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Production analysis and concept of marginality 3.1

PRODUCTION ANALYSIS (THEORY OF FIRM)

The theory of the firm consists of a number of economic theories, which describe the natureof the firm (company or corporation), including its behavioural aspects and its relationship

with the market.

In the theory of production, we leargely discuss the relation between inputs and outputs.

The inputs are what a firm buys (i.e. productive resource) and outputs (i.e. goods andservices produced) what it sells. The firm can be defined as base of the production or as thesmallest unit of production in an economy.

The theory of production is the study of:

factor of production and their organization,

law of production,

theories of population (in relation with an important and special factor of production- labour),

production function, law of return to scale,

Cost concepts and least- cost combination of factors,

Production theory describes physical (technical & technological) conditions under which

production take place, it brings out the relationship between output and inputs, i.e. variouscombination of inputs, and also explain how the least cost combination is arrived at. From

the perception of business administration, the theories also look at the economicconsequences of the different incentives influencing individuals working within companies,

tackling issues such as pay, agency costs and corporate governance structures.

FIRMS

The Firm generally term for a commercial organization, such as, business, company,concern, corporation, enterprise, partnership, proprietorship etc those are engage with

producing any sort of good or service. In economic analysis, firm is considered as the unitof production and used to describe a collection of individuals grouped together for

economic gain.

For many years, economists had little interest in what happened inside firms, preferringinstead to examine the workings of the different sorts of industries in which firms operate,ranging from perfect competition to monopoly. Since the 1960s, however, sophisticatedeconomic theories of how firms work have been developed. These have examined whyfirms grow at different rates and tried to model the normal life cycle of a company, fromfast-growing start-up to lumbering mature business. The aim is to explain when it pays toconduct an activity within a firm and when it pays to externalise it through short- or long-term arrangements with outsiders.

PRODUCTION

Production is one of the three major economic activities that is done in the human society.Production in an economy is generally understood as the process of transforming inputsinto outputs. It can also be defined as the process of creating utility, more precisely, thecreation of want satisfying goods and services in a planned manner by using naturalresources. In defining Production economic gives similar importance on value creation as

creation of utility. For instance, cooking food for family members is definitely an activityfor addition of utility, but cannot be recognized as economic production. Production,

therefore, should be defined as not as only creation of utility, but creation (or addition) ofvalue also.

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PRODUCTION FUNCTION

The production function relates the amount of output of a firm to the amount ofinputs, typically capital and labor, required to produce the output.

The production function is the relationship between the maximum amounts of output thatcan be produced by a firm (a unit of production) and the inputs required to make theoutput. It is defined for a given state of technological knowledge.

It is important to keep in mind that the production function describes technology, not

economic behavior. A firm may maximize its profits given its production function, butgenerally takes the production function as a given element of that problem. (In specialized

long-run models, the firm may choose its capital investments to choose among productiontechnologies.)

Q= f (K, L) is an example of typical production function.

Where, Q = Amounts of total output,K = capital and L = labour.

f is the (algebraic) expression of the functional relationship between inputs (K=capital

and L=labour) and output.

The following three production concepts are very familiar in the production theory ofeconomics.

(i) Total Product:Total production (TP) is the amount of total physical product. It designates the totalamount of output produced in physical units (ton, barrel, etc.)

(ii) Average Product:Average product (AP) measures the total output divided by total units of input. It is astatistical measurement of output.

(iii) Marginal Product:

The marginal product (MP) of an input is the extra product or output added by 1 extra unitof that input while other inputs are held constant, i.e., the marginal product is the outputproduced by one more unit of a given input.

LAW OF DIMINISHING MARGINAL RETURN:

The law of diminishing marginal returns is a production-principle propounded by DavidRicardo (1772-1823). The economic law states that if one input used in the manufacture ofa product is increased while all other inputs remain fixed, a point will eventually be reached

at which the input yields progressivelysmaller increases in output. For example, afarmer will find that a certain number offarm labourers will yield the maximumoutput per worker. If that number isexceeded, the output per worker will fall.

In common usage, the point of diminishing

returns is a supposed point at which

additional effort or investment in a givenendeavor will not yield correspondingly


Unit oflabour

TotalProduction

MarginalProduction

AverageProduction

0 0

1 2,0002,000

2,000

2 3,0001,000

1,500

3 3,500500

1,167

4 3,800300

950

5 3,900100

780


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Production Curve (Total Product)

0

1000

2000

3000

4000

5000

0 1 2 3 4 5

Unit of Input (Labour)

TotalProduct

Marginal Product Curve

0

500

1000

1500

2000

2500

0 1 2 3 4 5

Unit of Input (Labour)

MarginalProduct


increasing results.

The above table and the figures below show the mathematical and graphical example ofdiminishing marginal return of labour in a small agricultural firm.

SHORT RUN AND LONG RUN

There is no fixed time that can be marked on the calendar to separate the short run fromthe long run, because, long run and the short run do not refer to a specific period of timesuch as 3 months or 5 years. The difference between the short run and the long runisthe flexibility decision makers have. The short run is a period of time in which the

quantity of at least one input is fixed and the quantities of the other inputs can be varied.The long run is a period of time in which the quantities of all inputs can be varied.

The short run and long run distinction varies from one industry to another. An example oftoothbrushmanufacturing firm as well as industry can be considered here. A company in

this industry will need the following inputs to manufacture toothbrushes:

Raw materials (such as plastic)

Labor

Machinery

A (new) factory

In Short Run, Some inputs are variable and some are fixed. New firms do not enter theindustry, and existing firms do not exit. On the other hand, in long Run, all inputs arevariable; firms can enter and exit the market (in the industry).

FACTOR PRODUCTIVITY AND RETURN TO SCALE:

In economics, productivity is the amount of output created (in terms of goods produced or

services rendered) per unit input used. For instance, labour productivity is typicallymeasured as output per worker or output per labour-hour. With respect to land, the "yield"is equivalent to "land productivity". Thus, the factor productivity refers to productivity ofindividual factor, such as labour or land.

Labour productivity is generally speaking held to be the same as the "average product oflabour" (average output per worker or per worker-hour, an output which could bemeasured in physical terms or in price terms).It is not the same as the marginal product of

labour, which refers to the increase in output that results from a corresponding increase inlabour input.

Some economists write of "capital productivity" (output per unit of capital goodsemployed), the inverse of the capital/output ratio. "Total factor productivity," sometimes



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called multifactor productivity, also includes both labor and capital goods in the

denominator (weighted by their incomes).Unlike labor productivity, the calculation of both capital productivity and total factor

productivity is dependent on a number of doubtful assumptions and is subject to theCambridge critique. Even measures of land and labor productivity should be used only when

conscious of the role of the heterogeneity of these inputs to the production process

Returns to scale refers to a technical property of production that predicts what happens tooutput if the quantity of all input factors is increased by some amount/ percentage. Ifoutput increases by that same amount, it is called constant returns to scale (CRTS),sometimes referred to simply as returns to scale. If output increases by less than that

amount, it is decreasing returns to scale. If output increases by more than that amount, itis increasing returns to scale.

ECONOMY OF SCALE AND DISECONOMY OF SCALE

Ecomony of scale (ES) describes- as the volume of production increases, the cost ofproducing each unit decreases. Therefore, building a large factory will be more efficientthan a small factory because the large factory will be able to produce more units at a lower

cost per unit than the smaller factory.When more units of a good or a service can be produced on a larger scale, yet with (on

average) less input costs, economies of scale (ES) are said to be achieved. Alternatively,this means that as a company grows and production units increase, a company will have a

better chance to decrease its costs.Just opposite to the economies of scale, diseconomies of scale (DS) also exist. Thisoccurs when production is less than in proportion to inputs. What this means is that thereare inefficiencies within the firm or industry resulting in rising average costs.

ECONOMY OF SCOPE

An economic theory stating that the average total cost of production decreases as a resultof increasing the number of different goods produced.

For example, McDonalds can produce both hamburgers and French fries at a lower averagecost than what it would cost two separate firms to produce the same goods. This is becauseMcDonalds hamburgers and French fries share the use of food storage, preparationfacilities, and so forth duringdproduction.

Another example is a company such as Proctor & Gamble, which produces hundreds ofproducts from razors to toothpaste. They can afford to hire expensive graphic designers

and marketing experts who will use their skills across the product lines. Because the costsare spread out, this lowers the average total cost of production for each product.


3.1 production analysis and concept of marginality

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