chapter 4_laws of production

8/3/2019 Chapter 4_laws of Production

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Chapter 4: Theory & Laws ofProduction


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Meaning of production

Production may be defined as any activity, whether physicalor mental, which is directed to the satisfaction of otherpeoples wants through exchange. Prof J R Hicks

In modern context production is related to the value creationand may be defined as follows:

production is the process of transformation which leads to

creation or addition of value in a good or a factor

Input transformation output

transformation

Production process


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Since production is transformation, it can bedone through the following changes:

Change of shape

Change of appearance or form

Change of place

Change of time

Other methods


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Factors of production

Land

Labour

Capital

entrepreneurship


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Characteristics of factors ofproduction Complementarity

Substitutability

Specificity

Mobility


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The output can change undertwo conditions: Only one factor of production is

changed, while others are keptconstant (law of variable proportions)

All factors are changed in givenproportion (Returns to scale)


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LAW OF INCREASING RETURNS

According to Marshall an industry is subject toincreasing returns if an extra investment in industry isfollowed by more than proportionate returns i.e. ifmarginal productincreases. As the proportion of onefactor in a combination of factors is increased, up to apoint, marginal product of factor will increase. The

reason for increasing returns is because of Division ofLabor and specialization by industry. This law is alsocalled Law of Decreasing Cost, as marginal productkeeps on increasing and marginal cost keeps on

decreasing.

CONDITIONS OF THE LAW

1-----Factors of production should not be in short supply.

2-----Optimum level of production has not reached sofar.


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Now suppose expenses involved on per unit of labor and capital are Rs.1000 andoutput

are Socks. Marginal cost is calculated by dividing Rs.1000 with marginal productof

socks, Rs.1000/50 socks=Rs.20 per sock.


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LAW OF DIMINISHING RETURNS

According to Alfred Marshall an increase in labour and capital applied in the

cultivation of land causes in general a less than proportionate increase inthe amount of produce raised, unless it happens to co-inside with animprovement in arts of agriculture. With the continuous use of land itsfertility goes on diminishing therefore output goes on diminishing.

This law is particularly applicable to agriculture, but it is also applicable in

those sectors of economy where nature plays a dominating role such asfishery and mining. The law operates when mining operations are extendedto inferior, or on deeper mines and when fishing operations areconcentrated on specific place. This law is also called Law of IncreasingCost because as marginal product diminishes marginal cost increases.


1-----Quality of factors of production (land & labor) should be of same standard.

2-----Cultivation should be carried on continuous on the same plot of land.

3-----Cultivation/production methods should not change.


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Now suppose that expenses involved on per unit of labor and capital areRs.1000/- and output of wheat is in mounds. Marginal cost is calculated bydividing Rs.1000 withmarginal product of wheat (Rs.1000/50)=Rs.20 per mound.


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LAW OF CONSTANT RETURNS

Marshall said that an industry is subject to constant returns when whatever the output,

cost per unit remains unaltered or increased investment of labor and capital results in aproportionate increase in output.

The reason for constant returns is that an industry, which is involved in productionprocess might also be engaged in cultivation of raw material for its industrial unit, forexample a blanket industry might also be engaged in rearing of sheep for its wool

requirement. In sheep rearing or wool production law of diminishing returns will operateand in blanket manufacturing law of increasing returns will operate.

Another example may be of sugar cane production and manufacturing of sugar by samebusiness unit or fruit farming and fruit canning and processing factory by same owners.This law is also called Law of Constant cost because marginal product remainsunchanged and marginal cost also remains same.


Both agricultural sector and industrial unit should be under ownership and operation bysame owners so that the loss on one side is balanced from the profit of the other side ofbusiness.


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Now suppose that expenses involved on per unit of labor and capital areRs.1000 andoutput is sugar. Marginal cost is calculated by dividing Rs.1000 with marginalproduct of sugar i.e. Rs.1000/50 kgs = Rs.20 per kg.


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Law of variable proportions

if we keep other factors as constant and increase only onefactor of production, the Total Physical Product (TPP) will firstincrease at an increasing rate, then at a constant rate and

finally at a diminishing rate.

Assumptions of the law: Only one factor is increased while others are kept constant.

The various units of the variable factor are homogenous.

Conditions of production like production method, technique,climatic conditions etc. are constant.

This law is applicable only for physical output and not for itsvalue.


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In the table below up to third labor marginal product keeps on increasing from 80 to100

units but the 4th and 5th labors marginal product decreases by 98 and 62 unitsrespectively. This production behavior is divided into three stages, therefore this law

is also known as Stages of Production.


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Returns to scale It refers to changes in output resulting from a proportional change in all inputs

(where all inputs increase by a constant factor). If output increases by that same proportional change then there are constant returns

to scale (CRS).

If output increases by less than that proportional change, there are decreasing returnsto scale (DRS).

If output increases by more than that proportional change, there are increasing

returns to scale (IRS).

Thus the returns to scale faced by a firm are purely technologically imposed and are notinfluenced by economic decisions or by market conditions.

Example:

When all inputs increase by a factor of 2, new values for output will be: Twice the previous output if there are constant returns to scale (CRS)

Less than twice the previous output if there are decreasing returns to scale (DRS)

More than twice the previous output if there are increasing returns to scale (IRS)


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Increasing returns to scale


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Decreasing returns to scale


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Constant returns to scale


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Economies of large scale Internal economies of scale

Labour economies

Purchase economies

Marketing economies

Financial economies

Technological economies

Managerial economies

Internal diseconomies of scale There is always an optimum size beyond which a firm can get more

disadvantages than advantages; therefore a firm cannot expand its size in anunlimited manner. A firm may experience financial diseconomies in the form of

increased proportionate financial cost. When a firm having a very big size uses all possible division of labor and

specialized machines, a further increase in its size will result in dis-economiesbecause of lack of proper control/management hence cost will start increasing.

If firm continues unlimited diversification it would result in a greater risk andwould increase the economic fluctuations rather than covering these risks.


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External economies of scale Economies of concentration Economies of information

Economies of research and development

Economies of negotiation

External DiseconomiesWhen the industry is localized in a particular area, there is a huge demand of

skilled labor therefore, wages and price of land increases hence the cost ofproduction increases.

Firms compete themselves for hiring transport, hence freight charges increase.

Prices of raw material (especially of those which are in short supply) increase, dueto excessive demand by all firms of same industry of that area.

Due to concentration and localization of large factories of the same naturecongestion and pollution creates a lot of social/health problems.


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Production function is a relationship between maximum physical output andthe quantity of labor and capital used in the production process. It is a

technological relationship between inputs and outputs and depends on theavailable technology. Those firms which are less efficient will obtain less outputthan the ones which are efficient.

Technical efficiency : achieved when maximum amount of output is achievedwith a given combination of inputs.

Economic efficiency: achieved when a firm is producing a given output at thelowest possible total cost.

Inputs: Fixed inputs and variable inputs.

Short Run: At least one input is fixed. All changes in output achieved bychanging usage of variable inputs.

Long Run : All inputs are variable. Output changed by varying usage of allinputs.

Production function: BasicConcepts


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Short run production

In the short run, capital is fixed. Only changes in thevariable labor input can change the level of output.

Q = f(L, K) = f(L)


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FIXED PROPORTIONS PRODUCTIONFUNCTION


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ISO-PRODUCT CURVE

An Iso-product curve is also known as Iso-quant curve orEqual-Product curve. Isoquants means equal quantities.

It shows various combinations of two inputs required forproduction of the same output. In this situation the producerbecomes indifferent as to which combination of factors ofproduction he should choose.

It is similar to indifference curve when different combinationsof two goods x and y provide the same level of satisfaction.

VARIABLE PROPORTIONS PRODUCTION FUNCTION


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In graph Iso- product curve (IP) represents all those combinations of X & Yinputs i.e. labor and capital, which can produce 100 pens. In the above situationproducer has become indifferent as to which combination of labor and capital (X& Y) he should use for the production of 100 pens.


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HIGHER THE ISO-PRODUCT CURVE HIGHER THEPRODUCT


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MARGINAL RATE OF TECHNICAL SUBSTITUTION

M.R.T.S. means that the rate at which one unit of factor of production issubstituted for other units of factor of production while maintaining a

constant level of output.MRTS = MPL/MPK (As the labour is substituted by capital, MPL declinesand MPK increases , thus diminishing the MRTS)

In the first instance in order to increase one unit of X input, 3 units of Y are

substituted or released therefore MRTS is 1:3. As more and more of X is usedMRTS goes on diminishing and in the last for one additional X only one Y issubstituted or released, because some thing of Y is needed along with X input toproduce Pens. It means MRTS goes on diminishing for additional units of X.


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LEAST COST COMBINATION OF A FIRM Or ISO-COST LINE

Main objective of a firm is to maximize profit. If a firm wants to spendRs.100 for production of any good (pens), it will be in equilibrium positionwhen the firm utilizes that combination of inputs X & Y, (capital and labor),where Iso-product curve is tangent to Iso-cost line.

EQUILIBRIUM OF A FIRM


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Production Possibilities Curve indicates various combinations of two

goods that can be produced by an economy when all of its resources arefully and efficiently utilized. It represents graphically alternative productionpossibilities facing an economy. With limited resources an economy haslimited possibilities for production of goods and services. If govt.increases military goods then the consumer goods production willdecrease.

For an economy to be well off it is necessary that all resources are fullyemployed in a Technologically Efficient manner. To have more consumergoods in future, we must accept fewer consumer goods today. In otherwords, here an opportunity cost is involved. Every time we make a choicefor more goods today, we incur an opportunity cost of fewer goodstomorrow.

Production possibility curve is also called Transformation Curvebecause in moving from one point to another point on curve, onegood is transformed into another, not physically but by transferringresources from one use to another use.

PRODUCTION POSSIBILITIES CURVE


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1. Rate at which one product is transformed into another is called marginal rateof transformation.

2. MRT between missile and wheat is the amount of wheat, which has to besacrificed/given up for production of missile.


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1. Point R inside curve represents inefficient use of resources and Point Soutside the curve cannot be attained with current level of resources andtechnology of economy.

chapter 4_laws of production

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