CHAPTER-3

TOPIC: THEORY OF PRODUCTION_(1)

SESSION ON_11/08/2021

(BY- Dr. JATIN KUMAR LAMBA)

MEANING OF PRODUCTION

In Economics, production is any economic activity, whichis directed to the satisfaction of the wants of the people.

In other words, Production can also be defined ascreation or addition of utility - making of goods’ orproviding any service.

According to fundamental law of science man cannotcreate matter. Man can do only to create or add utility.

METHODS OF PRODUCTION (CREATION OF UTILITY)

1. Form Utility- Manufacturing companies, raw materialsconverted into finished goods.

2. Place Utility- Changing the place of the resources, fromthe place where they are of little or no use to another placewhere they are of greater use. This utility can be obtained by(i) extraction from earth e.g. removal of coal, gold etc. (ii)transferring goods -sand from rivers to houses.

3. Time Utility -Making available material at times when theyare not normally available.

4. Personal Utility - Making use of personal skills in the formof services, e.g. organizers, merchants etc.

(iv) Land differs in fertility: No two pieces of land possessthe same fertility. Mineral resources, river system, forestresources, mountain formation, fertility of soil, etc. differ fromregion to region.

(v) Specific factor of production: Land is a specific factorof production because without land we cannot produceanything.

(vi) Indestructible: According to Ricardo, land is anindestructible factor of production because it cannot bedestroyed.

(vii) Inelastic supply of land: In the sense of space andnatural resources, land is available in the same amountwhatever be the price offered. It is a free gift of nature.

2. LABOURLabour is a physical or mental effort of human being in theprocess of production for economic purpose. Any work donefor the sake of pleasure or love does not represent labour inEconomics.

Characteristics of labour: The following are the maincharacteristics of labour as a factor of production:

(i) Labour is directly connected with human efforts.

(ii) Labour is inseparable from labourer himself. It impliesthat the labourer embodies the services he performs.Labourer is the source of his own labour power.

(iii) Labour is perishable. It implies that the labourer cannotstore his labour and so he has no reserve price for his labour.The labourer has, therefore, to accept the wage offered tohim.

(iv) The labourer efficiency differs from labourer tolabourer. On the basis labour power, labour may be classifiedas unskilled labour, semi- skilled labour and skilled labour.(Heterogeneous Factor)

(v) Labour has a weak bargaining power. It is because thelabourer is economically weak, while the employer iseconomically powerful.

(vi) The labourer has to make a choice between the hoursof labour and hours of leisure. The supply of labour andwage rate is directly related. However, beyond a minimumlevel of income the labourer reduces the supply of labour andincreases the hours of leisure in response to a further rises inthe wage rate. Hence, the supply curve of labour isbackward bending.

(vi) All Labours are not productive. All efforts are not sure toproduce resources.

3. CAPITALCapital is man-made material source of production. Capitalconsists that part of production, which is used for furtherproduction. It is stock concept. It is produced factor ofproduction. All capital is wealth but all wealth is notcapital.

Types of Capital

Fixed capital: is that which exists in a durable shape andrenders a series of services over a period of time. For exampletools, machines, etc.

Circulating capital: is another form of capital which performsits function in production in a single use and is not available forfurther use. For example, seeds, fuel, raw materials, etc.

Real capital: refers to physical goods such as building, plant,machines, etc.

Human capital: refers to human skill and ability. This is calledhuman capital because a good deal of investment has gone intocreation of these abilities in humans.

Tangible capital: can be perceived by senses whereasintangible capital is in the form of certain rights and benefitswhich cannot be perceived by senses. For example, patents,goodwill, patent rights, etc.

Individual capital: is personal property owned by anindividual or a group of individuals.

Social Capital is what belongs to the society as a whole in theform of roads, bridges, etc.

CAPITAL FORMATION: -Capital Formation means asustained increase in the stock of real capital in the country.In other words, capital formation involves production of morecapital goods like machine, tools, factories, transportequipment, electricity etc which are all used for furtherproduction of goods. It is also known as investment. It is flowconcept.

Stages of capital formation: There are mainly three stagesof capital formation, which are as follows:(a) Savings: The basic factor on which formation of capitaldepends is the ability to save. The ability to save dependsupon the income of an individual. Higher savings generallyfollows higher incomes. A rich country has greater ability andthereby can get richer quickly compared to a poor country. Itis not only the ability to save but also willingness to savewhich counts a great deal. Willingness depends upon theindividual's concern about his future as well as upon the socialset-up in which he lives.

(b) Mobilization of savings: It is not enough that peoplesave money, what is required is that saved money enters intocirculation and facilitates the process by capital formation.There should be a widespread network of banking andother financial institutions to collect public saving andtake them to prospective investor.

(c) Investment: - The process of capital formation getscompleted only when the real savings get converted into realcapital assets. An economy should have a entrepreneurialclass which is prepared to bear the risk of business andinvest savings in productive avenues so as to create newcapital assets.

4. ENTREPRENEURSHIPThe entrepreneur owns Entrepreneurship. He is that man ofproduction who takes decisions and bears risk. He has alsobeen called the organizer, the manager or risk taker.

1. Functions of an entrepreneur-(i) Initiating a business enterprise and coordination:The first and foremost function of an entrepreneur is to start abusiness by collecting various factors of production.Entrepreneur pays remuneration, for the various factors ofproduction, remuneration for their services.

(ii) Risk bearing and Uncertainty: Many economists haveemphasized that true function of enterprise is to bear risk anduncertainty. According to F. H. Knight, certain risks like risks offire, thefts, and accidents etc. do not cause uncertainty andthus do not give rise to profits. It is only non-insurable risks(like risks relating to price decision, output decision, andproduct variation decision, etc.) that involve uncertainty andgive rise to profits.

(iii) Innovation: Some economists regard innovation as thetrue function of the entrepreneur. In broad sense, innovationsinclude introduction of new production methods, utilization ofnew sources of raw materials, adoption of new forms oforganization, introduction of new product, and discoveringnew markets.

Enterprise’s Objectives and ConstraintsThe objectives of an enterprise may be broadly categorisedunder the following heads: 1) Organic objectives 2) Economicobjectives 3) Social objectives 4) Human objectives 5)National objectives

1. Organic objectives: The basic minimum objective of allkinds of enterprises is to survive or to stay alive. An enterprisecan survive only if it is able to produce and distribute productsor services at a price which enables it to recover its costs.

2. Economic Objectives: The profit maximising behaviour ofthe firm has been the most basic assumption made byeconomists over the last more than two hundred years and isstill at the heart of neo classical micro economic theory. Thisassumption is simple, rational and quantitative and isamenable to equilibrium analysis. Under this assumption, thefirm determines the price and output policy in such a way as tomaximize profits within the constraints imposed upon it suchas technology, finance etc.

3. Social Objectives: Since an enterprise lives in a society, itcannot grow unless it meets the needs of the society. Some ofthe important social objectives of business are:To maintain a continuous and sufficient supply of unadulteratedgoods and articles of standard quality.To avoid profiteering and anti-social practices.To create opportunities for gainful employment for the peoplein the society.To ensure that the enterprise’s output does not cause any typeof pollution - air, water or noise.

4. Human Objectives: Human beings are the most preciousresources of an organisation. Some of the important humanobjectives are:

• To provide fair deal to the employees at different levels• To develop new skills and abilities and provide a work climate inwhich they will grow as mature and productive individuals.• To provide the employees an opportunity to participate in decision-making in matters affecting them.• To make the job contents interesting and challenging. If theenterprise is conscious of its duties towards its employees, it will beable to secure their loyalty and support.

5. National objectives: Some of the national objectives are:

• To remove inequality of opportunities and provide fair opportunityto all to work and to progress.• To produce according to national priorities.• To help the country become self-reliant and avoid dependence onother nations.• To train young men as apprentices and thus contribute in skillformation for economic growth and development.

Enterprise’s Problems

Problems relating to objectives Problems relating to location and size of the plant Problems relating to selecting and organising physicalfacilities Problems relating to Finance:

(i) determination of the amount of funds required for theenterprise with reference to the physical plans alreadyprepared

(ii) assessment of demand and cost of its products(iii) estimation of profits on investment and comparison withthe profits of comparable existing concerns to find out whetherthe proposed investment will be profitable enough and(iv) determining capital structure and the appropriate time forfinancing the enterprise etc.

Problems relating to organisation structure

Problems relating to marketing: After identifying the market,the enterprise has to make decision regarding 4 P’s namely,

Product: variety, quality, design, features, brand name,packaging, associated services, utility etc.

Promotion: Methods of communicating with consumersthrough personal selling, social contacts, advertising, publicityetc.

Price: Policies regarding pricing, discounts, allowance, creditterms, concessions, etc. Place: Policy regarding coverage,outlets for sales, channels of distribution, location and layout ofstores, inventory, logistics etc.

Problems relating to legal formalities Problems relating to industrial relations

Production Function states the relationship between inputsand outputs i. e. the amount of output that can be producedwith given quantities of inputs under a given state of technicalknowledge. Outputs takes the form of volume of goods orservices and inputs are the different factor of production i.e.land, labour, capital and Entrepreneurship.In other words, it is the transformation of inputs into

outputs.(1) Total Production (TP): TP is the total output resultingfrom the efforts of all the factors of production combinedtogether at any time.

(2)Average Production (AP): - Average product or averagephysical product (APP) may be defined as total product perunit employment of the variable input. Thus

(3) Marginal Production (MP)

MP is the change in TP due to change in the quantity of variablefactor i.e. labour. In other words, it is the additional TP due to anadditional unit of input. MP = Change TP / change in Labours orsay MP= change in TP/change in Labour

or MP = TP n – TP n -1

For eg. TP is 200 units when Labour is 10 and TP is 250 whenlabour is 15, MP will be calculated as follow-

RELATIONSHIP BETWEEN AP AND MP

(a) Both -AP and MP can be calculated by TP.

(b) When AP rises then MP also rises but MP >AP.

(c) When AP is maximum then MP =AP or say MP curve cutsthe AP curve at its maximum point.

(d) When AP falls then MP also falls but MP <AP.

(e) There may be a situation when MP decreases and APincreases but opposite never happened.

In the above figure when MP decreases (from a to e) then AP increases

(from b to e).

According to Law of Variable Proportions, as more and more

units of a variable factor are combined with same quantity of

fixed factors, total product first increases at an increasing rate

then at diminishing rate and finally starts diminishing. It

implies that marginal product first rises and then diminishes

eventually. Law of Variable Proportions is also known as Law

of Returns to a Factor, It is short-run concept.

Assumptions:1. The technology remains unchanged.

2. There must be some inputs whose quantity is kept fixed.

3. Law does not apply where factors are used in fixed proportions.

4. Only physical input and output are considered.

5. All the units of variable factors are homogeneous (same).

Law of variable proportion has three stages: -

STAGES TP MP AP

STAGE I Increases at anincreasing rate& then atdecreasing rate

Increases &reaches atmaximum point.Then startsdecreasing

Increases &reaches at itsmaximum point.

STAGE II Increases atdiminishing rate& reaches at itsmaximum point.

Decreases &becomes Zero.

Decreases

STAGE III Begins to fall Becomesnegative

Continues toDiminish

Explanation of increasing returns (stage I):

Indivisibility of fixed factors:-The law of increasing returns operates because

of indivisibility of fixed factors. It means, in order to produce goods up to a

given limit, at least one unit of the fixed factor is a fixed.

Division of labour and specialization: The second reason why we get

increasing returns in the initial stages is that with sufficient quantity of variable

factor, introduction of division of labour and specialization becomes possible,

which results in higher productivity.

Note: Point of Inflexion is that point on TP at which MP is maximum & the

curvature of TP gets change from convex to concave.

Explanation of diminishing returns (stage II):

Inadequate relative of fixed factors:-Once the point is reached at which the amount of variable factor issufficient to ensure the efficient utilization of the fixed factor, thenfurther increases in the variable factor will cause marginal andaverage product to decline because the fixed factor then becomesinadequate relative to the quantity of variable factors.

Explanation of negative returns (stage III):

Too excessive quantity of variable factor: ln this stage the quantity of

variable factor becomes too excessive relative to the fixed factor so that they

get in each other's way with a result that the total output falls instead of rising.

In such a situation a reduction in the units of the variable factor will increase the

total output.

Stage of Operation: The three stages together constitute the law of variable

proportions. Since the second stage is the most important so stage II will be

stage of operation and because of that in practice we normally refer to the law

of variable proportion as the law of diminishing returns.

THANK YOU