THEORY OF PRODUCTION

Umulkulthum Musa Yeya

School of Business
THE THEORY OF PRODUCTION
 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

Factors of Production

 Factors of production are input or resource of society used

in the process of production are classified in for brand
categories
1. Land
2. Labour
3. Capital
4. Entrepreneurship
 Land : refers to all natural resources over which people is
the power of disposal and which may be used to yield an
income. The reward for land is rent
 Labour:- is the exercise of human, mental and physical
effort in the process of production of goods and services.
Reward is salaries and wages
 Capital: is the man – made input which can be working
capital or circulating capital. Reward is interests.
 Entrepreneurship : the organization of all factors of
production in the view of profit making reward is profit
 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

 Reluctance of the family to move

 Cost involves in labour mobility
 Language barriers
 Adverse climatic condition
 Insecurity and political instability
SPECIALIZATION
 Specialization : is the concentration of activities in those lines of
production where the individual, firm or century has some natural
or acquired advantage.
 Forms of specialization
 International specialization: Is concentration by a country of its
resources on a specific area of production.

 Regional specialization: within a country where factor

endorsements and economic history have led industries to
concentrate in certain areas because it’s difficult for competitive
plant to be established elsewhere e.g. tea production concentration
in highlands

 Specialization between industries: each economy includes

many industries each producing different commodities

 Specialization between firms: industries are composed of

firms that can be regarded as units of production.
 Specialization between factories: - arises as one firm will often
control many factories and these are usually referred to as plants
and are unit’s production.
ADVANTAGES OF SPECIALIZATION
 The fundamental advantage of division of labour is increased output
arising from division of labour
 Since each person is endured with different attitude and skills , an
economic system that breaks down work into a variety of jobs gives
individual workers opportunity to exploit their particular talents fully.
 It improves skills and workers given that once a particular person
establishes himself in the job he usually finds that his skill on job
increases with practice
 No time wasted – not making between jobs hence more will be
produced
 Saving of time in training of operatives
 Makes possible the greater use of machinery since breaking up of a
complete process into services of separate for simpler tasks
 Reduces cost per unit given that not all costs of production rise as
output rises
 Increases leisure time available – allows same quantity of goods to
be produced for a lower expenditure of resources
 Enables labour to be released to other industries because he greater
productivity enables units of labour be released in order to develop
greater skills
DISADVANTAGES OF SPECIALIZATION
 Involves close interdependence given that no one
can specialize in making part of a product
 May lead to boredom or monetary –works perform
same operation hundred of time
 May be accompanied by a decline in craft
marking as skills are transferred from hand of
worker o a machine
 Associated with an increased risk of
unemployment specialization workers don’t have a
wide industrial training to make them adoptable to
changes
 Is economically limited by the extend of market –
methods of production using expensive capital
equipment are only worthwhile if there is a
potential demand for mass products
 Inevitably associated with standardized products
 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:

AP = Total product (TP)
 Number unit of variable factors
 E.g. the average product of workers and capital
are given by:
AP = TP; AP = TP
L K
 Marginal products it is changes in the total

product brought about by varying the

employment of the variable factors by one unit
e.g. increasing employment by 1 person.
 MP = Change in total product

Change in quality of labour employment

= ∆TP
∆L
 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.
LAW OF DIMINISHING MARGINAL RETURNS
APL
MPL

L
MPL
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 underutilized 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
BELOW

Labour Total Average product Marginal product

product (AP) (AP)
0 0 0 0
1 3 3 3
2 8 4 5
3 12 4 4
4 15 3.75 3
5 17 3.4 2
6 17 2.83 0
7 16 2.29 -1
8 13 1.625 -3

Law of diminishing marginal returns

 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
 The state of technology remains unchanged.
 Successive units of the variable factors are assumed to
be equally efficient
 Production take place in the short run where at least
one factor of production is fixed.
 There is one variable factor of production under
consideration.
 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
 There are only two factors of production i.e.

labour and capital

 It is possible to substitute labour for capital

and vise versa continuously in the production

process
K

K1
Q3

K2 Q2
Q1

L1 L2 L
 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
 They are convex to the origin

 Do not intersect

 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
 The firm takes the input prices as given by

the market
 There are two inputs; there are the labour

and the capital.

ISOCOST

C
PR
Increase in cost
outlay

Decrease in
cost outlay C
PL
Graphical representations of isocosts

The slope of an isocost line is given by ∆Pk

∆PL
 If the firm spends all the total outlay on
capital then he will purchase C units of
capital
 PK
 If the spends all the outlay in labour then

would purchase C
 PL
 By going the two points we get the is cost of

the firm and therefore the total cost for

utilizing labour and capital will be given by
 C = WL+rK Where w- price for labour; r- Price

for capital
 Optimal Input Utilization
For a firm to minimize the cost of production which is the optimal input utilization
point,it must do so that the point where the isoquant is tangent to Isocost line are
shown below

Capital K

B
Eq
• •
Labour L
At point A there will be under production since the resource are not
maximally utilized. At point Eq the firm achieves the optimum input
utilization.
At point B the firm is unable to produce since the resources are limited at
THE MARGINAL RATE OF SUBSTITUTION (MRTS)

 The slope of an isoquant measures the rate

at which labour can be substituted for capital
keeping the output constant.
 The MRTS refers to the slope of the isoquant

 The MRTS of labour for capital refers to the

amount of capital that a firm can give up by

one unit and still remain on the same
isoquant
 MRTs = MPl = ∆L

MPk ∆k

 MRTsk = MPk = ∆K
MPL ∆L
EXPANSION PATH

Expansion path
 In the long run all the factors of production

can be varied and thus there is no limitation

to the firms‟ expansion on its output.
 The objective of the is to choose the optimal

way of expanding its output so as to

minimize its cost and maximize the output
within a given factor prices and given the
production function, the optimal expansion
path is determined by the point of tangency
of successive isocost line sand successive
isoquant curves as shown in below.
EXPANSION PATH

Capital

K3

K2

K 1

L1 L2 L3
Labour
THANK YOU