Concept
INTRODUCTION
We are aware that both consumers and producers are needed for smooth functioning of an economy. In the previous three chapters, we focused our attention on the behaviour of consumers. Now, we will pay attention towards the producers.
A producer makes use of various inputs for production of goods and services. Production is an important economic activity as it enhances the utility of the product by changing it in the form needed by the consumers. For example, leather is of less use in its raw form until it is transformed into some desirable product like shoes, bags, jackets etc. The term production, in economics, covers a much wider range of activities, than in its everyday use.
To an economist, production means any process that converts a commodity or commodities into a different commodity. Production refers to transformation of inputs into output. For example: To manufacture shoes (output), we need various inputs like leather, nails, land, labour, capital, services of entrepreneur etc.
Concept
PRODUCTION FUNCTION
There exists some relationship between inputs and output of a firm. In Economics, such a relationship is known as production function. Production function is an expression of the technological relation between physical inputs and output of a good.
Symbolically: Ox= f (i1, i2, i3......) (Where: Ox = Output of commodity x; f= Functional relationship:, i1,i2,i3,…in = Inputs needed for 0x,)
Example of Production function
Suppose a firm is manufacturing chairs with the help of two inputs, say labour (L) and capital (K). Then, production function can be written as: Ochairs = f(L, K)
Production function defines the maximum chairs (Ochairs, which can be produced with the given capital and labour inputs. If production function is expressed as: 250 = (7L, 2K) . It means, 7 units of labour and 2 units of capital can produce maximum of 250 chairs.
More about Production Function
SHORT RUN AND LONG RUN
The functional relationship between change in output due to change in inputs is studied in two
phases: Short run and Long run time periods.
Concept
Short Run
Short run refers to a period in which output can be changed by changing only variable factors. In the short run, fixed inputs like plant, machinery, building, etc. cannot be changed. It means, production can be raised by increasing variable factors, but till the extent of capacity of fixed factors.
For example, if a producer wants to increase output in the short run, then this objective can be achieved by using more of raw materials and increasing number of workers with the existing factory building, plant and equipment. One cannot immediately expand factory building, install additional plant and equipment. So, in the short run, some factors are fixed and some are variable and fixed factors cannot be changed during such a short span of time.
Concept
Long Run
Long run refers to a period in which output can be changed by changing all factors of production. Long run is a period, that is long enough for the firm to adjust all its inputs according to change in the conditions. In the long run, firm can change its factory size, switch to new techniques of production, purchase new machinery, etc.
Concept
Important Points about Short run and Long run
The distinction between short run and long run does not refer to a calendar period and is not based on a fixed time span.
The period is rather a functional concept, which depends on production conditions. It varies from firm to firm and industry to industry. For example, a period of 10 years may be short run period for a steel industry, while, a period of one year may be a long-run period for a wheat producer.
Concept
Difference between Short Run and Long Run
Meaning
Short run refers to a period in which Long run refers to a period in which output can be changed by changing only variable factors.
Long run refers to a period in which output can be changed by changing all factors of production.
Classification
Factors are classified as variable and
fixed factor in the short run.
All factors are variable in the long run.
Price
Determination
In the short run, demand is more active in price determination as supply cannot be increased immediately with increase in demand. in the long run, both demand and supply play equal role in price determination as both can be increased.
VARIABLE FACTORS AND FIXED FACTORS
Production is the result of combined efforts of the factors of production. These factors are
broadly classified as: (i) Variable Factors; (ii) Fixed Factors.
Concept
Variable Factors
Variable Factors refer to those factors, which can be changed in the short run. For example, raw material, casual labour, power, fuel, etc.
Variable factors vary directly with the level of output. As output increases, requirement for variable factors also rises and vice-versa. It must be noted that variable factors are not required in case of zero output.
Concept
Fixed Factors
Fixed factors refer to those factors, which cannot be changed in the short run. For example, plant
and machinery, building, land, etc.
The quantity of fixed factors remain same in the short run irrespective of level of output, i.e.
they do not change, whether the level of output rises, falls or becomes zero.
Concept
Difference between Variable Factors and Fixed Factors
Basis :- 1) Meaning
Variable factors refer to those factors, which can be changed in the short run.
Fixed factors refer to those factors which cannot be changed in the
short run.
Relation with output
Variable factors
They vary directly with output.
Fixed factors
They do not vary directly with output.
Example
Example - Fixed and Variable Factors in Short and Long run
Example: Suppose, Shyam manufactures pens with the help of a machine (fixed factor). The maximum capacity of the plant is 2,000 pens. The variable factors needed to produce 2,000 pens are: 10 labours and 100 kg of raw material. However, due to low demand in the market, Shyam is manufacturing only 600 pens with 4 labours and 30 kg of raw material.
Short Run: Suppose further, Shyam gets an additional order of 900 pens. Now, to fulfill this order, he needs to increase only the variable factors (i.e. labour and raw material) as total production 600 + 900 = 1, 500pens is still within the maximum capacity of plant. The period, needed to complete the order of 900 pens is termed as short run. The period of short-run is too short to cause any change in the fixed factors. The production can be increased only to the extent of available capacity of fixed factors.
Long Run: However, if the order size is of 1,800 pens (instead of 900 pens), then total production needed will increase to 2,400 pens. But, the maximum capacity of plant is 2,000 pens. Now, Shyam needs to have one more plant in addition to more labour and raw material. The period, needed to complete the order of 1,800 pens is termed as long run. In the long run, distinction between fixed and variable factors disappears and all factors (plant, labour and raw mate rial) are variable.
Concept
Types of Production Function
The distinction between fixed and variable factors helps us to study the two types of production function:
Short Run Production Function (Variable Proportion Type):
Short run production function refers to a situation when output is increased by changing only one input while keeping other inputs unchanged. As there is change in variable input only, the ratio between different inputs tends to change at different levels of output. This relationship is explained by 'Law of Variable Proportions" (discussed in Section 5.6).
Long Run Production Function (Constant Proportion Type):
Long run production function refers to a situation when output is increased by increasing all the inputs simultaneously and in the same proportion. As all inputs are variable in the long run, the ratio between different inputs tends to remain the same at different levels of output. This relationship is explained by the Law of Returns to Scale' (discussed in Power Booster Section). Before we proceed to Law of Variable Proportions and Law of Returns to Scale, let us first discuss the various concepts of 'Product'.
Concept
CONCEPT OF PRODUCT
Product or output refers to the volume of goods produced by a firm or an industry during a specified period of time.
The concept of product can be looked at from three different angles:
Concept
Total Product (TP)
Total product refers to total quantity of goods produced by a firm during a given period of time with given number of inputs.
For example, if 10 labours produce 60 kg of rice, then total product is 60 kg.
In the short-run, a firm can expand TP by increasing only the variable factors. However, in the long-run, TP can be raised by increasing both fixed and variable factors.
Total Product is also known as Total Physical Product (TPP)' or Total Return' or 'Total Output.
Concept
Average Product (AP)
Average product refers to output per unit of variable input.
For example, if total product (TP) is 60 kg of rice, produced by 10 labours (variable input), then average product will be 60 ÷ 10 = 6 kg.
AP is obtained by dividing TP by units of variable factor. Average Product (AP) =
Total Product (TP) / Units of Variable Factor (n)
TP in terms of AP will be:
TP = AP x Units of Variable Factor
Average Product is also known as 'Average Physical Product (APP)' or 'Average Return'.
Concept
Marginal product
Marginal product refers to addition to total product, when one more unit of variable factor
is employed.
MP n = TPn -TP n-1
Where,
MPn = Marginal product of nth unit of variable factor;
TPn = Total product of n units of variable factor;
TPn-1= Total product of (n-1) units of variable factor; n n = number of units of variable factor.
For example, If 10 labours make 60 kg of rice and 11 labours make 67 kg of rice, then MP of 11th labour will be:
MP11 TP11-TP 10
MP11 = 67-60= 7 kg
Marginal Product (MP) is also known as 'Marginal Physical Product (MPP)' or 'Marginal Return'.
Concept
One More way to Calculate MP
We know, MP is the change in TP when one more unit of variable factor is employed. However, when change in variable factor is greater than one unit, then MP can be calculated as:
MP = Change in Total Product/Change in units of Variable Factor.. = △TP/ △n
Suppose 2 labours produce 60 units and 5 labours produce 90 units, then MP will be:
MP = TP of 5 labours-TP of 2 labours / 5 labours-2 labours
MP = 90-60 / 5-2
= 30/3
= 10 units
or
TP is summation of MP
Total Product can also be calculated as the sum of marginal product.
It means,
TPn= MP1+ MP2 + MP3+............. MPn
or,
TP = ΣMP
Concept
RETURNS TO A FACTOR: LAW OF VARIABLE PROPORTIONS
Returns to a factor refers to the resultant increase in the total product (return) when only one factor is increased, keeping all other factors fixed. In the short run, when one input is variable and all other inputs are fixed, the firm's production function exhibits the Law of Variable Proportions.
Statement of Law of Variable Proportions
Law of Variable Proportions (LVP) states that as we increase quantity of only one input keeping other inputs fixed, total product (TP) initially increases at an increasing rate, then at a decreasing rate and finally at a negative rate.
According to the Law of Variable Proportions, the changes in TP and MP can be classified into
Following three Phases:
Phase 1: TP rises at increasing rate. MP increases.
Phase II: TP rises at decreasing rate.
MP decreases and is positive.
Phase III: TP falls.
MP becomes negative.
Concept
Assumptions of Law of Variable Proportions
Let us now understand the law with the help of an Example
Suppose, a farmer has 1 acre of land (fixed factor) on which he wants to increase the production of wheat with the help of labour (variable factor). When he employed more and more units of labour, initially output increased at an increasing rate, then at a decreasing rate and finally, at a negative rate. This behaviour of output is shown in Table.
Table 5.1: Law of Variable Propertions
Factor ratio keeps on changing:-
It must be noted that production is carried out under conditions of ‘variable proportions’, i.e. proportion between fixed and variable factor changes with every additional variable factor. In Table, the ratio between land and labour changes from 1:1 to 1:2, then to 1:3 and so on , with addition of more and more units of labour.
:- Phase I
(between 0 to Q)
TP increases at an increasing rate and MP also increases.
:- Phase II
(between Q to M)
TP increases at decreasing rate and MP falls. This phase ends when MP becomes zero & TP reaches its maximum point.
:- Phase III
(beyond point M)
TP starts decreasing and MP not only falls, but also becomes negative.
:- Point of inflection
(point Q)
point ‘Q’ is known as point of inflection as curvature of TP curve changes at this point.
As seen in Table and Fig., when farmer increases the labour on the same piece of land, then, initially TP rises at an increasing rate, then at a decreasing rate and finally it falls. The resulting relation between input and output is discussed in three phases:
Concept
Phase I: Increasing Returns to a Factor (TP increases at an increasing rate):
In the first phase, every additional variable factor adds more and more to the total output. It means, TP increases at an increasing rate and MP of each variable factor rises.
Concept
Phase II: Diminishing Returns to a Factor (TP increases at diminishing rate):
In the second phase, every additional variable factor adds lesser and lesser amount of output. It means, TP increases at a diminishing rate and MP falls with increase in variable facter.
That is why, this phase is known as diminishing returns to a factor.
Concept
Phase III: Negative Returns to a Factor:
In the third phase (starting from 6 units of labour), the employment of additional variable factor causes TP to decline. MP now becomes negative.
Therefore, this phase is known as negative returns to a factor.
Phase of Operation
A rational producer will always seek to operate in Phase II of Law of Variable Proportions.
This brings us to the conclusion that a producer will aim to operate in Phase II, as TP is maximum and MP of each variable factor is positive.
Reasons for Law of Variable Proportions
The various reasons for 3 phases of Law of Variable Proportions are:
Concept
Reasons for Increasing Returns to a Factor (Phase I) There are three important reasons for the operation of increasing returns to a factor:
Better Utilization of the Fixed Factor:
In the first phase, the supply of the fixed factor (say, land) is too large, whereas variable factors are too few. So, the fixed factor is not fully utilised. When variable factors are increased and combined with fixed factor, then fixed factor is better utilised and output increases at an increasing rate.
Increased Efficiency of Variable Factor:
When variable factors are increased and combined with the fixed factor, then former is utilised in a more efficient manner. At the same time, there is greater cooperation and high degree of specialization between different units of the variable factor.
Indivisibility of Fixed Factor:
Generally, the fixed factors which are combined with variable factors are indivisible. Such factors cannot be divided into smaller units. Once an investment is made in an indivisible fixed factor, then addition of more and more units of variable factor, improves the utilisation of fixed factor. The increasing returns apply as long as optimum level of combination between variable and fixed factor is achieved.
Concept
Reasons for Diminishing Returns to a Factor (Phase II)
The main reasons for occurrence of diminishing returns to a factor are:
Optimum Combination of Factors:
Among the different combinations between variable and fixed factor, there is one optimum combination, at which total product (TP) is maximum. After making the optimum use of fixed factor, the marginal return of variable factor begins to diminish. For example, if a machinery (fixed factor) is at its optimum use, when 4 labours are employed, then addition of one more labour will increase TP by very less amount and MP will start diminishing.
Imperfect Substitutes:
Diminishing returns to a factor occurs because fixed and variable factors are imperfect substitutes of one another. There is a limit to the extent of which one factor of production can be substituted for another. For example, labour can be substituted in place of capital or capital can be substituted in place of labour till a particular limit. But, beyond the optimum limit, they become imperfect substitutes of one another, which leads to diminishing returns.
Concept
Reasons for Negative Returns to a Factor (Phase III) The main reasons for occurrence of negative returns to a factor are:
Limitation of Fixed Factor:
The negative returns to a factor apply because some factors of production are of fixed nature, which cannot be increased with increase in variable factor in the short run.
Poor coordination between variable and fixed factor:
When variable factor becomes too excessive in relation to fixed factor, then they obstruct each other. it leads to poor coordination between variable and fixed factor. As a result, total output falls instead of rising in marginal product becomes negative.
Decrease in efficiency of variable factor:
With continuous increase in variable factor the advantages of specialisation and division of labour start diminishing it results in efficiencies of variable factor which is another reason for the negative returns to eventually set in.
Concept Relationship between TP and MP
The relationship between TP and MP can be better understood with the help of following schedule and diagram:-
Table 5.3: Relationship between TP and MP
The relationship between TP and MP can be summarised as under:
Concept RELATIONSHIP BETWEEN AP AND MP
The relationship between AP and MP is discussed through Table and Fig. :
Table 5.4: Relationship between AP and MP
The relationship can be summarised as under:
1. As long as MP is more than AP, AP rises, i.e. up to 2nd unit of variable factor.
2. When MP is equal to AP, AP is at its maximum, i.e. at 3rd unit of variable factor.
3. When MP is less than AP, AP falls (from 4th unit of variable factor).
Thereafter, both AP and MP fall, but MP becomes negative, whereas, AP remains positive. MP falls at a faster rate in comparison to fall in AP.
It must be noted that both AP and MP are derived from TP. AP is calculated on the basis of all the units, whereas, MP is based on the additional unit only. So, it is the MP which pulls the AP up or down.
Concept
Solved Practical’s
Important formulas at glance
TP = units of variable factor* AP =€MP
AP = TP / Units of Variable factor;
MPn = TPn – TPn-1
Example 1. Calculate Average Product (AP) and Marginal Product (MP):
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