Unit 3

NOTES
Theory of Production:

 The process of transformation of resources (like land, labour, capital

and entrepreneurship) into goods and services of utility to consumers
and/or producers. ▪ The process of creation of value or wealth through
the production of goods and services that have economic value. ▪
Goods includes all tangible items such as furniture, house, machine,
food, car, television etc ▪ Services include all intangible items, like
banking, education, management, consultancy, transportation
Utilities of Production:

This refers to the value created by transforming raw materials or inputs into a
finished product that satisfies consumer needs. For example, a carpenter creating
a table from wood.
•Form Utility:
•Place Utility:
This is the value derived from making products or services available in locations
that are convenient for consumers. For example, having a store in a busy
shopping mall.
•Time Utility:
This refers to the value created by making products or services available at the
time consumers need or want them. For example, a restaurant being open during
dinner hours.
•Possession Utility:
This is the value created by transferring ownership of a product or service to the
consumer, allowing them to use and benefit from it. For example, a customer
buying a car and taking ownership of it
Factors of Production:
Factors of productions:

 Factors of production is an economic term that describes the inputs used

in the production of goods or services to make an economic profit.
 These include any resource needed for the creation of a good or service.
 The factors of production are land, labor, capital, and entrepreneurship.
 The state of technological progress can influence the total factors of
production and account for any efficiencies not related to the four typical
factors.
 Land as a factor of production can mean agriculture and farming as well
as the use of natural resources, and even land to construct buildings on.
Factor of production:

 Land
 It refers to all natural resources. All natural resources either on the surface of the earth or
below the surface of the earth or above the surface of the earth is Land.
 One uses the land to produces goods. It is the primary and natural factor of production. All
gifts of nature such as rivers, oceans, land, climate, mountains, mines, forests etc. are
land.
 The payment for land is rent.
 Characteristics of Land as a Factor of Production
 The land is a free gift of nature.
 The land has no cost of production.
 It is immobile.
 The land is fixed and limited in supply
Labor
All human effort that assists in production is labour. This effort can be
mental or physical. It is a human factor of production. It is the worker
who applies their efforts, abilities, and skills to produce.
The payment for labour is the wage.
Characteristic
•It is a human factor.
•One cannot store labour.
•No two types of labour are the same

Capital
Capital refers to all manmade resources used in the production process.
It is a produced factor of production. It includes factories, machinery,
tools, equipment, raw materials, wealth etc.
The payment for capital is interest
Entrepreneur
An entrepreneur is a person who brings other factors of production in one
place. He uses them for the production process. He is the person who
decides
•What to produce
•Where to produce
•How to produce
A person who takes these decisions along with the associated risk is an
entrepreneur
Characteristics of factor of
production:

 1Limited in quantity
 2Alternative uses
 3Uses in variable proportion
 Production function:
•Definition:
A production function quantifies the relationship between inputs and outputs in a production
process. It essentially describes how efficiently a firm can transform inputs into outputs.
•Inputs:
These are the resources used in the production process, commonly including:
•Labor: Human effort and skills.
•Capital: Man-made resources like machinery, equipment, and buildings.
•Land: Natural resources like raw materials and land itself.
•Entrepreneurship: The ability to organize and combine other factors of production.
•Output:
The goods or services produced by the firm.
•Mathematical Representation:
A common way to represent a production function is with an equation like: Q = f(K, L, P, H).
•Where:
•Q: represents the quantity of output.
•f: represents the production function itself.
•K: represents capital.
•L: represents labor.
•P: represents land.
•H: represents entrepreneurship.
Assumptions of production function:

assumptions:
 Constant Technology:
The production function assumes that the technology used in the production process remains
constant or unchanging during the period under consideration. If technology changes, it would
alter the input-output relationship, resulting in a shift in the production function.
 Efficient Resource Utilization:
It is assumed that firms utilize their inputs at maximum levels of efficiency, meaning they are
using the best available techniques and not wasting resources.
 Perfect Divisibility of Inputs and Outputs:
The production function assumes that both inputs and outputs can be perfectly divided into
smaller unit
•Diminishing Marginal Productivity:
As more of a variable input is added to a fixed
input, the marginal product (additional output from
each additional unit of input) will eventually
decline.
•Homogeneous Units of Inputs and Outputs:
The inputs and outputs used in production are
assumed to be homogeneous, meaning they are
identical and interchangeable.
•Fixed and Variable Inputs:
The production function distinguishes between
fixed inputs (those that cannot be easily changed
in the short run, like factory size) and variable
inputs (those that can be adjusted, like labor or
raw materials).
•Limited Substitution of Factors:
The production function assumes that there are
limitations to how easily one factor of production
can be substituted for another.
•Production Function is Related to a
Particular Period of Time:
The production function is defined within a specific
•Full Employment of Resources:
•The model assumes that all available resources are fully employed in
the production process.
•Constant Returns to Scale:
•The production function assumes that the increase in output resulting
from an increase in inputs is proportional.
Characteristics of factors of
Production:

 1Relation between physical quantities

 2Prices are not included
 3Given technology
 4A particular period of time
 5Substitution of factor of production
 6Some factors are fixed in short run
 7all the factors are variable in long run
 Short run and long run production function:

Short-Run Production Function:-:

The short run is a period where at least one factor of production (e.g., capital, land) is fixed, and a firm can only adjust output
by varying other factors (e.g., labor, raw materials).
•Example:
A bakery can increase output in the short run by hiring more bakers (variable input) while using the existing ovens and
building (fixed inputs)
•At least one input is fixed.
•Output changes are accompanied by changes in factor proportions.
•Focus on adjusting variable inputs to maximize output given fixed input
 Long run production function:
Long-Run Production Function:

The long run is a period where all factors of production can be varied, allowing firms to adjust the scale of their operations.
•Example:
A company can increase output in the long run by building a new factory (adjusting capital) and hiring more workers (adjusting
labor).

•All inputs are variable.

•Output changes are not necessarily accompanied by changes in factor proportions.
•Focus on adjusting all inputs to achieve optimal production levels.
Law of variable production in Short
run :

 The law of variable proportions is as follows: “If a producer increases

the units of a variable factor while keeping other factors fixed, then
initially the total product increases at an increasing rate, then it
increases at a diminishing rate, and finally starts declining.”
•Three Stages of Production:
•Increasing Returns: Initially, as you add more of the
variable input, output increases at an increasing rate. This
is because the fixed factors are being underutilized, and
the marginal product (output from one additional unit of
input) is rising.
•Diminishing Returns: Eventually, the marginal product
begins to decline, and output increases at a decreasing
rate. This stage is characterized by the fact that the fixed
factors are becoming overutilized.
•Negative Returns: At some point, adding more of the
variable input actually leads to a decrease in total
output. The marginal product becomes negative.
Causes of law of increasing return

 Indivisibility of some factor of production

 Economies of large scale of production
 Adequate supply
 Technological development
 Man power
Causes of application of law of diminishing return:

 One or more factor of production are fixed

 Imperfect substitution
 Limited supply
 Production beyond optimum combination.
Example:
Imagine a farmer with a fixed amount of land and equipment. Initially,
adding more workers (variable input) increases crop yield (output)
significantly. However, as the farmer adds more and more workers, the
land becomes overcrowded, and the marginal product of labor declines,
eventually leading to a point where adding more workers actually reduces
the total yield.
Law of return to scale in long run:

 Changes in output when all factors change in the same proportion are
referred to as the law of return to scale. This law applies only in the
long run when no factor is fixed, and all factors are increased in the
same proportion to boost production.
Law of return to scale:

 The law of Return to Scale in Production Functions Changes in output

when all factors change in the same proportion are referred to as the
law of return to scale. This law applies only in the long run when no
factor is fixed, and all factors are increased in the same proportion to
boost production.
Returns to scales :

 Returns to scale are of the following three types:

 1. Increasing Returns to scale.
 2. Constant Returns to Scale
 3. Diminishing Returns to Scale
Increasing returns to scale or diminishing cost refers to a situation when all
factors of production are increased, output increases at a higher rate. It means if
all inputs are doubled, output will also increase at the faster rate than double.
Hence, it is said to be increasing returns to scale
A decreasing returns to scale occurs when the proportion of output is
less than the desired increased input during the production process.
For example, if input is increased by 3 times, but output is reduced 2
times, the firm or economy has experienced decreasing returns to
scale.
•Constant returns to scale (CRS) is a concept in economics that
describes a production process where the output increases
proportionally to the increase in all inputs.
•Example:
If a company doubles its inputs (e.g., labor, capital, materials), its
output will also double, maintaining the same level of efficiency.