BA5101 ECONOMIC ANALYSIS FOR BUSINESS
Unit II
Production – Short-run and long-run Production Function – Returns to scale – economies Vs
diseconomies of scale – Analysis of cost – Short-run and long-run cost function – Relation between
Production and cost function
MEANING OF PRODUCTION
Production is a very important economic activity. The standard of living in the ultimate analysis,
depends on the volume and variety of goods and services produced in a country. In fact, the
performance of an economy is judged by the level of its production. Those countries which produce
goods in large quantities are rich and those which produce little of them are poor.
Thus, the amount of goods and services an economy is able to produce determines the richness or
poverty of that economy. The U.S.A. is a rich country just because its level of production is high. India
is not so because its level of production is not very high.
What exactly do we mean by production in Economics? In common parlance the term ‘production’ is
used for an activity of making something material. The growing of wheat, rice or any other
agricultural crop by farmers and manufacturing of cloth, radio-sets, wool, machinery or any other
industrial product is often referred to as production. But in Economics the word ‘production’ is used
in a wider sense. In Economics, by production we mean the process by which man utilises or converts
the resources of nature, working upon them so as to make them satisfy human wants. In other words,
production is any economic activity which is directed towards the satisfaction of the wants of the
people by converting physical inputs into the physical output. Whether it is the making of material
goods or providing any service, it is included in production provided it satisfies the wants of some
people. So, in Economics, if making of cloth by an industrial worker is production, the service of the
retailer who delivers it to consumers is also production. Similarly, the work of doctors, lawyers,
teachers, actors, dancers, etc. is production since the services are provided by them to satisfy the
wants of those who pay for them. The satisfying power of goods and services is called utility.
DEFINITION
Production can also be defined as creation or addition of utility. According to James Bates and J.R.
Parkinson “ Production is the organized activity of transforming resources into finished products in
the form of goods and services; and the objective of production is to satisfy the demand of such
transformed resources”.
It should be noted that production should not be taken to mean as creation of matter because
according to the fundamental law of science man cannot create matter. What a man can do is only to
create or add utility. When a man produces a table, he does not create the matter of which the wood is
composed. He only transforms wood into a chair. By doing so he adds utility to the goods. The money
expense incurred in the process of production, i.e., transforming resources into finished product
constitutes the cost of production.
Production consists of various processes to add utility to natural resources for gaining greater
satisfaction from them by :
(i) Changing the form of natural resources. Most manufacturing processes consist of taking raw
material and transforming them into some items possessing utility, e.g., changing the form of a log of
wood into a table or changing the form of iron into a machine. This may be called conferring utility of
form.
(ii) Changing the place of the resources, from the place where they are of little or no use to another
place where they are of greater use. This utility of place can be obtained by :
(a) extraction from earth e.g., removal of coal, minerals, gold and other metal ores from mines and
supplying them to markets.
1
,(b) transferring goods from where they give little or no satisfaction, to places where their utility is
more, e.g., tin in Malaya is of little use until it is brought to the industrialised centres where necessary
machinery and technology are available to produce metal boxes for packing. Another example is :
apples in Kashmir orchards have some use to farmers. But when the apples are transported to
markets where human settlements are thick and crowded like the city centres, they afford more
satisfaction to greater number of people, rather than to the farmers in the Kashmir apple orchards.
These examples only emphasise the additional utility conferred on all goods, by all forms of
transportation systems, by transport workers and by the agents who assist in the movement and
marketing of goods.
(iii) Making available materials at times when they are not normally available e.g., harvested
foodgrains are stored for use till next harvest. Canning of seasonal fruits is undertaken to make them
available during off season. This may be called conferring of utility of time.
(iv) Making use of personal skills in the form of services, e.g., those of organisers, merchants,
transport workers etc.
The fundamental purpose of all these activities is same, namely to create utility in some manner. So
production is nothing but the creation of utilities in the form of goods and services. For example, in
the production of a woollen suit utility is created in some form or the other. Firstly wool is changed
into woollen cloth at the spinning and weaving mill (utility created by changing the form). Then it is
taken to a place where it is to be sold (utility added by transporting it). Since woollen clothes are used
in winter they will be retained until such time when they are required by purchasers (time utility). In
the whole process, services of various groups of people are utilised (as that of mill workers,
shopkeepers, agents etc.) to contribute to the enhancement of utility. Thus the entire process of
production is nothing but creation of form utility, place utility, time utility and/or personal utility.
1.FACTORS OF PRODUCTION
The process of producing goods in the modern economy is very complex. A good has to pass through
many stages and many hands until it reaches the consumer’s hands in a finished form. Land, labour,
capital and entrepreneurial ability are all the factors or resources whichmake it possible to produce
goods and services. Even a small piece of bread cannot be produced without the active participation of
these factors of production. While land is a free gift of nature and refers to natural resources, the
human endeavour is classified functionally and qualitatively into three main components namely
labour, capital and entrepreneurial skills. We may discuss these factors of production briefly in the
following paragraphs.
1.1.0 Land : The term ‘land’ is used in a special sense in Economics. It does not mean soil or earth’s
surface alone but refers to all free gifts of nature which would include besides the land, in common
parlance, natural resources, fertility of soil, water, air, natural vegetation etc. It becomes difficult at
times to state precisely to what part of a given factor is due solely to the gift of nature and what part
belongs to human effort made on it in the past. Therefore, as a theoretical concept, we may list the
following characteristics which would qualify a given factor to be called land :
(i) Land is a free gift of nature. It is neither created nor destroyed by man.
(ii) Land is strictly limited in quantity. It is different from the other factors of production in that, for
practical purposes, it is permanently in being; no change in demand can affect the amount of land in
existence. In other words, the supply of land is perfectly inelastic from the point of view of the
economy. However, it is relatively elastic from the point of view of a firm.
(iii) According to Ricardo, the production power of soil is indestructible in the sense that the
properties of the land cannot be destroyed. Even if its fertility gets depleted it can be restored.
(iv) Land cannot be shifted from one place to another place. The natural factors typical to a given
place cannot be shifted to other places. It may, however be noted that man has been able to shift water
from one place to another e.g. Rajasthan Canal. Land can however, be used for varied purposes though
its suitability in all the uses is not the same.
(v) Land is said to be a specific factor of production in the sense that it does not yield any result unless
human efforts are employed. Land varies in fertility and uses.
2
,Labour : The term ‘labour’, means mental or physical exertion directed to produce goods or services.
In other words, it refers to various types of human effort which require the use of physical exertion,
skill and intellect. It is, however, difficult to say that in any human effort all the three are not required;
the proportion of each might vary. Labour, to have an economic significance, must be one which is
done with the motive of some economic reward. Anything done out of love and affection, although
very useful in increasing human well-being, is not labour in the economic sense of the term. It implies
that any work done for the sake of pleasure or love does not represent labour in Economics. It is for
this reason that the services of a housewife are not treated as labour, while those of a maid servant
are treated as labour. If a person sings before his friends just for the sake of pleasure, it does not mean
labour despite the exertion involved in it. On the other hand, if a person sings against payment of
some fee, then this activity signifies labour.
Characteristics of labour :
(1) Labour, as compared with other factors is different. It is connected with human efforts whereas
others are not directly connected with human efforts. As a result of this, there are certain human and
psychological considerations which may come up unlike in the case of other factors.
(2) Labour is highly ‘perishable’ in the sense that a day’s labour lost cannot be completely recovered
because the expenditure on maintenance has to be there. Whatever is lost in a day cannot be
recovered wholly by extra work next day. In other words, a labourer cannot store his labour and so he
has no reserve price for his labour.
(3) Labour is inseparable from the labourer himself. It implies that whereas labour is sold, the
producer of labour retains the capacity to work. Thus, a labourer is the source of his own labour
power.
(4) Labour power differs from labourer to labourer. On the basis of labour power a labour may be
classified as unskilled labour, semi-skilled labour and skilled labour. Labour power depends upon
physical strength, education, skill and upon the motivation to work.
(5) All labour is not productive in the sense that all efforts are not sure to produce resources.
(6) Labour has a weak bargaining power. It is because the labourer is economically weak while the
employer is economically powerful although things have changed a lot in favour of labour during the
20th century.
(7) A labourer has to make a choice between the hours of labour and the hours of leisure. The supply
of labour and wage rate are directly related. It implies that, as the wage rate increases the labourer
tends to increase the supply of labour by reducing the hours of leisure. However, beyond a minimum
level of income, the labourer reduces the supply of labour and increases the hours of leisure in
response to further rise in the wage rate. That is, he prefers to have more of rest and leisure than
earning more money.
(8) Labour is a mobile factor. Apparently, workers can move from one job to another or from one
place to another. But, in reality there are many obstacles in the way of free movement of labour from
job to job or from place to place.
1.1.2 Capital : We may define capital as that part of wealth of an individual or community which is
used for further production of wealth. In fact, capital is a stock concept which yields a periodical
income which is a flow concept. It is necessary to understand the difference between capital and
wealth. Whereas wealth refers to all those goods and human qualities which are useful in production
and which can be passed on for value, only a part of these goods and services can be characterised as
capital because if these resources are lying idle they will constitute wealth but not capital. Capital has
been rightly defined as ‘produced means of production’. This definition distinguishes capital from
both land and labour because both land and labour are not produced factors. They are primary or
original factors of production but capital is not a primary or original factor; it is a produced factor of
production. It has been produced by man by working with nature. Therefore, capital may well be
defined as man made instruments of production. Machine tools and instruments, factories, dams,
canals, transport equipment etc., are some of the examples of capital. All of them are produced by man
to help in the production of further goods.
Types of Capital:
3
, Fixed capital is that which exists in a durable shape and renders a series of services over a period of
time. For example tools, machines, etc.
Circulating capital is another form of capital which performs its function in production in a single use
and not available for further use. For example, seeds, raw material, etc.
Real capital refers to physical goods such as building, plant, machines, etc.
Human capital refers to human skill and ability. This is called human capital because a good deal of
investment has gone into creation of these abilities in humans.
Tangible capital can be perceived by senses whereas intangible capital is in the form of certain rights
and benefits which cannot be perceived by senses. For example, goodwill, patent rights,
etc.
Individual capital is the personal property owned by an individual or a group of individuals.
Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc.
PRODUCTION FUNCTION
Production function states the relationship between inputs and output i.e., the maximum amount of
output that can be produced with given quantities of inputs under a given state of technical
knowledge. It can also be defined as the minimum quantities of various inputs that are required to
yield a given quantity of output. The output takes the form of volume of goods or services and the
inputs are the different factors of production i.e., land, labour, capital and enterprise.
Production Function:
In short, the production function is a catalogue of output possibilities. The production function can be
algebraically expressed in an equation in which the output is the dependent variable and inputs are
the independent variables. The equation can be expressed as:
Where ‘q’ stands for the rate of output of given commodity Q=output/quantity, LB = Land & Buildings
= Labor., K = capital = raw material= time.The production function of a firm can be studied in the
context of short period or long period. Short period or short run is that period of time which is too
short for a firm to install a new capital equipment to increase production. It implies capital is a fixed
factor in the short run and the production function is studied by holding the quantities of capital fixed,
while varying the amount of other factors (labour, raw material etc.) Symbolically, Q = T (K, L). This is
done when the law of variable proportion is derived. The production function can also be studied in
the long run. The long run is a period of time (or planning horizon) in which all the factors of
production are variable. It is a time period when the firm will be able to install new machines and
capital equipment’s apart from increasing the units of labour. The behaviour of production when all
factors are varied is the subject matter of the laws of returns to scale.
Assumptions of Production Function:
The production function is based on the certain assumptions;
1. It is related to a particular unit of time.
2. The technical knowledge during that period of time remains constant.
3. The factors of production are divisible into most viable units.
4. The producer is using the best technique available.
Cobb-Douglas Production Function
A famous statistical production function is Cobb-Douglas production function. Paul H. Douglas and
C.W. Cobb of the U.S.A. studied the production function of the American manufacturing industries. In
its original form, this production function applies not to an individual firm but to the whole of
manufacturing in the United States. In this case, output is manufacturing production and inputs used
are labour and capital.
Cobb-Douglas production function
4
Unit II
Production – Short-run and long-run Production Function – Returns to scale – economies Vs
diseconomies of scale – Analysis of cost – Short-run and long-run cost function – Relation between
Production and cost function
MEANING OF PRODUCTION
Production is a very important economic activity. The standard of living in the ultimate analysis,
depends on the volume and variety of goods and services produced in a country. In fact, the
performance of an economy is judged by the level of its production. Those countries which produce
goods in large quantities are rich and those which produce little of them are poor.
Thus, the amount of goods and services an economy is able to produce determines the richness or
poverty of that economy. The U.S.A. is a rich country just because its level of production is high. India
is not so because its level of production is not very high.
What exactly do we mean by production in Economics? In common parlance the term ‘production’ is
used for an activity of making something material. The growing of wheat, rice or any other
agricultural crop by farmers and manufacturing of cloth, radio-sets, wool, machinery or any other
industrial product is often referred to as production. But in Economics the word ‘production’ is used
in a wider sense. In Economics, by production we mean the process by which man utilises or converts
the resources of nature, working upon them so as to make them satisfy human wants. In other words,
production is any economic activity which is directed towards the satisfaction of the wants of the
people by converting physical inputs into the physical output. Whether it is the making of material
goods or providing any service, it is included in production provided it satisfies the wants of some
people. So, in Economics, if making of cloth by an industrial worker is production, the service of the
retailer who delivers it to consumers is also production. Similarly, the work of doctors, lawyers,
teachers, actors, dancers, etc. is production since the services are provided by them to satisfy the
wants of those who pay for them. The satisfying power of goods and services is called utility.
DEFINITION
Production can also be defined as creation or addition of utility. According to James Bates and J.R.
Parkinson “ Production is the organized activity of transforming resources into finished products in
the form of goods and services; and the objective of production is to satisfy the demand of such
transformed resources”.
It should be noted that production should not be taken to mean as creation of matter because
according to the fundamental law of science man cannot create matter. What a man can do is only to
create or add utility. When a man produces a table, he does not create the matter of which the wood is
composed. He only transforms wood into a chair. By doing so he adds utility to the goods. The money
expense incurred in the process of production, i.e., transforming resources into finished product
constitutes the cost of production.
Production consists of various processes to add utility to natural resources for gaining greater
satisfaction from them by :
(i) Changing the form of natural resources. Most manufacturing processes consist of taking raw
material and transforming them into some items possessing utility, e.g., changing the form of a log of
wood into a table or changing the form of iron into a machine. This may be called conferring utility of
form.
(ii) Changing the place of the resources, from the place where they are of little or no use to another
place where they are of greater use. This utility of place can be obtained by :
(a) extraction from earth e.g., removal of coal, minerals, gold and other metal ores from mines and
supplying them to markets.
1
,(b) transferring goods from where they give little or no satisfaction, to places where their utility is
more, e.g., tin in Malaya is of little use until it is brought to the industrialised centres where necessary
machinery and technology are available to produce metal boxes for packing. Another example is :
apples in Kashmir orchards have some use to farmers. But when the apples are transported to
markets where human settlements are thick and crowded like the city centres, they afford more
satisfaction to greater number of people, rather than to the farmers in the Kashmir apple orchards.
These examples only emphasise the additional utility conferred on all goods, by all forms of
transportation systems, by transport workers and by the agents who assist in the movement and
marketing of goods.
(iii) Making available materials at times when they are not normally available e.g., harvested
foodgrains are stored for use till next harvest. Canning of seasonal fruits is undertaken to make them
available during off season. This may be called conferring of utility of time.
(iv) Making use of personal skills in the form of services, e.g., those of organisers, merchants,
transport workers etc.
The fundamental purpose of all these activities is same, namely to create utility in some manner. So
production is nothing but the creation of utilities in the form of goods and services. For example, in
the production of a woollen suit utility is created in some form or the other. Firstly wool is changed
into woollen cloth at the spinning and weaving mill (utility created by changing the form). Then it is
taken to a place where it is to be sold (utility added by transporting it). Since woollen clothes are used
in winter they will be retained until such time when they are required by purchasers (time utility). In
the whole process, services of various groups of people are utilised (as that of mill workers,
shopkeepers, agents etc.) to contribute to the enhancement of utility. Thus the entire process of
production is nothing but creation of form utility, place utility, time utility and/or personal utility.
1.FACTORS OF PRODUCTION
The process of producing goods in the modern economy is very complex. A good has to pass through
many stages and many hands until it reaches the consumer’s hands in a finished form. Land, labour,
capital and entrepreneurial ability are all the factors or resources whichmake it possible to produce
goods and services. Even a small piece of bread cannot be produced without the active participation of
these factors of production. While land is a free gift of nature and refers to natural resources, the
human endeavour is classified functionally and qualitatively into three main components namely
labour, capital and entrepreneurial skills. We may discuss these factors of production briefly in the
following paragraphs.
1.1.0 Land : The term ‘land’ is used in a special sense in Economics. It does not mean soil or earth’s
surface alone but refers to all free gifts of nature which would include besides the land, in common
parlance, natural resources, fertility of soil, water, air, natural vegetation etc. It becomes difficult at
times to state precisely to what part of a given factor is due solely to the gift of nature and what part
belongs to human effort made on it in the past. Therefore, as a theoretical concept, we may list the
following characteristics which would qualify a given factor to be called land :
(i) Land is a free gift of nature. It is neither created nor destroyed by man.
(ii) Land is strictly limited in quantity. It is different from the other factors of production in that, for
practical purposes, it is permanently in being; no change in demand can affect the amount of land in
existence. In other words, the supply of land is perfectly inelastic from the point of view of the
economy. However, it is relatively elastic from the point of view of a firm.
(iii) According to Ricardo, the production power of soil is indestructible in the sense that the
properties of the land cannot be destroyed. Even if its fertility gets depleted it can be restored.
(iv) Land cannot be shifted from one place to another place. The natural factors typical to a given
place cannot be shifted to other places. It may, however be noted that man has been able to shift water
from one place to another e.g. Rajasthan Canal. Land can however, be used for varied purposes though
its suitability in all the uses is not the same.
(v) Land is said to be a specific factor of production in the sense that it does not yield any result unless
human efforts are employed. Land varies in fertility and uses.
2
,Labour : The term ‘labour’, means mental or physical exertion directed to produce goods or services.
In other words, it refers to various types of human effort which require the use of physical exertion,
skill and intellect. It is, however, difficult to say that in any human effort all the three are not required;
the proportion of each might vary. Labour, to have an economic significance, must be one which is
done with the motive of some economic reward. Anything done out of love and affection, although
very useful in increasing human well-being, is not labour in the economic sense of the term. It implies
that any work done for the sake of pleasure or love does not represent labour in Economics. It is for
this reason that the services of a housewife are not treated as labour, while those of a maid servant
are treated as labour. If a person sings before his friends just for the sake of pleasure, it does not mean
labour despite the exertion involved in it. On the other hand, if a person sings against payment of
some fee, then this activity signifies labour.
Characteristics of labour :
(1) Labour, as compared with other factors is different. It is connected with human efforts whereas
others are not directly connected with human efforts. As a result of this, there are certain human and
psychological considerations which may come up unlike in the case of other factors.
(2) Labour is highly ‘perishable’ in the sense that a day’s labour lost cannot be completely recovered
because the expenditure on maintenance has to be there. Whatever is lost in a day cannot be
recovered wholly by extra work next day. In other words, a labourer cannot store his labour and so he
has no reserve price for his labour.
(3) Labour is inseparable from the labourer himself. It implies that whereas labour is sold, the
producer of labour retains the capacity to work. Thus, a labourer is the source of his own labour
power.
(4) Labour power differs from labourer to labourer. On the basis of labour power a labour may be
classified as unskilled labour, semi-skilled labour and skilled labour. Labour power depends upon
physical strength, education, skill and upon the motivation to work.
(5) All labour is not productive in the sense that all efforts are not sure to produce resources.
(6) Labour has a weak bargaining power. It is because the labourer is economically weak while the
employer is economically powerful although things have changed a lot in favour of labour during the
20th century.
(7) A labourer has to make a choice between the hours of labour and the hours of leisure. The supply
of labour and wage rate are directly related. It implies that, as the wage rate increases the labourer
tends to increase the supply of labour by reducing the hours of leisure. However, beyond a minimum
level of income, the labourer reduces the supply of labour and increases the hours of leisure in
response to further rise in the wage rate. That is, he prefers to have more of rest and leisure than
earning more money.
(8) Labour is a mobile factor. Apparently, workers can move from one job to another or from one
place to another. But, in reality there are many obstacles in the way of free movement of labour from
job to job or from place to place.
1.1.2 Capital : We may define capital as that part of wealth of an individual or community which is
used for further production of wealth. In fact, capital is a stock concept which yields a periodical
income which is a flow concept. It is necessary to understand the difference between capital and
wealth. Whereas wealth refers to all those goods and human qualities which are useful in production
and which can be passed on for value, only a part of these goods and services can be characterised as
capital because if these resources are lying idle they will constitute wealth but not capital. Capital has
been rightly defined as ‘produced means of production’. This definition distinguishes capital from
both land and labour because both land and labour are not produced factors. They are primary or
original factors of production but capital is not a primary or original factor; it is a produced factor of
production. It has been produced by man by working with nature. Therefore, capital may well be
defined as man made instruments of production. Machine tools and instruments, factories, dams,
canals, transport equipment etc., are some of the examples of capital. All of them are produced by man
to help in the production of further goods.
Types of Capital:
3
, Fixed capital is that which exists in a durable shape and renders a series of services over a period of
time. For example tools, machines, etc.
Circulating capital is another form of capital which performs its function in production in a single use
and not available for further use. For example, seeds, raw material, etc.
Real capital refers to physical goods such as building, plant, machines, etc.
Human capital refers to human skill and ability. This is called human capital because a good deal of
investment has gone into creation of these abilities in humans.
Tangible capital can be perceived by senses whereas intangible capital is in the form of certain rights
and benefits which cannot be perceived by senses. For example, goodwill, patent rights,
etc.
Individual capital is the personal property owned by an individual or a group of individuals.
Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc.
PRODUCTION FUNCTION
Production function states the relationship between inputs and output i.e., the maximum amount of
output that can be produced with given quantities of inputs under a given state of technical
knowledge. It can also be defined as the minimum quantities of various inputs that are required to
yield a given quantity of output. The output takes the form of volume of goods or services and the
inputs are the different factors of production i.e., land, labour, capital and enterprise.
Production Function:
In short, the production function is a catalogue of output possibilities. The production function can be
algebraically expressed in an equation in which the output is the dependent variable and inputs are
the independent variables. The equation can be expressed as:
Where ‘q’ stands for the rate of output of given commodity Q=output/quantity, LB = Land & Buildings
= Labor., K = capital = raw material= time.The production function of a firm can be studied in the
context of short period or long period. Short period or short run is that period of time which is too
short for a firm to install a new capital equipment to increase production. It implies capital is a fixed
factor in the short run and the production function is studied by holding the quantities of capital fixed,
while varying the amount of other factors (labour, raw material etc.) Symbolically, Q = T (K, L). This is
done when the law of variable proportion is derived. The production function can also be studied in
the long run. The long run is a period of time (or planning horizon) in which all the factors of
production are variable. It is a time period when the firm will be able to install new machines and
capital equipment’s apart from increasing the units of labour. The behaviour of production when all
factors are varied is the subject matter of the laws of returns to scale.
Assumptions of Production Function:
The production function is based on the certain assumptions;
1. It is related to a particular unit of time.
2. The technical knowledge during that period of time remains constant.
3. The factors of production are divisible into most viable units.
4. The producer is using the best technique available.
Cobb-Douglas Production Function
A famous statistical production function is Cobb-Douglas production function. Paul H. Douglas and
C.W. Cobb of the U.S.A. studied the production function of the American manufacturing industries. In
its original form, this production function applies not to an individual firm but to the whole of
manufacturing in the United States. In this case, output is manufacturing production and inputs used
are labour and capital.
Cobb-Douglas production function
4
