Prepared byRaj NaikSY CE-1

150410107053

Theory of Production

Production theory is the study of production, or the economic process of converting inputs into outputs. 

An input is good or service that goes into the process of production and output is any good or service that comes out of production process.

Production involves transformation of inputs such as capital, equipment, labor, and land into output - goods and services

Production theory

The factors of production describe the function that each resource performs in the business environment.

The inputs or resources used in the production process are called factors of production.

They are:1.Land2.Labour3.Capital4.Entrepreneurship

Factors Of production

Land is the economic resource encompassing natural resources. This resource includes timber, fisheries, farms etc.

Land is usually a limited resource for many economies.

Nations must carefully use their land resource by creating a mixture of natural and industrial uses.

Land

Labor represents the human capital available to transform raw materials into consumer goods.

This factor of production is a flexible resource as workers can be allocated to different areas of the economy for producing consumer goods or services.

Labor

Capital can represent the monetary resources companies use to purchase natural resources , land and other capital goods.

Capital also represents the major physical assets that companies and individuals use when producing goods and services.

Capital

Entrepreneurs usually have an idea for creating a valuable good or service and assume the risk involved with transforming economic resources into consumer products.

Entrepreneurship is also considered as a factor of production since someone must complete the managerial functions of gathering, allocating and distributing economic resources or consumer products to individuals and other businesses in the economy.

Entrepreneurship

The production function shows the relation between input changes and output changes. It also shows the maximum amount of output that can be obtained by the firm from a fixed quantity of resources.

Production Function is the relation between a firms physical production and the material factors of production.

Q= f (L, C, N ) Where, Q= quantity of output, L=Labour, C=Capital, N=Land

Production function

The volume of output of the firm’s product, per period of time, depends on the quantities of these factors that are used by the firm.

The firm wishes to increase its volume of output. This can be achieved by increasing the inputs of one or both factors of production.

However, it is very easy to vary the quantity of labour in the production process. It can be done very quickly (in a week or a month).

On the other hand, a fairly long period of time is required to vary the quantity of other factors, for example, change the quantity (or usage) of capital, e.g. to install a new machine.

Production function

Here, the firm is making decisions within two time periods which are production function — the short-run and the long-run.

The distinction between the short-run and the long-run is based on the difference between fixed and variable factors.

A factor of production is treated as a fixed factor if it cannot easily be varied over the time period under consideration. Ex. Capital

On the other hand, a variable factor is one which can be varied over the time period under consideration. Ex. Labor

The short-run refers to the period of time over which one or more factors of production are fixed.

In the real world, land and capital (such as plant and equipment) are usually treated as fixed factors. Here we are considering a simple production process with only two factors. We treat capital as the fixed factor and labour as the variable factor.

An increase in production during this period is possible only by variable input.

If the firm wishes to vary its production in the short-run, it can do so only by changing the quantity of labour. 

In some Industries short run maybe a matter of few weeks or a few months and in some others it may extent even up to three or four years.

Short run

On the other hand the long- run is defined as the period over which all factors of production can be varied, within the confines of existing technology.

In the long-run all factors are variable.More capital and less labour or more labour and

less capital can be used to produce a fixed amount of output.

The long run refers to a period of time in which supply of all the input is elastic; but not enough to permit a change in technology.

Thus in long run, production of commodity can be increased by employing more of both ,variable and fixed inputs.

Long run

The boundary between the short-run and the long- run is not defined by reference to any calendar—a year, or a month or a quarter.

It varies from industry to industry and from time to time within the same industry.

In most plantation industries the long-run is 15-20 years.

For example, rubber trees require a very long time to grow. On the other hand, in a barber’s shop it may be just a week.

The Boundary Between the Two:

This law examines the production function with one factor variable, keeping the quantities of other factors fixed.

In other words, it refers to the input-output relation when output is increased by varying the quantity of one input.

When the quantity of one factor is varied, keeping the quantity of other factors con stant, the proportion between the variable factor and the fixed factor is altered.

Variable proportions is also known as the “Law of Diminishing Returns” of classical economics.

This law has played a vital role in the history of economic thought and occupies an equally important place in modern economic theory.

Law of variable proportion

Total Product is the total of output, resulting from efforts of all factors of production.

Average Product is the total product per unit of the variable factor.

Marginal Product is addition made to the Total Product as a result of production of one more unit of output.

The law of “Diminishing returns” levels that any attempt to increase output by increasing only one factor finally faces diminishing returns.

The law states that when some factor remain constant, more and more units of a variable factor are introduced the production may increase initially at an increasing rate; but after a point it increases only at diminishing rate.

Land and Capital remain fixed in the short term whereas labour shows a variable nature.

Amount of variable factor

Total Product Average Product

Marginal Prouct

12345678910

10223652667682858583

1011121313.212.711.710.59.058.3

101214161410630-2

Here from the table both AP and MP first rise, reach a maximum then decline.

AP is the product for a unit of labour. It is arrived by dividing the TP by number of workers.

MP is found out by dividing the change in TP by the change in worker.

Here additional labour at the 4th place which clearly faces the law of diminishing returns.

The maximum MP is 16 after which it continues to fall, ultimately becoming negative.

Thus when more and more units of labour are combined with other fixed factors the total output increases first at an increasing rate than at a diminishing rate finally it becomes negative.

The graphical representation is as below,

Here the TP curve has a steep rise till the employment of the 4th worker. This shows that the output increases at an increasing rate till the employment of the 4th labour. TP curve still goes on increasing but only at a diminishing rate. Finally TP curve shows a downward trend.

At the first stage, TP increasing at a increasing rate. The MP at this stage increases in a increasing rate resulting in a greater increases in TP. The average product also increases. This stage continues up to the point where AP is equal to MP. The law of increasing returns is in operation at this stage.

The law of increasing returns operates from the second stage onwards. At second stage, the TP continues to increase but at a diminishing rate. As the MP at this stage starts falling, the AP also declines. The second stage comes to an end where TP become max and MP become zero.

The MP becomes negative in the third stage. So the TP also decline in the third stage.

The production technology remains unchanged. If there is improvement in the technology, then marginal and average products may rise instead of diminishing.

There must be some inputs whose quantity is kept fixed. This law does not apply in case all factors are proportionately varied.

The variable factor is homogeneous.Any one factor is constant.

Assumptions of the Law:

In the long run all the factor of production are variable and an increase in output is possible by increasing all the inputs.

The law of returns to scale explains, how a simultaneous and proportionate increase in all the inputs affect the total output.

Law of returns to scale

Returns to scale are of the following three types:

Increasing Returns to scale Constant Returns to Scale Diminishing Returns to Scale

When proportionate increase in all factor of production results in a more than proportionate increase in output and this results in the first stage of production which is known as increasing returns to scale.

Marginal output increases at this stage.Higher degree of specialization, falling cost

will lead higher efficiency which results increase returns in very first stage of production

Increasing Returns To Scale

The table shows that the input is increasing by 100%, on the other hand the output is increased by 150%. This shows the increasing returns to scale. As changes in the output is more than the change in input.

Firms cannot maintain increasing returns to scale indefinitely after the first stage , firm enters a stage when total output tends to increase at a rate which is equal to rate of increase in inputs.

Constant returns to scale

The above example shows that as the inputs (i.e. labour and capital) increased to 100%, output also increased to 100%.

In this stage ,a proportionate increase in all the input result only less than proportionate increase in output.

When the firm grows further , the problem of management arise which result inefficiency and it will affect the position of output.

Diminishing returns to scale

The above shows, that inputs ate increases to 100% but the increase output is 50%, which shows that there is decreasing returns to scale.

Philips was established in 1891 and made light bulbs - a simple product.

Throughout the years the company increased its portfolio into technology products that became too complex for most users.

When Philips realised this, it decided to make life easier and so launched a brand repositioning all about simplicity.

'sense and simplicity' is the brand promise that Philips has identified through its research.

A Philips Case Study

It illustrates two key dimensions:1. Simplicity2. value-for-money technology products.

The stages involved in moving a product are:1. Carrying out research to find out the

weaknesses of the starting position2. Researching a right direction 3. Making plans and taking actions to improve

the position.

 Creating a repositioning strategy

The brand promise 'sense and simplicity' is so important to Philips.

This entails three main elements:

The problem facing the company was lack of constancy and direction.

Resources were being spread too thinly across too many products.

Decision making within the Philips organisation had become patchy.

This was plain to see - there were too many products, too many markets and a lack of consistency in advertising.

For the consumer it was hard to tell what was and what was not a Philips product.

The first challenge was to change the Philips image.This was built around 'sense and simplicity'.

Creating consistency and direction

They have main focused on meeting customer needs.

New Philips' products are:1. Advanced - based on market leading technologies2. Designed around you - based on the findings of

careful customer research3. Easy to experience - easy to use.

Philips is also looking at all of its existing products to make sure they fit the needs of 'sense and simplicity'.

We can show the new repositioning strategy by taking the example of some of the high-tech products that Philips has just worked on.

A good example of this is Senseo®. Senseo® Coffee System has been developed

through a partnership between Philips and Sara Lee, a Fast Moving Consumer Goods (FMCG) supplier.

The key aspects of Senseo® are:1. Cool design2. Easy-to-use technology3. Amazing coffee.

Illustrating the strategy - products

Between 2001 and 2005 more than 10 million of these coffee machines were sold in eight countries - an impressive total. The product embodies what Philips is trying to achieve in everything it does. This is to join an exciting state-of-the-art product with simplicity. The coffee makers are combined with Douwe Egberts Senseo® coffee pods to give customers the taste they want.

At the heart of business, success is good communication.

There are a number of ways that Philips does this:1. As it is a global company, it is important to make

direct contact from the centre. This ensures that the 'Philips message' is conveyed consistently.

2. Philips believes that there should be a single insight for each product.

3. All creative work carried out by advertising agencies must be based on the 'sense and simplicity' promise.

4. Television and print (for example, magazine) adverts are presented in a standard way - at least three Philips adverts in a single magazine.

Communicating "sense and simiplicity"

‘Sense and simplicity’ is the brand promise for the Philips organisation.

The need for change was seen as a result of customer research. Products and processes need to be made with the customer in mind.

Modern consumers want to use high-tech products. They also want to find that these products are simple and easy to use.

Philips has therefore transformed all aspects of its planning.

It has also looked closely at operations to make sure that 'sense and simplicity' drives everything that the company does.

It also operates with outside experts, such as the Simplicity Advisory Board, to create an outside-in way of working.

 Conclusion

Thank you…