MICRO ECONOMICS UNIT-III

 

Production:

According to Bates and Parkinson:

“Production is the organised activity of transforming resources into finished products in the form of goods and services; the objective of production is to satisfy the demand for such transformed resources”.

According to J. R. Hicks:

“Production is any activity directed to the satisfaction of other peoples’ wants through exchange”. This definition makes it clear that, in economics, we do not treat the mere making of things as production. What is made must be designed to satisfy wants.

 

Three Types of Production:

For general purposes, it is necessary to classify production into three main groups:

1. Primary Production:

Primary production is carried out by ‘extractive’ industries like agriculture, forestry, fishing, mining and oil extraction. These industries are engaged in such activities as extracting the gifts of Nature from the earth’s surface, from beneath the earth’s surface and from the oceans.

2. Secondary Production:

This includes production in manufacturing industry, viz., turning out semi-finished and finished goods from raw materials and intermediate goods— conversion of flour into bread or iron ore into finished steel. They are generally described as manufacturing and construction industries, such as the manufacture of cars, furnishing, clothing and chemicals, as also engineering and building.

3. Tertiary Production:

Industries in the tertiary sector produce all those services which enable the finished goods to be put in the hands of consumers. In fact, these services are supplied to the firms in all types of industry and directly to consumers. Examples cover distributive traders, banking, insurance, transport and communications. Government services, such as law, administration, education, health and defence, are also included.

FACTORS OF PRODUCTION

Factors of production include any resource needed for the creation of a good or service. At the core, land, labor, capital and entrepreneurship encompass all of the inputs needed to produce a good or service. Land represents all natural resources, such as timber and gold, used in the production of a good. Labor includes all of the work that laborers and workers perform at all levels of an organization, except for the entrepreneur. The entrepreneur is the individual who takes an idea and attempts to make an economic profit from it by combining all other factors of production. The entrepreneur also takes on all of the risks and rewards of the business. Capital is made up of all of the tools and machinery used to produce a good or service.

 

(1) Land and Natural Resources:

In economics the term land is used in a broad sense to refer to all natural resources or gifts of nature. As the Penguin Dictionary of Economics has put it: “Land in economics is taken to mean not simply that part of the earth’s surface not covered by water, but also all the free gifts of nature’s such as minerals, soil fertility, as also the resources of sea. Land provides both space and specific resources”.

From the above definition, it is quite clear that land includes farming and building land, forests, and mineral deposits. Fisheries, rivers, lakes, etc. all those natural resources (or gifts of nature) which help us (the mem­bers of the society) to produce useful goods and services. In other words, land includes not only the land surface, but also the fish in the sea, the heat of the sun that helps to dry grapes and change them into resins, the rain that helps farmers to grow crops, the mineral wealth below the surface of the earth and so on.

(2) Labour:

Like land, labour is also a primary factor of production. The distinctive feature of the factor of production, called labour, is that it provides a human service. It refers to human effect of any kind—physical and mental— which is directed to the production of goods and services. ‘Labour’ is the collective name given to the productive services embodied in human physical effort, skill, intellectual powers, etc.

As such, there are different types of labour input, varying in effort and skill content, and in particular types of skill content. Thus, like ‘land’, labour is not homogeneous. The term covers clerical, managerial and administrative functions as well as skilled and unskilled manual work.

 (3) Capital:

Capital, the third agent or factor is the result of past labour and it is used to produce more goods. Capital has, therefore, been defined as ‘produced means of production.’ It is a man-made resource. In a board sense, any product of labour-and-land which is reserved for use in future production is capital.

To put it more clearly, capital is that part of wealth which is not used for the purpose of consumption but is utilised in the process of production. Tools and machinery, bullocks and ploughs, seeds and fertilizers, etc. are examples of capital. We have already identi­fied certain things described as capital in our discussion on producers’ goods.

Classification of Capital:

Capital can be classified in two broad categories that which is used up in the course of production and that which is not.

Fixed and Circulating Capital:

Fixed capital means durable capital like tools, machinery and factory buildings, which can be used for a long time. Things like raw materials, seeds and fuel, which can be used only once in production are called circulating capital. Circulating capital refers to funds embodied in stocks and work-in- progress or other current assets as opposed to fixed assets. It is also called working capital.

 (4) Enterprise (Organisation):

Organisation, as a factor of production, refers to the task of bringing land, labour and capital together. It involves the establishment of co-ordination and co-operation among these factors. The person in charge of organisation is known as an organiser or an entrepreneur. So, the entrepreneur is the person who takes the charge of supervising the organisation of production and of framing the necessary policy regarding business.

 

Law of Variable Proportions

Law of Variable Proportions occupies an important place in economic theory. This law is also known as Law of Proportionality.

Keeping other factors fixed, the law explains the production function with one factor variable. In the short run when output of a commodity is sought to be increased, the law of variable proportions comes into operation.

According to Benham “As the proportion of the factor in a combination of factors is increased after a point, first the marginal and then the average product of that factor will diminish.”

According to Samuelson “An increase in some inputs relative to other fixed inputs will in a given state of technology cause output to increase, but after a point the extra output resulting from the same additions of extra inputs will become less and less.”

Therefore, when the number of one factor is increased or decreased, while other factors are constant, the proportion between the factors is altered. For instance, there are two factors of production viz., land and labour.

Land is a fixed factor whereas labour is a variable factor. Now, suppose we have a land measuring 5 hectares. We grow wheat on it with the help of variable factor i.e., labour. Accordingly, the proportion between land and labour will be 1: 5. If the number of laborers is increased to 2, the new proportion between labour and land will be 2: 5. Due to change in the proportion of factors there will also emerge a change in total output at different rates. This tendency in the theory of production called the Law of Variable Proportion.

 

 

 

 

 

Law of variable proportions is based on following assumptions:

(i) Constant Technology: The state of technology is assumed to be given and constant. If there is an improvement in technology the production function will move upward.

(ii) Factor Proportions are Variable: The law assumes that factor proportions are variable. If factors of production are to be combined in a fixed proportion, the law has no validity.

(iii) Homogeneous Factor Units: The units of variable factor are homogeneous. Each unit is identical in quality and amount with every other unit.

(iv) Short-Run: The law operates in the short-run when it is not possible to vary all factor inputs.

 

Stages of Law of variable proportion

 

 

 

 

 

 

 

 

 

 

Law of Return to Scale:

In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale of production can be changed by changing the quantity of all factors of production.

Definition:

According to Koutsoyiannis “The term returns to scale refers to the changes in output as all factors change by the same proportion.”

According to Leibhafsky “Returns to scale relates to the behaviour of total output as all inputs are varied and is a long run concept”.

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Explanation:

In the long run, output can be increased by increasing all factors in the same proportion. Generally, laws of returns to scale refer to an increase in output due to increase in all factors in the same proportion. Such an increase is called returns to scale.

 

1. Increasing 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. This increase is due to many reasons like division external economies of scale.

2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation, where if all the factors of production are increased in a given proportion, output increases in a smaller proportion. It means, if inputs are doubled, output will be less than doubled. If 20 percent increase in labour and capital is followed by 10 percent increase in output, then it is an instance of diminishing returns to scale.

3.Constant Returns to Scale:

Constant returns to scale or constant cost refers to the production situation in which output increases exactly in the same proportion in which factors of production are increased. In simple terms, if factors of production are doubled output will also be doubled.

 

Iso-Quant

An isoquant is a firm’s counterpart of the consumer’s indifference curve. An isoquant is a curve that shows all the combinations of inputs that yield the same level of output. ‘Iso’ means equal and ‘quant’ means quantity. Therefore, an isoquant represents a constant quantity of output. The isoquant curve is also known as an “Equal Product Curve” or “Production Indifference Curve” or Iso-Product Curve.”

An Iso-product or Iso-quant curve is that curve which shows the different combinations of two factors yielding the same total product. Like, indifference curves, Iso- quant curves also slope downward from left to right. The slope of an Iso-quant curve expresses the marginal rate of technical substitution (MRTS).

Accounting to Bilas “The Iso-product curves show the different combinations of two resources with which a firm can produce equal amount of product.”

According to Samuelson “Iso-product curve shows the different input combinations that will produce a given output.”

 According to Ferguson “An Iso-quant is a curve showing all possible combinations of inputs physically capable of producing a given level of output.”

 

Assumptions:

The main assumptions of Iso-quant curves are as follows:

1. Two Factors of Production: Only two factors are used to produce a commodity.

2. Divisible Factor: Factors of production can be divided into small parts.

3. Constant Technique: Technique of production is constant or is known before hand.

4. Possibility of Technical Substitution: The substitution between the two factors is technically possible. That is, production function is of ‘variable proportion’ type rather than fixed proportion.

5. Efficient Combinations: Under the given technique, factors of production can be used with maximum efficiency.

 

Iso-Product Schedule:

Let us suppose that there are two factor inputs—labour and capital. An Iso-product schedule shows the different combination of these two inputs that yield the same level of output

Iso-Product Curve:

From the above schedule iso-product curve can be drawn with the help of a diagram. An. equal product curve represents all those combinations of two inputs which are capable of producing the same level of output. The Fig. 1 shows the various combinations of labour and capital which give the same amount of output. A, B, C, D and E.

Iso-Product Map or Equal Product Map:

An Iso-product map shows a set of iso-product curves. They are just like contour lines which show the different levels of output. A higher iso-product curve represents a higher level of output. In Fig. 2 we have family iso-product curves, each representing a particular level of output.

The iso-product map looks like the indifference of consumer behaviour analysis. Each indifference curve represents particular level of satisfaction which cannot be quantified. A higher indifference curve represents a higher level of satisfaction but we cannot say by how much the satisfaction is more or less. Satisfaction or utility cannot be measured.

Properties of Iso-Product Curves:

1. Iso-Product Curves Slope Downward from Left to Right:

They slope downward because MTRS of labour for capital diminishes. When we increase labour, we have to decrease capital to produce a given level of output.

2. Isoquants are Convex to the Origin:

Like indifference curves, isoquants are convex to the origin. In order to understand this fact, we have to understand the concept of diminishing marginal rate of technical substitution (MRTS), because convexity of an isoquant implies that the MRTS diminishes along the isoquant.

3. Two Iso-Product Curves Never Cut Each Other:

As two indifference curves cannot cut each other, two iso-product curves cannot cut each other. In Fig. 6, two Iso-product curves intersect each other. Both curves IQ1 and IQ2 represent two levels of output. But they intersect each other at point A. Then combination A = B and combination A= C. Therefore B must be equal to C.

4. Higher Iso-Product Curves Represent Higher Level of Output:

5. Isoquants Need Not be Parallel to Each Other:

It so happens because the rate of substitution in different isoquant schedules need not be necessarily equal. Usually they are found different and, therefore, isoquants may not be parallel 

6. No Isoquant can Touch Either Axis:

If an isoquant touches X-axis, it would mean that the product is being produced with the help of labour alone without using capital at all. 

7. Each Isoquant is Oval-Shaped.

It means that at some point it begins to recede from each axis. This shape is a consequence of the fact that if a producer uses more of capital or more of labour or more of both than is necessary, the total product will eventually decline. The firm will produce only in those segments of the isoquants which are convex to the origin and lie between the ridge lines.

Difference between Indifference Curve and Iso-Quant Curve:

The main points of difference between indifference curve and Iso-quant curve are explained below:

1. Iso-quant curve expresses the quantity of output. Each curve refers to given quantity of output while an indifference curve to the quantity of satisfaction. It simply tells that the combinations on a given indifference curve yield more satisfaction than the combination on a lower indifference curve of production.

2. Iso-quant curve represents the combinations of the factors whereas indifference curve represents the combinations of the goods.

3. Iso-quant curve gives information regarding the economic and uneconomic region of production. Indifference curve provides no information regarding the economic and uneconomic region of consumption.

4. Slope of an iso-quant curve is influenced by the technical possibility of substitution between factors of production. It depends on marginal rate of technical substitution (MRTS) whereas slope of an indifference curve depends on marginal rate of substitution (MRS) between two commodities consumed by the consumer.

Producer’s Equilibrium through an Iso quant

 

As we all know, producers generally strive hard to maximize profit at minimum cost. A producer can attain equilibrium by applying the least cost combination of factors of production to attain maximum profit.

Therefore, he/she needs to decide the appropriate combination among different combinations of factors of production to get maximum profit at least cost. The producers try to use ratios of factors in such a way so that maximum output can be obtained, while keeping the cost as low as possible. The decision of a producer depends on the principal of substitution. Suppose a producer has two factors of production, A and B. In these factors A can produce more output than B with the same amount of money spent on them.

This would make the producer to substitute A for B The producer equilibrium would be attained when the output produced by spending an additional unit of money (marginal rupee) on A is equal to the output produced by spending an additional unit of money on B. The producer would keep on substituting one input with the other to get maximum output till the producer equilibrium is not reached.