Principles of Economics First Semester (2022/2023)

LECTURE 3:

THE THEORY OF PRODUCTION, ITS FACTORS AND COSTS

Producing an economic good or service requires a combination of land, labour, capital and
entrepreneurs. The theory of production deals with the relationship between the factors of
production and the output of goods and services.

The theory of production generally is based on the short run, a period of production that allows
producers to change only the amount of the variable input called labour. This contrasts with the
long run, a period of production long enough for producers to adjust the quantities of all their
resources, including capital. For example, Ford Motors hiring 300 extra workers for one of its
plants is a short-run adjustment. If Ford builds a new factory, this is a long-run adjustment.

Basic Concepts of Production and Cost

Production – is the process of transforming resources into finished products. Alternatively, it is

the combination of inputs to form a desired output.

Inputs – these are the raw materials or resources used in the production of goods and services.

Output – refers to goods and services. It is the resulting outcome of the transformation process.

Fixed input – is an input that does not change during a given period of time. This time period can
be measured as the short run e.g. factory building is a fixed input

Variable input – is an input that can be changed during a given period of time. E.g. a firm’s
workforce (labour force) and raw materials can often be increased or decreased over a given
period of time.

Types of Production

Primary production is the production of organic compounds from atmospheric or aquatic

carbon dioxide, principally through the process of photosynthesis, with chemosynthesis being
much less important. All life on earth is directly or indirectly reliant on primary production.
Primary production involves the extraction of raw materials (e.g. coal, agricultural commodities,
iron ore). Raw materials can be:

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• Extracted – e.g. coal, iron ore, crude oil

• Harvested / collected – e.g. fish
• Grown – e.g. timber, cereal

There is little value added in primary production. the aim is usually to produce the highest
quantity at the lowest cost to a satisfactory standard.

Secondary production involves the transformation of raw materials into goods. There are two
main kinds of goods:

 Consumer goods – Goods bought by consumers for consumption purposes e.g. washing
machines, DVD Players.
 Industrial / capital goods – e.g. plants and machinery, complex information systems.
They are goods used by businesses themselves during the production process.

In the secondary production sector, value is “added” to the raw material inputs. For example
foodstuffs are transformed into ready meals for sale in supermarkets; metals, fabrics, and plastics
are transformed into motor vehicles. There are many different industry sectors in secondary
production. For example;

• Construction
• Electronic instruments
• Pharmaceuticals (drugs)
• House-building

Tertiary production is associated with the provision of services (an intangible product). As with
the secondary sector, there are many tertiary production markets. For example, hotels, private
healthcare and education, accounting.

The Factors of Production

The reason people cannot satisfy all their wants and needs is the scarcity of productive resources.
The factors of production, or resources required to produce the things we would like to have,

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are land, capital, labour, and entrepreneurs. As shown in the Diagram below, all four are
required if goods and services are to be produced.

The Factors of Production

Land Capital Labour Entrepreneurs

Land includes the Capital includes the tools Labour includes people Entrepreneurs are
“gifts of nature,” or equipment, and factories with all their efforts individuals who
natural resources used in production. and abilities. start a new not
created by business or bring
human effort. a product to
market.

Land: In economics, land refers to the “gifts of nature,” or natural resources not created by
humans. “Land” includes deserts, fertile fields, forests, mineral deposits, livestock, sunshine, and
the climate necessary to grow crops. Because only so many natural resources are available at any
given time, economists tend to think of land as being fixed, or in limited supply. It is the basic
factor of production and all products we use are traced to land.

For example, there is not enough good farmland to adequately feed all of the earth’s population,
nor enough oil and minerals to meet our expanding energy needs indefinitely. Because the supply
of a productive factor like land is relatively fixed, the problem of scarcity is likely to become
worse as population grows in the future.

Features of Land

 Land is a free gift of nature

 It is permanent and fixed
 It is limited in area, and is of great variety
 The value of land depends on its fertility and location
 The reward for land is rent

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Capital: Another factor of production is capital – the tools, equipment, machinery, and factories
used in the production of goods and services. Such items also are called capital goods to
distinguish them from financial capital, the money used to buy the tools and equipment used in
production. Unlike land, it is a man-made instrument of production which can be seen as a
wealth that is used in the production of another wealth. Capital is unique in that it is the result of
production. A bulldozer, for example, is a capital good used in construction. It also was built in a
factory, which makes it the result of earlier production. Like the bulldozer, the cash register in a
neighbourhood store is a capital good, as are the computers in your university lab that are used to
produce the service of education.

Functions of Capital

 Provision of Raw Material – capital provides industry with raw materials of suitable
quality for use in stages of production.
 Provision of Machinery and Appliances – capital by providing plant, machinery and tools
makes production quick, accurate and automatic.
 Provision of Subsistence – capital provides food, clothes, shelter etc. to enable workers,
to maintain themselves in the process of production which is roundabout and lengthy.
 Provision of Employment – investment of capital in agriculture, industry, trade, transport
etc. provides gainful employment to numerous people.
 Capital is also essential to create auxiliary services like transport, insurance, warehousing
etc.

Labour: A third factor of production is labour – people with all their efforts, abilities, and skills.
It can be described as the application of mental and physical powers of man to the
accomplishment of an economic result. Labour means the exertion of mind or body to earn some
income or means of satisfying his needs. This category includes all people except for a unique
group of individuals called entrepreneurs, which we single out because of their special role in the
economy.

Unlike land, labour is a resource that may vary in size over time. Historically, factors such as
population growth, immigration, famine, war, and disease have had a dramatic impact on both
the quantity and quality of labour.

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Features of Labour

 Labour sells his services and not himself

 He has feelings, emotions, linking etc
 Labour is less mobile and has bargaining power compared to capital

Efficiency of Labour – this means better result can be achieved with better work and systematic
efforts in respect of the job assigned. Efficiency is the measured power or ability of the labour to
produce results.

Efficiency depends on the following:

 Conducive climate leads to effective work

 Racial qualities or inborn capacity for hard work
 Physical ability – stamina, good health etc.
 Mental capacity – intelligence, judgement, presence of mind etc.
 Qualities of honesty, integrity, regularity and punctuality etc.
 Educational qualifications suited for the job on hand
 Adequate wages, regular payment, incentive bonus for better and quicker work stimulate
efficiency
 Reasonable hours of work with rest pauses and holidays ensure efficiency

 Security of employment

Entrepreneurs: Some people are special because they are the innovators responsible for much

of the change in our economy. Such an individual is an entrepreneur, a risk-taker in search of

profits and growth opportunities who does something new with existing resources to capitalize

on those opportunities. Entrepreneurs often are thought of as being the ability to start new

businesses or bring new products to market. They provide the initiative that combines the

resources of land, labour, and capital into new products.

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Why Entrepreneurship?

• To improve backwardness of the people.

• Economic development of the region.

• To analyse resource utilization.

PRODUCTION

When all factors of production – land, capital, labour, and entrepreneurs – are present,

production, or the process of creating goods and services, can take place. In fact, everything we

produce requires these factors. For example, the whiteboards, desks, and audio-visual equipment

used in universities are capital goods. The labour is in the form of services supplied by lecturers,

administration, and other employees. Land, such as the iron ore, granite, and timber used to make

the building and desks, as well as the land where the university is located, is also needed. Finally,

entrepreneurs are needed to organize the other three factors and make sure that everything gets

done.

Law of Variable Proportions

The Law of Variable Proportions states that, in the short run, output will change as one input is

varied while the others are held constant. Although the name of the law is probably new to you,

the concept is not. For example, if you are preparing a meal, you know that a little bit of salt will

make the food taste better. A bit more may make it tastier still. Yet, at some point, too much salt

will ruin the meal. As the amount of the input – salt – varies, so does the output – the quality of

the meal.

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The law of variable Proportions deals with the relationship between the input of productive

resources and the output of final products. The law helps answer the question: How is the output

of the final product affected as more units of one variable input or resource are added to a fixed

amount of other resources?

A farmer, for example, may have all the land, machines, workers, and other items needed to

produce a crop. However, the farmer may have some questions about the use of fertilizer. How

will the crop yield be affected if different amounts of fertilizers are added to fixed amounts of the

other inputs? In this case, the variable input is the fertilizer added per acre.

Of course, it is possible to vary all the inputs at same time. The farmer may want to know what

will happen to output if the fertilizer and other factors of production are varied. Economists do

not like to do this, however, because when more than one factor of production is varied, it

becomes harder to gauge the impact of a single variable on total output.

The Production Function

The Law of Variable Proportions can be illustrated by using a production function – a concept

that describes the relationship between changes in output to different amounts of a single input

while other inputs are held constant. The production function can be illustrated with a schedule,

such as the one in Diagram A or a graph like the one in Diagram B.

The production function can be mathematically stated as Q = f(L, K), where Q is the quantity of

output, L is the quantity of labour used, and K is the quantity of capital employed. This is

expression tells us that the maximum quantity of output the firm can get depends on the

quantities of labour and capital it employed.

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Note: Fixed and variable inputs are often connected with the period of time involved.

In the short run – is defined as a period of time during which one or more inputs cannot be

changed. If a firm is in the short run, some of its inputs cannot be changed. These inputs are fixed

with respect to the firm’s short run output decision. So, if it wants to increase or decrease its

short run output, it must do so by changing other inputs (its variable inputs) and the effect on

output of this change in a variable input while others are held constant is what we intend to

measure using this function.

In the long run – the firm can change all of its inputs when choosing how much output to

produce. Therefore, all inputs are variable in the long run.

Since in the short run at least one input is fixed, and the output can only change when we change

various amounts of the variable inputs. In this function we are looking at the change in output as

one input (labour) is changed while others (capital, land) are held constant.

The production schedule in the figure lists hypothetical output as the number of workers is varied

from zero to 12. With no workers, for example, there is no output. If the number of workers

increases by one, output rises to seven. Add yet another worker and total output rises to 20. This

information is used to construct the production function that appears as the graph in Diagram B.

where the variable input is shown on the horizontal axis with total production on the vertical

axis.

In this example, only the number of workers changes. No changes occur in the amount of

machinery used, the level of technology, or the quantities of raw materials – unprocessed

natural products used in production. Under these conditions, any change in output must be the

result of the variation in the number of workers.

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Total Product: the maximum quantity of output that can be produced with a given combination

of inputs (that is, q)

The second column in the production schedule in the Diagram A shows total product, or total

output produced by the firm. The numbers indicate that the plant barely operates when it has only

one or two workers. As a result, some resources stand idle much of the time.

Total Product Rises

As more workers are added, however, total product rises. More workers can operate more

machinery, and plant output rises. Additional workers also mean that the workers can

personalize. For example, one group runs the machines, another handles maintenance, and a third

group assembles the products. By working in this way – as a coordinated whole – the firm can be

more productive.

Total Product Slows

As even more workers are added output continues to rise, but it does so at a slower rate until it

can grow no further. Finally, the addition of the eleventh and twelfth workers causes total output

to go down because these workers just get in the way of the others. Although the ideal number of

workers cannot be determined until costs are considered, it is clear that the eleventh and twelfth

workers will not be hired.

Marginal Production: The marginal product is the additional output that results from adding

one more unit of labour i.e., MPL = ∆q/∆L.

The measure of output shown in the third column of the production schedule in Diagram A is an

important concept in economics. The measure is known as marginal product, the extra output or

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change in total product caused by the addition of one more unit of variable input. As we can see

in the diagram, the marginal product, or extra output of the first worker, is seven. Likewise, the

marginal product of the second worker – which is equal to the change in total product – is 13.

Together, both workers account for 20 units of total product.

Average Product: Total product or output divided by labour, in the schedule, i.e. AP L = q/L,

where L measures labour-hours. Even though there is no column for average product level, but

the average production level for the first two workers would be their total product of 20

divided by the number of labour which is 2, which equals 10 (Hence the AP for the first two

workers is 10)

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The Law of Variable Proportions: The Production Schedule

Number of Workers Total Product Marginal Product* Regions of

Production
0 0 0 Stage 1
1 7 7
2 20 13
3 38 18
4 62 24
5 90 28
6 110 20 Stage 2
7 129 19
8 138 9
9 144 6
10 148 4
11 145 -3 Stage3
12 135 -10
*All figures in terms of output per day

Diagram A
The Production Function

160

140

120

100

80

60

40

20

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Diagram B Vertical Axis = Total Product Horizontal Axis= Variable Input: Number of
Workers

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Three Stages of Production and the Law of Diminishing Marginal Returns

The law of diminishing marginal returns states that as one more unit of the variable input (labour)

is added to a fixed input (land and capital) total output will start to increase and then fall.

Diminishing returns to labour occurs when marginal product starts to fall. This means that total

output will increase at a decreasing rate when more workers are employed.

When it comes to determining the optimal number of variable units to be used in production,

changes in marginal product are of special interest. Diagram A shows the three stages of

production – increasing returns, diminishing returns, and negative returns – that are based on the

way marginal product changes as the variable input of labour is changed.

The behaviour of marginal product is linked directly to the productivity of each additional

worker. At low levels of employment, the fixed factors of production, land and capital are

underutilized. This means that each additional worker will have plenty of capital to use, as a

result, marginal product will rise. However, beyond a certain point the fixed factors of

production become scarcer and new workers will not have much capital to work with. Indeed,

eventually the workers will start to get in each other’s way. As a result, the productivity of each

additional worker falls. As the labour input increases, so the capital per worker ratio declines and

this can negatively affect overall productivity.

In stage 1, the first workers hired cannot work efficiently because there are too many resources

per worker. As the number of workers increases, they make better use of their machinery and

resources. This result in increasing returns (increasing marginal products) for the first five

workers hired.

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As long as each worker hired contributes more to total output than the worker before, total output

rises at an increasingly faster rate. Because marginal output increases by a larger amount every

time a new worker is added, stage 1 is known as the stage of increasing returns. Companies,

however, do not knowingly produce in stage 1 for very long. As soon as a firm discovers that

each new worker adds more output than the last, the firm is tempted to hire another worker.

In stage 2, the total production keeps growing, but by smaller and smaller amounts. Any

additional workers hired may stock shelves, package parts, and do other jobs that leave the

machine operators free to do their jobs. The rate of increase in total production, however, is now

starting to slow down. Each additional worker, then, is making a diminishing, but still positive,

contribution to total output.

Stage 2 illustrates the principle of diminishing returns, the stage where output increases at a

diminishing rate as more units of a variable input are added. In Diagram A, Stage 2 begins when

the sixth worker is hired, because the 20-unit marginal product of that worker is less than the

28unit marginal product of the fifth worker.

The third stage of production begins when the eleventh worker is added. By this time, the firm

has hired too many workers, and they are starting to get in each other’s way. Marginal product

becomes negative and total plant output decreases.

Most companies do not hire workers whose addition would cause total production to decrease.

Therefore, the number of workers hired would be found only in Stage 2. The extra number of

workers hired depends on the cost of each worker. If the cost is low, the firm should hire at least

six, but no more than 10, workers.

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Graphical relationship among TP, AP and MP

Graphically the law of diminishing marginal returns can be explained in three stages
as outline below:

• Stage 1 – at this stage of the production process any increase in the variable

input raises the average product; hence this is the stage of increasing

marginal returns.

• Stage 2 – at this stage in the production process any increase in the variable

input decreases average product, but the marginal product remains positive.

This stage in the production process is called constant marginal returns

• Stage 3 – this is the stage at which the use of the variable input will lead to

negative values of the marginal product hence this is the stage of decreasing

marginal returns or diminishing marginal returns.

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COSTS OF PRODUCTION

SHORT-RUN COSTS: Total and Average Costs

Since it is now clear how much a firm would produce with different amount of the variable unit

(labour), it is also good to know the cost of these inputs in producing any given amount of

output. Apparently, it would depend on the prices of the inputs necessary to produce the output.

Fixed Costs: These are costs on fixed inputs that do not change over time. Example cost on rent,

plant and machinery.

Variable Costs: These are costs on variable inputs that changes over time. Example cost on

wages of labourers.

Total Cost: Is the sum of the fixed costs and variable costs: Expressed as TC = TFC + TVC

Average Total Cost (ATC): It’s the cost per unit of output. Expressed as ATC = TC/q Where q

= the output

Average Fixed Cost (AFC): The AFC is always falling. Why? The total fixed cost is by

definition fixed at the numerator. Therefore, as the denominator (q) increases, the AFC must fall.

Average Variable Cost (AVC): Is concave to the origin (Bowl shaped), it falls for a while and

then rises eventually. Why? It’s closely related to the average product of labour. AVC is

payments to variable inputs such as labour. The total payments to labour are wL, where w is the

wage, and so AVC = wL/q. We already know that APL = q/L, which we saw earlier rises and

then falls, when q/L increases, that means L/q decreasing, and that means it takes fewer workers

per unit of output. And that means the labour cost per unit of output; wL/q is also declining.

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Therefore, when APL is getting bigger, the number of workers per unit of output is declining.

And that means labour cost per unit is falling as well. The reverse is also true: when APL is

falling, the labour cost per unit is rising. Thus:

Increasing APL decreasing AVC Decreasing

APL increasing
AVC

Average Total Cost (ATC): It is the sum of the AVC and AFC. The ATC is shaped just like the
AVC, a bowl shape. But the existence of overhead spreading (through AFC) causes it to be
decreasing for longer.

Marginal Cost (MC): It’s the additional cost of producing one more unit of output. It is expressed
as MC = ∆TC/∆q, where the change is q is usually one.

Relationship between Average Cost and Marginal Cost curves

From the above diagram the average cost is falling whenever the marginal cost is below it and
rising whenever marginal cost is above it. As a result, MC must cross ATC at its minimum point.
MC also crosses AVC at its minimum point, which is to the left of ATC’s lowest point.

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LONG RUN COST

In the long run, all factors of production vary and the firm can change its size to meet the changes

in demand. In other words, there are no fixed costs in the long run.

Long Run Average Cost (LRAC) Curve

The long run average cost curve is the total cost per unit of output when the firm varies all its

factors of production so that it uses the most profitable size of the plant and combine the best

proportion of fixed and variable inputs for any given output.

SRATC1 SRATC
SRATC 2 3

LRATC

The U-shape of the LRAC reflects the law of returns to scale. Initially the long run average costs

decreases as the output increase due to economies of scales. When there are economies of scale

and diseconomies of scale is yet to set in the LRAC curve would reach its minimum point. At the

minimum of the LRAC the firm is employing the optimal plant size and operating this plant to

full capacity. If the plant size increases further than the optimal size there will be diseconomies

of scale and cause the LAC to turn upwards. The LAC curve is U-shaped but its sides are flatter

than the u-shaped SACs.

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ECONOMIES AND DISECONOMIES OF SCALES

Economies of scale occurs when output increases proportionately more than cost. For

instance, the firms can double its outputs by less than doubling it costs of production. This

takes place because of specialization – not just specialization among the tasks given to

workers but also specialization in the use of capital.

Diseconomies of scale occur when output increases proportionately less than cost. It takes

place when the cost of large-scale activities is greater than the benefits of specialization and

mass production. Too many layers in management, difficulty of communication, problems

with monitoring would lead to diseconomies of scale. Strike by trade unions for higher pay

would also prompt diseconomies of scale.

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In the LRATC curve economies and diseconomies of scale are respectively the downward

sloping and upward sloping portions of the curve. Economies of scale mean q increases a higher

rate than LRTC, so LRTC/q must decline, and vice versa for diseconomies of scale. In addition,

a LRATC may have a flat section in the middle. This section is called constant returns to scale.

Economies of scale are important because:

 Firstly, because a large business can pass on lower costs to customers through lower
prices and increase its share of a market. This poses a threat to smaller businesses that can
be “undercut” by the competition
 Secondary, a business could choose to maintain its current price for its product and accept
higher profit margins.

There are two main types of economies of scale:

• Internal and
• External

Internal economies of scale have a greater potential impact on the costs and profitability of a
business.

Internal Economies of Scale

Internal economies of scale relate the lower unit costs a single firm can obtain by growing in size
itself. There are five types of internal economies of scale.

Bulk-buying Economies: as businesses grow they need to order large quantities of production

inputs. For example, they will order more raw materials. As the order value increases, a business

obtains more bargaining power with suppliers. It may be able to obtain discount and lower prices

for the raw materials.

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Technical Economies: businesses with large-scale production can use more advanced machinery

(or use existing machinery more efficiently). This may include using mass production

techniques, which are a more efficient form of production. A larger firm can also afford to invest

more in research and development.

Financial Economies: many small businesses find it hard to obtain finance and when they do

obtain it, the cost of the finance is often quite high. This is because small businesses are

perceived as being riskier than larger businesses that have developed a good track record. Larger

firms therefore find it easier to find potential lenders and to raise money at lower interest rates.

Marketing Economies: every part of marketing has a cost – particularly promotional methods

such as advertising and running a sales force. Many of these marketing costs are fixed costs and

so as a business gets large, it is able to spread the cost of marketing over a wider range of

products and sales – cutting the average marketing cost per unit.

Managerial Economies: as a firm grows, there is greater potential for managers to specialize in

particular tasks (e.g. marketing, human resource management, finance). Specialist managers are

likely to be more efficient as they possess a high level of expertise, experience and qualifications

compared to one person in a smaller firm trying to perform all of these roles.

External Economies of Scale

External economies of scale occur when a firm benefit from lower unit costs as a result of the
whole industry growing in size. The main types are:

Transport and Communication Links improve; as an industry establishes itself and grows in

particular region, it is likely that the government will provide better transport and communication

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links to improve accessibility to the region. This will lower transport costs for firms in the area as

journey times are reduced and also attract more potential customers.

Development of research and development facilities that several businesses in an area can benefit

from.

Relocation of component suppliers and other support businesses close to the main centre of

manufacturing are also an external cost saving.

Checking for Understanding

• Using a graphic organizer to list what occurs during the three stages of production
explain how production activity is affected by a change in inputs
• Describe the relationship on which the theory of production is based.
• Explain how marginal product changes in each of the three stages of production.
• Discuss the relationship between the different costs of production.

Reading Assignment

Read on the following:

• Productivity,
• Division of labour and
• Specialization

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PRACTICE PROBLEM

PART 1
Madam Fozieh’s Frozen Yogurt is a small shop that sells cups of frozen yogurt at Mokonde.
Madam Fozieh owns three frozen-yogurt machines. Her other inputs are refrigerators, frozen-
yogurt mix, cups, sprinkle toppings, and, of course, workers. She estimates that her daily
production function when she varies the number of workers employed (and at the same time, of
course, yogurt mix, cups, and so on) is as shown in the accompanying table.
Quantity of Quantity of
Labor Frozen Yogurt
(Workers) (Cups)
0 0
1 110
2 200
3 270
4 300
5 320
6 330

a. What are the fixed inputs and variable inputs in the production of cups of frozen yogurt?

b. Draw the total product curve. Put the quantity of labor on the horizontal axis and the quantity
of frozen yogurt on the vertical axis.

c. What is the marginal product and average product of the first to sixth worker and show this on
the same schedule and graph where the total product is drawn? Explain the relationship
between them? Why does marginal product decline as the number of workers increases?

PART 2

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The production function for Madam Fozieh’s Frozen Yogurt is given in PART 1 above. She pays
each of her workers $80 per day. The cost of her other variable inputs is $0.50 per cup of yogurt.
Her fixed cost is $100 per day.

d. What is Fozieh’s variable cost and total cost when she produces 110 cups of yogurt? 200 cups?
Calculate variable, total and average total costs for every level of output given in PART 1.

e. Draw Madam Fozieh’s variable cost curve. On the same diagram, draw her total cost curve.

f. What is the marginal cost per cup for the first 110 cups of yogurt? For the next 90 cups?
Calculate the marginal cost for all remaining levels of output.

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