MBA.

Sem- I PRODUCTION

PRODUCTION
Meaning, Factors and Law of Diminishing Return

©All Right Reserved

Prepared by
ANIL KUMAR SINGH
Assistant Professor; Department of Business Administration
SACHCHIDANAND SINHA COLLEGE, AURANGABAD, BIHAR

1
Notes by Prof. ANIL KUMAR SINGH Ph: 9471838900
MBA. Sem- I PRODUCTION

INTRODUCTION TO PRODUCTION
Production is an important economic activity which satisfies the wants and needs of the people.
Production is the method of turning raw materials or inputs into finished goods or products in a
manufacturing process. In other words, it means the creation of something from basic inputs.
Production may also refer to the goods being produced. For instance, some business call a set of
products being produced at the same time a production run.
In economics, Production is a process of transforming tangible and intangible inputs into goods or
services. Raw materials, land, labour and capital are the tangible inputs, whereas ideas, information
and knowledge are the intangible inputs. These inputs are also known as factors of production.

DEFINITION OF PRODUCTION
According to James Bates and J.R. Parkinson - ‘Production in Economics can be defined as an
organised activity of transforming physical inputs (resources) into outputs (finished products), which
will satisfy the products’ needs of the society’.

According to J.R. Hicks – ‘Production in Economics is an activity whether physical or mental, which is
directed to the satisfaction of other people’s wants through exchange’.

CONCEPT OF PRODUCTION
Production in Economics can be defined as the process of converting the inputs into outputs. Inputs
include land, labour and capital, whereas output includes finished goods and services.
In other words, Production in Economics is an act of creating value that satisfies the wants of the
individuals.
Organisations engage in production for earning maximum profit, which is the difference between the
cost and revenue. Therefore, their production decisions depend on the cost and revenue. The main
aim of production is to produce maximum output with given inputs.

NATURE OF PRODUCTION
1. Production implies the making of a commodity or the supplying of a Service.
2. It is different from Creation.
3. As the saying goes “God creates but man produces”
4. Creation implies the production of something out of nothing.
5. Production on the other hand refers to the making of a Commodity or Service out of something
else.
TYPES OF PRODUCTION
For Study purposes, It is necessary to classify production into three main group:
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
Notes by Prof. ANIL KUMAR SINGH Ph: 9471838900
MBA. Sem- I PRODUCTION

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 defense, are also included.

FACTORS OF PRODUCTION
Types of Production in Economics are the inputs that are used for producing the final output
with the main aim of earning an economic profit.

There are four main factors of production. Each and every factor is important and plays a
distinctive role in the organization. Factors of production include resource inputs used to
produce goods and services. Economist categories input factors into four major categories such
as Land, Labour, Capital and Enterprise/organization.

LAND

FACTORS OF LABOUR

PRODUCTION
CAPITAL

ENTERPRISE
Factors of Production

1. LAND: In ordinary sense ‘land’ refers to the soil or the surface of the earth or ground. But,
in Economics, land means all gifts of Nature owned and controlled by human beings which yield
an income. Land is the original source of all material wealth. The economic prosperity of a
country depends on the richness of her natural resources. The quality and quantity of
3
Notes by Prof. ANIL KUMAR SINGH Ph: 9471838900
MBA. Sem- I PRODUCTION

agricultural wealth are determined by the nature of soil, climate and rainfall. The agricultural
products are the basis of trade and industry. Industry survives on the availability of coal-mines
or waterfall for electricity production. Hence, all aspects of economic life like agriculture, trade
and industry are generally influenced by natural resources which are called as “Land” in
economics. 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.

CHARACTERISTICS OF LAND

· Land is a primary factor of production.

· Land is a passive factor of production.

· Land is the free gift of Nature.

· Land has no cost of production.

· Land is fixed in supply. It is inelastic in supply.

· Land is permanent.

· Land is immovable.

· Land is heterogeneous as it differs in fertility.

· Land has alternative uses.

· Land is subject to Law of Diminishing Returns.

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. The supply of labour is affected by the change in
its prices. It increases with an increase in wages. The return for labour is called wages and
salary.

4
Notes by Prof. ANIL KUMAR SINGH Ph: 9471838900
MBA. Sem- I PRODUCTION

CHARACTERISTICS OF LABOUR
· Labour is the animate factor of production.
· Labour is an active factor of production.
· Labour implies several types: it may be manual (farmer) or intellectual
(teacher, lawyer etc).
· Labour is perishable.
· Labour is inseparable from the Labourer.
· Labour is less mobile between places and occupations.
· Labour is a means as well as an end. It is both the cause of production
and consumer of the product.
· Labour units are heterogeneous.
· Labour differs in ability.
· Labour-supply determines its reward (wage).
· Labour has weak bargaining power.

NOTE: Labour differs from land in an important way. While land is a stock, labour is a flow. The
term ‘labour’ is used to refer to the flow of labour service per unit of time. So labour is perishable.
If we do not make use of today’s labour power, a correspondingly large amount is not made
available tomorrow (and in future).

A related, but important point should be noted in this context. The worker sells his services in the
market, but retains his capital (working ability). In other words, what is bought and sold is the
service of labour, not labour itself. A firm cannot buy and sell labour in the same way that it can
buy land and capital.

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.
Economists use the term capital to mean goods used for further production. In the business world,
however, capital is always expressed in terms of money. The business-person thinks of money as

5
Notes by Prof. ANIL KUMAR SINGH Ph: 9471838900
 MBA. Sem- I PRODUCTION

capital because he can easily convert money into real resources like tools, machines and raw
materials, and use these resources for the production of goods.
Physical capital includes tangible resources, such as buildings, machines, tools and equipment, etc.
Human capital includes knowledge and skills of human resource, which is gained by education,
training and experience. Return for capital is termed as interest.

CHARACTERISTICS OF CAPITAL
 Capital is a man-made factor.
 Capital is mobile between places and persons.
 Capital is a passive factor of production.
 Capital’s supply is elastic.
 Capital’s demand is a derived demand.
 Capital is durable.

TYPES OF CAPITAL
 Fixed capital
 Circulating capital
 Real capital
 Human capital
 Tangible capital
 Individual capital
 Social Capital
4. ENTERPRISE/ORGANISATION: The man behind organizing the business is called as
‘Organizer’ or ‘Entrepreneur’. An organiser is the most important factor of production.
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.

6
Notes by Prof. ANIL KUMAR SINGH Ph: 9471838900
MBA. Sem- I PRODUCTION

FUNCTION OF AN ORGANISER/ENTREPRENEUR
Initiation: An organizer is the initiator of the business, by considering the situation and
availability of resources and planning the entire process of business or production.

Innovation: A successful entrepreneur is always an innovator. He introduces

new methods in the production process.

Coordination: An organizer applies a particular combination of the factors of production

to start and run the business or production.

Control, Direction and Supervision: An organiser controls so that nothing prevents

the organisation from achieving its goal. He directs the factors to get better results and
supervises for the efficient functioning of all the factors involved in the process of
production.

Risk-taking and Uncertainty-bearing: There are risk-taking and uncertainty-

bearing obstacles. Risks may be insured but uncertainties cannot be insured. They
reduce the profit.

PRODUCTION FUNCTION
Production may be defined as a process through which a firm transforms inputs into
output. It is the process of creating goods and services with the help of factors of
production or inputs for satisfaction of human wants. In other words, ‘transformation of
inputs into output’ whereby value is added, is broadly called production. Whatever is
used in the production of a commodity is called input. For example, in the production of
wheat, the use of land, seed, fertilizer water, pesticides, tractors, labour etc. are inputs
and wheat is output. The relationship between inputs and output of a commodity
depends upon the state of technology because with the help of advanced technology
more can be produced with the help of same inputs or same output can be produced
with the help of less inputs.

In economics, production function refers to the physical relationship between inputs

and output under given technology. In other words production function is a
mathematical functional/technical/engineering relationship between inputs and output
such that with a given combination of factor inputs and technology at a given period of

7
Notes by Prof. ANIL KUMAR SINGH Ph: 9471838900
MBA. Sem- I PRODUCTION

time, the maximum possible output can be produced. Such as land, labour capital and
entrepreneurship.
If there are two factor inputs: labour (L) and capital (K), then production function can be
written as:
Qx = f (L, K)
where Qx is the quantity of output of commodity x, f is the function and L and k are the
units of labour and capital respectively. It says that quantity of output depends on units
of labour on capital used in production.

Here two points are worth considering. Firstly, production function must be considered
with reference to particular period of time i.e. short period and long period:

(i) Short run production function: A production function that shows the changes in output
when only one factor is changed while other factor remains constant is termed as a short run
production function.
(ii) Long run production function: A long run production function studies the impact on
output when all the factors of production can be changed simultaneously and in the same
proportion. So in the long run size of operation of the firm can be expanded or contracted
depending on the fact that the factors of production are increased or decreased.

MANAGERIAL USES OF PRODUCTION FUNCTION:

Production functions are logical and useful. Production analysis can be used as aids in
decision making because they can give guidance to obtain the maximum output from a
given set of inputs and how to obtain a given output from the minimum aggregation of
inputs. The complex production functions with large numbers of inputs and outputs are
analyzed with the help of computer based programmes.

LAW OF DIMINISHING RETURN

Law of diminishing returns explains that when more and more units of a variable input
are employed on a given quantity of fixed inputs, the total output may initially increase
at increasing rate and then at a constant rate, but it will eventually increase at
diminishing rates.

8
Notes by Prof. ANIL KUMAR SINGH Ph: 9471838900
MBA. Sem- I PRODUCTION

In other words, the total output initially increases with an increase in variable input at
given quantity of fixed inputs, but it starts decreasing after a point of time.

According to G. Stigler, “As equal increments of one input are added; the inputs of
other productive services being held, constant, beyond a certain point the resulting
increments of product will decrease, i.e., the marginal product will diminish.”
According to F. Benham, “As the proportion of one factor in a combination of factors
is increased, after a point, first the marginal and then the average product of that factor
will diminish.”
In the words of Alfred Marshall, “An increase in the Capital and Labour applied
in the cultivation of land causes, in general, less than proportionate increase in
the amount of produce raised unless it happens to coincide with an
improvement in the art of agriculture.”
Assumptions made for the application of law of diminishing returns
i. Assumes labor as an only variable input, while capital is constant

ii. Assumes labor to be homogeneous

iii. Assumes that state of technology is given

iv. Assumes that input prices are given

Significance of Law of Diminishing Returns

The law of diminishing returns can be applied in a number of practical situations. The
law has implication in most of the productive activities, but cannot be applied in all
productive activities. Therefore, it cannot be applied universally. The application of this
law has been seen more in agricultural production rather than industrial production.

This is because the inputs in agriculture production are natural, while in industrial
production, inputs are generally manmade. Therefore, if increasing variable input is
applied to fixed inputs, then the marginal returns start declining.

9
Notes by Prof. ANIL KUMAR SINGH Ph: 9471838900
MBA. Sem- I PRODUCTION

Law of diminishing returns helps mangers to determine the optimum labor required to
produce maximum output. In addition, with the help of graph of law of diminishing
returns, it becomes easy to analyze capital-labor ratio.

The Law Of Returns To Scale

In the long run the fixed inputs like machinery, building and other factors will change
along with the variable factors like labour, raw material etc. With the equal percentage
of increase in input factors various combinations of returns occur in an organization.
Returns to scale: the change in percentage output resulting from a percentage change
in all the factors of production. They are increasing, constant and diminishing returns to
scale.
Increasing returns to scale may arise: if the output of a firm increases more than in
proportionate to an increase in all inputs. For example the input factors are increased by
50% but the output has doubled (100%).
Constant returns to scale: when all inputs are increased by a certain percentage the
output increases by the same percentage. For example input factors are increased by
50% then the output has also increased by 50 percentages. Let us assume that a laptop
consists of 50 components; we call it as a set. In case the firm purchases 100 sets they
can assemble 100 laptops but it is not possible to produce more than 100 units.
Diminishing returns to scale: when output increases in a smaller proportion than the
increase in inputs it is known as diminishing return to scale. For example 50% increment
in input factors lead to only 20% increment in the output.

10
Notes by Prof. ANIL KUMAR SINGH Ph: 9471838900