Theory of Production, Cost and Revenue

1. Definition of Production

  • Production is the process of converting inputs into useful outputs.
    • Change in form: Raw materials transformed into finished goods.
    • Change in place: Supply chain, factory to retailer.
  • It includes all activities that increase the utility or value of goods and services.

2. Basic Concepts of Production Theory

  • Input: A good or service used in the production process.
    • Anything a firm buys for use in its production process.
    • Examples: Land, labor, capital, and entrepreneurship.
  • Output: Any good or service that results from a production process.
  • Fixed Inputs: Do not change in the short run (e.g., land).
    • Technically, an input that remains constant for a certain level of output.
  • Variable Inputs: Can change in the short run (e.g., labor).
    • Technically, an input that changes with changes in output.
  • Short Run: At least one input is fixed; changes in output are achieved by changing the usage of variable inputs.
  • Long Run: All inputs are variable, and output is changed by varying the usage of all inputs.

3. Factors of Production

  • Classical factors: Land, labor, and capital.
  • Modern factors: Includes entrepreneurship.

Land

  • In economics, 'land' refers to all free gifts of nature.
    • Includes natural resources, soil fertility, water, air, light, heat, and natural vegetation.

Characteristics of Land

  • (i) Free gift of nature: No human effort is required to make land available for production. It has no supply price.
  • (ii) Fixed supply: Land is limited in quantity. The total supply of land is perfectly inelastic from an economy's point of view but relatively elastic from a firm's point of view.
  • (iii) Permanent and indestructible: Land is permanent and cannot be destroyed. Ricardo stated that land possesses original and indestructible powers.
  • (iv) Passive factor: Land does not produce anything on its own without human effort.
  • (v) Immobile: Land cannot be shifted geographically from one place to another.
  • (vi) Multiple uses: Land can be used for various purposes, though its suitability varies.
  • (vii) Heterogeneous: No two pieces of land are alike; they differ in fertility and situation.

Labour

  • 'Labour' means any mental or physical exertion directed to produce goods or services.
    • All human efforts of body or mind undergone to secure an income, apart from the pleasure derived directly from the work, are termed as labour.

Characteristics of Labour:

  • (1) Human Effort: Labour is directly connected with human efforts, unlike other factors. Leisure, fair treatment, and a favorable work environment are essential for laborers.
  • (2) Perishable: Labour is highly perishable; a day’s labour lost cannot be completely recovered.
  • (3) Active factor: Land and capital may not produce anything without the active participation of labour.
  • (4) Inseparable from the labourer: A labourer must be physically present where their services are delivered. The labourer sells their labour against wages but retains the capacity to work.
  • (5) Heterogeneous: Labour power differs from person to person, depending on inherent and acquired qualities, work environment, and incentives.
  • (6) Poor bargaining power: Labour has a weak bargaining position because it cannot be stored. Labourers are often compelled to work at wages offered by employers and can be exploited.
  • (7) Mobile: Labour can move from one job to another or from one place to another, although there may be obstacles to free movement.

Capital

  • Capital is that part of an individual's or community's wealth used for further production of wealth.
    • Capital refers to all man-made goods used for further production of wealth.

Types of Capital:

  • Fixed capital: Exists in a durable shape and provides a series of services over time (e.g., tools, machines).
  • Circulating capital: Performs its function in production in a single use and is then not available for further use (e.g., seeds, fuel, raw materials).
  • Real capital: Physical goods such as buildings, plants, and machines.
  • Human capital: Human skill and ability, developed through investment.
  • Tangible capital: Can be perceived by the senses.
  • Intangible capital: Exists in the form of certain rights and benefits that cannot be perceived by the senses (e.g., patents, goodwill, patent rights).
  • Individual capital: Personal property owned by an individual or a group.
  • Social capital: Belongs to society as a whole (e.g., roads, bridges).

Entrepreneur

  • The entrepreneur mobilizes factors of production, combines them in the right proportion, initiates the production process, and bears the risks involved.

Functions of an Entrepreneur:

  • Initiating business enterprise and resource co-ordination.
  • Risk bearing or uncertainty bearing.
  • Innovations.

4. Production Function

  • A production function shows the relationship between input and output.
  • Q = f(L, K), where Q is output, L is labor, and K is capital.
  • Helps firms in resource allocation and planning.

5. TP, AP, MP in Short Run

  • Total Product (TP): Total quantity of output.
  • Average Product (AP): Total Product divided by units of input.
  • Marginal Product (MP): Additional output from one more unit of input.
  • MP = ΔTP / ΔL
  • AP = TP / L

6. Law of Diminishing Returns

  • States that as more units of a variable input (e.g., labor) are added to fixed inputs (e.g., land or capital), the extra output from each new input decreases.
  • Example: Adding more workers initially increases total output quickly, but eventually, each additional worker adds less and less.
  • This law applies only in the short run where at least one input is fixed.
  • Assumes constant technology and quality of input.

Assumptions of the Law

  • The state of technology is constant.
  • Only one input should be variable, keeping other inputs constant.
  • The law doesn't apply where fixed proportions of inputs are required.
  • Only physical inputs and outputs are considered, not economic profitability in monetary terms.

Stages of the Law of Diminishing Returns

  • Three stages: Increasing, diminishing, and negative returns.

Stage I: Increasing Returns

  • Total output increases at an increasing rate with each additional unit of the variable input.
  • Example: If a machine requires four workers for its optimum utilization, and currently, two workers operate it, adding another worker would lead to an increase in output. Further addition of a worker would lead to optimum utilization and hence production would increase.

Stage II: Diminishing Returns

  • Total product keeps increasing, but at a diminishing rate.
  • The end of this stage is marked by the total product attaining its maximum value and the marginal product becoming zero.

Stage III: Negative Returns

  • Starts from the maximum point of the TP curve.

  • The TP curve starts to decline, and the MP curve becomes negative, coupled with a fall in the AP curve.

  • Excessive addition of variable inputs leads to negative returns due to crowding of variable factors.

  • There is no coordination, and hence the output falls.

  • As more of a variable input is added to a fixed input, output increases at a decreasing rate.

  • Assumes constant technology and homogeneous input.

  • Three stages: Increasing, diminishing, and negative returns.

7. Law of Returns to Scale

  • Explains output change when all inputs change proportionally.
  • Increasing Returns to Scale: Output increases by a greater proportion than inputs.
  • Constant Returns to Scale: Output increases by the same proportion as inputs.
  • Decreasing Returns to Scale/ Diminishing returns to scale: Output increases by a smaller proportion than inputs.

8. Cost Analysis

  • Cost: The value of resources used in production.
  • Fixed Cost: Business expenses that do not depend on the level of goods or services produced.
  • Total Fixed Cost (TFC): Total cost for all fixed inputs of the firm per time.
  • Variable Cost (TVC): Costs that change in proportion to the good or service produced.
  • Total Cost (TC): Sum of fixed costs and variable costs.
  • TC = TFC + TVC
  • Average Cost/Unit Cost: Production cost per unit of output, computed by dividing the total of fixed costs and variable costs by the total units produced.
    • Lower average costs are a potent competitive advantage.
  • AVC = (FC + VC) / Total Output
  • Marginal Cost (MC): Additional cost incurred for the production of an additional unit of output.
  • MC= TC/ Q
    • TC = Change in Total Cost and Q = Change in Quantity
  • Short-run includes fixed and variable costs; long-run all costs are variable.

9. Revenue Concepts

  • Revenue: The total amount of money a firm receives from selling a given quantity of goods or services at a particular price.
  • Total Revenue (TR): The overall income a firm receives.
  • TR = P × Q
    • Example: If a company sells 100 units at TZS 500 each, TR = 100 × 500 = TZS 50,000
  • Average Revenue (AR): Revenue per unit sold.
  • AR = TR / Q
  • Marginal Revenue (MR): Additional revenue generated by selling one more unit.
  • MR = ΔTR / ΔQ