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CHAPTER 6 :

THEORY OF PRODUCTION

Definition of production : Production mean the process of using the services of labour and machine along with natural resources and raw materials (factors of production) to produce goods and services. In other means, we can say that production is the process of transforming input to output. Input processing Output

Factor of production (input) refer to those goods and services which assist the production process like natural resources, labour, capital and interpreneur. Output give a mean what we get after finish process in production or refer to finished goods.

Classification of factor of production: We can divide inputs into the broad categories of labour, materials, capital and entrepreneur, each of which might include more narrow subdivision. In microeconomics, input for the production divided into four factors of production: 1. Land Land means to all natural resources or gift s of nature which are available for free such as land surface, air, lake, water, minerals, forest, seas, mountains, and others. In other word, land includes all natural resources that are not made by human. Land is most important source in starting point to make a production . For example, in food industry land is important to build factory or plants in order to start the production. Further natural resource such water is used in mixing process and flour is used to make bread as well as other materials in processing to make a final product.

2. Labour Labour refers to all activities, physical or mental, which are undertaken by man in exchange for a monetary reward. Labour one more important factor in play role in production, because natural resources of a country cannot be utilized if the absence of

labour. Labor inputs include skilled worker and unskilled worker. Example of labours are teacher, doctor, lawyer, prime minister, designers, and managers used their mental talents in production process. Meanwhile, farmer, factory workers, construction workers, clerks, farmer will use their physical strength in production . Their services will count in hours they working.

3. Capital Capital refer that part of man-made wealth, which is used in further producing wealth. Factories, building, tools, machinery, lorry example of capital. Money also can consider as capital if contributed and employed in business or production. However, if that money used as investment in stock market, its not considered as capital because its not involve in production of out output. If dont have capital, production cannot processed although have land and labour. In other word, capital is what all whealth used to produce more good and services. For example of capital is machine operation production used to process bread. However, have different between capital goods and consumer goods. Consumer products refer to finished good, used customer. For example, in the production of bread, machine production is capital and bread is a consumer good.

4. Entrepreneur Entrepreneur refer to combination of three factors of production; land, labour and capital together, organizing, bearing the risk and uncertainties in production and coordinating their working. An entrepreneur must be a person who have intelligence, ability and capability to take decision, complete knowledge about business, innovation, inspire confidence in others and also updated with latest development in his/her area of business. Entrepreneur most important person in factor of production, because, if dont have entrepreneur, all process and procedures cannot running.

Production Function Production of goods and services involves transforming resources such as labor power, raw materials, and the services provided by facilities and machines (input) into finished products. In the production process, firm turn inputs, which are also called factors of production, into output (product). For example, a bakery uses inputs that include the labor of its workers; raw materials, such as flour and sugar; and the capital invested in its ovens, mixers, and other equipment to produce such outputs as bread, cake, and pastries. A production function is a statement of the functional relationship between inputs and outputs; where it shows the maximum output that can be produced with given input. Production function can be applied to every good and service produced such as manufacturing goods, agriculture goods and anything else that involve production process. Production function can be represented in the form of a mathematical equal such as: Q = f (L, K) where Q is the quantity of output produced per unit of time, L is the quantity of labor used (in term of hours spent in the production process), and K is the quantity of capital employed (number of machine). This expression tells us that the maximum quantity of output the firm can get depends on the quantities of labor and capital it employs. The more inputs are used in production, the more will be amount of output produced. Every firm can decide to use various combinations of inputs in production function. The output can be produced in many ways. Based on production function, firm can choose to use more capital units and less labour units or beside that. For example in manufacturing sector, the sector can be labour intensive by hiring cheap worker or can be capital intensive with fewer worker.

Time Frame for Production Function Time is an factor for firm adjust their input to transform to output. Have a two types of time frame in running business; 1) short run time 2) long run time

Short time period refer to a time frame where at least one of the input (factor of production) cannot be varied practically, but the other inputs are variable. The input that cannot be varied practically in the short time period is called fixed input. Fixed input is an input in which the company does not change according to output. For example, machinery, land, building, tool, equipment and others. Long term period refer to a time frame in which all inputs are variable. At this time, firm has enough time to adjust all their input, because that in the long run time, all fixed inputs do not exist and all the input are variable. Suppose that one day a bakery company has more work than its crew can handle. Even if it wanted to, the firm does not have time to buy or rent an extra production machine to produce bread; these inputs are fixed in the short run. However, in the long run, the firm can adjust all inputs. If the firm want to produce more bread every day, it can hire more full-time workers and purchase a second production machine.

Short-Run Production: One Variable and One Fixed Input In short-run, at least one of input is fixed (capital) and another input are variable. In this production, only two inputs are used in the production; labour and capital. So, when the firm to increase the production, they only can increase the amount of variable input, that is labour. Short run production can calculated as:

Q=f(L,K) where Q is the quantity of output, L is the quantity of labor used, and K is the fixed input of capital. Example the shortrun production process is a firm that produces MP3 player. The firm cannot increase the capital such as machine production to increase output in the short run, but the firm can hire more labours in order to increase the output. The firm can also pay extra to the current labour to work overtime to increase the production.

Capital (Fixed input) 10 10 10 10 10 10 10 10 10 10 10

Labour (Variable input) 0 1 2 3 4 5 6 7 8 9 10

Total Product 0 10 30 60 80 95 108 112 112 108 100

Marginal Product 10 20 30 20 15 13 4 0 -4 -8

Average Product 10 15 20 20 19 18 16 14 12 10

Stages of Production

Rajah 6.1 Total product Total product is the amount of output produced when a given amount of that input is used along with fixed inputs. Table 6.1 shows the relationship between total product and labour with capital fixed for a firm producing MP3 Player. The first column table shows the amount of capital used that fixed in production process. From the table, when the amount of labour increase in production,the total product or output also will increase. The total produce increase initially but will decline at later stage as the number of labour increases which is shown in column three.

When the fim uses zero worker, production cannot produce output. When uses one labour, the output MP3 player will increase to 10 units. As the firm increase the labour from 1 to 2, the output will increase from 10 units to 30 units. The firm can increase additional labour to increase the production until maximum output. In the table, the maximum output the firm can produce 112 units of MP3 player per day with use 7 or 8 labour. If the firm add an extra labour more than 8, the production level will reduce. So, conclusion here, firm doed not hire more 8 labours because production will be inefficient.

Average Product and Marginal Product The average product (AP) can be obtaining by dividing the total product by the amount of that input used in the production. The average product is calculated by dividing the total output (Q) per unit of labour input (L). The average product can be obtained as follow: Average Product (AP) = Total Product (Q) Total Labour (L) In order to hire additional labour, the firm has to know whether additional labour can increase the output in proportion of additional labour. The fourth column in table 6.2 show average product of labour, the average product increased to 20 units for the third and fourth labour. The average product decline to 19 units when the firm adds the fifth labour. From table 6.1 we can see that the average product declines steadily when the firm hires more than 5 labours in the short run.

The marginal product (MP) is change in the total product of that input corresponding to an addition unit change in its labour assuming other factor, that is capital, is fixed. Marginal product is the additional to total product when one more labour is employed. The marginal product of labour can be calculated as follow : Marginal Product (MP ) = Change in Total Product ( TP) Change in Labour ( L)

Table 6.1 have the list of marginal product value in column four. If uses zero labour in the production then the output also will zero. When the firm used one labour in production then the marginal product will be 10 units. As the firm increase the labour 1 to 2 the marginal product will increase to 20. The marginal product starts to decrease after 3 units of labour used.

The average product and marginal product curves are closely related. When the marginal product is greater than the average product, the average produce is increasing, as shown between outputs 1 and 4 in Figure 6.2(b). For example, suppose that the only employee of an advertising firm can write 10 advertisement per day, so that initially 10 is the average product of labor. Now, a more productive employee is hired who can produce 20 ads per day. The marginal product of labor, 20 ads, is greater than the average, 10. And because both workers combine to produce 30 adsin two days of labor, the new average product has increase to 15 ads. Similary, when the marginal product less than the average product, the average product is decreasing, as shown between outputs 4 and 10 in Figure 6.2(b). In prvious example had the first worker been productive of the two, the marginal product of the first worker would have been 20 ads and the marginal product of the second 10 ads. Since the marginal product (10 ads) would than be less than the average product (20ads), the new average product would have fallen to 15 ads. Because the marginal product is above the average product when the average product is increasing, and below the average product when the average product is decreasing, its follow the marginal product must equal the average product reachs its maximum. This happens at point E in Figure 6.2(b). The geometric relationship between the total product and the average and marginal product curves is shown in Figure 6.2(a). The average product of labor is the total product divided by the quantity of labor input. For example, at B the average product is equal to be output of 60 divided by the input of 3, or 20 units of output per unit of labor input. But this is just slope of the line running from the origin to B in Figure 6.2(a). In general, the average product of

labor is given by the slope of the line drawn from the origin to the corresponding point on the total product curve. The marginal product of labor is the change in the total product resulting from an increase of one unit of labor. For example, at A the marginal productis 20 because the tangent to the total product curve has a slope of 20. In general, the marginal product of labor at the point is given by the slope of the total product at the point. We can see in Figure 6.2(a) that the marginal product of labor increases iniatially, peaks at an input of 3, and then declines as we move up the total product curve to C and D. At D, when total output is maximized, the slope of the tangent to the total product curve is 0, as is the marginal product. Beyond the point, the marginal product becomes negative.

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The Law of Diminishing Marginal Return The law of diminishing marginal return holds that if firm keeps increasing an input, holding all inputs and technology constrant, the corresponding increases in output will become smaller eventually. When the labor input is small (and capital is fixed), small increment in labor input add substantially to output as worker are allowed to develop specialized tasks. Eventually, however, the law of diministing return applies. When there are too many workers, some worker become ineffective, and marginal product of labor falls. In table 6.1, if the firm goes from 1 to 2 labor, the marginal product of labor is 20. The marginal product for 3 labor is 30. However, if the firm increase the number of labor beyond 3, the marginal product fall. The marginal product of 4 labor is 20, and for 5 labor is 15.Beyond 3 labors, each extra labor adds less and less extra output, so the total product curve rises by smaller increments. At 8 workers, the marginal product is zero. In short, the law of diminishing marginal returns says that if a firm keeps adding one more unit of an input, the extra output grows smaller and smaller. This diminishing return to extra labor may be due to too many labor sharing too few machines, as labor get in each othes way.Thus, as the amount of labor used grows large enough, the marginal product curve approaches zero and the corresponding total product curve becomes nearly flat.

Three Stages of Production The three stages of economic production is a function between variable inputs---labor---and overall product produced. This function is based on the Law of Diminishing Returns, which happens when the return on production decreases after a certain threshold of labor is reached. Companies use this concept to make production schedules and as a basis for hiring decisions.

Stage I : Increasing return Stage one is the period of most growth in a company's production. In this period, each additional variable input will produce more products. This signifies an increasing marginal return; the investment on the variable input outweighs the cost of producing an additional product at an increasing rate. As an example, if one employee produces five cans by himself, two employees may produce 15 cans between the two of them. All three curves are increasing and positive in this stage. Stage II : Diminishing Return Stage two is the period where marginal returns start to decrease. Each additional variable input will still produce additional units but at a decreasing rate. This is because of the law of diminishing returns: Output steadily decreases on each additional unit of variable input, holding all other inputs fixed. For example, if a previous employee added nine more cans to production, the next employee may only add eight more cans to production. The total product curve is still rising in this stage, while the average and marginal curves both start to drop. Stage III : Negative Returns In stage three, marginal returns start to become negative. Adding more variable inputs becomes counterproductive; an additional source of labor will lessen overall production. For example, hiring an additional employee to produce cans will actually result in fewer cans produced overall. This may be due to factors such as labor capacity and efficiency limitations. In this stage, the total product curve starts to trend down, the average product curve continues its descent and the marginal curve becomes negative.