Production
Production refers to the output of goods
and services produced by businesses within a market. This production creates
the supply that allows our needs and wants to be satisfied. To simplify the
idea of the production function, economists create a number of time periods for
analysis.
Short run production
The short run is a period of time when there
is at least one fixed factor input. This is usually the capital input such as
plant and machinery and the stock of buildings and technology. In the short
run, the output of a business expands when more variable factors of production
(e.g. labour, raw materials and components) are employed.
Long run
production
In the long
run, all of the factors of production can change giving a business the
opportunity to increase the scale of its operations. For example a business may
grow by adding extra labour and capital to the production process and
introducing new technology into their operations.
Costs of production
Costs are defined as those expenses faced by
a business when producing a good or service for a market. Every business faces
costs and these must be recouped from selling goods and services at different
prices if a business is to make a profit from its activities. In the short run
a firm will have fixed and variable costs of production. Total cost is made up
of fixed costs and variable costs
Fixed Costs
These costs relate do not vary directly with
the level of output. Examples of fixed costs include:
- Rent paid on buildings and business
rates charged by local authorities.
- The depreciation in the value of capital
equipment due to age.
- Insurance charges.
- The costs of staff salaries e.g. for
people employed on permanent contracts.
- Interest charges on borrowed money.
- The costs of purchasing new capital
equipment.
- Marketing and advertising costs.
Variable
Costs
Variable
costs vary directly with output. I.e. as production rises, a firm will face
higher total variable costs because it needs to purchase extra resources to
achieve an expansion of supply. Examples of variable costs for a business
include the costs of raw materials, labour costs and other consumables and
components used directly in the production process.
Theory of production
In
economics, an effort to explain the principles by which a business firm decides
how much of each commodity that it sells (its “outputs” or “products”) it will
produce, and how much of each kind of labour, raw material, fixed capital good,
etc., that it employs (its “inputs” or “factors of production”) it will use.
The theory involves some of the most fundamental principles of economics. These
include the relationship between the prices of commodities and the prices (or
wages or rents) of the productive factors used to produce them and also the
relationships between the prices of commodities and productive factors, on the
one hand, and the quantities of these commodities and productive factors that
are produced or used, on the other.
The Law of variable proportions
There
are three phases or stages of production, as determined by the law of variable
proportions:
(i)
Increasing
returns.
(ii)
Diminishing
returns.
(iii)
Negative returns.
(i) Stage of Increasing Returns. The first
stage of the law of variable proportions is generally called the stage of
increasing returns. In this stage as a variable resource (labor) is added to
fixed inputs of other resources, the total product increases up to a point at
an increasing rate. In the first stage, marginal product curve of a variable
factor rises in a part and then falls. The average product curve rises
throughout .and remains below the MP curve.
Causes of Initial Increasing Returns: The phase of increasing returns starts when
the quantity of a fixed factor is abundant relative to the quantity of the
variable factor. As more and more units of the variable factor are added to the
constant quantity of the fixed factor, it is more intensively and effectively
used. This causes the production to increase at a rapid rate. Another reason of
increasing returns is that the fixed factor initially taken is indivisible. As
more units of the variable factor are employed to work on it, output increases
greatly due to fuller and effective utilization of the variable factor.
Diagram/Graph: These stages can be explained with the help of graph below:
Causes of Diminishing Returns: The 2nd phase of the law occurs when the
fixed factor becomes inadequate relative to the quantity of the variable
factor. As more and more units of a variable factor are employed, the marginal
and average product decline. Another reason of diminishing returns in the
production function is that the fixed indivisible factor is being worked too
hard. It is being used in non-optimal proportion with the variable factor, Mrs.
J. Robinson still goes deeper and says that the diminishing returns occur
because the factors of production are imperfect substitutes of one
another.
(iii) Stage of Negative Returns. In the 3rd
stage, the total production declines. The TP, curve slopes downward (From point
H onward). The MP curve falls to zero at point L2 and then is negative. It goes
below the X axis with the increase in the use of variable factor (labor).
Causes of Negative Returns: The 3rd phases of the law starts when the
number of a variable, factor becomes, too excessive relative, to the fixed
factors, A producer cannot operate in this stage because total production
declines with the employment of additional labor. A rational producer will always seek to
produce in stage 2 where MP and AP of the variable factor are diminishing. At
which particular point, the producer will decide to produce depends upon the
price of the factor he has to pay. The producer will employ the variable factor
(say labor) up to the point where the marginal product of the labor equals the
given wage rate in the labor market.
A firm's production function could exhibit
different types of returns to scale in different ranges of output. Typically,
there could be increasing returns at relatively low output levels, decreasing
returns at relatively high output levels, and constant returns at one output
level between those ranges.
Short and Long-Run Costs
In the long run, firms change
production levels in response to (expected) economic profits or losses,
and the land, labor, capital goods and entrepreneurship vary to
reach associated long-run average cost. In the simplified case of plant
capacity as the only fixed factor, a generic firm can make these changes in the
long run:
enter an industry in response to (expected)
profits: 1)leave an industry in response to losses, 2) increase its plant in
response to profits, 3) decrease its plant in response to losses.
The long run is associated with the long-run average cost (LRAC) curve in microeconomic models
along which a firm would minimize its average cost (cost per
unit) for each respective long-run quantity of output.
Long-run marginal cost (LRMC) is the added cost of providing an
additional unit of service or commodity from
changing capacity level to reach the lowest cost associated with that extra
output. LRMC equalling price is efficient as to resource allocation in the long run. The concept of long-run
cost is also used in determining whether the long-run expected to induce the
firm to remain in the industry or shut down production there.
The long run is a planning and implementation
stage. Here a firm may decide that it needs to produce on a larger scale by
building a new plant or adding a production line. The firm may decide that new
technology should be incorporated into its production
process. The firm thus considers all its long-run production options and
selects the optimal combination of inputs and technology for its long-run
purposes. The optimal combination of inputs is the least-cost combination of
inputs for desired level of output when all inputs are variable. Once the
decisions are made and implemented and production begins, the firm is operating
in the short run with fixed and variable inputs.
Long-run average total cost curve. In the
long-run, all factors of production are variable, and hence, all costs are
variable. The long-run average total cost curve ( LATC) is found by varying the
amount of all factors of production.
Short run
All production in real time occurs in the
short run. The short run is the conceptual time period in which at least one factor of production is fixed in amount and others are variable
in amount. Costs that are fixed, say from existing plant size, have no impact
on a firm's short-run decisions, since only variable costs and revenues affect
short-run profits. Such fixed costs raise the
associated short-run average cost of an output long-run average cost if the
amount of the fixed factor is better suited for a different output level. In
the short run, a firm can raise output by increasing the amount of the variable
factor(s), say labor through overtime.
A generic firm already producing in an
industry can make three changes in the short run as a response to reach a
posited equilibrium: 1) increase production, 2) decrease production, 3) shut
down.
In the short run, a profit-maximizing firm will: 1)increase production if marginal cost is (<)
less than marginal revenue
(added revenue per additional unit of output); 2) decrease production if marginal cost is (>)
greater than marginal revenue;
3) continue producing if average variable cost is (<) less than price per unit, even if average total cost is greater than price; 4) shut down if average variable cost is (>) greater than price at each level of output.
In the short-run, some factors of production
are fixed. Corresponding to each different level of fixed factors, there will
be a different short-run average total cost curve ( SATC). The
average total cost curve is just one of many SATCs that can be obtained
by varying the amount of the fixed factor, in this case, the amount of capital.
