ICAI Notes- Unit 1: Theory of Production | Business Economics for CA Foundation PDF Download

 Page 1


 
 
LEARNING OUTCOMES 
 
THEORY OF PRODUCTION 
AND COST
 
 
UNIT -1: THEORY OF PRODUCTION 
 
 
After studying this unit, you would be able to:  
? Define Production and Describe Production Function.  
? Describe the Characteristics of various Factors of Production. 
? Distinguish between Short run and Long run Production Functions. 
? Illustrate the Law of Diminishing Returns and Returns to Scale. 
? Describe Production Optimisation using Isoquants and Iso-cost 
curves. 
 
    
 
 
CHAPTER 
3 
© The Institute of Chartered Accountants of India
Page 2


 
 
LEARNING OUTCOMES 
 
THEORY OF PRODUCTION 
AND COST
 
 
UNIT -1: THEORY OF PRODUCTION 
 
 
After studying this unit, you would be able to:  
? Define Production and Describe Production Function.  
? Describe the Characteristics of various Factors of Production. 
? Distinguish between Short run and Long run Production Functions. 
? Illustrate the Law of Diminishing Returns and Returns to Scale. 
? Describe Production Optimisation using Isoquants and Iso-cost 
curves. 
 
    
 
 
CHAPTER 
3 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.2 
 
1.0  MEANING OF PRODUCTION  
Production is a very important economic activity. As we are aware, the survival of any firm in 
a competitive market depends upon its ability to produce goods and services at a 
competitive cost. One of the principal concerns of business managers is the achievement of 
optimum efficiency in production by minimising the cost of production. The performance of 
an economy is judged by the level of its production. The amount of goods and services an 
economy is able to produce determines the richness or poverty of that economy. In fact, the 
standard of living of people depends on the volume and variety of goods and services 
produced in a country. Thus, the U.S.A. is a rich country just because its level of production 
is high. 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
Page 3


 
 
LEARNING OUTCOMES 
 
THEORY OF PRODUCTION 
AND COST
 
 
UNIT -1: THEORY OF PRODUCTION 
 
 
After studying this unit, you would be able to:  
? Define Production and Describe Production Function.  
? Describe the Characteristics of various Factors of Production. 
? Distinguish between Short run and Long run Production Functions. 
? Illustrate the Law of Diminishing Returns and Returns to Scale. 
? Describe Production Optimisation using Isoquants and Iso-cost 
curves. 
 
    
 
 
CHAPTER 
3 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.2 
 
1.0  MEANING OF PRODUCTION  
Production is a very important economic activity. As we are aware, the survival of any firm in 
a competitive market depends upon its ability to produce goods and services at a 
competitive cost. One of the principal concerns of business managers is the achievement of 
optimum efficiency in production by minimising the cost of production. The performance of 
an economy is judged by the level of its production. The amount of goods and services an 
economy is able to produce determines the richness or poverty of that economy. In fact, the 
standard of living of people depends on the volume and variety of goods and services 
produced in a country. Thus, the U.S.A. is a rich country just because its level of production 
is high. 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
 
v 
 
3.3 
THEORY OF PRODUCTION AND COST 
In common parlance, the term ‘production’ is used to indicate an activity of making 
something material. The growing of wheat, rice or any other agricultural crop by farmers and 
manufacturing of cement, radio-sets, wool, machinery or any other industrial product is 
often referred to as production. What exactly do we mean by production in Economics? In 
Economics the word ‘production’ is used in a wider sense to denote the process by which 
man utilises resources such as men, material, capital, time etc, working upon them to 
transform them into commodities and services so as to make them satisfy human wants. In 
other words, production is any economic activity which converts inputs into outputs which 
are capable of satisfying human wants. Whether it is making of material goods or providing 
a service, it is included in production provided it satisfies the wants of some people. 
Therefore, in Economics, activities such as making of cloth by an industrial worker, the 
services of the retailer who delivers it to consumers, the work of doctors, lawyers, teachers, 
actors, dancers, etc. are production.  
According to James Bates and J.R. Parkinson “Production is the organized activity of 
transforming resources into finished products in the form of goods and services; and 
the objective of production is to satisfy the demand of such transformed resources”. 
It should be noted that production should not be taken to mean as creation of matter 
because, according to the fundamental law of science, man cannot create matter. What a 
man can do is only to create or add utility to things that already exist in nature. Production 
can also be defined as creation or addition of utility. For example, when a carpenter 
produces a table, he does not create the matter of which the wood is composed of; he only 
transforms wood into a table. By doing so, he adds utility to wood which did not have utility 
before.  
Production consists of various processes to add utility to natural resources for gaining 
greater satisfaction from them by: 
(i) Changing the form of natural resources. Most manufacturing processes consist of use 
of physical inputs such as raw materials and transforming them into physical 
products possessing utility, e.g., changing the form of a log of wood into a table or 
changing the form of iron into a machine. This may be called conferring utility of 
form. 
(ii) Changing the place of the resources from a place where they are of little or no use to 
another place where they are of greater use. This utility of place can be obtained by: 
(a) Extraction from earth e.g., removal of coal, minerals, gold and other metal 
ores from mines and supplying them to markets. 
(b) Transferring goods from where they give little or no satisfaction, to places 
where their utility is more, e.g., tin in Malaya is of little use until it is brought 
© The Institute of Chartered Accountants of India
Page 4


 
 
LEARNING OUTCOMES 
 
THEORY OF PRODUCTION 
AND COST
 
 
UNIT -1: THEORY OF PRODUCTION 
 
 
After studying this unit, you would be able to:  
? Define Production and Describe Production Function.  
? Describe the Characteristics of various Factors of Production. 
? Distinguish between Short run and Long run Production Functions. 
? Illustrate the Law of Diminishing Returns and Returns to Scale. 
? Describe Production Optimisation using Isoquants and Iso-cost 
curves. 
 
    
 
 
CHAPTER 
3 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.2 
 
1.0  MEANING OF PRODUCTION  
Production is a very important economic activity. As we are aware, the survival of any firm in 
a competitive market depends upon its ability to produce goods and services at a 
competitive cost. One of the principal concerns of business managers is the achievement of 
optimum efficiency in production by minimising the cost of production. The performance of 
an economy is judged by the level of its production. The amount of goods and services an 
economy is able to produce determines the richness or poverty of that economy. In fact, the 
standard of living of people depends on the volume and variety of goods and services 
produced in a country. Thus, the U.S.A. is a rich country just because its level of production 
is high. 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
 
v 
 
3.3 
THEORY OF PRODUCTION AND COST 
In common parlance, the term ‘production’ is used to indicate an activity of making 
something material. The growing of wheat, rice or any other agricultural crop by farmers and 
manufacturing of cement, radio-sets, wool, machinery or any other industrial product is 
often referred to as production. What exactly do we mean by production in Economics? In 
Economics the word ‘production’ is used in a wider sense to denote the process by which 
man utilises resources such as men, material, capital, time etc, working upon them to 
transform them into commodities and services so as to make them satisfy human wants. In 
other words, production is any economic activity which converts inputs into outputs which 
are capable of satisfying human wants. Whether it is making of material goods or providing 
a service, it is included in production provided it satisfies the wants of some people. 
Therefore, in Economics, activities such as making of cloth by an industrial worker, the 
services of the retailer who delivers it to consumers, the work of doctors, lawyers, teachers, 
actors, dancers, etc. are production.  
According to James Bates and J.R. Parkinson “Production is the organized activity of 
transforming resources into finished products in the form of goods and services; and 
the objective of production is to satisfy the demand of such transformed resources”. 
It should be noted that production should not be taken to mean as creation of matter 
because, according to the fundamental law of science, man cannot create matter. What a 
man can do is only to create or add utility to things that already exist in nature. Production 
can also be defined as creation or addition of utility. For example, when a carpenter 
produces a table, he does not create the matter of which the wood is composed of; he only 
transforms wood into a table. By doing so, he adds utility to wood which did not have utility 
before.  
Production consists of various processes to add utility to natural resources for gaining 
greater satisfaction from them by: 
(i) Changing the form of natural resources. Most manufacturing processes consist of use 
of physical inputs such as raw materials and transforming them into physical 
products possessing utility, e.g., changing the form of a log of wood into a table or 
changing the form of iron into a machine. This may be called conferring utility of 
form. 
(ii) Changing the place of the resources from a place where they are of little or no use to 
another place where they are of greater use. This utility of place can be obtained by: 
(a) Extraction from earth e.g., removal of coal, minerals, gold and other metal 
ores from mines and supplying them to markets. 
(b) Transferring goods from where they give little or no satisfaction, to places 
where their utility is more, e.g., tin in Malaya is of little use until it is brought 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.4 
to the industrialised centres where necessary machinery and technology are 
available to produce metal boxes for packing. Another example is: apples in 
Kashmir orchards have a little utility to farmers. But when the apples are 
transported to markets where human settlements are thick and crowded like 
the city centres, they afford more satisfaction to greater number of people. 
These examples emphasise the additional utility conferred on goods, by all 
forms of transportation systems, by transport workers and by the agents who 
assist in the movement and marketing of goods. 
(iii) Making available materials at times when they are not normally available e.g., 
harvested food grains are stored for use till next harvest. Canning of seasonal fruits is 
undertaken to make them available during off-season. This may be called conferring 
of utility of time. 
(iv)  Making use of personal skills in the form of services, e.g., those of organisers, 
merchants, transport workers etc. 
The fundamental purpose of all these activities is the same, namely to create utility in some 
manner. Thus, production is nothing but creation of utilities in the form of goods and 
services. For example, in the production of a woollen suit, utility is created in some form or 
the other. Firstly wool is changed into woollen cloth at the spinning and weaving mill (utility 
created by changing the form). Then, it is taken to a place where it is to be sold (utility 
added by transporting it). Since woollen clothes are used only in winter, they will be retained 
until such time when they are required by purchasers (time utility). In the whole process, the 
services of various groups of people are utilised (as that of mill workers, shopkeepers, 
agents etc.) to contribute to the enhancement of utility. Thus, the entire process of 
production is nothing but creation of form utility, place utility, time utility and/or personal 
utility. 
It should be noted that the production process need not necessarily involve conversion of 
physical inputs into physical output. For example, production of services such as those of 
lawyers, doctors, musicians, consultants etc. involves intangible inputs to produce intangible 
output. But, production does not include work done within a household by anyone out of 
love and affection, voluntary services and goods produced for self-consumption. Intention 
to exchange in the market is an essential component of production.  
The money expenses incurred in the process of production, i.e., for transforming resources 
into finished products constitute the cost of production. Although cost of production is not 
taken into account for a pure production analysis, it is an extremely vital matter for any 
business decision-making. Nevertheless, in the theory of production, we would confine 
ourselves to laws of production, production function and methods of production 
optimisation. However, it is necessary to remember that a production decision cannot 
© The Institute of Chartered Accountants of India
Page 5


 
 
LEARNING OUTCOMES 
 
THEORY OF PRODUCTION 
AND COST
 
 
UNIT -1: THEORY OF PRODUCTION 
 
 
After studying this unit, you would be able to:  
? Define Production and Describe Production Function.  
? Describe the Characteristics of various Factors of Production. 
? Distinguish between Short run and Long run Production Functions. 
? Illustrate the Law of Diminishing Returns and Returns to Scale. 
? Describe Production Optimisation using Isoquants and Iso-cost 
curves. 
 
    
 
 
CHAPTER 
3 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.2 
 
1.0  MEANING OF PRODUCTION  
Production is a very important economic activity. As we are aware, the survival of any firm in 
a competitive market depends upon its ability to produce goods and services at a 
competitive cost. One of the principal concerns of business managers is the achievement of 
optimum efficiency in production by minimising the cost of production. The performance of 
an economy is judged by the level of its production. The amount of goods and services an 
economy is able to produce determines the richness or poverty of that economy. In fact, the 
standard of living of people depends on the volume and variety of goods and services 
produced in a country. Thus, the U.S.A. is a rich country just because its level of production 
is high. 
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 
 
 
v 
 
3.3 
THEORY OF PRODUCTION AND COST 
In common parlance, the term ‘production’ is used to indicate an activity of making 
something material. The growing of wheat, rice or any other agricultural crop by farmers and 
manufacturing of cement, radio-sets, wool, machinery or any other industrial product is 
often referred to as production. What exactly do we mean by production in Economics? In 
Economics the word ‘production’ is used in a wider sense to denote the process by which 
man utilises resources such as men, material, capital, time etc, working upon them to 
transform them into commodities and services so as to make them satisfy human wants. In 
other words, production is any economic activity which converts inputs into outputs which 
are capable of satisfying human wants. Whether it is making of material goods or providing 
a service, it is included in production provided it satisfies the wants of some people. 
Therefore, in Economics, activities such as making of cloth by an industrial worker, the 
services of the retailer who delivers it to consumers, the work of doctors, lawyers, teachers, 
actors, dancers, etc. are production.  
According to James Bates and J.R. Parkinson “Production is the organized activity of 
transforming resources into finished products in the form of goods and services; and 
the objective of production is to satisfy the demand of such transformed resources”. 
It should be noted that production should not be taken to mean as creation of matter 
because, according to the fundamental law of science, man cannot create matter. What a 
man can do is only to create or add utility to things that already exist in nature. Production 
can also be defined as creation or addition of utility. For example, when a carpenter 
produces a table, he does not create the matter of which the wood is composed of; he only 
transforms wood into a table. By doing so, he adds utility to wood which did not have utility 
before.  
Production consists of various processes to add utility to natural resources for gaining 
greater satisfaction from them by: 
(i) Changing the form of natural resources. Most manufacturing processes consist of use 
of physical inputs such as raw materials and transforming them into physical 
products possessing utility, e.g., changing the form of a log of wood into a table or 
changing the form of iron into a machine. This may be called conferring utility of 
form. 
(ii) Changing the place of the resources from a place where they are of little or no use to 
another place where they are of greater use. This utility of place can be obtained by: 
(a) Extraction from earth e.g., removal of coal, minerals, gold and other metal 
ores from mines and supplying them to markets. 
(b) Transferring goods from where they give little or no satisfaction, to places 
where their utility is more, e.g., tin in Malaya is of little use until it is brought 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.4 
to the industrialised centres where necessary machinery and technology are 
available to produce metal boxes for packing. Another example is: apples in 
Kashmir orchards have a little utility to farmers. But when the apples are 
transported to markets where human settlements are thick and crowded like 
the city centres, they afford more satisfaction to greater number of people. 
These examples emphasise the additional utility conferred on goods, by all 
forms of transportation systems, by transport workers and by the agents who 
assist in the movement and marketing of goods. 
(iii) Making available materials at times when they are not normally available e.g., 
harvested food grains are stored for use till next harvest. Canning of seasonal fruits is 
undertaken to make them available during off-season. This may be called conferring 
of utility of time. 
(iv)  Making use of personal skills in the form of services, e.g., those of organisers, 
merchants, transport workers etc. 
The fundamental purpose of all these activities is the same, namely to create utility in some 
manner. Thus, production is nothing but creation of utilities in the form of goods and 
services. For example, in the production of a woollen suit, utility is created in some form or 
the other. Firstly wool is changed into woollen cloth at the spinning and weaving mill (utility 
created by changing the form). Then, it is taken to a place where it is to be sold (utility 
added by transporting it). Since woollen clothes are used only in winter, they will be retained 
until such time when they are required by purchasers (time utility). In the whole process, the 
services of various groups of people are utilised (as that of mill workers, shopkeepers, 
agents etc.) to contribute to the enhancement of utility. Thus, the entire process of 
production is nothing but creation of form utility, place utility, time utility and/or personal 
utility. 
It should be noted that the production process need not necessarily involve conversion of 
physical inputs into physical output. For example, production of services such as those of 
lawyers, doctors, musicians, consultants etc. involves intangible inputs to produce intangible 
output. But, production does not include work done within a household by anyone out of 
love and affection, voluntary services and goods produced for self-consumption. Intention 
to exchange in the market is an essential component of production.  
The money expenses incurred in the process of production, i.e., for transforming resources 
into finished products constitute the cost of production. Although cost of production is not 
taken into account for a pure production analysis, it is an extremely vital matter for any 
business decision-making. Nevertheless, in the theory of production, we would confine 
ourselves to laws of production, production function and methods of production 
optimisation. However, it is necessary to remember that a production decision cannot 
© The Institute of Chartered Accountants of India
 
 
 
v 
 
3.5 
THEORY OF PRODUCTION AND COST 
depend merely on physical productivity based on operating efficiency alone. The 
profitability of a productive activity would depend upon the revenue realised from the 
output and the costs incurred in raising that output. Aspects of cost and revenue will be 
discussed in the following units. 
1.1  FACTORS OF PRODUCTION  
Factors of production refer to inputs. An input is a good or service which a firm buys for use 
in its production process. Production process requires a wide variety of inputs, depending 
on the nature of output. The process of producing goods in a modern economy is very 
complex. A good has to pass through many stages and many hands until it reaches the 
consumers’ hands in a finished form. Land, labour, capital and entrepreneurial ability are the 
four factors or resources which make it possible to produce goods and services. Even a small 
piece of bread cannot be produced without the active participation of these factors of 
production. While land is a free gift of nature and refers to natural resources, the human 
endeavour is classified functionally and qualitatively into three main components namely, 
labour, capital and entrepreneurial skills. 
 
 
 
 
 
 
 
 
 
 
 
 
We may discuss these factors of production briefly in the following paragraphs. 
© The Institute of Chartered Accountants of India