Theory of Production (Part - 1) CA Foundation Notes | EduRev

Business Economics for CA Foundation

CA Foundation : Theory of Production (Part - 1) CA Foundation Notes | EduRev

The document Theory of Production (Part - 1) CA Foundation Notes | EduRev is a part of the CA Foundation Course Business Economics for CA Foundation.
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LEARNING OUTCOMES
At the end of this Unit, you should 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 Isocost curves 

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
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, radiosets, 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:

  1. Extraction from earth e.g., removal of coal, minerals, gold and other metal ores from mines and supplying them to markets.
  2. 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 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.
  3. 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.
  4. 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 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.
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
Theory of Production (Part - 1) CA Foundation Notes | EduRev
We may discuss these factors of production briefly in the following paragraphs. 

Land
The term ‘land’ is used in a special sense in Economics. It does not mean soil or earth’s surface alone, but refers to all free gifts of nature which would include besides land in common parlance, natural resources, fertility of soil, water, air, light, heat natural vegetation etc. It becomes difficult at times to state precisely as to what part of a given factor is due solely to gift of nature and what part belongs to human effort made on it in the past. Therefore, as a theoretical concept, we may list the following characteristics which would qualify a given factor to be called land:
(i) Land is a free gift of nature: No human effort is required for making land available for production. It has no supply price in the sense that no payment has been made to mother nature for obtaining land
(ii) Supply of land is fixed: Land is strictly limited in quantity. It is different from other factors of production in that, no change in demand can affect the amount of land in existence. In other words, the total supply of land is perfectly inelastic from the point of view of the economy. However, it is relatively elastic from the point of view of a firm.
(iii) Land is permanent and has indestructible powers: Land is permanent in nature and cannot be destroyed. According to Ricardo, land has certain original and indestructible powers and these properties of land cannot be destroyed.
(iv) Land is a passive factor: Land is not an active factor. Unless human effort is exercised on land, it does not produce anything on its own.
(v) Land is immobile: in the geographical sense. Land cannot be shifted physically from one place to another. The natural factors typical to a given place cannot be shifted to other places.
(vi) Land has multiple uses: and can be used for varied purposes, though its suitability in all the uses is not the same.
(vii) Land is heterogeneous: No two pieces of land are alike. They dier in fertility and situation.
Labour:
The term ‘labour’, means any mental or physical exertion directed to produce goods or services. All human efforts of body or of mind undergone partly or wholly with a view to secure an income apart from the pleasure derived directly from the work is termed as labour. In other words, it refers to various types of human efforts which require the use of physical exertion, skill and intellect. It is, however, difficult to say that in any human effort all the three are not required; the proportion of each might vary. Labour, to have an economic significance, must be one which is done with the motive of some economic reward. Anything done out of love and affection, although very useful in increasing human well-being, is not labour in the economic sense of the term. It implies that any work done for the sake of pleasure or love does not represent labour in Economics. It is for this reason that the services of a house-wife are not treated as labour, while those of a maid servant are treated as labour. If a person sings just for the sake of pleasure, it is not considered as labour despite the exertion involved in it. On the other hand, if a person sings against payment of some fee, then this activity signifies labour.
Characteristics of labour:
(1) Human Effort: Labour, as compared with other factors is different. It is connected with human efforts whereas others are not directly connected with human efforts. As a result, there are certain human and psychological considerations which may come up unlike in the case of other factors. Therefore, leisure, fair treatment, favourable work environment etc. are essential for labourers.
(2) Labour is perishable: Labour is highly ‘perishable’ in the sense that a day’s labour lost cannot be completely recovered by extra work on any other day. In other words, a labourer cannot store his labour.
(3) Labour is an active factor: Without the active participation of labour, land and capital may not produce anything.
(4) Labour is inseparable from the labourer: A labourer is the source of his own labour power. When a labourer sells his service, he has to be physically present where they are delivered. The labourer sells his labour against wages, but retains the capacity to work.
(5) Labour power dffers from labourer to labourer: Labour is heterogeneous in the sense that labour power differs from person to person. Labour power or efficiency of labour depends upon the labourers’ inherent and acquired qualities, characteristics of work environment, and incentive to work.
(6) All labour may not be productive: (i.e.) all efforts are not sure to produce resources.
(7) Labour has poor bargaining power: Labour has a weak bargaining power. Labour has no reserve price. Since labour cannot be stored, the labourer is compelled to work at the wages offered by the employers. For this reason, when compared to employers, labourers have poor bargaining power and can be exploited and forced to accept lower wages. The labourer is economically weak while the employer is economically powerful although things have changed a lot in favour of labour during 20th and 21st centuries.
(8) Labour is mobile: Labour is a mobile factor. Apparently, workers can move from one job to another or from one place to another. However, in reality there are many obstacles in the way of free movement of labour from job to job or from place to place.
(9) There is no rapid adjustment of supply of labour to the demand for it: The total supply of labour cannot be increased or decreased instantly.
(10) Choice between hours of labour and hours of leisure: A labourer can make a choice between the hours of labour and the hours of leisure. This feature gives rise to a peculiar backward bending shape to the supply curve of labour. The supply of labour and wage rate is directly related. It implies that, as the wage rate increases the labourer tends to increase the supply of labour by reducing the hours of leisure. However, beyond a desired level of income, the labourer reduces the supply of labour and increases the hours of leisure in response to further rise in the wage rate. That is, he prefers to have more of rest and leisure than earning more money.

Capital:
We may define capital as that part of wealth of an individual or community which is used for further production of wealth. In fact, capital is a stock concept which yields a periodical income which is a flow concept. It is necessary to understand the difference between capital and wealth. Whereas wealth refers to all those goods and human qualities which are useful in production and which can be passed on for value, only a part of these goods and services can be characterised as capital because if these resources are lying idle they will constitute wealth but not capital.
Capital has been rightly defined as ‘produced means of production’ or ‘man-made instruments of production’. In other words, capital refers to all man made goods that are used for further production of wealth. This definition distinguishes capital from both land and labour because both land and labour are not produced factors. They are primary or original factors of production, but capital is not a primary or original factor; it is a produced factor of production. It has been produced by man by working with nature. Machine tools and instruments, factories, dams, canals, transport equipment etc., are some of the examples of capital. All of them are produced by man to help in the production of further goods.
Types of Capital:
Fixed capital is that which exists in a durable shape and renders a series of services over a period of time. For example tools, machines, etc.
Circulating capital is another form of capital which performs its function in production in a single use and is not available for further use. For example, seeds, fuel, raw materials, etc.
Real capital refers to physical goods such as building, plant, machines, etc.
Human capital refers to human skill and ability. This is called human capital because a good deal of investment has gone into creation of these abilities in humans.
Tangible capital can be perceived by senses whereas intangible capital is in the form of certain rights and benefits which cannot be perceived by senses. For example, patents, goodwill, patent rights, etc.
Individual capital is personal property owned by an individual or a group of individuals. Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc. Capital Formation: Capital formation means a sustained increase in the stock of real capital in a country. In other words, capital formation involves production of more capital goods like, machines, tools, factories, transport equipments, electricity etc. which are used for further production of goods. Capital formation is also known as investment.
The need for capital formation or investment is realised not merely for replacement and renovation but for creating additional productive capacity. In order to accumulate capital goods, some current consumption has to be sacrificed and savings of current income are to be made. Savings are also to be channelised into productive investment. The greater the extent that people are willing to abstain from present consumption, the greater the extent of savings and investment that society will devote to new capital formation. If a society consumes all what it produces and saves nothing, the future productive capacity of the economy will fall when the present capital equipment wears out. In other words, if the whole of the current present capacity is used to produce consumer goods and no new capital goods are made, production of consumer goods in the future will greatly decline. It is prudent to cut down some of the present consumption and direct part of it to the making of capital goods such as, tools and instruments, machines and transport facilities, plant and equipment etc. Higher rate of capital formation will enhance production and productive capacity, increase the efficacy of production efforts, accelerate economic growth and add to opportunities for employment.
Stages of capital formation:
There are mainly three stages of capital formation which are as follows:
1. Savings: The basic factor on which formation of capital depends is the ability to save. The ability to save depends upon the income of an individual. Higher incomes are generally followed by higher savings. This is because, with an increase in income, the propensity to consume comes down and the propensity to save increases. This is true not only for an individual but also for the economy as a whole. A rich country has greater ability to save and thereby can get richer quickly compared to a poor country which has no ability to save and therefore has limited capacity for growth in national income, given the capital output ratio. It is not only the ability to save, but the willingness to save also counts a great deal. Willingness to save depends upon the individual’s concern about his future as well as upon the social set-up in which he lives. If an individual is far sighted and wants to make his future secure, he will save more. Moreover, the government can enforce compulsory savings on employed people by making insurance and provident fund compulsory. Government can also encourage saving by allowing tax deductions on income saved. In recent years, business community’s savings and government’s savings are also becoming important.
2. Mobilisation of savings: It is not enough that people save money; the saved money should enter into circulation and facilitate the process of capital formation. Availability of appropriate financial products and institutions is a necessary precondition for mobilisation of savings. There should be a wide spread network of banking and other financial institutions to collect public savings and to take them to prospective investors. In this process, the state has a very important and positive role to play both in generating savings through various fiscal and monetary incentives and in channelising the savings towards priority needs of the community so that there is not only capital generation but also socially beneficial type of capital formation.
3. Investment: The process of capital formation gets completed only when the real savings get converted into real capital assets. An economy should have an entrepreneurial class which is prepared to bear the risk of business and invest savings in productive avenues so as to create new capital assets.

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