Production: Definition, Function, Short vs Long Run

Definition of Production

• Production turns inputs into outputs, using factors of production to create goods and services
• Inputs such as land, labour, capital, and entrepreneurship are transformed into outputs

Production Function

• It illustrates the relationship between inputs and outputs, shown by a mathematical equation e.g., Q = f(K, L, M)
• Output quantity (Q) depends on input quantities: K (capital), L (labour), and M (raw materials)
• The quality of inputs is assumed to be homogeneous

Short Run and Long Run

• Short run is when at least one input is fixed, others are variable, increasing output by applying variable factors to the existing fixed factor
• A fixed factor’s quantity remains constant regardless of output level, like land, machines, and buildings
• A variable factor's quantity changes with the output level, such as raw materials, labour, fuel, and electricity
• Long run is when all inputs are variable, allowing adjustment of all factors to change output levels, giving firms flexibility to adjust production

Law of Diminishing Returns

• Applicable in the short run with at least one fixed factor
• Increasing variable factor quantities added to the fixed factor results in total output rising at an increasing rate initially, then at a decreasing rate
• This means the marginal product is falling

Table Data Analysis

• Total Product (TP) increases at an increasing rate when variable factors (e.g. labour) are added, shown by an upward-sloping Marginal Product (MP) curve
• The Marginal Product (MP) is above the Average Product (AP) because fixed and variable factors are used in better proportion
• Total Product (TP) continues to rise but at a decreasing rate and the Marginal Product (MP) decreases as more labour is added because the fixed factor is overworked
• The Marginal Product (MP) curve is below the Average Product (AP) curve
• Total Product (TP) reaches its maximum, then declines; Marginal Product (MP) becomes negative, meaning additional labour hinders production and the producer will not operate at this stage

Employees Working in a Factory

• One worker performing all tasks means fixed factors (equipment) are under-utilized
• Division of labour with more workers increases efficiency and better use of the fixed factor
• Too many workers for too few fixed factors results in underutilization and inefficient combination
• Marginal product is low and Total Product increases at a diminishing rate
• Negative Marginal Product means variable factors are disproportionately large compared to fixed factor

Relationship Between Total Product (TP), Average Product (AP), and Marginal Product (MP)

• TP increases at an increasing rate, then increases at a decreasing rate, reaches maximum, and falls
• MP increases, then falls
• When TP falls, MP is negative
• When AP increases, MP > AP
• When AP is at the maximum, MP = AP
• When AP falls, MP < AP

Types of Cost of Production

• Explicit cost is direct payment for factors of production, such as rent, wages, and raw materials
• Accounting profit only considers explicit costs: Accounting profit = Total revenue – Explicit costs
• Implicit cost is the cost incurred for using owned factors of production, like land or capital, usually not paid and valued using opportunity cost
• Accountants exclude implicit costs, but economists include them
• Economic profit = Total revenue – Explicit cost – Implicit costs
• Total Fixed Cost (TFC), also called overhead costs, applies only in the short run, remains constant regardless of output, and is incurred even with no production, for example, rental payments
• Total Variable Cost (TVC) changes with output and is incurred when variable inputs are purchased, zero when output is zero, examples include raw materials, wages, transportation and fuel cost
• Total Cost (TC) in the short run factors in fixed and variable factors: TC = TFC + TVC
• In the long run, all costs are variable: TC = TVC
• Total Fixed Cost (TFC) is constant and unaffected by output, exists even with zero output; represented by a horizontal line
• Total Variable Cost (TVC) is zero when output is zero and rises with output, originating from the origin and sloping upwards
• Total Cost (TC) aggregates Total Fixed Cost (TFC) and Total Variable Cost (TVC) curves, starting from the Total Fixed Cost and sloping upwards
• The vertical distance between Total Cost (TC) and Total Variable Cost (TVC) is Total Fixed Cost (TFC)

Average Fixed Cost (AFC)

• fixed cost per unit of output such as AFC = TFC / Q
• AFC decreases continuously as fixed costs are spread over increasing output

Average Variable Cost (AVC)

• variable cost per unit of output: AVC = TVC / Q
• AVC decreases initially, reaches a minimum, and then increases; the curve is U-shaped

Average Cost (AC)

• cost per unit of output: AC = AFC + AVC or AC = TC / Q
• AC decreases initially, reaches a minimum, and then increases; the curve is U-shaped

Marginal Cost (MC)

• change in total cost from producing an extra unit
• also known as additional cost incurred in producing an additional unit
• MC declines, reaches a minimum, and then increases; the curve is U-shaped
• Marginal Cost is caluclated by using: MC = Δ TC / ΔQ

Economies of Scale and Diseconomies of Scale

• Economies and diseconomies of scale apply to long-run production when all inputs are variable factors
• Economies of scale are benefits and advantages a firm gains as it grows, allowing production at a lower unit cost, associated with the advantages of large-scale production, leading to increasing returns and decreasing cost

Internal Economies of Scale

• Benefits from actions within the firm itself
• Average production cost is declining, as indicated by a downward-sloping Long-Run Average Cost (LRAC) curve
• Internal economies of scale refer to the benefits from actions inside the firm, the long-run average cost declines as output increases, as shown on a downward-sloping LRAC curve

Reasons for Internal Economies of Scale

• Marketing economies: bulk buying of raw materials results in lower prices and savings in advertising/packaging costs; large firms can sell in large amounts locally and globally
• Financial economies: large firms can borrow money more cheaply and easily due to their financial stability, with lower interest rates, longer maturity periods, and less collateral required
• Managerial economies: specialization of labour increases productivity and lowers unit costs; large firms employ professionals and attract management talent with higher salaries
• Technical economies: large firms can afford modern machinery for technological advancements, maximizing production capacity and reducing average costs

External Economies of Scale

• Benefits enjoyed by the entire industry as a whole
• Average production cost is declining, indicated by the Long-Run Average Cost (LRAC) curve shifting downwards
• External economies of scale benefit the entire industry, the long-run average cost decreases, indicated by a downward shift of the LRAC curve

Reasons for External Economies of Scale

• Economies of concentration: firms in the same industry benefit from mutual advantages like reduced advertising costs, steady demand, skilled workers, and better infrastructure
• Economies of information: firms cooperate through research facilities, journals, conferences, seminars, and trade fairs to share knowledge and improve productivity
• Economies of marketing: firms cooperate in bulk purchasing of raw materials to reduce costs

Diseconomies of Scale

• Problems and disadvantages faced by a firm as it grows larger, leading to declining returns and increasing cost
• Diseconomies of scale are the disadvantages of large-scale production

Internal Diseconomies of Scale

• Refer to problems and disadvantages faced by the firm itself
• Average production cost is increasing, as indicated by an upward-sloping Long-Run Average Cost (LRAC) curve
• Internal diseconomies of scale arise from the firms actions, increasing long-run average costs with increased output, illustrated by an upward-sloping LRAC curve

Reasons for Internal Diseconomies of Scale

• Labour diseconomies: division of labour leads to boredom, reduced productivity, lack of identity, and higher unit costs
• Management problems: difficulty in managing large firms leads to slow decision-making, administrative issues, and ineffective monitoring
• Technical difficulties: overuse of machinery leads to breakdowns and increased repair/replacement costs

External Diseconomies of Scale

• Problems and disadvantages faced by the entire industry
• Average production cost is increasing, as indicated by the Long-Run Average Cost (LRAC) curve shifting upwards
• External diseconomies of scale are the problems of the entire industry, increase long-run average costs, and shift the LRAC curve upwards

Reasons for External Diseconomies of Scale

• Concentration problems: traffic congestion and pollution increase transportation costs and reduce productivity
• Scarcity problem: competition for raw materials and land leads to higher prices and increased fixed costs
• Wage problem: shortage of skilled labour leads to higher wages and increased variable costs