Factors of Production PDF

Week 5 Factors of Production Production is the process of using the resources to produce Goods & Services for the economy. And the different resources are classified as Factors of Production. The four different factors of production are - Land, Labour, Capital and Entrepreneur. Land Land is a...

Week 5 Factors of Production Production is the process of using the resources to produce Goods & Services for the economy. And the different resources are classified as Factors of Production. The four different factors of production are - Land, Labour, Capital and Entrepreneur. Land Land is a broad term that includes all the natural resources that can be found on land, such as oil, gold, wood, water, and vegetation. Some other salient features of this factor are that it has no cost of production and it is immobile which means you cannot move it from one place to another. So, a land in Pune remains as a land in Pune. At the same time, it is limited, indestructible (as you cannot destroy land – building/ vegetation/ forest etc. may be destroyed by not land) and a passive factor of production. This is also a free gift of nature. Labour Labor as a factor of production refers to the effort that individuals exert when they produce a good or service. So, it includes all the physical or mental labour for which individuals receive wages in return. The salient features of Labor as a factor of production are: - Labor cannot be separated from laborer. - Labor is defined as the perishable factor of production which means it has a limited life. Let us explain this with an example: If an employee does not work a shift today, the time that is lost today cannot be recovered by working another day. - Labor is an active factor of production (labour is the one that either works on land or on capital to produce output, hence active) and has weak bargaining power. - Labor creates capital (as it is a man-made resource, man makes machines, plants, tools, which are regarded as capital) and supply of labor is inelastic (since it cannot be immediately increased or decreased, as the population is fixed). - Labor is considered to be heterogeneous, because the efficiency and quality of work are different for each person. It differs because it depends on an individual’s unique skills, knowledge, motivation, work environment, and work satisfaction. Capital Capital refers to all the man-made resources used for further production. Capital is a manmade factor of production for example, capital goods like machines and equipment are created by individuals, unlike land and natural resources. It is mobile because it can be transported to different places, such as computers and other equipment. It loses its value over a period of time and hence it depreciates. The supply of capital is elastic and it is a passive factor of production. Capital is also destructible so for example a building’s condition may deteriorate over a period of time. Entrepreneur In very simple language entrepreneur is someone who brings together all the other factors of production to produce something of value So, an Entrepreneur is innovative and Creative. He has great administrative power. He has Vision and foresight and is a person of action. An entrepreneur must have the ability to organize and to bear risk. Entrepreneurs are important because they are the ones taking the risk of the business and identifying potential opportunities. Law of Variable Proportion Production Function A production function shows a Functional relationship between inputs and outputs. It tells us how the output will change as there are changes in the input. Mathematically it is denoted as: Q = f(K, L, etc.) Where: Q = Output K = Capital L = Labour Fixed and variable factors of production Fixed Factor – A factor of production whose quantity cannot readily be changed; example – machinery, plant, etc. Variable Factor – A factor of production whose quantity can readily be changed; example – labour, raw materials, etc. Short run and Long run Short Run – A period of time where Some inputs/ variables are fixed while others can be changed or are variable Long Run – A period of time where All the inputs/ variable can be changed or become variable factors Total, Average & Marginal Product Total Product (TP) – The amount of output produced when a given amount of a particular input is used for the production process along with fixed input. Average Product (AP) – The total product divided by the number of units of the input used (TP/n) Marginal Product (MP) – The change in TP due to a unit change in the given input (TPn – TPn-1). The Law of Variable Proportion The law of Variable Proportion states that, “as the number of units of a variable factor goes on increasing keeping other factors constant, the total output increases initially at an increasing rate, then at a diminishing rate and eventually declines.” 1. The assumptions of the law are: 2. Technology is Constant – The technology remains the same, so whatever changes happen the TP, is a result of increasing the Variable factor and nothing else  3. At least one fixed factor – Short Run – This law determines production in the short run, hence some factors need to be fixed while others are variable 4. Possibility of varying factor proportions – There should be possibility of production of output by varying/ changing the amount of fixed and variable factors, if the production of a product required factors in rigid proportion only, then the law would not work 5. Variable factor is homogenous Example Capital Labour Total Average Marginal Stages of (Fixed (Variable Product Product Product Production Factor) Factor) (TP) (AP = (MP = TPn- (n) TP/n) TPn-1) 5 0 0 0 0 5 1 10 10 10 5 2 25 12.5 15 STAGE I 5 3 45 15 20 5 4 60 15 15 5 5 70 14 10 STAGE II 5 6 70 11.67 0 5 7 65 9.28 -5 STAGE III As we can see in the tabulation, the capital is the fixed factor (constant at 5 units) and the abour is the variable factor which is ‘0’ in the beginning and increases in one addition unit. Some observations: Till the third unit of labour, the MP is increasing and is greater than the AP, the TP is increasing at an increasing rate At the 4th unit of labour, the MP and AP are the same and the TP now starts to increase at a diminishing rate (this is the stage where stage 1 comes to an end) 5 unit of labour the AP is greater than MP, TP is increasing at a diminishing rate 6th unit of labour MP is ‘0’, TP is maximum (this is the stage where stage 2 comes to an end)  7th unit of labout, TP has begun to decline and MP becomes negative (this marks the beginning if stage 3) This is the graphical representation of the tabulation we had seen earlier, the upper diagram is depicting the TP and the lower diagram depicts the AP & MP. As we can see, with increase in the variable factor, the TP increases at an increasing rate initially, also marked by MP being greater than AP, this marks stage 1 and this stage comes to an end when MP = AP. Beyond this point AP is greater than MP but both are falling but positive, as a result the TP increases at a diminishing rate, reaching a maximum at 6th level of labour, corresponding to MP = 0 marking the end of stage 2. Any increase in labour beyond this level will case the TP to decline and MP to become negative, marking the beginning of stage 3 First stage – Increasing Returns to Factor – TP increasing at increasing rate – MP is always greater than AP Second stage – Diminishing Returns to Factor – TP increasing at decreasing rate – AP is greater than MP; but, MP is positive Third Stage – Negative Returns to Factor – MP is negative but AP is positive & greater than MP – TP had started to decline The factors that cause the first stage (Stage of Increasing Returns to Factor) in the law of variable proportion to occur Indivisibility of Fixed Factor – The fixed factor cannot be divided into smaller units, you have to take the entire thing or leave it. So for example, if you have a machine and there are 6 people required for it to work efficiently, you have to purchase the  machine, even if you have just 1 person, you cannot divide the machine into 6 pieces and just take a piece. Division of Labour – As the number of variable factor increase, there is scope for division of labour, which further increases the level of out put Better utilization of Fixed Factor – As the number of variable factor increases, the fixed factor is better utilized and there us better Coordination among variable factors, causinf output to increase further. The factors that cause the first stage (Stage of Decreasing Returns to Factor) in the law of variable proportion to occur Optimum combination of Fixed and Variable factor is crossed – As a result any increase in the variable factor now, causes the variable factor to be much greater and the fixed factor lesser, causing output to increase at a diminishing rate Fixed and Variable Factors are imperfect substitutes of each other – They are not perfect substitutes of each other, hence in the beginning (stage 1) variable factor is limiting and later by the time we get to stage 3, fixed factor becomes limiting, this is what causes the 3 stages to occur. The factors that cause the first stage (Stage of Negative Returns to Factor) in the law of variable proportion to occur Indivisibility/ limitation of fixed factor – The fixed factor now get over used and hence the productivity begins to decline Fall in efficiency of Variable factor – advantages of division of labour and specialization start to fall, as there is too much variable factor Poor coordination of variable factor – the variable factor starts to obstruct each other, instead of supporting each other Returns to Scale Returns to Scale shows the degree by which the level of output changes in response to all the inputs in a production system changing in the same proportion. Which implies that if you used 3 units of labour and 2 units of capital in your production and got a level of output what would happen if the inputs go up to 6 units of labour and 4 units of capital; and then increase to 9 units of labour and 6 units of capital As we will see, what happens is the firm experiences: – Increasing Returns to Scale – Constant Returns to Scale – Diminishing Returns to Scale Let’s say that a firm by operating in the short run was able to determine that 1 unit of capital and 3 units of labour gave the most optimal level of output.  So, in returns to scale, which is production in the long run, we will multiply the scale (1 unit of capital and 3 units of labour) over and over again to see what happens to our level of output. As you can see in the tabulation, as the scale of production goes on increasing, the TP also goes on increasing, initially at an increasing rate (change in output is greater than the change in input), followed by constant returns (change in output is the same as the change in input) and eventually diminishing returns (change in output is lesser than the change in input) This is also, demonstrated by the MP, which is initially increasing, then constant and eventually diminishing. The same behaviour is also reflected in the graph that you have in front of your screen. When there is increasing returns the MP line is upward sloping, when it is constant returns the MP line is a horizontal line parallel to the X-axis, and eventually when it is diminishing line the MP curve is downward sloping. Factors that cause the 3 stages to occur 1. Stage of Increasing Returns to Scale: When all the factors of production are increased in a given proportion and the output increases by a greater proportion, it is regarded as increasing returns to scale. The factors that cause the increasing returns to scale are: – Specialization – As the scale of production goes on increasing there is scope for greater specialization leading to greater output – Managerial Efficiency – With the increase in the scale of production, the manager becomes more and more efficient and thereby further enhance the level of output – Economies of scale – These are factors apart from direct production, that help in the improvement in the level of output, like institutional policies/ communication/ etc. 2. Constant Returns to Scale: When all the factors of production are increased in a given proportion and the output also increases by the same proportion, it is regarded as Constant Returns to Scale. The factors that cause the constant returns to scale are: – Benefits of specialization have been realized – So all the scope of specialization has been achieved and now there is nothing that can be done. As a result, the organization continues to operate at that efficiency for some time leading to constant returns to scale – Benefits of Managerial Efficiencies have been realized – Similarly, the benefits of Managerial Efficiency have also been completely realized and there is nothing that can be done. As a result, the organization continues to operate at that efficiency for some time leading to constant returns to scale So, it would be safe to say, that in Constant Returns to Scale the firm is simply reaping the benefits of specialization and managerial efficiency developed in the increasing returns to scale. 3. Diminishing returns to scale: When all the factors of production are increased in a given proportion and the output increases by a lesser proportion, it is regarded at diminishing returns to scale. The factors that cause the diminishing returns to scale are: – Managerial inefficiencies – The managerial efficiency that let to the increasing returns in the beginning now becomes a hindering factor as managerial inefficiency begin to set in as a result of significant increase in the scale of production. As a result, ego clashes/ other issues among managers come up which leads to a fall in production, – Indivisibility of enterprise – The enterprise has a specific size of operation, if the scale of production increases beyond that level it becomes extremely difficult to manage leading to fall in the level of output – Diseconomies of Scale – This is the opposite of economics of scale, these are again factors apart from direct production, that help in the fall in the level of output like infrastructure bottlenecks/ pollution/ limited raw materials/ etc. Cost Concepts Costs refers to the money expenses incurred by a firm in the production of goods and services. There are various cost concepts that a firm considers relevant under various circumstances. In economics, the term cost is used in a broader sense, and we will go through various cost concepts in more detail as we progress through this lecture. The various cost concepts are: – Nominal Cost and Real Cost – Explicit & Implicit Cost – Accounting & Economic Cost – Direct & Indirect Cost – Actual & Opportunity Cost – Private & Social Cost – Incremental & Sunk Cost – Historical & Replacement Cost – Production Costs Fixed & Variable Cost Total, Average & Marginal Cost Short run & Long run cost 1. The concepts of Nominal Cost and Real Cost: Nominal cost is the money cost of production. These include expenses paid to the factors of production employed or for the raw materials used in production. This is the cost that is identifiable since it is paid for in money terms.  Real cost is the cost of producing a good or service, including the cost of all resources used including time, labor, lost opportunity, etc. It also includes the cost of not employing those resources in alternative uses. Thus, it is the nominal cost that is seen and accounted for as well as the cost that is not accounted for. 2. The concepts of Explicit and implicit cost: Explicit costs are those payments that must be made to the factors hired from outside; or basically all the costs incurred. Hence, they are the monetary payments such as rent, wages, interest, etc. On the other hand, Implicit costs refers to the payments made to the self- owned resources used in production. For example, a businessman utilizes his services in his own business leaving his job as a manager in a company or if he uses his own space instead of renting a place for his business. Thus, the value of the rent or his salary which in not directly visible is implicit cost. 3. The Accounting & Economic Cost Accounting cost is the money cost of production. These include wage of labour, interest on borrowed funds, cost of raw materials, etc. that can be recorded in the book of accounts. Thus, the accounting cost is also known as explicit cost (Accounting Cost = Explicit Cost). While, Economic cost is the total cost of production irrespective of whether it can be recorded in the book of accounts or no. Thus, economic cost includes implicit cost like – imputed value of the entrepreneur’s own resources and services, etc. in addition to the explicit cost. Hence, Economic Cost = Explicit Cost + Implicit 4. The concepts of Direct & Indirect Cost Direct costs are the costs that have a direct relationship with production, i.e., they can be easily and directly identified. For example, the salary of a manager. Direct costs directly enter into the cost of production but retain their separate identity. As they may be put under specific budget heads While, Indirect costs are the costs that have do not have a direct relationship with production, i.e. they cannot be easily and directly identified, but are required for general business expenses. For example, depreciation of capital assets, rent, utilities, etc. 5. Actual & Opportunity Cost Actual costs refer to the costs which a firm incurs for acquiring inputs or producing a good and service such as the cost of raw materials, wages, rent, interest, etc. It includes the total money expense recorded in the books of accounts are the actual costs. On the other hand, the Opportunity cost is the cost of sacrifice of the best alternative foregone in the production of a good or service being produced. The opportunity cost  of using land for growing rice is the value of alternative crop that could have been grown on it. The opportunity cost of labour is what it could get in some alternative employment. 6. The concepts of Private & Social Cost Private costs are the costs incurred by a firm in producing a commodity or service. These include both explicit and implicit costs. The production activities of a firm may lead to economic benefit or harm for others. For example, production of commodities like steel, rubber and chemicals, pollutes the environment which leads to social costs. On the other hand, production of services like – education, sanitation services, etc. leads to social benefits. Thus, the Social cost = Private cost + external cost arising to society. 7. The concept of Incremental & Sunk Cost Incremental costs represent the total additional costs associated with the change in the nature and level of business activity. Adding or replacing a machine, changes in distribution channel, addition in man power etc. are all examples of incremental cost Sunk cost on the other hand includes all the past or actual costs. Thus, sunk costs are irrelevant for decision making as they do not vary with the changes expected for future 8. Historical Cost and Replacement Cost The historical cost is the actual cost of an asset incurred at the time the asset was acquired. It means the cost of a plant at a price originally paid for it. Historical cost of assets is used for accounting purposes, in the assessment of net worth of the firm Replacement cost on the other hand means the price that would have to be paid currently for acquiring the same plant. Replacement cost is used for business decision regarding the renovation of the firm. Production costs Production Costs – Fixed & Variable Cost – Total, Average & Marginal Cost – Short run & Long run Cost 1. Fixed and the Variable Cost: Fixed costs are the expenditure incurred on the factors such as capital, equipment, plant, factory building which remain fixed in the short run and cannot be changed. Therefore, fixed costs are independent of output in the short run i.e., they do not vary with output in the short run. Even if no output is produced in the short run, these costs will have to be incurred.  Variable costs are costs incurred by the firms on the employment of variable factors such as labour, raw materials, etc., whose amount can be easily increased or decreased in the short run. Variable costs vary with the level of output in the short run. If the firm decides not to produce any output, variable costs will not be incurred. 2. Total, Average & Marginal Cost Total cost refers to the total outlays of money expenditure, both explicit and implicit on the resources used to produce a given output. Average cost is the cost per unit of output which is obtained by dividing the total cost (TC) by the total output (Q), i.e., TC/Q Marginal cost is the addition made to the total cost as a result of producing one additional unit of the product. Marginal cost is defined as: TCn – TCn-1 3. Short run and Long run cost Short-run costs are the costs which vary with the change in output, the size of the firm remaining the same. Short-run costs are fixed cost + variable costs. In the short run you can change the level of output only by changing the variable factors of production keeping some factors fixed Long-run costs are incurred on increasing the scale of production. In the long run there are no fixed costs as all the costs become variable. As the size of the firm or scale or production is increased, it leads to long run cost. Short Run Cost Curves Cost Cost is defined in simple terms as a sacrifice or foregoing which has already occurred or has potential to occur in future with an objective to achieve a specific purpose measured in monetary terms. Cost results in current or future decrease in cash or other assets, or a current or future increase in liability. Short run and Long run Short Run A production period in which at least one of the input is fixed. A fixed input is an input which the quantity does not change according to the amount of output. E.g. machinery Long Run A production period in which all the inputs are variable. A variable input is an input which the quantity varies according to the amount of output. E.g. labour The total fixed cost, does not vary with the level of output; e.g. plant, machinery, building. So whether you produce the entire capacity of the plant or just 1 unit, the fixed cost would remain the same. Shape of Total Fixed Cost (TFC): TFC curve is a straight line, parallel to the quantity axis, indicating that output may increase to any level without causing any change in the fixed cost.The total variable cost, is the costs that varies with level of output and will be zero if no production is undertaken; e.g. cost of raw materials, wages. So, as you go on increasing the level of production, the variable cost will also go on increasing. Shape of Total Variable Cost (TVC) Normally TVC is an inverted S shaped upward sloping curve, due laws of variable proportions.TVC may also be a straight line starting from origin. Total Cost is the sum of TFC and TVC. Slope of TC curve is determined by that of the TVC. Hence, the TC can be a straight line starting from the Y-axis (if TVC is linear). Or, it can be an inverted S-shaped curve if the TVC is inverted S-Shaped Curve Average Cost (AC) is total cost per unit of output. AC is equal to the ratio of TC and units of output. (TC/Q) AC=AFC+AVC Similarly, Average Fixed Cost (AFC) is fixed cost per unit of output (AFC= TFC/Q) Average Variable Cost (AVC) is variable cost per unit of output (AVC= TVC/Q) Marginal cost (MC) is an extremely important concept in microeconomics, – (MC) is the change in total cost due to a unit change in output. MCq= TCq – TCq-1 Since the fixed component of cost cannot be altered, MC is virtually the change in variable cost per unit change in output. – Also known as rate of change in total cost. All decisions are made keeping the marginal cost in mind. The shape of the short run cost curves is determined by Law of Variable Proportion TFC is a horizontal line parallel to X-Axis – Since the Fixed cost does not change TVC & TC are inverted S–Shaped – due to increasing and decreasing returns to factor AVC & AC are U Shaped – Since the AP is first increasing and then decreasing MC is J–Shaped – Since the MP is first increasing and then decreasing AFC is downward sloping but never touches X-Axis Figure: The shapes of the various cost curves The relationship between AC & MC When the MC is declining, the AC is also declining The MC reaches a minimum & begins to rise even while the AC is falling The MC rises much faster than the AC curve It is the MC that drives the AC The MC cuts the AC from below Figure: The relationship between AC & MC Long Run Average Cost Curve Cost is defined in simple terms as a sacrifice or foregoing which has already occurred or has potential to occur in future with an objective to achieve a specific purpose measured in monetary terms. Cost results in current or future decrease in cash or other assets, or a current or future increase in liability. Short Run is a production period in which at least one of the input is fixed. A fixed input is an input which the quantity does not change according to the amount of output. E.g. machinery Long Run is a production period in which all the inputs are variable. A variable input is an input which the quantity varies according to the amount of output. E.g. labour. All costs are variable in the long run since factors of production, size of plant, machinery and technology can be varied in the long run. The long run cost function is often referred to as the “planning cost function” and the long run average cost (LAC) curve is known as the “planning curve”. As all costs are variable, only the average cost curve is relevant to the firm’s decision making process in the long run. One important point to note is that, the long run consists of many short run period (just like days make months and months make years), therefore the long run cost curve is the composite of many short run cost curves. Figure: Long run average cost curve In the long run the firm may increase plant size to increase output (if the cost on the current plant goes on increasing). Thus, as output is increased from q0 to q1 capacity at SAC1 is overworked, since the cost at SAC1 is increasing and that at SAC2 is decreasing. It would make more sense for a producer to move from SAC1 to SAC2 and produce a greater level of output. Hence the firm shifts to a higher plant size SAC2. This shift lowers the average cost of production for the firm. The same process would be repeated if the firm increases its output further to q2, in this case the firm will move from SAC2 to SAC3 as the level of output goes beyond Q3. Thus, we can see a curve that is covering/ enveloping all the short run cost curves, this is known as the long run average cost curve. The red curve in the graph is the Long Run Average Cost Curve.