Theory of Production and Cost

An economic unit engaged in the production of one of more economic goods or services is a business firm.
Created On: Nov 29, 2014 18:37 IST

What is theory of production?

The theory involves some of the most fundamental principles of economics. It is an effort to explain the principle, by which a business firm decides how much of each commodity that it sells,it will produce and how much of labour, raw material, fixed capital good, etc., it will use.

This also includes the relationship between the prices of commodities and the wages or rents of the productive factors used to produce them. On the one hand, it explains the relationship between the prices of commodities and productive factors, on the other, the quantities of these commodities and productive factors that are produced or used.

Meaning of Business Firm 
An economic unit engaged in the production of one of more economic goods or services is a business firm. It combines economic resources i.e. factors of production, to produce one or more goods for the purpose of making profits. .

Relativity of Production and Cost

A business firm buys economic resources called inputs, and sells the goods it produces called outputs. The factors of production used by a firm in the production of a good or a service are generally referred to as inputs A firm has to pay for the inputs it needs. Inputs generate costs and generateoutput. 

To elaborate more, a factor of production that cannot be changed in the short-run is called Fixed Input whereas; a factor of production that depends upon the level of production is called Variable Input. Variable inputs change depending upon how much we choose to produce.

Cost Theory

Cost theory is directly related to production theory, they are often used together.The query is usually how much to produce, incontrast to which inputs to use. That is, how much should we produce in order to minimize costs and to maximize profits?  We need to also learn a lot about what kinds of costs matter for decisions made by managers, and what kinds of costs do not.

Meaning of Law of diminishing return

A concept in economics that if one factor of production,  for example number of workers, is increased while other factors  for example machines and workspace are held constant, the output per unit of the variable factor will eventually diminish or reduce.

The marginal productivity of the workforce decreases, as output increases. To explain with an example, diminishing returns do not mean negative returns until the number of workers exceeds the available machines. In everyday experience, this law is expressed as "the gain is not worth the pain."

To clarify more, law of diminishing returns

  • requires that the method of production does not change as variable input changes
  • does not apply when all inputs are varied.
  • is when applied to production we get the classical production function.
  • increasing marginal returns at first and decreasing marginal returns afterwards.
  • it is possible that marginal returns could decrease in the beginning with the first application of the variable input.

Factors of Production 

Thebasic, land, labour, capital and entrepreneurship cover all of the inputs needed to produce a good or a service. Labour means, all of the work that labourers and workers perform at all levels of an organization, except for the entrepreneur who is the individual who takes an idea and attempts to make an economic profit from it. The entrepreneur does this by combining all other factors of production.

The entrepreneur also is entitled for all of the risks and rewards of the business. The capital is all of the tools and machinery used to produce a good or service.

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