Theory of The Firm

Theory of production
Factors of production
 The sum total of the economic resources which we have in order to provide
for our economic wants are termed as factors of production. Traditionally
economists have classified these under four headings. They are
 Labour
 Land
 Capital
 enterprenuership
Factors of production and their reward
 Factor reward
 Land rent
 Labor salary/wages
 Capital interest
 Entrepreneur profit
Theory of the firm
 This deals with how firms combine various inputs to produce a stipulated output in an economically efficient manner, given
technology.
 Varying the proportions

 In making a product, a firm does not have to combine the inputs in fixed proportions.
 basic concepts
 i. The short run: The period of time in which at least one factor is fixed in supply i.e. cannot be varied.

 ii. The long run: The period, in which all factors may be varied, in which firms may enter or leave the industry.

 iii. Variable (factor) Input: This is a factor of production which varies with output in the short run and is one whose
quantity may be changed when market conditions require immediate change in output.

 iv. Fixed Input: Is factor whose quantity in the short run cannot readily be changed when market conditions require an
immediate change in output.

 v. Total Physical Product (TPP): This is the total output realized by combining factors of production.
 . Average Physical Product (APP): This is the average of the Total Physical product
per unit of the variable factor of production in the short run. Thus, if the variable
factor is labour, average physical product is output per unit of labour e.g.

 Total Physical Product = Total Physical Product

 Number of Workers

 vii. Marginal Physical Product (MPP): Is the addition to the total physical product
attributed to the addition of one extra unit of the variable input to the production
process, the fixed input remaining unchanged.

Factor combination in short run
 In the short run at least one of the factors of production will be fixed and
changes in output will be caused by varying only one input
 Assumptions for factor combination in short run
 1. The time period must be the short run i.e. there must be a fixed
factor of production.
 2. There must be a variable factor of production.
 3. Successive units of the variable factors must be equally efficient.
 4. There should be no changes in the production techniques

Plot this coordinates
 Table 1

 1 2 3 4
 No. of workers Total product Average product Marginal product
 0 0 0
 1 8 8 8
 2 24 12 16
 3 54 18 30
 4 82 20.5 28
 5 95 19 13
 6 100 16.7 5
 7 100 14.3 0
 8 96 12 -4
observation
 i) MPP begins by rising, reaches a maximum and then falls.

 ii) When TPP is increasing at an increasing rate, MPP is raising
 iii) When TPP is at increasing at a decreasing rate, MPP is falling
 iv) When TPP is at the maximum i.e. increasing at a zero rate when MPP is
equal to zero,
 when TPP is falling i.e. increasing at a negative rate, MPP is negative; hence MPP is
the measure of the rate of change in TPP.
 v) APP begins by rising, reaches a maximum and then falls.
 vi) When APP is rising, MPP is above it, although MPP begins to fall earlier than
APP, when APP is falling, MPP is below it. MPP is equal to APP when is at the
maximum
THE LAW OF DIMINISHING RETURNS
(LAW OF VARIABLE PROPORTIONS)
 The law of diminishing returns comes about because of several reasons:


 1. The ability of labour to substitute for the fixed quantity of land.


 2. The marginal physical output of labour increases for a time, as the benefits of
specialization and division of labour make for greater efficiency.

 3. Later all the advantages of specialization are exhausted.


 4. The law of diminishing returns comes about because each successive unit of the
variable factor has less of the fixed factor to work with. In fact, they therefore start
getting in the way of others with the fixed factor with consequent decline in output.
Factor combination in the long run
 In the long run it is possible to vary all factors of production. The firm is
therefore restricted in its activities by the law of diminishing return to
scale.
 ISOQUANT ANALYSIS
 If the various combinations of factors of production which produce the same
amount of output are plotted on a graph this produces an isoquant or equal
product curve
Units Y
Of Capital
6
5
4
• 2 3 4 5 6 X
Units of labour

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Theory of production

 Total Physical Product = Total Physical Product

 i) MPP begins by rising, reaches a maximum and then falls.

 The law of diminishing returns comes about because of several reasons:

 1. The ability of labour to substitute for the fixed quantity of land.

 3. Later all the advantages of specialization are exhausted.

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