Principles of Production

Principles of Production

In this lesson, you’re expected to:
– understand how resources are allocated
– learn about the factors of production
– discover how the production function and production possibility frontier work

Resource Allocation

Economic resources are the goods or services available to individuals and businesses used to produce valuable consumer products. The classic economic resources include land, labor and capital. Entrepreneurship is also considered an economic resource because individuals are responsible for creating businesses and moving economic resources in the business environment.

These economic resources are also called the factors of production. The factors of production describe the function that each resource performs in the business environment.

Producing a Commodity

Whatever is used to produce a commodity is called its inputs. For example, for producing wheat, a farmer uses inputs like soil, a tractor, tools, seeds, manure, and water.

All  inputs are classified into two groups — primary inputs and secondary inputs. Primary inputs render services only whereas secondary inputs get merged with the commodity for which they are used.

In the above example, soil, the tractor, tools and the farmer’s services are primary inputs because they render services only whereas seeds, manure, water and insecticides are secondary inputs because they get merged with the commodity for which they are used. It is the primary inputs which are also known as factors of production.

Primary inputs are also called factor inputs and secondary inputs are known as non-factor inputs. Alternatively, production is undertaken with the help of resources which can be categorized into:
– natural resources (land)
– human resources (labour and entrepreneurship)
– manufactured resources (capital)

These four components (Land, Labor, Capital, and Entrepreneurship) make up the Factors of Production.

Let’s look at each of these factors in more detail.

What are the Factors of Production?

The resources that are needed to create goods and services are called the factors of production.

All factors of production are traditionally classified in the following four groups:

1) Land

Land refers to all of the natural resources that businesses need to make and distribute goods and services. This could include physical land, farms, fisheries or other extractable natural resources such as coal, oil and gas.

All of these things are alike in that they are provided by nature rather than made by humans.

Land is usually a limited resource for many economies.

2) Labor

Labor represents the human capital available to transform raw or natural resources into consumer goods. This means the employees and workers who contribute to the production of goods and services.

Human capital includes all able-bodied individuals capable of working in the nation’s economy and providing various services to other individuals or businesses. This factor of production is a flexible resource as workers can be allocated to different areas of the economy for producing consumer goods or services.

Labor includes not just the number of employees but also the various abilities required from workers.

For example, the labor needs of a paper company would probably differ substantially from the labor needs of a computer company, even if both needed the same number of employees.
Labor is divided into three types – unskilled, skilled, and professional.

1) Unskilled labor refers to people without formal training who are paid wages to do repetitive tasks like perform assembly­ line production.

2) Skilled labor refers to people paid wages for what they know and what they can do. For example, electricians or mechanics.

3) Professional laborers are paid wages for what they know. Doctors, lawyers, and scientists are inluded in this category.

3) Capital

This factor of production has a dual meaning. Capital refers to the finance invested in the firm by the owner/shareholders, but it also includes all man-made tools that help production such as equipment, machinery, vehicles, and buildings.

In addition, capital is also defined to include the money used to buy such equipment and to start and maintain business operations.

4) Entrepreneurship

The role of an entrepreneur is to bring together the factors of production in order to produce a good or service.

Entrepreneurship is considered a factor of production since economic resources can exist in an economy and not be transformed into consumer goods.

Entrepreneurs usually have an idea for creating a valuable good or service and assume the risk involved with transforming economic resources into products.

[Optional] The Four Factors of Production
Watch this 2-minute video to learn more.
Link to the video:
The production function & PPF
Law of Diminishing Returns

This law comes into play whenever a firm tries to increase output by applying additional variable inputs to a fixed factor.

Production requires the combination of both fixed and variable factors to create an output. Economic theory predicts that if firms increase the number of variable factors they use, such as labor, while keeping one factor fixed, such as machinery, the extra output or returns from each additional, marginal unit of the variable factor must eventually diminish.

Diminishing marginal returns forms part of a larger principle, called the principle of variable proportions. This states that, assuming one factor is fixed, the marginal returns generated from adding new variable factors will not be constant.

In fact, returns will rise at first, reach a turning point, and then eventually diminish. The law of diminishing marginal returns simply refers to the last phase of this principle.

Production Function

Production is the result of the cooperation of the four factors of production.

This is evident from the fact that no single commodity can be produced without the help of any one of these four factors of production. Therefore, the producer combines all the four factors of production with the aim of maximizing profit. For this to be possible, the producer decides to maximize the production at minimum cost by means of the best combination of factors of production.

Enlarged version:
The Production Function Explained

In simple terms, the production function refers to the functional relationship between the quantity of a good produced (output) and factors of production (inputs).

In this way, the production function reflects how much output we can expect depending on how much labor or capital is used.

In other words, we can say that production function is an indicator of the physical relationship between the inputs and output of a firm.

Mathematically, such a basic relationship between inputs and outputs may be expressed as:
Q = f ( L, K, N )

Where Q = Quantity of output
L = Labour
K = Capital
N = Land

Hence, the level of output (Q), depends on the quantities of different inputs (L, C, N) available to a firm.

Production Possibility Frontier

A production possibility frontier (PPF) shows the maximum possible output combinations of two goods or services an economy can achieve when all resources are fully and efficiently employed.

We normally draw a PPF on a diagram as concave to the origin i.e. as we move down the PPF, as more resources are allocated towards Good X, the extra output gets smaller – so more of Good Y has to be given up in order to produce Good X.

Enlarged version:
Use of a Production Possibility Frontier

A production possibility frontier is used to illustrate the concepts of opportunity cost, trade-offs, scarcity and also show the effects of economic growth.

Points within the curve (D,E) indicate that resources are not being fully utilized while points lying on the curve (A,B,C) are efficient output combinations.

See enlarged image:
[Optional] Opportunity Cost in a Production Possibility Frontier
Watch this 3-minute video to see how a PPF can be used to explain Opportunity Cost.
Link to the video:
Jim Rohn Sứ mệnh khởi nghiệp