Production and Costs: Understanding Business Efficiency
Theory of Production and Costs
Production is defined as any use of resources that can transform a good into a different one. Production includes both goods and services because, from an economic point of view, they are the same; both have been used in your work and factor generation capital.
Company
A company is defined as any organization where there is an employer and one or more employees. The purpose of a company is to purchase, hire, and process resources for selling goods and services. Employees receive a fixed salary provided for a period on contract, regardless of the rate of production, sales, or profits of the company. The employer, who organizes production and assumes the risk of business, does not receive a wage rate set forth in a contract as employees do, but appropriates the profit.
Considerations in Production
Transaction Costs: A transaction between two individuals or organizations generates costs called “transaction costs.” Businessmen have to minimize these costs in areas such as:
- Efficiency
- Avoiding maximum specialization
- The recruitment of inputs from other companies
The role of supervisors is also important in minimizing transaction costs.
Goal of Firms
The main goal of firms is profit maximization.
Basic Elements of Profit Maximization
- Maximizing sales
- Growth maximization
- Cost minimization
Production Supplies
Factors of production, or productive resources, include items such as:
- Talent for business
- Risk-taking
- Different kinds of machinery
- Labor
- Construction services
To simplify the classification of inputs, we can categorize them as labor and capital. We can also classify them as fixed or variable.
- Short Term: Only variable supplies change.
- Long Term: All factors of production are variable.
Relationship Between Production and Supplies
An enterprise gathers certain types of inputs and combines them to obtain a product that is what the company finally sells. Therefore, the company needs to be efficient in terms of technology.
Technical Efficiency
The production process requires that no more supplies than needed are used to get a given level of output, given the existing technology.
Considerations
- Relative price of technological inputs
- Continuity of supply
- Abundance of work
Function of Production
The relationship between physical supplies and product is defined as the mathematical ratio establishing the maximum amount of product that may be obtained from certain sets of inputs. Q = f(L, K)
In the long term, Q = f(L, K).
Role of Production in the Short Term
- Total Physical Product: In this case, it is assumed that there is a factor of production that varies over time, “the labor factor,” while the “capital factor” remains constant.
- Average Physical Product: Defined as total output divided by the number of variable inputs.
- Marginal Physical Product: Defined as the change in total product (in absolute value) related to an increase or decrease of one unit of variable input.
The Law of Diminishing Marginal Returns
Keeping technology and all supplies constant except one, as the variable input is incremented in equal amounts, beyond a certain point, the resulting production increase will decrease. In other words, after a certain point, the marginal physical product of the variable input begins to diminish.
Conditions for the Law of Diminishing Marginal Returns
- Only one input in production is amended, and all else remains strictly constant.
- The “state of knowledge” is fixed; that is, technology does not change.
- Production ratios are variable; that is, we are not working with a function of fixed proportions in which one unit of labor is used with, say, two units of capital.