We have so many successful businesses across many industries, how do you think they make their decisions on the commodity they sell and the appropriate amount to produce? They do this using the theory of production. 

What is the Theory of Production in Economics?

The theory of production is an economic concept that helps companies or individuals understand how many goods and services can be sold, and the kind of resources such as labour, raw material, and capital among others, that are required to be used.

This theory helps companies and individuals understand the number of goods and services they need to produce to respond to the demand in the market.

In economics, production can be seen as any activity that satisfies human wants. 

Example of Theory of Production

Using a bakery as an example, the bakery owner needs inputs such as flour, equipment and labour combined to produce pastries being sold at the bakery. The theory of production helps the bakery owner understand that the cost of all those inputs, equipment maintenance and labour wages should be added to the overall cost of production.

Theory of Production Function

The theory of the production function shows the relationship that exists between the physical inputs, which are the factors of production, and the physical outputs of a production process. This function shows how the change in capital and labour quantities affect output.

Factors of production

In economics, factors of production refer to the inputs that are needed for creating a good or service. There are four factors of production and they are explained below.

Land 

Land is a free gift of nature, it includes all natural resources like minerals, oceans, soil, air etc. 

Characteristics of land

Here are the characteristics of land.

• Land is nature’s free gift.
• Land needs the interference of human effort to bring results.
• Land is immobile. 
• Land properties are indestructible.

Labour 

Labour is any kind of physical or mental effort. In economics, work is the endeavours applied to deliver any labour and products. It encompasses all human efforts, including mental exercise, intellectual use, and physical exertion. done in exchange for monetary compensation.

Characteristics of labour 

Here are the characteristics of labour.

• Labour is perishable. 
• Labour requires human efforts.
• Labor is quite heterogeneous.
• Not all labour is productive.
• Labor is mobile, but still experiences barriers in movements.

Capital 

Capital can be defined as the productive portion of an individual or company’s wealth used to produce goods and services. 

Characteristics of Capital

Here are the characteristics of capital.

• Capital is passive and needs labour to be productive.
• Capital is the most mobile among the other factors of production.
• Capital is destructible. 

Entrepreneur 

An entrepreneur starts the whole production process by mobilizing all the factors of production and mobilizing them for use.

Functions of the Entrepreneur

Here are the characteristics of an entrepreneur.

• Bears the risk. 
• Starts the business.
• Technological risk.
• Innovation.

Theory of Product Pricing

This is a strategy that explores all economic options on how businesses can determine the price of their goods and services. Businesses will be able to increase both their profitability and revenue thanks to a profitable pricing framework.

One can be sure that the product will meet consumer demand, outperform rivals, and generate profits when the pricing strategy is carried out appropriately in accordance with the theory of product pricing.

Understanding the various pricing frameworks and the process by which an organization must establish the appropriate framework for pricing its products is important.

Key Concepts Relating to the Theory of Product Pricing

Here are key concepts you should have in mind about the theory of product pricing.

• Demand and supply: The law of supply states that an increase in price leads to an increase in supply. The demand and supply of products will help the market determine the price.
• Cost of production: Businesses will take into account the direct cost and the expenses of goods and services such as the cost of labour, machinery, equipment and the manufacturing and transportation of the products. All these being considered can influence the pricing of the products.
• Having a market-suitable price: This has to do with understanding what consumers are willing to pay for your product and services. You will also need to check what your competitors are selling if you have any, and what unique selling point you are offering to warrant the price you want to set. 

Theory of Production and Cost

The theory of production and cost explains the functional relationship between the production of goods and services and the cost needed to produce that goods and services. When determining a product’s cost, numerous factors must be considered.

Short run cost

These are costs that have a short-term impact on the production process because they are used for a limited range of output. They are the expenses in the production process that are brought about once and can’t be utilized over and over, like an instalment of wages, or raw materials. Most of the factors of production in short-run cost are variable with at least one fixed cost.

Examples of short-run cost 

A bakery is running a pop-up shop for two days at a popular music festival and will need to produce more pastries than they would on a normal workday. To meet the demand in the short run, they can increase their level of output with variable factors. Such as the bakery can employ some ad-hoc bakers or purchase the raw material in bulk.

However, the oven and other baking equipment which are fixed cost, cannot be altered to enhance the bakery’s production capacity. Therefore, all costs incurred on variable factors such as labour and raw material are the short-run cost.

Long run cost

This is a planning and implementing stage where all factors are variable. In the long run, there is no fixed cost.

Example of long-run cost

Using the bakery as an example, if the owner of the bakery operates its business on lease and rent, this is said to be a long-run cost. Because this is a shop and equipment leased and rented, they can alter or moderate it if needed to suit the bakery business.

Fixed cost and variable cost

You’ve probably wondered what fixed and variable cost means. Here is a simple definition of both.

• Fixed cost: Fixed costs are expenses that do not change when production or sales volumes increase or decrease. This is because they are not directly involved in providing a service or manufacturing a product.
  
  Examples of fixed costs are rent, lease, and salaries among others.
  
• Variable cost: Variable costs are expenses that change in proportion to a business’s production or sales volume. Examples of variable costs are raw materials, and daily temporary staff payments among others.

Key Takeaways

• The theory of production helps businesses or individuals understand how many goods and services can be sold, and the kind of resources such as labour, and raw material,  among others,  is required.
• Understanding production pricing will help businesses determine the best way to price their goods and services.
• The theory of production and cost is based on the short-run and long-run theory.

FAQs

Q. What is the theory of production in microeconomics?

Ans: The theory of Production in microeconomics is how businesses decide the amounts of goods and services to produce to respond to consumer demand.

Q. What is Cobb Douglas’s theory of production?

Ans: The Cobb Douglas theory of production function explains the relationship between the physical output of production and production inputs (factors).

Q. What is the importance of theory and production?

Ans: The theory of production helps businesses or individuals understand how many goods and services can be sold, and the kind of resources such as labour, and raw material,  among others,  is required.

Q. What are the factors of production?

Ans: The four factors of production are Land, Labour, Capital and Entrepreneur.

Take a quiz

Q. Which of these factors of production is immobile?

1. Land
2. Labour
3. Capital 

Q. Which theory is the theory of production based on?

1. Short run
2. Long run
3. All of the above.

Q. Should a business consider if their price is suitable for the market they’re going for?

1. Yes
2. No
3. Maybe