Theory of Production and Cost: Meaning and Need

How does a business firm decide how much of the commodity it will sell? Why is it essential to determine the selling units? Until the organisation chooses the quantity to sell, it can not be sure about the amount to produce. Kinds or types of labour, cost of delivery, procurement of raw materials, and other factors of production depend upon this decision. Therefore, to decide the relationship between commodity to produce and its price, it is essential to understand the theory of production and cost.

Factors of Production

The factors of production are the inputs for producing goods or services. As per the theory of cost formula, there are four types of elements of production:

A-Labour:

Labour means the efforts put in by individuals to bring products or services to the market. All human endeavours, whether physical or mental, are defined as labour. It is so because no production can occur without people’s efforts, abilities, and skills. Labour can be skilled, unskilled, semi-skilled, or professional. 

B-Land:

Land as a factor of production includes entire natural resources, be they are above the surface of Earth or below the surface. It is the primary factor of production, and all the gifts of nature, such as rivers, climate, and mountains, are these factors of production.

C-Capital:

Capital is an artificial factor of production. As per the cost of production theory, capital means money. However, capital does not produce goods or services but facilitates production. It helps the entrepreneurs purchase other production factors and pay wages.  

D-Entrepreneur:

According to the production and cost theory, an entrepreneur uses all the other factors of production in the production process. He decides what to produce, where to produce, and how to produce. 

He is the one with imagination and creative powers. He is a knowledgeable person with a professional attitude and knows how to organise other factors and be cost-effective.

Theory of Production 

The cost of production theory explains the relationship between commodity production and its sales and other factors involved. It is also the relationship between the price of the final commodity and the cost of wages, labour, and rent. It is the relationship between the price and productive factors.

A company uses certain production factors to produce goods and services. These factors are called inputs, and the company has to pay a certain amount as a cost for generating these inputs; these costs are the outputs.

An organisation cannot change its fixed cost of production in the short run, but it can undoubtedly curtail its variable cost to increase the profit margin. The cost of production theory means that cost is directly proportional to production. The theory of production and cost is to minimise the cost of production to maximise profits.

Law of Diminishing Returns

The cost of production theory of value mentions that if one factor of production increases while other factors remain the same, then the per unit output of the variable element will eventually reduce.

With the increase in output, there is a decrease in the marginal productivity of the workforce. The law of diminishing returns does not mean negative returns, but it will show negative returns when the numbers of workers are more than the number of machines available. 

Thus, as per the theory of cost formula:

• The production method is inversely proportional to the variable input.
• When all the factors of production are inconsistent, then this law does not apply.
• The marginal return increases at first, and then they start decreasing.
• The marginal returns may decrease at first using the first variable factor.

Theory of Cost

The cost incurred in any enterprise depends upon the supply and expenses. The cost is either a short-run cost or a long-run cost.  

A-Short Run Cost 

Short-run cost means expenses of a company during the short run. The theory of production and cost defines the relation between input and output. A company can increase its output by changing variable factors, and the fixed variables remain the same. The cost of production theory of value says that short-term costs have short-term implications, giving a short output range.

B-Long Run Cost

A company functioning for an extended period can change any cost or factor of production to obtain the output of their interest. 

As per the theory of production and cost, cost and production are directly related. Different expenses affect the organisation’s decisions. Every entrepreneur wants to produce the maximum at minimum possible prices to maximise profits.

Conclusion:

The theory of production and cost is very important for pricing. It is the base for a company’s demand for production factors about their supply. This relation decides the prices of products and services. The theory of production and cost further helps in maximising profit. Every organisation must consider the marginal and average cost of production to define the relationship between input and output.