PRODUCTION THEORY

PRODUCTION THEORY

Increasing the supplies of any consumer good or service requires
the relevant producers to employ more resources and/or to
increase the PRODUCTIVITY of each resource. Leaving aside productivity
for the moment, consider the issue of how many and what
sort of factors of production to employ. What is the ideal mix of
resources to secure the most efficient level of output for any one
consumer good and also, given this factor combination, is there
some ideal size or scale of enterprise to produce the good or service
in question?
The first question relates to the optimum employment ratio of
land/labour/capital; the second refers to the OPTIMUM SIZE OF FIRM.
The Law of Diminishing Returns
If an entrepreneur experiments with employment ratios to find the
ideal blend of, say, labour to capital in production, he/she will run
up against one of the oldest laws in economics. Consider the
employment of labour and capital in, for example, running a coffee
shop in the centre of town.
© 2004 Tony Cleaver
What would your choices be if you were the entrepreneur making
the business decisions? Suppose first of all that the service you
provide is winning you lots of custom – people are queuing up to
come in to your premises. Clearly you want to expand the service –
sell more coffee and make more profits – but if there are so many
customers that you cannot maintain the same high standards, you
will lose the opportunity to make money as potential sales are lost to
rival suppliers. Solution: employ more waiters and bar staff. Taking
on one more worker may boost sales and profits significantly. If
customers keep on coming, you may need to employ more, and
more labour.
But what about capital equipment? Additional seating, the
crockery and cutlery, the espresso machine, and so on? If there is no
corresponding increase in these inputs to match the increase in
labour to your business then you cannot expect your profits to keep
growing.
If all other factors remain fixed, therefore, each additional input
of labour soon results in the increase in gains being eroded. What at
first may have led to a 25 per cent increase in outputs may soon lead
to an increase of, say, 10 per cent then 5 per cent then 2 per cent then
less and less. Each additional worker hired brings falling benefits.
It is the law of diminishing returns: a principle as old as economics
itself. Output grows with additional inputs – but in steadily
decreasing amounts. There is clearly a limit to how much growth can
be stimulated if you continuously increase employment of only one
factor where others are fixed. (This law was famously outlined by
Thomas Malthus in 1798 who argued that there was a tendency of
the population, if unchecked, to increase faster than the food supply
until poverty for all resulted. More and more people trying to farm
the Earth would lead to smaller and smaller increases in outputs: a
pessimistic scenario shared by many environmentalists today.)
This having been said, there are still great differences between
businesses as to what is the optimum combination of capital to
labour and, therefore, when the point of diminishing returns sets
in. Generally speaking, service industries tend to have a higher
proportion of labour to capital compared to manufacturing – but
even that is changing. Improvements in technology embodied in
the latest capital equipment can, for example, greatly increase
productivity, increase the most efficient capital/labour ratio and
© 2004 Tony Cleaver
thereby postpone the onset of diminishing returns to the employment
of capital. (This may change the demand for labour – creating
jobs for some, creating unemployment for others. Information technology
has completely transformed employment in banks and
financial services, for example. Far fewer office clerks and secretaries
are now employed per unit of capital in such workplaces
whereas higher skilled job opportunities have mushroomed.)