Production theory basics

Efficiency and X-efficiency

A production process is efficient if a given quantity of outputs cannot be produced with any less inputs. It is said to be inefficient when there exists another feasible process that, for any given output, uses less inputs. Some economists (in particular Leibenstein) use the term X-efficiency to indicate that production processes tend to be inherently inefficient due to satisficing behaviour. The “rate of efficiency� is simply the amount of (or value of) outputs divided by the amount of (or value of) inputs. If a production process uses 50 units of input (or $5000 worth of inputs) to produce one unit of output it is more efficient than a process that uses 55 units of input (or $5500 worth of inputs) to produce the same level of output. It is said to be 10% more efficient ({55-50}/50=1/10=10%).

Factors of production

The inputs or resources used in the production process are called factors by economists. The myriad of possible inputs are usually grouped into four or five categories. These factors are:

    * Raw materials (natural capital)

    * Labour services (human capital)

    * Capital goods

    * Land

Sometimes a fifth category is added, entrepreneurial and management skills, a subcategory of labour services. Capital goods are those goods that have previously undergone a production process. They are previously produced means of production. Some textbooks use "technology" as a factor of production.

In the “long run� all of these factors of production can be adjusted by management. The “short run� however, is defined as a period in which at least one of the factors of production is fixed. A fixed factor of production is one whose quantity cannot readily be changed. Examples include major pieces of equipment, suitable factory space, and key managerial personnel. A variable factor of production is one whose usage rate can be changed easily. Examples include electrical power consumption, transportation services, and most raw material inputs. In the short run, a firm’s “scale of operations� determines the maximum number of outputs that can be produced. In the long run, there are no scale limitations.

Many ways of expressing the production relationship

The total, average, and marginal physical product curves mentioned above are just one way of showing production relationships. They express the quantity of output relative to the amount of variable input employed while holding fixed inputs constant. Because they depict a short run relationship, they are sometimes called short run production functions. If all inputs are allowed to be varied, then the diagram would express outputs relative to total inputs, and the function would be a long run production function. If the mix of inputs is held constant, then output would be expressed relative to inputs of a fixed composition, and the function would indicate long run economies of scale.

Rather than comparing inputs to outputs, it is also possible to assess the mix of inputs employed in production. An isoquant (see below) relates the quantities of one input to the quantities of another input. It indicates all possible combinations of inputs that are capable of producing a given level of output.

Rather than looking at the inputs used in production, it is possible to look at the mix of outputs that are possible for any given production process. This is done with a production possibilities frontier. It indicates what combinations of outputs are possible given the available factor endowment and the prevailing production technology.

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