Chapter 5: The Production Theory

5.1 The Production Concept

Production refers to the creation of wealth for the sole purpose of utility in order to improve the welfare of people. It is the creation of goods and provision of services to satisfy human wants.

Types of production/Forms of production

Production can be undertaken either directly or indirectly

  1. Direct production

This refers to the process where goods and services are produced for one’s own use. It is also known as subsistence production. This production was very common in the past though still practiced in some developing countries. Examples of such production include growing of crops, fishing, keeping poultry, and hunting.

Characteristics or features of direct production

  • The goods or services produced are mainly for one’s own use.
  • It is usually carried out in small scale.
  • The methods used for production are usually simple
  • It involves little or no specialization.
  • The quantities produce are relatively low
  • There is usually no surplus for the market.

2) Indirect production

It refers to a type of production where goods and services are produce for sale. It can also be described as production for the market or commercial production.

Characteristics/features of indirect production

  • Goods and services produced are mainly for sale-income got
  • Modern technology is extensively used in the production process – capital intensive
  • Production is usually on large scale – thus one enjoys economies of scale
  • Surplus goods are produced – no deficit
  • Producers tend to specialize in different areas – efficiency
  • The goods and services produced are usually of higher quality.

Today, most production is of the indirect type because most people and countries goods and services are for sale.

5.2 Levels of Production

Production is a broad process which includes five main activities and they include extraction, manufacturing, trade and distribution, warehousing and the provision of services. Productive activities are closely linked to what is generally referred to as levels of production. Production may be divided into three levels e.g.

1) Primary production/extraction

Primary production is the level of production in which the main activity is extraction of natural resources. It may also involve looking after natural resources. The products may be consumed in their natural state, cooked before eating, or used as raw materials for producing other goods. The occupations involved in the primary production or extraction level range from quarrying, mining, forestry, fishing, farming and lumbering.

2) Secondary production

This involves changing of raw materials into finished products. In this level, raw materials extracted at the primary level are processed into finished goods. This creates more utility in the in the goods mainly through a process called also includes construction activities e.g. some of the raw materials of quarrying are used in construction of buildings, roads and bridges. The main occupations include processing, manufacturing, oil refining and construction of roads, buildings and bridges. Machines and modern technology is usually used.

3) Tertiary production

This production level involves activities carried out in provision of services. The two main types of tertiary production include direct and commercial services.

  • Direct services: These are services that are provided directly to the consumers who are involved in occupations like health care, legal services, domestic services, security, lighting, education, preaching, nursing and entertainment. They are produced both in private practice and in the government through local authorities. Public facilities include garbage collection, sewerage services trucks, hospitals and schools. Current economic systems allow the private individuals to use their private facilities to do so.
  • Commercial services: they are services that support various production processes. They include transport, communication, warehousing, advertising, banking and insurance. These services are important in creating place and time utility in goods. They are referred to as aids to trade.

5.3 Factors of Production and their Rewards

To produce adequate goods for the satisfaction of human wants a combination of natural and artificial and human resources must be present. These economic resources are referred to as factors of production. The natural resources are represented by land (primary) and the artificial resources by the capital (secondary), and the human resource by labor (primary) and the entrepreneur (secondary).

1) Land


  • It is used to refer to all the natural resources below or above the earth’s surface that are needed to support production. They are sometimes referred to as gift of nature because they occur naturally.
  • A basic factor of production
  • Lacks geographical mobility (immobile)
  • Quality is not homogenous
  • Can be put in various uses.
  • Supply of land is fixed, however some resources can get depleted e.g. forests, lakes etc
  • Quality can be improved for better use
  • Reward is rent
  • Human being can increase the productivity of land using greater units of labor capital, application of fertilizers, gabions, mixed farming, intercropping, afforestation, crop rotation, controlling soil erosion, giving land sometime to gain fertility.
  • Subject to law of diminishing marginal returns.

2) Capital

This refers to all the artificial resources used for production of goods and services. Capital can either be fixed or circulating.

Characteristics of Capital

  • It’s manmade
  • A basic factor of production
  • Reward is interest
  • It’s subject to depreciation/decreasing value
  • Usually not consumed in its production process.

3) Labour

This is the mental (doctors and teachers) or physical (farm workers) human effort exercise in the production process for a reward.

Characteristics of Labour

  • A basic factor of production
  • It cannot be separated from the provider.
  • A laborer sells his/her labor and not himself.
  • Mobile geographically and occupationally.
  • Productivity can be increased by motivating workers.
  • The reward for labor is salary (fixe amount), wage (temporary) or commissions, fees (usually a pre-determined amount) earned to professionals for services rendered to clients in their private practice e.g. doctors, lawyers, accountants and architects.
  • Can be skilled or semi-skilled

4) Entrepreneur

This is the person who comes up with a business idea.

Characteristics of an entrepreneur

  • Basic factor of production
  • Brings all the required resources together in a bid to start and operate a business with a view of earning profit.
  • Reward is profit.
  • A distinct factor of production which must be distinguished from specialized labor.
  • Entrepreneurs differ in ranges of self-employed (kiosk owners), opportunistic (hire others), inventors (mpesa, Ipads), pattern multipliers (supermarkets + petrol stations), economies of scale exploiters (hawkers sell at discount so as to increase turn over), acquirers (uchumi),buy-sell artist, speculators, artisans/craft man (beautician/mechanic), intrapreneurs (James mwangi, bob collymore, michael joseph)

Division of Labour and Specialisation

Division of labor and specialization occurs when the production process is split into many stages or operations. Each stage is the special task of one worker or a group of workers. The people working in each stage are then said to be specialized in their respective activities. The principle of division of labor is commonly applied in various manufacturing processes. When one worker performs certain tasks of a job. It is referred to as specialization. This process creates interdependence among the parts involved. This concept has some advantages and disadvantages.

Advantages of division of Labour and Specialisation

  • Workers skills are enhanced because of performing repetitive tasks.
  • The worker suffers less fatigue as they concentrate on doing one task in one place.
  • There is a likelihood of new talents developing and also new inventions
  • The rate at which work is done increases leading to faster or quicker results.
  • The goods and services produced are usually of high quality since they are produced by specialists.
  • Use of machines is made possible, which leads to standardization of commodities and lower production costs which may lead to higher profits
  • The overall output increases because the work is done at a faster rate.
  • Planning and management of work becomes easy which enhances efficiency in the organization.
  • Less time is spent on movements from one site of work to another since the worker performs only a specific task.

Disadvantages of division of Labour and Specialisation

  • The workers suffer from boredom due to the monotony of doing the same task or job repeatedly
  • Because of the splitting of the production tasks where each worker performs only a specific task, a problem at one stage can affect the whole production process, leading to loss of time, reduction in output and possible loses.
  • Since a worker performs only a small part of the whole process, there is lack of motivation as it is difficult for the individual workers to identify themselves with the final product.
  • In case of a fall in demand in the jobs that the specialized workers are engaged, they find it difficult to enter into new jobs. This is due to specialization in a particular field only.
  • Specialized firms may become dominant in the market and therefore they may increase the prices of their products at will
  • The interdependence between countries or firms created by specialization may lead to shortages of goods and services at certain times e.g. during conflicts of war leading to shortages in other regions.
  • Use of machines not only reduces employment opportunities but it also denies people the opportunity to apply their skills.

Mobility of Factors of Production

Mobility of factors of production refers to ease with which a factor can be transferred from one use or location to another. If easy to transfer factor from one use or location to another, the factor is said to be mobile and if it is not it is said to be immobile. There are two aspects to the mobility to factors of production

  • Mobility from one employment to another. This is called occupational mobility
  • Mobility from one place to another otherwise called geographical mobility

Land: Physically, land is immobile. Thus can’t be moved from one place to another. Therefore geographically, land is not mobile. Occupationally; land is mobile since it can be used to produce different products.

Capital: Generally, capital is mobile both geographically and occupationally. This is because most types of capital such as vehicles can be moved from one place to another and put to different uses. However infrastructure such as roads, railway, networks and heavy machinery are immobile.

Entrepreneur: It is probably the most mobile factor of production. This is partly because the basic functions of the entrepreneur are common to all industries. The entrepreneur is also able to move to any region and work there.

Labour: It is relatively mobile geographically but less mobile occupationally. Thus, while labor can move from one area to another, it is more difficult for people to change occupations, especially if they are highly specialized or skilled.

Factors Affecting the Mobility of Factors of Production

  • Specificity of the factor – a factor is said to be specific then it is specialized. Specific factors are immobile.
  • Time taken to modify a factor-it refers to time it takes to acquire new skills, to retain or to modify a specific factor. If it takes a very long time, the factor will be immobile but if it takes a short time, it will be fairly mobile.
  • The reward offered in new location or occupation. If it is substantially better than what the factor is currently earning, it is likely to be mobile. However if the reward is less, the factor the factor will be immobile.
  • The duration a factor has been in the present occupation. After being in an occupation for a long time there is a tendency especially for labor to get used to and prefer the current occupation.
  • Security of job and fringe benefits offered .this condition particularly applies to labor.
  • The general state of applies to the location of new job.
  • The nature of the factor
  • Cost of living
  • Social, cultural and political differences
  • Age

Demand of Labor

It refers to number of laborers/employees which a firm is willing and able to hire at given wage rate over a specified period of time. It’s a derived demand since it arises from the demand of goods and services

Determinants of demand for labor

  • Demand for goods and services the firm is producing. As demand for goods increase, demand for labor increases.
  • Productivity of labor. If labor is more productive compared to other factors, the demand for labor increases.
  • Changes in the prices of other factors of production. Comparing price of labor and capital, if price of capital increases relative to that of labor, then the demand for labor increases.
  • The wage rate: The higher the wage rate the lower the demand

Supply of Labor

This refers to the number of workers willing and able to work (or man-hours available for work) at a given wage rate and over given period of time.

Labour is no doubt the most important of all factor or production, for the efficiency of any production will to a large extent depend on the efficiency and supply of the labour working in the process. Besides labour is also the end for which all production is undertaken.

Determinants of Supply of Labor

The supply of labour will be determined by:

  • Population Size: In any given economy, the population size determines the upper limit of labour supply. Clearly there cannot be more labour than there is population.
  • Age Structure – The population is divided into three age groups. These are:
    • The young age group usually below the age of 18, which is considered to be the minimum age of adulthood. People below this age are not in the labour supply, i.e. they are not supposed to be working or looking for work.
    • The working age group, usually between 18 and 60, although the upper age limit for this group varies from country to country. In Kenya for example, for public servants, it is 55 years. It is the size of this group which determines the labour supply.
    • The old age group, i.e. above 60 years are not in the labour force.
  • The Working Population: Not everybody in the working age group will be in the labour force. What is called the working population refers to the people who are in the working group, and are either working or are actively looking for work, I.e. would take up work if work was offered to them. These are sometimes called the actively active people. Hence this group excludes the sick, the aged, the disabled and (full time) housewives, as well as students. These are people who are working and are not willing or are not in a position to take up work was given to them.
  • Education System and training: If the children are kept in school longer, then this will affect the size of the labour force of the country.
  • Length of the Working Week: This determines labour supply in terms of Man-hours. Hence the fewer the holidays there are, the higher will be the labour supply. This does not, however mean that if the number of working hours in the week are reduced, productivity if there is a high degree of automation.
  • Remuneration/wage rate: The preceding five factors affect the supply of labour in totality. Remuneration affects the supply of labour to a particular industry. Thus, an industry which offers higher wages than other industries will attract labour from those other industries.
  • The Extent to Barriers to Entry into a Particular Occupation: If there are strong barriers to the occupation mobility of labour into a particular occupation, e.g. special talents required or long periods of training, the supply of labour to that occupation will be limited.
  • Retirement age policy of the government.
  • Technology – means of production

Efficiency of Labor

Efficiency of labour refers to the ability to achieve a greater output in a shorter time without any falling off in the quality of the work – that is to say, increase productivity per man employed. The efficiency of a country’s labour force depends on a number of influences.

  • Climate: This can be an important influence on willingness to work, for extremes of temperatures or high, humidity are not conducive to concentration even on congenial tasks.
  • Education and training: Education and training produce skills and therefore efficient labour. Education has three aspects: general education, technical education and training within industry. A high standard of general education is essential for developing intelligence and providing a foundation upon which more specialized vocational training can be based. Technical training provided in the universities, colleges and by industry itself. Training within industry is given by each firm to its employees.
  • Working Conditions: Research has shown that if working conditions are safe and hygienic, the efficiency of labour will be higher than if the conditions were unsafe or unhygienic.
  • Health of the worker: The efficiency of the worker is closely related to his state of health which depends on his being adequately fed, clothed, and housed.
  • Peace of Mind: Anxiety is detrimental to efficiency. People (workers) may be tempted to overwork themselves to save at the expense of health to provide for contingencies like times of sickness, unemployment and old age. Others may be worried about their work or their private problems.
  • Efficiency of the Factors: The productivity of labour will be increased if the quality of other factors of production is high. The more fertile the land, the greater will be the output per mass, other things being equal. Similarly, the greater the amount and the better the quality of the capital employed, the greater will be the productivity of the labour. Efficiency of the organisation is even more important since this determines whether the best use is being made of factors of production
  • Motivating factors: These are factors which boost the morale of the workers and hence increase the efficiency. They include such things as free or subsidised housing, free medical benefits, paid sick leave, allowing workers to buy shares in the company and incorporating workers’ representatives in the decision-making of the firm. In this way the workers feel that they are part and parcel of the organisation and are not being used.
  • The Extent of Specialisation and Division of Labour: The greater the amount of specialisation, the greater will be the output per man. Division of labour increases the efficiency of labour.
  • The Entrepreneur: Land, capital and labour are of no economic importance unless they are organised for production. The entrepreneur is responsible not only for deciding what method of production shall be adopted but for organising the work of others. He has to make many other important decisions such as what to produce and how much to produce.

5.4 Law of Diminishing Marginal Returns/Law of Variable Proportions

It states that holding other factors constant as additional unit of a variable factor are added to a given quantity of a fixed factors, the total product and the marginal product will initially increase at an increasing rate but beyond a certain level of output it will increase at a decreasing rate and eventually fall.

Law of diminishing marginal returns

As the units of a variable input are added to a fixed factor, its marginal/additional production initially increases at an increasing rate, then increases at a decreasing rate before finally declining.

The law of diminishing marginal returns on scale

The law of diminishing marginal returns on scale states that as more and more factors of production are added to fixed factors, additional/marginal output initially increases at an increasing rate until the optimum point beyond which it starts to decline. This explains the three stages of production namely:

  • The increasing returns.
  • Constant returns /decreasing rate and
  • Decreasing/declining returns

law of diminishing returns on scale

One factor is fixed and the rest are variable.

  • All units of the variable are similar or alike.
  • Prices of the factors of production remain constant.
  • Production is continuous
  • Technology remains constant.
  • Only during the short-term period.

Weaknesses of the law of diminishing marginal returns

  • It is a theory of static situations which cannot be realistic in current scientifically dynamic world.
  • It is assumed that land is a natural resource and man has nothing to do to increase its supply which isn’t true.
  • It is possible to improve the industrial machinery and other equipment’s so that extra people on land can move to industry bringing down the diminishing returns.