The basic function of a firm is to produce one or more goods and/or services and sell them in the market. Production requires employment of various factors of production, which are substitutes among themselves to certain extent. Thus, every firm has to decide what combination of various factors of production, also called inputs, to choose to produce a certain fixed or variable quantities of a particular good. The problem is referred to as â€œhow to produce?â€
Production has a broad meaning in economics. It means presenting an item for sale, where the item could be a tangible good or an intangible good. Tangible goods could be presented for sale though either their manufacturing or through just trading in them. The latter would include activities such as transporting, storing, and packaging of goods. Thus, people who are engaged in transporting, say, wheat from Haryana to Kerala, are also considered as producers of wheat. So are the people who buy wheat at the time of harvest when its price is low, and sell it at a later date when its price is high Firms which procure wheat from the market, convert it into wheat flour and then pack it in bags under their brand name are also producers of wheat. In case of services, however, intermediaries do not exist and their production comes through manufacturing (rendering) only.
A production function expresses the technological or engineering relationship between output of a good and inputs used in the production, namely land, labor capital and management (organization). Both the quantities and qualities of these inputs have bearing on the output. Traditionally, production functions are defined in terms of quantities of output and inputs. The quality of inputs is accounted for by introducing a variable called, technology. This is a separate input variable in the production function. The technology variable consists of all improvements in technology, including introduction of computer which permits a firm to produce a given output with fewer raw materials, energy or/and labor, and training programs which increase the productivity of labor. Thus, a production function could be written as
Q = f (Ld, L, K, M, T)
= f1, f2, f3, f4,f5 > 0
Q = output in physical units of good X
Ld= land units employed in the production of Q
L = Labor units employed in the production of Q
K = capital units employed in the production of Q
M= managerial units employed in the production of Q
T = technology employed in the production of Q
f= unspecified function
fi = partial derivative of Q with respect to ith input.
Function assumes that output is an increasing function of all inputs. This is generally true. However, it is conceivable that if an input is excessively applied in relation to other inputs, and increase in it, other inputs help constant, might lead to a decrease in output. For example, consider a piece of land, with certain doses of fertilizers, water, ploughing etc and a certain quantity of labor used to cultivate it. If one goes on employing more and more units of labor (or any other input) on it without increasing the units of other inputs, including land, it is possible that after a certain point the quantity of output produced would decline This is because the labor input becomes relatively excessive, thereby excessive, thereby the extra labor, instead of extending helping hands, prohibit the earlier labor to work. A provision for such a saturation of output would be included in the discussion later.