The importance of the theory of production can be studied under the following heads:
(1) Price Theory:
The theory of production plays a vital role in the price theory. It provides a base for the firm’s demand for factors of production, which together with their corresponding supply determine the prices of the factors.
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Further, the physical relationship between inputs and outputs as well as the prices of factors of production (inputs) influence the costs of production and hence supply of the product. This supply together with demand plays an important role in fixing the price of the product.
(2) Theory of Firm:
The theory of production helps us to determine the profit maximising output, which depends on marginal and average costs of production besides demand conditions (marginal and average revenues).
The changes in marginal and average costs of production as a result of increase in output are determined by the physical relationship between inputs and outputs, besides the prices of factors of production.
Thus, the theory of production has a great relevance for the theory of firm. The theory of production also explains the optimum combinations of factors so as to minimise the cost of production by a firm.
(3) Demand for Factors of Production:
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Theory of production explains the forces which determine the original productivity of the factors. Hence, the relative prices of the factors, i.e., wages (of labour), rent (for land), interest (on capital) and profits (to entrepreneurs) are determined through their corresponding demands, which depend on the marginal productivities of the factors.
Thus, the theory of production has relevance to the micro theory of distribution (the theory of relative prices). Hence, the problem of how factors of production are used to produce goods (problem of how to produce or choice of technique) is resolved.
(4) Theory of Distribution:
The theory of production can also be used to determine the aggregate distributive shares of the various factors in the economy. Elasticity of substitution between factors (discussed later in this chapter) is an important concept of the theory of production, which can be used for this purpose to determine the aggregate shares of various factors like those of wages and profits in national income. This will resolve the problem of for whom to produce or the problem of distribution.
(5) Study of Production Function:
The theory of production is essentially a study of the production function, to which we now turn. Production function like the demand or supply function is to be considered with reference to a particular period of time. It expresses a flow of inputs resulting in a flow of output in a specific period of time.
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Production function is determined by technological or engineering knowledge provided by the production managers or engineers of the firm. As a result of advancement of technology, new production function yields greater flow of output from the given inputs.
A production function assumes that the firm utilises its inputs at maximum level of efficiency at a specified period of time. Further, technology is assumed to be invariant. If technology changes, it would result in alteration of input – output relationship depicted by the production function. The production function can be studied in short period as well as long period.