S5: Entrepreneurship

Key unit competence: To be able to determine the profit of the busine

4.1. Introduction to production

Introductory activity

Read the case study bellow and answer the questions that follows ; Every business requires resources to produce a certain amount of goods and services. However, these resources are not easily accessible to every entrepreneur as a business owner, hence one has to rent or buy such resources in order to enable production and achieve the given goals. Some resources are needed and acquired daily, while others are acquired once and for all, unless they lose value after a long time.

Required: 

a) What economic term is given to expenses on resources in production? 

b) What do you think needs to be spent on as a resource in production? 

c) Why do you think it is important to calculate expenses in production?

Learning activity 4.1:

Analyse the case studies bellow and answer the questions that follow: 

Muhizi, a farmer in Nyagatare, rears cows for milk and purposely for his home consumption. He only sells some few litres when he wants to buy some basic items at home like, salt, soap etc. 

 Mwiza, a poultry farmer in Kamonyi, raises chicken purposely for selling to different markets and rarely eats them at home.

Required: 

 a) What economic name is given to Muhizi’s and Mwiza’s act of production respectively? 

 b) Describe the characteristics of each person’s activities named above

The theory of production in economics strives to explain the principles by which firms make decisions about their output or products they will produce in relation to their inputs or factors of production that they will use. The theory incorporates some of the most fundamental principles of economics, involving the relationship between the quantities and prices of commodities and the factors of production used to produce them, in order to minimize costs and maximize profits. Therefore, the theory of production relates to the mixture/combination of the factors of production and how to make maximum use of these factors.

4.1.1. Meaning of production 

Production is the organized activity of transforming resources into finished products in form of goods and services. It can also be explained as the process through which resources are converted into intermediate or final goods. Intermediate goods are goods, which can be used to produce other goods and services. In other words, it is a process of turning the inputs into outputs.

4.1.2. The purpose of production. 

The purpose of production is consumption. With a market system firms specialize in producing particular types of capital goods and consumer good. Their direct motivation for producing these goods is to sell them for a profit.

4.1.3. Types and levels of production

a) Types of production

There are basically two types of production. These include: 

1. Direct production: This is the production of goods and services by an individual for personal use (one’s own consumption). It is at times referred to as subsistence production. However, a small surplus, if any, may be exchanged for one’s other requirements. For example, if Mr. Mugisha grows maize, rice and rears cows for milk, chicken for eggs, builds his own residential house etc., all this is direct production. 

 2. Indirect production: This is production of goods and services for sale/ exchange/market. It is at times called commercial production. With this type of production, the money got from the sale of items is used to acquire other items one requires, which he/she cannot produce him/herself.

b) Levels of production. 

Every product we see in the market undergoes several production processes. In a sugar factory for instance, there is need for the raw material (sugarcane) to be harvested first, and then transported to the factory, before commencing the production process. The same process applies to all other products. 

For general purposes, it is necessary to classify production into three main levels: 

i) Primary Production: This refers to the extraction of commodities in their raw form as provided by nature. It is the first stage of production. Primary production is carried out by ‘extractive’ industries which are engaged in such activities as extracting the gifts of nature from the earth’s surface, beneath the earth’s surface and from the water bodies like agriculture. it includes activities like forestry, fishing, mining, oil extraction, hunting, quarrying etc. 

ii) Secondary Production: This is the transformation of raw materials and intermediate goods into semi-finished and finished products. Generally, the output of primary production is used as input for the secondary production.

For instance, production of sugarcane is the primary production used to produce sugar. At times, primary products are converted into semi-finished products and then used by other manufacturing units to produce final goods. Examples of such industries include; Construction, manufacturing ( (cars, furnishing, textiles, engineering), processing (fruits into juice, milk into butter, ghee, yoghurt, sugarcane into sugar), oil refining (petroleum into diesel, petrol, paraffin), leather tanning. Etc.

 iii) Tertiary Production: This involves the provision of services only. It includes the processes which increase the value or utility of commodities. Tertiary production starts after producing the final product. Industries in the tertiary sector produce all those services which enable the finished goods to be put in the hands of consumers. In fact, these services are supplied to the firms in all types of industry and directly to consumers. Examples include banking, insurance, transport and communications, government services, such as law, administration, education and health, etc.

Application activity 4.1

Observe the pictures above to answer the question below

iv) Identify the economic activities taking place in each of the above pictures, A, B and C. 

v) Under what level of production would you categorize the activities taking place in above pictures, A, B and C.? 

vi)Give at least two more examples of economic activities that fall under the three levels of production mentioned in (ii) above.

4.2. Factors of production

Learning activity 4.2:

Think about the scenario where your friend comes to you seeking advice about his proposal to start up a given business in their locality, what resources would you advise him to have before the start of the business. 

Group those resources into categories depending on their similarities or kind, then present to the class

Production of a good or service requires the use of certain resources or factors or agents of production. Since most of the resources necessary to carry on production are scarce relative to demand for them, they are called economic resources. Therefore, factors of production are the resources or inputs required in the production of a commodity. Production is made possible by combining certain resources in various ways, by firms or enterprises, to produce an annual flow of goods and services. They include land (natural resource), labor (human resource), capital (man-made resource), and entrepreneurship (organizational and risk-taking resources).

4.2.1. Land

a) Meaning of land 

In economics the term land is used in a broad sense to refer to all natural resources or gifts of nature on earth, beneath or above the earth’s surface. It includes farming and building land, forests, and mineral deposits, soil, fisheries, rivers, lakes, oceans, the sun, rain etc. all those natural resources (or gifts of nature) which help us (the members of the society) to produce useful goods and services. The reward to land for its contribution in the production process is rent.

b) Characteristics of land

• Land has fixed supply: The total land area of earth (in the sense of the surface area available to men) is fixed. Therefore, the supply of land is strictly limited. 

• Land is a free gift of nature: Land existed long ago, before human beings came in existence. Land is not as a result of human effort.

• Land is permanent: it is not easy to destroy it. Even when destroyed, it can be restored after sometime.

• Land is a primary factor of production: Any production process starts with land.

• Land is geographically immobile but can be occupationally mobile since it can have alternative uses. 

• Land has inelastic supply: The supply of land cannot be adjusted according to its demand.

• Land is differentiated: Land is not homogeneous i.e. it differs in fertility and thus productivity which results into different prices of land. 

• Demand for land is derived: land is demanded not for its own sake but for the production of goods and services. 

• Alternative uses: Although the total supply of land is fixed, land has alternative uses.

• No cost of production: Since land is a gift of nature, it has no cost of production (zero supply price). i.e. since land is already in existence, no costs are to be incurred in creating it just like training labour or creating capital. 

• Operation of the law of diminishing return: This simply means that as more and more workers are employed on the same plot of land, output per worker will gradually fall

c) Importance of land 

Land as a factor of production is of immense importance such as: 

• It is a source of water for home use, using in industries and generation of electricity. 

• It is a source of medicine like herbs which help promote health standards of nationals of a given country. 

 • It helps in transport systems like road network, railways, air transport which aids production directly and or indirectly. 

• It is the original source of raw-materials for industries, thus promotes industrialization.

 • It includes soils and climate which are vital for agriculture. 

• It is a source of fuel like oil, coal, firewood etc. 

• It is a source of fish which is used for food or exchange locally or  externally

• It provides scenery for tourism e.g. waterfalls, wild animals, natural forests, mountains etc. all which earns a country revenue in form of forex. 

• It provides a site on which all developments stand. 

 • It is a source of minerals like gold, copper etc. which can be exchanged to provide revenue. 

• Land is taxed to earn government revenue.

d) Rent and its Determinants 

 Recall that the rent is explained as the reward for use of land. Its determinants include the following:

• Size of rental property: The size of the rental property determines the rent to be paid. If the rental property is big then rent will be high and if it is small then rent will be low. 

 • Location: Rental properties that are located in areas that strategically located in areas that have access to roads, communication network and other social economic infrastructures, will attract high rent than those located in remote areas that have no access to such infrastructures. 

• Amenities: properties that have more facilities will attract high rent than those that have less facilities. 

• Demand and supply: When the demand for rental property is high, rent will also be high but if demand is low as compared to supply, rent will be low. 

 • Ability: The ability of the customers will also determine the rent to be charged. When their ability to pay is high, high rent will be charged but if their ability is low, low rent will be charged. 

 • Competitors: The degree of competition among property owners influences the rent to be charged. If competition is high, rent will be low but if competition is low, rent will be high. 

• Prevailing market conditions: The existing economic conditions such as level of inflation, government policies, taxes and subsidies among others determine the rent to be charged. If these conditions are favourable, rent will be low and if they are unfavorable rent will be high.

a) Meaning of labour 

Labour refers to any human effort, mental and or physical, that contributes towards the production of goods and service. Labour can be productive labour or unproductive labour. Productive labour is the labour that is engaged in producing goods and services, and it is paid a wage/ salary. Unproductive labour is the labour that does not produce goods or services and therefore it receives no wage.

b) Characteristics of labour 

Labour is human. Every labourer has his or her own preferences, habits and feelings which must be put into consideration by the employer. 

• Labour is geographically and occupationally mobile. Labour can easily be transferred from one occupation to another or from one geographical location or area to another 

• Labour supply is regressive. An increase in wages may reduce the supply of labour. This is because achievement of targets may reduce and more time set aside for leisure. 

• Labour is both the beginning and the end of production. Production can only start if labour is applied to land and capital while the end of production is consumption of final goods and services, which is done by labour. 

 • Labour is heterogeneous. There are differences in labour efficiency. Some labourers are more efficient than others. This can be due to differences in skills, experience gained, natural ability and level of training 

• Labour has weak bargaining power. As a result, its payment is usually low compared to other factors of production. Since labour cannot be stored, it is less organized and lacks reserve funds to support it when there is no work.

• Labour is perishable. It cannot be stored, postponed or accumulated for the next period or for future. 

 • Labour cannot be separated from the owner or labourer. Labour and the provider are the same.

c) Categories of labour Labour can be categorized into: 

i) Skilled labour: This is labour which is highly trained and experienced and can engage in productive activities without any supervision e.g. teachers, doctors, lawyers, engineers and veterinary officers. 

 ii) Semi-skilled: This is labour which is partly trained and has some degree of experience but requires some supervision to complete certain tasks e.g. drivers, tailors, hair dressers, carpenters, mechanics, plumbers and artisans etc. 

 iii) Unskilled labour: This is labour which lacks training and experience in any particular job. E.g. house maids, wheel barrow pushers, cleaners, car washers, herds boys, and farm workers. 

d) Specialisation and Division of labour 

• Specialisation refers to an economic situation where labour concentrates in the production of one or very few commodities in a more effective and efficient way. In this case, resources are concentrated in production of relatively few commodities. Specialisation at individual level refers to the allocation of tasks among workers so that each worker concentrates on the task he or she is most effective and efficient. Example, the specialisation of teachers in different subjects in Accounting. Specialisation by individual tasks is called ‘division of labour’. 

 • Division of labour refers to the separation of a 458 work process into a number of simple and separate tasks, with each task being performed by a separate person or a group of people. Each worker is responsible for a particular task where he or she can perform better 

Advantages of specialisation and division of labour: 

• Time is saved because workers are able to concentrate on only tasks they perform better and this eliminates the constant need to move from one operation to the next by the workers. 

• Use of specialised machinery may arise from the division of the general manufacturing process into small, separate and simple tasks. This in turn may greatly speed up the individual jobs which are automated.

• It is also generally considered that, because of the cost of training, workers to perform simple tasks is far less than training each worker to complete the whole production process, division of labour can lower average cost of production. 

• Specialisation and international trade increases the size of the market, offering opportunities for large-scale production for a larger market.

 • There is increased competition for domestic producers which acts as an incentive to minimize costs and to be innovative to remain competitive. Competition will help to keep the prices lower in the economy. 

• Workers become very skillful and effective into their single allocated task because 

• There is increase in levels of outputs produced because work is done by specialized people which leads to reduction in the price levels in the country. 

 • There is production of high quality products which in turn leads to improvement in people’s standards of living. 

 • Consumers’ choice increases because through specialization and division of labour a variety of goods and services are produced.

Disadvantages of specialisation and division of labour: 

Although division of labour can lead to considerable gains in the productivity and quality of production, division of labour can also have negative effects on the production for the following reasons: 

• Division of labour increases industrial interdependence which results into delays in production, inefficiency and losses in case of a breakdown in the process of production or an absence of a worker can halt the whole production process. For example, a strike in one part of the factory can halt the whole production process. 

• It reduces mobility of labour because a worker is trained to handle only part of the whole task. This makes it hard for the worker to find a similar job in another place. 

 • It can result into the rise of monopoly as a worker specializes in performance of a given task he or she may become a monopolist in that field and may end up cheating customers. 

• Specialisation leads to loss of craftsmanship (skills) because it results into increased use of machines. As a result, labour becomes machine attendant hence low skill utilization. 

• Very high degree of division of labour can create demand for very specific, narrow skills, which creates the possibility of increased unemployment among the labour force of the country. In the long-term, this may lead to structural unemployment where the worker is replaced by a machine, and because the worker’s skill is no longer required, the worker has trouble finding employment, because he is not trained in anything else.

• Division of labour leads to boredom and hostility (disaffection), which people may experience because of doing the same task continuously. This may have a negative effect on the labour force and labour relations and eventually the productivity of the workers 

• There is a possibility of overproduction. Due to specialisation, there is large scale production which creates excess supply. This leads to losses to the producers.

e) Labour mobility 

 Labour mobility is the ease with which labour can move from one occupation to another or from one geographical area to another. The movement of labour from one occupation to another is known as occupational mobility of labour. The movement of labour between geographical areas is known as geographical mobility of labour. It should be noted that labour can move within the same occupation either vertically or horizontally, or in different occupations.

• Vertical mobility of labour is the movement of a worker from one position (or job group) to another, but within the same occupation. This involves change of status. It may be a promotion or a demotion. For example, a teacher may be promoted from being a classroom teacher to a Senior Teacher, a deputy or a head teacher. 

• Horizontal mobility is the movement of labour from one job to another at the same level in a given industry. A secretary for instance, can be moved from finance department to the human resource department, within the same firm or industry.

f) Labour efficiency Labour efficiency is the ability of labour to produce the greatest quality and quantity of output within the shortest time possible. It is the productivity of a unit of labour per unit of time.

4.2.3. Capital

a) Meaning of capital 

Capital refers to all manmade resources used in the production process of goods and services. Or it is any physical asset capable of creating further goods and services. It is also used to refer to wealth used to produce more wealth. Capital is that part of wealth which is not used for the purpose of consumption but is utilized in the process of production. Capital has also been defined as “produced means of production”. Thus, all those items produced by man to help in the production of further goods and services are examples of capital e.g. Tools and machinery, factories, dams, canals, transport equipment, stocks of raw-materials, seeds and fertilizers, etc. are examples of capital. Capital is rewarded with interest in the market of factors of production.

b) Forms of capital: 

• Money /nominal /liquid capital: This is capital which is in monetary form or near liquid assets. It is the paper notes and coins, and it is used as a method of payment for capital goods. It is not directly productive. To a lay person, it is money capital that matters while to an economist, it is real capital that matters. 

• Real/physical/fixed capital is the stock of physical assets capable of producing goods and services. It is not for satisfying wants directly but is used in production. Real capital increases the volume of goods and services. Examples are roads, railways, machines, factories, buildings, etc. 

• Human capital: This is productive qualities found in human beings that are used in production of goods and services. Such qualities are acquired through training and education. 

• Sunk capital: This capital which is specialised and cannot be easily adopted to an alternative use e.g. railways. 

• Private capital: This is capital owned exclusively by an individual and it yields him/her income 

• Social overhead capital or public capital: This is capital which is in most cases owned by the state on behalf of the people e.g. roads schools, hospitals defense etc.

• Floating capital: This is capital that can be used for a number of purposes in a number of ways e.g. Money and raw materials.

c) Role of capital 

Capital plays a vital role in the modern productive system 

• Capital enables the use of monetary exchange thus reduces the subsistence sector and its negative effects. 

 • As finance, capital increases the level of savings which stimulates investments in the economy. 

 • Capital breaks the state of technological backwardness by enabling the country to acquire modern technology thus promotes technological development. 

• Capital increases occupational and geographical mobility of other factors of production which results into efficient distribution of resources and increase in quantity of resources available 

• Capital facilitates production of high-quality goods and services because with it producers are in position to use high levels of technology in production. 

 • Capital facilitates research which helps the producers to increase on the quality and quantity of outputs. Capital makes it possible for producers to undertake research which improves their operations thus becoming more innovative and more competitive in the markets 

 • Capital can be exported in form of loans, grants, foreign investments which can create more income to the country and employment. 

 • Capital enables labour to specialise in operating different tasks which enables them acquire more skills thus increasing their efficiency and production of more goods and services 

• It creates employment opportunities in the country when it is invested. When the capital is produced, some workers have to be employed to make capital goods like machinery, factories, dams and irrigation works. And at the same time, more labour force has to be employed when capital has to be used for producing further goods. 

 • It increases the levels of outputs produced when it is invested. Capital adds greatly to the production of more outputs in the economy due to growth of technology and specialization associated with capital which in turn leads to economic growth. 

 • It also leads to infrastructural developments when it is invested. Capital facilitates construction of dams, roads, irrigation works, railway lines, air ports bridges and many others which all contribute towards economic growth and development.

• Capital enables the country to improve her balance of payment (BOP) position through establishing import substitution industrial strategy where a country invests so much in establishing industries to produce goods which were previously imported into the country and this in turn reduces the amount of goods imported and then improves on the country balance of payment.

 • It also leads to the exploitation of idle resources in the country for example idle land, minerals and other resources which later leads to economic growth. 

 • The use of capital enables a country to achieve a self-sustaining economic growth and thus helps to break through vicious cycle of poverty.

d) Capital accumulation/ formation:

 People use capital goods like machines, equipment, etc. because they (capital goods) are the creators of other goods and services. Capital also helps to produce goods and services with less effort and lower costs than would be the case if labour were not assisted by capital. But in order to use capital goods people must first produce them. This calls for a sacrifice of current consumption to increase on capital goods. Thus, the opportunity cost of the capital goods is the potential output of consumer goods which has to be foregone in order to produce that capital. This means that the production of capital demands abstinence from current consumption. This is what we call capital accumulation or formation. Therefore, capital accumulation/ formation refers to the process of increasing a country’s stock of real capital/ assets over a given period of time. Or it is the increase in the stock of capital goods.

Factors that affect capital accumulation (formation) 

• Government policy of Taxation or subsidization. Favourable government policy on taxes and subsidies encourage savings and investment and production hence increasing the formation of capital. Unfavourable policies on taxes and subsidies discourage savings, investment and production and thus reduce the process of capital accumulation. 

• Level of infrastructure development. A country that has well developed and equally distributed socio-economic infrastructures attracts more investments leading to higher capital accumulation than when socioeconomic infrastructures are undeveloped and unevenly distributed 

• The level of savings. Whenever one’s levels of saving increase, his/her levels capital accumulated increase, but when levels of saving reduce even the levels of capital accumulated reduce.

• Culture of the society. If the culture of the society is favourable for example favouring people to save, invest and to be good entrepreneurs, the levels of capital formation will be higher than when culture is not favourable. 

 • Extended family system. In most cases, people with small families are always able to save more money because of having low expenditures leading to higher levels of capital accumulation than extended families with high level of expenditures and low saving levels. 

 • Level of financial sector development. If the economy has a welldeveloped financial sector e.g. enough good commercial banks; this will encourage most people to save their money in banks which in turn increases capital accumulation, but if it not well-developed, most people will keep their money in cash form which reduces levels of saving and capital accumulation. 

• Government and security. Capital formation is a function of good governance and management of the country’s resources. A politically stable environment ensures investors’ confidence in the economy, which in turn favours the capital formation process than a politically unstable one which scares away potential investors both local and foreign. 

 • The profit levels. When profit levels are high, producers will be encouraged to re- invest their capital leading to higher levels of capital accumulation but when profit levels are low they will be discouraged from re- investing leading low levels of capital accumulation. 

 • Labour productivity. Well trained and skilled workers always produce more and high quality products which increases capital accumulation but when workers are not well trained and skilled their productivity will be low leading to low capital accumulation 

• Technology levels. If the levels of technology are high a country will be able to produce more and high quality output which leads to higher capital accumulation than when the levels of technology are low.

 • Level of entrepreneurship: The higher the level of entrepreneurial skills in a country the greater the level of investments and capital accumulation, and the lower the level of entrepreneurial skills, the lower the level of investments and capital accumulation. 

• Capital stock. The existing levels of capital stock are vital in explaining the levels of investment and capital accumulation in an economy. If the existing stock of capital is big the level of investment and capital accumulation will be higher than when the existing capital is small. 

 • The wage rate and remuneration. If the payments for workers are high they will be motivated and this will increase their productivity, and the profits of the firms leading to higher capital accumulation than when their wages and remunerations are low. Low payments always discourage workers from their hard work which in turn affects the profit levels of the firms. What a worker earns is important in explaining a firm’s output levels and subsequently the profit levels.

• Rate of capital flows: High levels of capital inflows lead to an increase in capital accumulation while high levels of capital outflows lead to a decrease in capital accumulation. 

• The size of market: existence of well-organized and expanding market encourages production of goods and services and generates more incomes. This leads to more savings for re-investment leading to increased capital accumulation. When the size of the market is small, it discourages production leading to low incomes, low savings. Low investment and less capital accumulation. 

 • Population structure: A high population growth rate with more dependents, increase expenditures and reduce savings leading to low capital accumulation while a low population growth rate with a big size of the working class encourages savings, investment, more output hence increased capital accumulation

4.2.4 An Entrepreneur

a) Meaning of an entrepreneur 

An entrepreneur is a person who organises and co-ordinates other factors of production to produce goods and services. An entrepreneur hires labour and land and looks for capital. The entrepreneur then combines these factors in appropriate proportions to produce goods and services. The entrepreneur is the pivot around which all the activities of the firm revolve. He/she is the one who gives direction to the business firms & ensures its effective operation. The entrepreneur is rewarded profit for his contribution in the production process.

b) Characteristics of an entrepreneur: 

• Risk taker and bearer i.e. an entrepreneur has the ‘willingness to assume risk’ arising out of the creation and implementation of new ideas. New ideas are always uncertain and their results may not be immediate/prompt and positive. Therefore, he/she always finds out ways and techniques of reducing or minimizing risks for his/her benefit. 

• Passion and motivation i.e. an entrepreneur should be able to work over and over again without getting bored, keep awake at night because he/ she hasn’t finished a certain task yet, have to build something and want to continue to improve upon it. 

 • Self-belief, hard work and disciplined dedication i.e. entrepreneurs believe in themselves and are confident and dedicated to their project. Their intense focus on and faith in their idea may be misunderstood as stubbornness, but it is this willingness to work hard and defy the odds that make them successful. 

 • Adaptable and flexible i.e. successful entrepreneurs welcome all suggestions for optimization or customization that may enhance their offering and satisfy client and market needs. 

 • Product and market knowledge. Entrepreneurs know their product inside and out i.e. successful entrepreneurs create something that didn’t already exist or significantly improves an existing product after experiencing frustration with the way it worked. 

 • Strong financial management i.e. successful entrepreneurs plan for present and future financial obligations and set aside an emergency fund. Even after securing funding or going fully operational, a successful businessperson keeps a complete handle on cash flow, as it is the most important aspect of any business. 

 • Effective planning skills i.e. successful entrepreneurs have a business plan in place, but remain capable of dealing with unforeseen possibilities. 

 • Make the right connections i.e. successful entrepreneurs reach out to mentors with more experience and extensive networks to seek valuable advice. If they don’t have the necessary technical or marketing skills, they find someone who does and delegate these tasks so they can focus on growing the business.

• Exit preparedness since entrepreneurs aren’t always successful at the first time around, but they have to know when to cut their losses.

Therefore, sometimes the best solution is to call it quits and try something new instead of continuing to dump money into a failing business. 

 • Ability to question him/herself intimidating questions like; “can I do this? Do I want to do this?” etc. 

 • Committed to outcome i.e. an entrepreneur rebukes and disciplines self for failing to perform.

Other factors of production are: 

i) Time

ii) Technology

c) Functions of an entrepreneur:

The entrepreneur in modern business performs the following useful functions: 

• Entrepreneur undertakes risks and bears the burden of uncertainties of the business. 

• He/she is an initiator. The start of any business enterprise is as the result of the initiative of the entrepreneur. 

 • He/she directs the development of the enterprise. An entrepreneur develops concrete plans for the development of the enterprise • He/she organizes other factors of production. 

 • He/she is an innovator. An entrepreneur introduces new methods of production to improve the quality and quantity of output

 • Co-ordinates other factors of production. An entrepreneur sets goals and co-ordinates other factors of production to produce goods and services. 

• He/she is a decision maker. The entrepreneur undertakes all the decisions of the business.

d) Barriers to entrepreneurship development 

Barriers are the factors that hinder or limit the development of entrepreneurship. Barriers can prevent an entrepreneur from accessing customers or sources of getting more capital for the business. Barriers also hinder entrepreneurs from exploiting their potential. Some of these barriers include the following:

• Poor entrepreneurship skills 

Most entrepreneurs and potential entrepreneurs have little or no entrepreneurship skills. 

They lack creativity, innovativeness, endurance, flexibility and other entrepreneurship characteristics. 

• Lack of business and technical skills 

 Marketing, accounting and management skills are some of the skills required by all practicing entrepreneurs to effectively manage their ventures. Many ventures also require specialized technical know how to set up, operate and manage. Lack of these skills and high rates of illiteracy at times limits the capacity of entrepreneurs to effectively exploit the full potential of their ventures.

• Lack of mobility and exposure 

Exposure of entrepreneurs normally offers them biggest revelation for new ideas that shape their creativity and innovativeness as entrepreneurs. However, many of them do not travel, research nor explore widely. This limits the creativeness and innovativeness of potential and practicing entrepreneurs. 

 • Lack of business ethics 

 Many entrepreneurs have failed to run and sustain their businesses because of unethical behavior. In most cases, there are problems of unpaid loans, debts and accumulated expenses. At times, entrepreneurs evade paying tax and registering their businesses legally, while others engage in corruption, smuggling and drug trafficking. Such tendencies are illegal and should be stopped immediately. 

 • Career dependency 

 Most people in our country especially the learned, depend wholly on their careers for their livelihoods. Entrepreneurship has long been regarded as a last resort, considered only after failure to secure a white collar job. Entrepreneurship is regarded as a job for the less educated. Although this attitude is rapidly changing, its effects remain a big barrier to entrepreneurship in Rwanda. 

• Lack of role models in entrepreneurship 

 Rwanda has few role models in the field of entrepreneurship. This limits the number of people who willingly aspire for careers in entrepreneurship. The available few cannot fully meet the demands of the many upcoming entrepreneurs. 

• Inadequate finance 

 Banks and micro finance institutions charge high interests on their loans. As a result, entrepreneurs fear seeking for loans to advance in their businesses. In additions the conditions set for one to access a loan may not favour upcoming entrepreneurs. The terms of credit are unreasonable, requiring difficult collateral securities to secure loans and charge high interest rates. 

 • Low purchasing power 

 Low incomes and high rates of unemployment limit the purchasing power of the population. This makes it hard for businesses in general and entrepreneurs in particular to acquire the necessary economies of scale.

Application activity 4.2

Reflect back in your communities, identify people who have successfully started businesses and are still running them. 

 a) List down the types of businesses they run. 

 b) Identify the characteristics that they have that enable them manage their businesses. 

 c) Analyse the role they have played in the development process of the areas where they operate from and the entire economy.

 d) Describe the resources they have used to start and explain how they relate to the factors of production learnt above.

4.3. Production function (Input-output Relationship)

Learning activity 4.3:

To teach students, there is need of teachers, classrooms, teaching and learning materials. 

 To have a healthy population, there is need of medical personnel and facilities. 

 To produce food, there is need for land and capital. 

 a) From the statements above, categories different things mentioned as output and inputs. 

 b) How are the two categories related?

4.3.1. Meaning, function and planning periods

a) Meaning and function of production

Production function is an expression of the relationship between physical quantities of inputs and output. It shows the maximum output that can be obtained from a given quantity of physical inputs.

i) As a statement Q = f(L,K,N,M,T). 

 The relationship can be expressed mathematically as follows: Q= f (L, K, N, M, T).

Where Q is output, K is capital, N is land, M is organisation, T is technology and L is labour. f stands for function. The left hand side (Q) represents the dependent variable while the right hand side represents the independent variables. Thus output is the dependent variable while input is the independent variable.

ii) As an equation Y = a + bx. 

Where Y is output, a and b are constants and x is variable input.

iii) As a graph.

The production function can also be represented using a graph, as below

a) Planning periods 

 Planning periods are reference periods by any production unit when making production decisions. To study the relationship between a firm’s output decision and its costs, we distinguish the two primary time periods or decision time frames /reference periods (i.e. short-run, long-run). Any production unit shows its performance for short run or long run or very long run. These periods do not show specific period of time e.g. a week, month or year, but it depends on the production unit making decision and what it is able to do with in that time. These periods are actually relative for different production units. For example, short run period for one firm, may be long run period for another.

Very long run 

This is the very long period in which the company is able to change technology. The company can conduct research and development programs for new technologies during this long period. New products can also be produced 

• Long run period 

 This is the period that is long enough for a business/ company to vary all factors of production. For example, the company can buy more land, train top management, etc. However, the level of technology does not change. Therefore, the company can increase output by expanding the size of the company. That is, the company increases output by using variable and fixed factors of production. 

 • Short run period 

 It is a period during which at least one factor of production is fixed and one or more factors are variable. Since there is a fixed factor, the law of diminishing returns is likely to operate in the short run. In this period output can be increased by adding units of variable factors to the fixed factor. For example, in agriculture, output can be increased by adding units of capital and labor (variable factors) into land (fixed factors). 

 • Very short run period 

It is a very short period of time during which supply cannot increase through production. Perhaps this supply can be increased in the market by pulling stock from stores.

4.3.2.Product of the firm (TP, AP and MP) 

a) Forms of product of the firm There are basically 3 major forms:

 i) Total product 

This is the overall amounts of products or output that are produced by a given ratio of factors combinations in a particular period of time. Or it is the total output resulting from the employment of all factors of production. TP is always considered or measured in physical units e.g. kilograms, tons, grams, liters etc. but not in prices.

 ii) Average product (AP) 

This is output per unit of a variable factor employed (holding other factor inputs constant). Or it is how much each unit of a variable factor has produced. It is given by the total product divided by the variable inputs employed.

iii) Marginal product (MP) 

This refers to the additional output resulting from employment of an extra unit of variable factor when all other units are held constant. It is the change in output as a result of change in the variable factor.

b) Relationship between TP, AP and MP:

This can be explained by a production schedule or curves as below

Production function schedule:

The analysis of the table shows that the total, average and marginal product increase at first, reach a maximum and then start declining. 

The TP reaches its maximum when 7 units of labour are employed and it declines. The AP continues to rise till the 4th unit while the MP reaches its maximum at the 3rd unit of labour, then they also fall. This can be illustrated on curves as as follows:

From the curves above, it is seen that: 

• TP, AP and MP first increase, reach their maximum and begin to decline. 

– The point of maximum and of falling are not the same for TP, AP and MP. i.e., MP reaches its maximum first, followed by AP and later on TP.

 – When TP is at maximum, MP equals to zero. After this point, TP falls and MP becomes negative. 

 – The AP is at its maximum when it is equal to MP. The AP starts falling after meeting MP curve but MP is below AP after that point. 

 – The TP curve first rises at an increasing rate, the reaches the highest point at a decreasing rate and then starts falling

4.3.3. Law of diminishing marginal returns and its assumptions

The law of diminishing returns states that, given a short run situation with 2 factors of production, one variable and another fixed, “As more and more units of a variable input are applied to the fixed factor in a given state of technology, the marginal product of the variable factor will eventually diminish.” This law is also called the law of variable proportions.

Assumptions of the law of diminishing returns

 i) Existence of a variable factor of production and other factors are constant.

ii) All units of the variable factor are homogeneous. 

iii) The price of the product is given and constant. 

iv) It assumes a short run period. 

v) It assumes that technology is constant. 

vi) It is possible to change the proportions in which various inputs are combined

4.3.4. Isoquant and Isocost

a) Meaning 

Isoquant is the locus of points showing various combinations of the factors of production that yield the same output.

Isocost is a locus of points showing different combinations of factors of production that cost the production firm equally.

b) Equations

– Isocost equation

Consider the following model:

C = P_K K + P_L L

Where:

C: The total cost/the constraint

K: The amount of capital 

PK: The cost of each unit of capital 

L: Amount /size/number of labor 

P_L: Price of labor 

 The equation C = P_K K + P_L L defines a function C with variables capital and labour.

If you want to make capital or labour the subject of the formula:

Where capital (K) is given as the function of labour (L). 

This equation is very vital because:

– It shows the nature of isocost curve

– It gives the direct relationship between the capital and labour used since the cost is constant

– Isoquant equation Consider the following equation: 

P f KL = ( , ) 

This equation is stated generally because the ratio or the portion of contribution of the factors can either be fixed or varying.

Each of the factor combinations A, B and C produces the same level of output; that is why an isoquant curve may be called an equal product curve. 

– Isoquant Map

– The slope of an isoquant 

The slope of an isoquant is known as the marginal rate of technical substitution (MRTS)since it shows the rate at which one input is substituted for another while maintaining the same level of output. It can be illustrated from the hypothetical isoquant schedule below. 

• Hypothetical isoquant schedule

The table shows that a firm can produce 100 units of output at point A by having a combination of 10 units of capital and 4 units of labour. Similarly point B shows a combination of 8 units of capital and 9 units of labour. Point C, 6 units of capital and 14 units of labour and point D, 4 units of capital and 19 units of labour to yield the same amount of 100 units.

When labour units are measured along the X- axis and capital units along the Y axis, the first, second, third and fourth combinations are shown as A, B, C and D respectively. When we connect all these points, we get the isoquant curve

• Properties of Isoquants 

Isoquants possess certain characteristics, which are similar to those of indifference curves: 

 – Isoquants are negatively inclined. That is to say as the amount of capital decreases, that of labour increases so that output remains constant. 

 – An isoquant lying above and to the right of another represents a higher output level. 3. No two isoquants can intersect each other, that is, the point of intersection combination would bear less and more output at the same time which is not possible. – In between two isoquants, there can be a number of isoquants showing various levels of output. 

 – No isoquant can touch either axis. If an isoquant touches the X- axis, it would mean that the product is being produced with the help of labour alone without using any capital. 

 – Each isoquant is convex to the origin. As more units of labour are employed to produce 100 units of a product, lesser and lesser units of capital are used. This is because the marginal rate of substitution between the two factors diminishes

• The least cost combination 

The Isocost curve represents the locus of all combinations of the two factor inputs which result from the same total cost. If for example the unit cost of labour (L) is w and the unit cost of capital (k) is r, then the total cost is:

Total Cost = + rK wL

The firm will be in equilibrium when the highest isoquant curve becomes tangent to the isocost line. At point E, the equilibrium position of the firm is defined as the level of maximum output, subject to the cost constraint. This point is always shown where the isoquant curve is tangent to the isocost. The point of tangency represents the least cost combination of the two factors for producing a given o 

If all points of tangency like L, M and N are joined by a line, that ‘joining’ line is known as the expansion path or the output factor curve. It shows how the proportions of the two factors used might be changed as the firm expands

Application activity 4.3

Given the following information, carry out research from the library or the internet and answer the questions that follow;

i) Using the above case of input-output ratio, Calculate AP and MP and

ii) Illustrate the relationship between TP, AP and MP and make p

4.4. Theory of costs, production, and Profit of the business/ firm

Learning activity 4.4:

3. Discuss the following terms:

i) Costs

ii) Long run

iii) Short run

iv) Variable cost

v) Fixed cost

6. Give examples of costs incurred by your business club and explain how they differ considering their categorization as fixed and variable costs.

4.4.1. Theory of costs

Every firm spends on their daily activities. These expenditures come in different 

forms and way. For any firm to realise its main objective of maximising the profit, 

it must incur some costs during production and sales. Not all costs incurred 

during production must involve the exchange of money.

Costs are the expenses of a firm incurred during production process. Costs 

consist of payments to factors of production and therefore closely linked to the 

theory of production. Costs are derived from the production function.

Costs are divided into two: 

1) Implicit costs: These are basically social costs. They are costs that cannot 

be included in the computation of the firm’s profits. This is because such costs 

cannot easily be monetised. They include noise, time wasted, and opportunity 

cost.

2) Explicit costs: These are costs for items for which the firm can make specific 

payments on. It is the actual expenditure of a firm incurred when purchasing the 

input factors. These include costs of raw materials, labour, transport, energy 

and many others. They include both fixed and variable costs.

Variation of costs in the short & long run

• Short run costs of the firm:

Short run is a period in which the firm cannot change its plant, equipment and 

the scale of operations. To meet increased demand, it can only raise output by 

hiring more labour and raw materials or asking the existing labour force to work

overtime. The short- run total costs are divided into:

i) Total Fixed Costs (TFC).

ii) Total Variable costs (TVC). And the 

iii) Total Costs (TC)

This is the sum of the total fixed costs and the total variable costs in the business. 

TC= TFC + TVC

 When the output is zero, total cost will equal fixed costs since variable costs 

will be zero. When production begins to increase, total costs will continue to 

rise as variable costs increase since variable costs must increase as output 

expands.

In the short run analysis average costs are more important than total costs. The 

units of output that a firm produces do not cost the same amount to the firm, 

but they must be sold at the same price. Therefore the firm must know per unit 

cost or the average cost. The short run average costs of a firm are the average 

variable cost (AVC), the average fixed cost (AFC) and the average total cost 

(ATC). 

The total cost curve cuts the vertical axis at a point above the origin and rises 

continuously from left to right. This is because even when no output is produced 

the firm has to incur fixed costs. The TVC curve starts from the origin (0) because 

when output is zero, the variable costs are also zero. They increase as output 

increases.

The average fixed cost (AFC)

 This is the total fixed cost at each level of output divided by number of units 

produced. 

That is: 

The average fixed cost diminishes continuously as outputs increases. This is 

because when a constant figure such as the TFC is divided by continuously 

increasing unit of output, the result is a continuously diminishing average fixed 

cost. Thus the AFC curve is down ward slopping but doesn’t cross the quantity 

or output axis because if it did, then AFC would be zero in which case TFC 

would be zero which cannot be the case.

The average variable costs (AVC)

 This is the total variable cost at each level of output divided by the number of 

units produced. 

That is:

The curve is U- shaped because of the law of diminishing marginal returns. The 

AVC first declines with the rise of output as larger quantities of variable factors 

are applied to fixed factors but eventually they begin to rise due to the law of 

diminishing marginal returns.

The average total cost (ATC)

This is the average cost of producing any given output.

 ATC = TC/Q = (TFC + TVC)/Q = TFC/Q + TVC/Q 

ATC = AFC + AVC 

The marginal cost (MC) 

A fundamental concept for the determination of the exact level of output of a firm 

is the marginal cost (MC). Marginal cost is an additional cost that is incurred to 

produce an extra unit of output.

MC = ΔTC/ ∆Q

The relationship between short run cost curves

The AFC declines continuously and is asymptotic to both axes that is, it never 

touches either axes. 

The AVC curve first declines, reaches minimum at point A and rises thereafter. 

The ATC first declines, reaches a minimum point P and the MC = ATC.

The relationship between MC and ATC 

There is a direct relationship between the ATC and the MC

Both curves are U- shaped and when the ATC falls MC is less than the ATC. 

This is because a fall in MC is related to one unit of output while in case of ATC; 

the same decline is spread over all units of output. 

When the ATC is at minimum, it’s equal to the MC. The MC curve cuts the 

ATC curve from below at its minimum point R. 

When the ATC rises, MC is greater than ATC. The MC curve is above ATC when 

ATC is rising i.e. MC is greater than the ATC

The long run cost curves

In the long run, all inputs (factors of production) are variable and firms can 

enter or exit any industry or market. Consequently, a firm’s output and costs are 

unconstrained in the sense that the firm can produce any output level it chooses 

by employing the needed quantities of inputs (such as labour and capital) and 

incurring the total costs of producing that output level.

In the long run, the law of diminishing marginal returns does not operate and 

do not guide production and cost. Instead long run average cost is affected by 

increasing and decreasing returns to scale, which translates into economies 

of scale and diseconomies of scale.

Long run average cost curves (LAC) 

The Long-run Average cost Curve (LAC) of a firm shows the minimum average 

cost of producing various levels of output from all possible short run average 

cost curves (SAC), thus the LAC is derived from the SAC curves that is the 

LAC can be viewed as a series of alternative short run situations into any 

one of which the firm can move. Each Short-run Average Curve (SAC) curve 

represents a plant of a particular size which is suitable for a particular range of 

output. The firm will therefore make use of the various plants up to that level 

where the short run average costs fall with an increase in output. The firm will 

not produce beyond the minimum short run of producing various outputs from 

all the plants used together.

Deriving the long run average cost curve (LAC)

Let us assume that we have five plants represented by their short run average 

cost curves SAC1, SAC2, SAC3 up to SAC4 where each curve represents the 

scale of the firm. The long run average cost curve is shown as smooth curve 

fitted to the short run average cost curves so that it is tangent to each of them 

at some point as shown in the illustration below:

The LAC is U- shaped due to economies and diseconomies of scale. These are 

the advantages and disadvantages of producing on a large scale respectively. 

The LAC curve can be divided into three parts.

Part I shows that the costs of the firm are falling while output is increasing. In 

this region there are increasing returns to scale. 

In part II LAC is constant but output is increasing, there are constant returns to 

scale in this region. The factor inputs increase by the same proportion as the 

increase in factor output. In part III output is increasing at increasing costs and 

this is due to the diseconomies of scale thus there are diminishing returns to 

scale in this region.

Economies and diseconomies of scale:

Growth brings both advantages and disadvantages to a business. These interact, 

and depending on the nature of the business and the way it is managed, decide 

the optimum or most efficient size for the business. This results into the area 

of economies and diseconomies of scale. It should be noted that average 

cost falls as output increases, with the result that large firms may enjoy lower 

costs than smaller competitors. This competitive cost advantage allows large 

firms to have larger profit margins and have more options in pricing policy.

a) Economies of scale:

 These are advantages that a firm enjoys in form of reduced average costs as the 

firm expands its scale of production. The most common reason for economies 

of scale is that some production costs are fixed (as production increases these 

costs stay constant) e.g. managerial, marketing and technical costs are paid for 

as a fixed amount. Therefore, since costs per unit (Average Costs) are calculated 

by dividing the cost by the number of units of output; AC= TC/Q. 

Then any average involving Fixed Costs (Numerator) must decrease as quantity 

produced (Denominator) increases.

 Economies of scale can be categorized into internal and external economies. 

i) Internal economies of scale:

These are benefits enjoyed by a single firm as a result of increasing its scale of 

production. Or they are the unit cost advantages from expanding the scale of 

production in the long run. Internal economies of scale come from the long-term 

growth of the firm. Examples of internal economies of scale include:

• Technical economies: The large-scale firms can use modern 

machinery and get many advantages.

• Financial economies: The large-scale firms get financial assistance 

easily in the form of borrowings, loans, credits at a low rate of interest.

• Marketing economies: The large-scale firms get raw materials at a 

cheaper rate because they purchase raw materials or factor inputs in 

bulk or a large quantity at discounted prices.

• Managerial economies: The large-scale firms can manage their 

business more efficiently because they use division of labour and can 

use various strategies to manage their workforce effectively.

• Risk bearing economies: Large-scale firms have the greater ability 

to manage the business risks. If there are losses in one market, they can 

withstand because of the wider markets which the company has.

• Research and development economies: When a firm expands, it 

can raise funds to undertake research, develop new designs, invest 

new products and undertake trade missions which cannot be afforded 

by small scale firm. 

• Social and welfare economies: As a firm expands its scale of 

production, it is in position to provide fringe benefits to its workers 

like better housing facilities, medical insurance and recreation which 

improve the efficiency of labour. 

• Storage economies: A big firm is capable of hiring large stores that 

can store large stock, storage costs per unit of output decrease when 

commodities are stored in bulk

ii) External economies

External economies of scale occur outside of a firm but within an industry. For 

example, investment in a better transportation network servicing an industry 

resulting in a decrease in costs for a company working within that industry. 

Examples of external economies of scale include: 

• Transportation and communication economies: Concentration of 

firms provides better communication system for all. Rail, road facilities 

become available to all, the transport system reduces costs. 

• Economies of skilled labor: With the concentration of firms skilled 

labour is available to all the firms because people living in the nearby 

areas get technical training. 

• Facility of workshop economies: Concentration of firms provides 

incentive for the technical persons to establish their workshops and 

hence, all the firms benefit from these, because they need not to incur 

costs in establishing the workshops. 

• Economies of helping industry: In local industry it becomes possible 

to split up some of the processes which are taken over by specialist 

firms. For example, in an area where there is a textile firm, textile mills 

dying factories, designing centers, ginning factories and calendaring 

plants have been established.

• Research and experiment economies: An industry is in a better 

position to establish research centers and disseminate the research 

findings in form of new inventions to the member firms through scientific 

journals thereby increasing the production efficiency of individual firms 

and a reduction of cost production. 

• Banking facility economies: In a localized industry or business 

centers bank opens their branches and all the firms benefit from banking 

and credit facility. The banking system helps in promoting trade and 

business. 

• Economies of cooperation: Due to expansion of an industry there 

is more cooperation between firms which enables them to establish 

common services like research centers, organisation of trade fairs 

among others. 

• Economies of specialisation: Due to the expansion of the industry, 

individual firms start specialising in different processes and in the end 

the industry benefits as a whole. 

• Transport economies: When the industry expands, individual firms 

may benefit from the infrastructure networks set up by other firms or by 

the state. 

• Economies of security: The firm enjoys joint security service. 

b) Diseconomies of scale: 

When a firm continues to expand beyond the optimum capacity, economies of 

scale will disappear and will give place to diseconomies. A given percentage 

increase in all the factors will be followed by less than a proportionate increase 

in the total output. Average and marginal product will diminish as a result. 

Thus, diseconomies are the disadvantages which a firm faces by 

expanding the scale of production beyond the point of optimal 

capacity. Like economies, diseconomies are also of two types i.e. internal and 

external diseconomies.

i) Internal diseconomies 

These are the disadvantages or problems faced by a firm which has increased 

its scale of production beyond the optimal capacity. These problems are only 

experienced by a single firm and they are not shared by other firms in the 

industry. These include:

• Managerial diseconomies: When a firm expands it faces the problem 

of supervision, coordination, control and communication of decisions, 

bureaucracy increases, time wastage and rigidity also increases which 

results into higher costs per unit of output.

• Technical diseconomies: A large firm realizes disadvantages 

of specialisation and incurs high costs of maintaining complicated 

machines and buying raw materials hence higher average costs of 

production. 

• Financial diseconomies: A large firm may face financial disadvantages 

especially if funds are not secured in time which delays production and 

limits expansion of the firm. 

• Risk bearing diseconomies: Due to expansion a firm faces more 

disadvantages in case of uninsurable risks like a war since it loses on 

a very large scale. 

• Marketing diseconomies: A large firm faces the problem of scarcity 

of raw materials, changes in tastes and preferences of consumers, 

declining demand for its products etc. which may result into higher 

costs and more losses. 

• Limited availability of natural and human resources: With 

expansion in the scale of production, workers may have to be recruited 

from other regions by offering them higher wages. Limited availability of 

natural resources also causes diminishing returns to scale. 

• Advertising diseconomies: To get rid of extra output, large firms 

incur high costs of advertising.

• Storage diseconomies: Due to large scale production, output 

increases so the firm may lack adequate stores and the available may 

tend to be expensive hence increasing costs of production.

ii) External Diseconomies: 

These are disadvantages realised by a firm from outside due to expansion 

of the industry. These problems are shared by the firms operating within the 

industry. These diseconomies arise due to much concentration and localization 

of industries beyond a certain stage. Localization leads to increased demand 

for transport and, therefore, transport costs rise. External diseconomies of scale 

occur when an industry growing in size causes negative externalities and rising 

long-run average costs. Examples of external diseconomies include: 

• Congestion diseconomies: If an industry grows rapidly in size, it may 

cause traffic congestion. 

• Labour diseconomies: As an industry expands it becomes more 

difficult to secure labour with the appropriate skills resulting into higher 

wages for labour and higher costs of production. 

• Marketing diseconomies: As a result of expansion of an industry, 

competition for markets increases resulting into higher marketing costs 

and lower profits.

• High demand for raw-materials: The expansion of an industry 

results into higher demand for raw materials hence higher costs of 

production. 

• Scarcity of land: Expansion of an industry creates scarcity of land 

for expansion for individual firms which increase rent, congestion and 

transport costs hence higher average costs of production. 

• Competition diseconomies: When an industry expands, firms will 

be challenged by the shortage of infrastructure facilities and social 

amenities. This will mean that the cost of transport and communication 

will be very high hence leading to high cost of production. 

• Pollution diseconomies: The localization of industries in a particular 

place or region pollutes environment. The polluted environment acts as 

a health hazard for the laboratories

4.4.2. Revenues and profits of the business/firm

• Revenue of the business

Revenue of the firm refers to sum of money received from the sale of various 

quantities of output by the firm at a given price at a given time. In economics, 

there are different forms of revenue and can be classified into three categories 

such as: 

a) Total revenue (TR) 

This is the total sum of money received from all unit output sold by the firm at a 

given price in a given period of time. Total revenue = price × quantity (TR = P 

x Q) 

b) Average revenue (AR) 

This refers to the revenue per unit of output sold. It is obtained by dividing total 

revenue by output.

Average revenue= Total revenue / Total output

Since Total revenue is (P x Q), Then 

This implies that the average revenue equals the price. (AR= P)

c) Marginal revenue (MR) 

This refers to the additional revenue from an extra unit of output sold. Or it 

refers to a measure of the instantaneous rate of change of total revenue with 

respect to change in output (Q) sold. It is obtained by dividing the change in 

total revenue by the change in total product.

MR=∆TR/∆Q

• Relationship between AR and MR. 

The relationship between AR and MR can be seen through calculations and 

illustrations as below;

a) Calculations of revenues.

The revenue position of a perfectly competitive firm.

In the above table total revenue (TR) is obtained by multiplying output (Q) and 

price (P). Average revenue (AR) is obtained by dividing total revenue (TR) by 

quantity (Q) while marginal revenue (MR) is obtained by dividing changes in 

total revenue by changes in quantities sold. The table above represents perfect 

competition market where average revenue is equal to marginal revenue. 

(AR=MR)

a) Relationship between average revenue (AR) and marginal 

revenue (MR) using curves. 

From the above table we can represent the relationship between AR and MR 

as below.

From the above figure, it can be concluded that, there was only one price that 

prevailed in the market. Each firm had to take the market price as given and sell 

its quantity at the ruling market price. The firm’s demand curve is infinitely elastic. 

Therefore, the relationship is in such a way that, as the firm sells more and more 

at the given price, its total revenue will increase but the rate of increase in the 

total revenue will be constant, making AR = MR.

The revenue position of a firm operating under imperfect competition.

In the table above, Total revenue first increases reaches maximum and then 

start to fall. Average and marginal revenues start off as equal but thereafter as 

the firm sells a higher level of output, marginal revenue falls further below the 

average revenue. Both the average revenue and marginal revenue decrease as 

more is sold. The MR reaches a point and becomes negative, but AR will never 

be negative. This relationship can be represented in a graph as below.

Under imperfect competition, average revenue is not the same as marginal 

revenue. It is always greater than marginal revenue at all levels of output. This is 

because the business persons want to sell more, they must reduce price, not 

only on the extra units sold, but also on the earlier units. This can be seen in the 

table of revenue position and curve above.

• Profit of The Business / Firm

Profit refers to the earnings to an entrepreneur as a factor of production. It can 

also be taken as the difference between total revenue received by the firm and 

the total costs incurred by the same firm. In economics, there are different forms 

of profits. These include:

a) Normal profit

 This refers to the minimum level of profits which can maintain a firm in business. 

It is realised when average cost is equal to average revenue that is AC = AR. 

Normal profits are also known as the transfer earning or supply price of the firm. 

It is also called zero economic profits. 

b) Abnormal/supernormal profit. 

This refers to profits which are more and above the normal profits. They are 

earned if average revenue is greater than average cost. They are also known as 

monopoly rent if earned in the long run. 

c) Subnormal profit 

This refers to the profits which are lower than normal profits obtained where 

average cost is greater than average revenue but average revenue is greater 

than average variable cost that is AC > AR > AVC.

Condition for profit maximization:

The necessary and sufficient condition for maximum profit states that if 

the firm is to obtain maximum profit, it would have to equate its MR and MC 

(MR=MC), or, it would have to remain at the point of intersection between its 

MR and MC curves but the slope of the MR curve, should be less than the slope 

of the MC curve.

Condition for profit maximisation is illustrated as below:

a) Condition for profit maximisation under perfect markets. 

From the above illustration the firm maximizes profits at point B where MC=MR 

but the slope of MC is greater than the slope of MR. The profit maximizing 

output is output OQ2 because it is greater than output OQ1 . The equilibrium 

price is Pe which is equal to average revenue (AR) and as well equal to marginal 

revenue (MR). i.e. (P=AR=MR).

b) Condition for profit maximisation under imperfect markets.

From the above illustration the firm maximizes profits at point “e” where MC=MR 

but the slope of MC curve is greater than the slope of MR curve; the profit 

maximizing output Qe (equilibrium output) is produced and sold at price Pe. 

(Equilibrium price).

4.4.3. A firm, plant and industry,their location and localization

People mistakenly use the terms firm, plant and industry interchangeably, yet 

they are different. These terms are clearly defined as follows:

• A firm: A firm refers to a single production unit or enterprise under one 

ownership, management and control. It may be small thus controlled 

by one man or through partnership, or a large-scale production unit 

e.g. public corporation. It may be private businessmen or joint stock 

companies or owned by the government or both government and 

private individuals. 

• A plant: A plant refers to a place or establishment where goods are 

produced. For example, Coca-Cola, Inyange factory etc. So plant 

means a factory, shopping center, or any other establishment. Different 

firms have different plants. A plant includes not only the building and 

machinery, but also the workers employed therein.

• An industry: An industry is made up of several firms that compete 

in the production of the related product or service. It can also be 

defined as combination of different firms producing related products. 

E.g. sugar industry, Textile Industry, Cement Industry, Mining Industry, 

Entertainment industry, transport industry, soft drinks industry. An 

industry is normally known by the name of the commodity produced by 

the various firms in it.

Deriving the supply curve of an industry

Since the industry is a combination of firms, its supply curve can be derived 

by horizontal summation of supply curves of the various firms in the industry. 

This is illustrated graphically as follows: 

Equilibrium of firms and equilibrium of an industry.

The term equilibrium refers to the state of stability where there is no tendency 

to change. 

Equilibrium of the firm is the point of a profit maximization when the firm has 

no tendency to increase or reduce output. At this point, Marginal Cost (MC) is 

equal to the Marginal Revenue (MR). If the firm increases output and produces 

beyond this point, marginal cost would be greater than marginal revenue and 

hence the firm would be operating at a loss. 

When the firm produces below the point where MC=MR, profits would be less 

because less units of output are produced. The condition for profit maximization 

(MC=MR at the highest level of output) applies to all firms. 

Equilibrium of an industry: This is when there is no tendency for the output 

of the whole industry to increase or to reduce. At this point, there is no new firms 

entering the industry nor old firms leaving the industry. In other words, all firms 

are earning normal profits which neither attract new firms nor force firms out of 

the industry immediately.

Location and Localization of the firms

a) Location of firms.

Location of firms refers to establishment of a firm or industry in a particular 

geographical area. Or it is a site or place where a firm or industry is established 

or set up. The place might be convenient or economic to the entrepreneur 

irrespective of whether there are others or not. The basic principle behind 

location of a firm is cost minimization. The producer selects the location of a 

firm, where costs of production are at minimum.

Factors influencing location of a firm and an industry. 

There are several factors that determine location of firms or industry. These 

factors may be geographical, economic or political. They may be having a 

bearing on costs of production or not depending on what circumstances are 

compelling a firm’s set up. Some, among others include the following; 

i) Availability of raw materials: A firm can be located in an area where 

raw materials are, especially when the raw materials are heavy and it would 

be costly transport them from distant places. Such firms are called rooted 

firms/industries e.g. cement firms.

ii) Availability of the market: Firms can be located in areas where the 

market for its finished products is available as this reduces the firm’s 

expenditure to market its products and hence an increase in firm sales 

and profits. Such firms are called tied firms/industries.

iii) Government policy: The policy of the government concerning 

industrialisation influences location of firms. For example, government may 

have the goal of regional balance in development and therefore my dictate 

where to locate certain firms in order to realize this goal.

iv)Transport and communication network: Firms can be located in 

areas where the transport and communication infrastructure is developed. 

This eases transportation of the firm’s products to market and the raw 

materials to the firm as well as keeping in touch with its partners through 

efficient communication network. 

v) Availability of power: Firms can be located in an area where power 

is available and less costly. This is because every firms need power in the 

production process and therefore its absence implies that the firm cannot 

undertake production. 

vi)Availability of labour or skill base in the area: A firm can be located 

in an area where there is availability of abundant labour, with the required 

skills that the firm can employ to facility its production process. 

vii) Availability of land: Availability of enough land which the firm can 

acquire at a low cost and also where it can expand its scale of operations 

in future influences the location the firm.

viii) Political stability/security: Firms can be located in an area where there 

is political stability since it will be sure of the security of its investments.

ix)Commercial institutions: Presence of developed commercial institutions 

such as banks, insurance companies and advertising companies. They 

facilitate the firm to acquire credit and promote its products in case of 

advertising companies influence location of firms. 

x) Industrial inertia: Industries tend to develop at the place of their original 

establishment, though the original cause may have disappeared. This 

phenomenon is referred to as inertia, sometimes as geographical inertia 

and sometimes industrial inertia. Industrial inertia refers to the tendency 

for an industry to remain in a location or keep attracted there even when 

the factors that attracted them before there no longer exist.

xi)Climate: Harsh climate is not much suitable for the establishment of 

industries. There can be no industrial development in extremely hot, humid, 

dry or cold climate. For example, Cotton textile industry requires humid 

climate because thread breaks in dry climate. 

xii) Water is another important requirement for industries. Many industries 

are established near rivers, canals and lakes, because of this reason. Iron 

and steel industry, textile industries and chemical industries require large 

quantities of water, for their proper functioning.

b) Localization of firms

In today’s economy, firms depend on one another. One firm’s waste material may 

be used by another firm as a raw material. Due to this interdependency among 

firms, most entrepreneurs decide to construct their firms near the ones that may 

provide raw materials. Or it may be due to government policy. This helps in cutting 

down the transportation and disposal of waste costs for the firms. Localization of 

firms therefore, refers to the concentration of many firms in an area. 

Localization is related to the territorial division of labour, that is, specialisation by 

areas or regions. A certain town or region tends to specialise in the production of

a particular commodity. And a situation of transferring firms from the area of high 

concentration to areas of low concentration is known as delocalization. Localization 

can also lead to establishment of forward linkage and backward linkage. 

Localization promotes linkages between or among firms in a localized area. 

Forward linkage happens where the products of one industry are used as 

the raw material of another industry. For example, the development of forest 

resources for the export trade in raw timber leads to the development of a saw 

milling industry using the same basic resource inputs. 

Backward linkage happens where an existing industry encourages investment 

in the earlier stage of production. For instance, the development of sugar industry 

creates demand for sugarcane growing to provide sugar canes as inputs in the 

sugar industry.

Advantages of localization of firms:

 Localization of firms has the following merits to the localized area or the entire 

economy as below. 

i) Creation of employment: Localization leads to creation of more 

employment opportunities because as many firms are established in a 

given area more jobs are created. 

ii) Development of infrastructure: Localization results into improvement 

of infrastructure by the government such as roads and telecommunications 

to cater for the firm’s needs. 

iii)Urbanization: Concentration of firms in a particular area results into 

urbanization with its advantages like improvement of cultures and attitudes, 

encouraging hard work hence promotion of economic development. 

iv)Improved quality: Concentration of firms in area results into production 

of high quality products due to competition among many firms. 

v) Improved reputation: localization enables the area to gain reputation 

and the same will apply to the goods produced from that area which 

creates wider markets for its products. 

vi)Supply of skilled labour: Concentration of firms in an area attracts 

skilled labour to that area which in the long run promotes specialization 

and division of labour in the production process with its associated 

advantages. 

vii) External economies: Concentration of firms in an area results into 

generation of various external economies like transport economies, 

marketing economies, labour economies, research economies and many 

others which reduce the production costs of the different firms. 

viii) Industrial expansion: Localization of firms results into growth 

of subsidiary industries to supply raw materials, machine tools, component 

parts etc. hence expansion of the industrial sector. 

Disadvantages of localization of firms:

 Localization of firms has the following demerits to the localized area or the 

entire economy as below:

i) Regional imbalances: As a result of localization, the localized region 

grows faster than others leading to regional imbalances in development.

ii) Development of slums: Localization results into development of slums 

and its negative effects due to lack of adequate housing facilities to house 

the large number of people in the localized area.

iii) Social problems: Concentration of firms in an area results into social 

problems like congestion, overpopulation, traffic jam and accidents which 

reduce labour efficiency and industrial production.

iv) Rural-urban migration: Due to Localisation, many people move to 

urban centers in search of employment. This results into high crime rates 

and other social problems in urban areas.

v) Over-straining infrastructure: As a result of Localisation, infrastructures 

like roads are excessively used which increases wear and tear, costs of 

replacement hence constraining the government budget. 

vi)Diseconomies: Due to concentration of many firms in an area, 

diseconomies of scale arise such as high cost of labour, transport 

problems, failure to secure credit, competition for raw materials resulting 

into high costs of production.

vii) Increased cost of living: Concentration of firms in an area results into 

shortage of essential commodities in the area due to increased demand 

for those products, hence resulting into increased cost of living.

viii) Increased dependence: Localization results into overdependence on 

a particular area for a particular product which is dangerous in case of 

war, natural disasters or in an economic crisis. ix) Exhaustion of resources: 

Concentration of firms in an area leads of over exploitation of resources in 

the area resulting into quick exhaustion of the resources which deprives 

the future of access to those resources.

• Classification of firms

Firms or industries are usually grouped or classified according to the factors 

that tend to influence their locations as follows: 

i) Rooted industries 

These are firms or industries, which must be located, near the sources of raw 

materials. They cannot be located anywhere else apart from the raw materials 

sources e.g. cement factory which has to be located near limestone source. 

ii) Tied industries 

These are firms or industries which are located near their markets i.e. they are 

industries whose location are tied to the market for their finished products e.g. 

bakeries furniture workshops etc. 

iii) Foot loose industries 

These are industries that can be located anywhere without any negative effects 

on the private costs of production. They are the types of industries that have no 

specific factors dictating them to be located in any areas. 

iv)Bulk reducing or weight losing industries 

These are firms or industries that use bulky raw materials to produce light 

products. Such firms are usually located at the source of the bulky raw materials 

in order to reduce the cost of transporting the bulky raw materials. Since the 

products are less bulky, they can easily and cheaply be transported to the 

markets e.g. copper processing plant, sawmills. 

v) Bulk increasing or weight gaining industries 

These are firms or industries that produce bulky finished products out of relatively 

light raw materials. These industries are usually located near the market because 

of the bulk nature of the finished product e.g. furniture workshop.

Application activity 4.4

1. Distinguish between the long run and the short run periods of 

production.

2. Explain the different economies of scale clearly indicating whether 

they are internal economies or external economies

3. Discuss the factors that influence the firms location

Skills Lab 4

In your respective teams, evaluate and analyze the expenses incurred by 

your business club as per your respective product teams and determine:

a) Variable Costs 

b) Fixed Costs and 

c) Total Costs

Illustrate the VC, FC and TC for your respective product and provide advice 

to the entire class on how your team intends to minimize the expenditures.

End of unit assessment

1. Case study:

Nyirangarama enterprise is a firm that produces a variety of products. In 

order for the firm to meet its obligations it makes a number of expenditures. 

At its inception it incurred initial expenditures which included; Land for 

5,000,000 FRW, registration for 50,000Frw, construction of firm buildings 

for 20,000,000Frw and advertising expenditure 2,000,000Frw. The 

proprietor had earlier borrowed 100, 000,000Frw for which the firm will 

be paying 18% interest annually. After beginning operations, the firm 

incurred expenditures on raw materials for 4,000,000Frw, salaries for staff 

for 1,500,000Frw monthly and for administration 2,000,000Frw, transport 

for 1,000,000Frw. 

Required:

a) After studying the case study, discuss the concept of costs and 

identify the types of costs in the case study.

b) Explain which of the above costs are implicit and which ones 

are explicit. 

 Present your ideas to the rest of the class.

2. Construct the difference between the economies of scale and 

diseconomies of scale.

3. Analyse the table below and answer the questions that follow.

Required: 

a) Calculate and fill up the blank spaces. 

b) Illustrate AFC, AVC, AC, and MC on a graph.