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LAWS OF RETURNS
LAW OF VARIABLE PROPORTIONS
RETURNS TO SCALE
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LAW OF DIMINISHING RETURNS
According to Alfred Marshall an increase in labor and capital applied in the cult ivation of land causes in general a less than proportionate increase in the amount of produce raised, unless it happens to co-inside with an improvement in arts of agriculture. With the continuous use of land its fertility goes on diminishing therefore output goes on diminishing .
This law is particularly applicable to agriculture, but it is also applicable in those sectors of economy where nature plays a dominating role such as fishery and mining. The law operates when mining operations are extended to inferior, or on deeper mines and when fishing operations are concentrated on specific place. This law is also called Law of
Increasing Cost because as marginal product diminishes marginal cost increases.
CONDITIONS OF THE LAW
1-----Quality of factors of production (land & labor) should be of same standard.
2-----Cultivation should be carried on continuous on the same plot of land.
3-----Cultivation/production methods should not change.
APPLICATION/ IMPORTANCE OF LAW OF DIMINISHING RETURNS
1-----Validity of law of diminishing returns is not merely based on theoretical reasoning but extensive reasoning has supported it. It has been remarked that if diminishing return did not occur we could grow sufficient food grains on a very small plot of land.
2-----Malthusian theory of population, which says that population, increases faster than food supply is based on the fact that production of food is subject to law of diminishing returns.
3-----Ricardian theory of Rent explains the determination of rent on the assumption that inferior lands have to be cultivated on account of the operation of law of diminishing returns. The margin of cultivation descends and rent rises .
4-----Marginal productivity theory, which determines share of a factor of production in national income, is also based on operation of law of diminishing returns.
5-----Law of diminishing returns has vast general applicability and it equally applies to agriculture and industry. Whenever some factors of production are fixed and some other are increased, diminishing returns are bound to occur both in agriculture as well as in industry.
6-----Law of diminishing returns has stated that technical knowledge and equipment should remain the same, then and only then this law will be in operation. Developed countries of Europe and America have made much progress in technical knowledge by
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Now suppose that expenses involved on per unit of labor and capital are Rs.1000/- and output of wheat is in mounds. Marginal cost is calculated by dividing Rs.1000 with marginal product of wheat (Rs.1000/50)=Rs.20 per mound.
Units of labor and capital
1
2
3
4
50
40
30
20
10
A
T.P.
(Mds)
50
90
120
140
B
C
M.P.
(Mds)
50
40
30
20
D
A.P.
(Mds)
50
45
40
35
MP
50
33
30
25
20
10
A
M.C
Rs 1000/50 mds
Rs 1000/40 mds
Rs 1000/30 mds
Rs 1000/20 mds
B
Marginal cost per unit (Rs .)
20
25
33
50
C
D
M C
0 0
0 1 2 3 4 1 2 3 4
Units of Labor & Capital Units of labor & Capital
LAW OF INCREASING RETURNS
According to Marshall an industry is subject to increasing returns if an extra investment in industry is followed by more than proportionate returns i.e. if marginal product increases. As the proportion of one factor in a combination of factors is increased, up to a point, marginal product of factor will increase. The reason for increasing returns is because of Division of Labor and specialization by industry. This law is also called Law of Decreasing Cost, as marginal product keeps on increasing and marginal cost keeps on decreasing.
CONDITIONS OF THE LAW
1-----Factors of production should not be in short supply.
2-----Optimum level of production has not reached so far.
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Now suppose expenses involved on per unit of labor and capital are Rs.1000 and output are Socks. Marginal cost is calculated by dividing Rs.1000 with marginal product of socks, Rs.1000/50 socks=Rs.20 per sock.
Units of labor and capital
1
2
3
4
T.P
50
110
180
260
M..P
50
60
70
80
A..P.
50
55
60
65
M.C.
Rs.1000/50 socks
Rs.1000/60 socks
Rs.1000/70 socks
Rs.1000/80 socks
M.C.
Rs. per socks
20
16
14
12.50
80
70
60
50
A
B
C
D
MP
20
16
12
8
A
B
C
D
M C
0 1 2 3 4
0
1 2 3 4
Units of labor and capital
Units of labor and capital
LAW OF CONSTANT RETURNS
Marshall said that an industry is subject to constant returns when whatever the output, cost per unit remains unaltered or increased investment of labor and capital results in a proportionate increase in output. The reason for constant returns is that an industry, which is involved in production process might also be engaged in cultivation of raw material for its industrial unit, for example a blanket industry might also be engaged in rearing of sheep for its wool requirement. In sheep rearing or wool production law of diminishing returns will operate and in blanket manufacturing law of increasing returns will operate. Another example may be of sugar cane production and manufacturing of sugar by same business unit or fruit farming and fruit canning and processing factory by same owners. This law is also called Law of Constant cost because marginal product remains unchanged and marginal cost also remains same.
Now suppose that expenses involved on per unit of labor and capital are Rs.1000 and output is sugar. Marginal cost is calculated by dividing Rs.1000 with marginal product of sugar i.e. Rs.1000/50 kgs = Rs.20 per kg.
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CONDITIONS OF THE LAW
Both agricultural sector and industrial unit should be under ownership and operation by same owners so that the loss on one side is balanced from the profit of the other side of business.
Units of labor and capital
1
2
3
4
T.P
50
100
150
200
M.P
50
50
50
50
A.P
50
50
50
50
M.C.
Rs.1000/50
Rs.1000/50
Rs.1000/50
Rs.1000/50
M.C. per
Unit unit
20
20
20
20
50
25
A B C D
MP
20
10
A B C D
M C
0
1 2 3
Units of Labor & Capital
4
0
1 2 3 4
Units of labor & Capital
LAW OF VARIABLE PROPORTIONS
This law is called law of variable proportions because output of firm changes with the variation in factor-proportions. Fixed factor of production that is plant and machinery remains unchanged whereas only numbers of workers are increased. In this situation every time factor-proportions are disturbed and changed by increasing variable inputs such as one machine plus two workers, one machine plus three workers, one machine plus four workers etc. Machine remains only one where number workers are being increased.
The law states that with increase in one factor of production (labor) marginal product of additional labor after a certain point, goes on decreasing. At the beginning output increases with addition of more variable inputs bringing about a more intensive use of fixed input (machine). Eventually, as output is increased an optimal factor combination is attained at which variable and fixed inputs are mixed in most appropriate proportions to give maximize output. There after, further additions of variable inputs (number of workers) to the (now overworked) fixed input (machines) leads to a less than proportionate increase in output so that marginal product declines.
In the table below up to third labor marginal product keeps on increasing from 80 to 100 units but the 4 th
and 5 th
labor’s marginal product decreases by 98 and 62 units
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___________________________________________________________________________________________________ respectively. This production behavior is divided into three stages, therefore this law is also known as Stages of Production.
Labor T.P. M.P. A.P.
Stages
5
6
7
8
1
2
3
4
9
10
80
170
270
368
430
480
504
504
495
470
62
50
24
0
80
90
100
98
-9
-25
86
80
72
63
80
85
90
92
55
47
ONE
TWO
THREE
Stage one
N
W
Stage two
L
Stage
Three
TP
AP
0 3 8
Number of workers
MP
12
STAGE ONE
1-----Total product is increasing with employment of additional labor and up to 3 rd labor at point N increase in rate of total product is fast and thereafter increase rate is slow.
2-----MP is maximum at point W (100units) and there after starts decreasing.
3-----AP increases; reaching to maximum level of 92 units and there after starts decreasing.
STAGE TWO
1-----Total product is increasing in this stage but its rate of increase rate is slow. Total product reaches to the highest level at Point L (50 units) at the 8 th
labor and there after it declines.
2-----Marginal product keeps on decreasing from 98 to 24 units till it becomes zero at the end of this stage.
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3-----Average product keeps on decreasing from 92 to 72 units.
4-----At this stage optimum proportion of labor and machinery is disturbed hence output per worker decreases.
STAGE THREE
1-----Total product starts decreasing after point L from 504 to 440 units.
2-----Marginal product becomes negative from 9th labor.
3-----Average product starts decreasing from 72 to 44 units.
4-----This is a bad stage because labor is being paid but his marginal output is negative.
RETURNS TO SCALE
Many people confuse Economies of Scale with the concept of increasing returns to scale.
Economies of scale are related with to money costs of production whereas returns to scale are related only with the physical output of the factors or production. If physical output increases more than proportionately as the scale of all the inputs is changed, increasing returns to scale occur. Decreasing returns to scale and constant returns to scale are other possibilities. Increasing returns to scale contribute to economies of scale in the form of technical economies. It is the impact of diminishing marginal returns on costs and profits of a firm in economic short run that encourages the firm to change the scale of its operations in long run.
In the case of diminishing returns, increasing returns or constant returns only one factor that is labor is increased and other factors of productions are held constant.
But in case of Returns to Scale all factors of productions i.e. land, labor and capital are increased in the same proportion/rsatio.
1---INCREASING RETURNS TO SCALE
Factors of production
Land + Labor+ Capital
1
2
Output
Increasing returns
10 units
25 units
Change in factors = 2-1 = 1 = 1 = 100% change in factors
Original factors 1 1
Change in output = 25--10 = 15 = 1.5 = 150% more than 100%
Original output 10 10 in output.
In the above table all factors of production (land, labor and capital) have been doubled, there is 100 percent increase in the factors of production where as output has increased from 10 units to 25 units, which is more than double. There is an increase in output by
150%. It means increase in all inputs leads to a more than proportional increase in the output of the firm. Here increasing returns to scale is operating. Increasing returns to scale is achieved in the manufacturing industries.
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2----DECREASING RETURNS TO SCALE
Factors of production
Land + Labor+ Capital
Output
Decreasing returns
1
2
10 units
15 units
Change in factors = 2-1 = 1 = 1 = 100% change in factors
Original factors 1 1
Change in output = 15-10 = 5 = .5 = 50%= Less than 100% change in
Original output 10 10 output
In the above table all factors of production (land, labor and capital) have been double d.
There is 100 percent increase in the factors of production where as output has increased from 10 units to 15 units, which is less than double. There is an increase in output by
50%. It means increase in all inputs leads to a less than pr oportional increase in the output of the firm. Here diminishing returns to scale are operating. Diminishing returns to scale is achieved in those activities involving natural resources such as growing agricultural products.
3--- CONSTANT RETURNS TO SCALE
Factors of production
Land + Labor+ Capital
Output
Constant returns
1
2
10 units
20 units
Change in factors = 2-1 = 1 = 1 = 100% change in factors
Original factors 1 1
Change in output = 20-10 = 10 = 1 = 100% change in output
Original output 10 10
In the above table all factors of production (land, labor and capital have been doubled)
There is 100% increase in the factors of production where as output has increased from
10 units to 20 units which is in the same ratio There is increase in output by 100%. It means increase in all inputs leads to a proportional increase in the output of the firm.
Here constant returns to scale are operating. Constant returns to scale is achieved in the handicrafts industries
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ADVANTAGES OF LARGE SCALE PRODUCTION or BUSINESS
1
A large-scale business having large finances can install heavy machinery, which gives greater production. It can have its own workshop facilities hence cost of production reduces.
2
3
In it Division of labor is possible. Division of labor increases output because each worker is given that job in which he has a particular training and expertise.
Useful goods can be made from waste material, which increases revenue of the firm.
4 It can provide securities and therefore can easily obtain loan facilities from banks.
6 It can easily face adverse business situations.
It is in a position to spend a lot of money on advertisement campaign for its
7 products.
8 It can spend a lot of money on research facilities for developing new products
1
2
3
DISADVANTAGES LARGE SCALE PRODUCTION or BUSINESS
In this business uniform types of goods are produced and individual customer’s choice is not given any importance.
There is lack of supervision on the staff as well as on the product and due to carelessness and dishonesty of workers cost of production increases.
There is always rift between owners and employees in a large business due to lack of confidence trust and friendly relationship between the two sides. This situation results in strikes and lockouts .
4
Proper control and supervision is not possible hence quality of goods deteriorates and much wastes takes place.
5 There is a cutthroat competition among the large firms, which ruins all of them.
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ADVANTAGES SMALL SCALE PRODUCTION or BUS INESS
1 Small businessman can take quick and prompt decisions about his business
2
3
Since business is very small and owner is always present there is no waste of raw material or machinery
There are friendly ties between owner and workers therefore there are no strikes and lockouts in this type of business
4 Goods are produced as per demand and requirement of individual customer
Owner works very hard for his business thus there is little loss or loss
DISADVANTAGES SMALL SCALE PRODUCTION/BUSINESS
1
2
Due to shortage of capital, installation of large machinery and division of labor is not possible.
It purchases raw material in less quantity therefore price concessions are not available to it.
3
It cannot offer proper securities to banks therefore loan is not easily available to small business.
4 Due to lack of finance it is not in a position to properly advertise its product .
5
It cannot use waste material and cannot make by-products due to shortage of machinery and overhead facilities. It will rather have to spend money to throw out the waste material.
ECONOMIES OF SCALE
Economies of scale means the long run reduction in average costs that occur as scale of firm’s output is increased. Economies (benefits) of large-scale production are divided into
Internal Economies and External Economies. The internal economies benefits arise within a particular firm due to increase in its size/scale of production. Some of the benefits are as under: -
INTERNAL ECONOMIES
1 -----TECHNICAL ECONOMIES
These economies or benefits arise to firm when it uses large and modern machinery whose operating cost is relatively less but output is greater.
2 -----MANAGERIAL ECONOMIES
Managerial expenses can be reduced by increasing size of an establishment by specialization and division of labor or by grouping a number of establishments under one management.
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3 -----COMMERCIAL ECONOMIES
Large firm can purchase raw material in bulk at a cheaper rate. This firm also gets freight concessions from truck owners and railways. With increase in production, advertising cost per unit of output also decreases.
4-----FINANCIAL ECONOMIES
A large firm can offer securities to banks and can obtain loan at low interest. It can also collect fund by issue of shares & debentures in the open market.
5 --- RISK BEARING ECONOMIES
Large firm may spread its risk by diversifying its output or markets or sources of supply of processes of manufacture. Thus large firm is often less exposed to risks .
INTERNAL DISECONOMIES
1---There is always an optimum size beyond which a firm can get more disadvantages than advantages; therefore a firm cannot expand its size in an unlimited manner. A firm may experience financial diseconomies in the form of increased proportionate financial cost.
2---When a firm having a very big size uses all possible division of labor and specialized machines, a further increase in its size will result in dis-economies because of lack of proper control/management hence cost will start increasing.
3---If firm continues unlimited diversification it would result in a greater risk and would increase the economic fluctuations rather than covering these risks.
EXTERNAL ECONOMIES
1 -----ECONOMIES OF CONCENTRATION
When many firms of same industry concentrate on one particular location, then trained labor force, cheap raw material, cheap transport, better roads, cheap spare parts, technical training centers meeting the requirement of industry etc. are easily available to all firms of the same industry. All these facilities cut down cost of production of all firms.
2 -----ECONOMIES OF INFORMATION
All the firms can drive benefits from the publications of trade and technical journals and research facilities set up by other people in that particular area for that particular industry.
3 -----ECONOMIES OF DISINTEGRATION
When a particular industry grows (for example textile industry) it becomes possible to split up some of production processes, which are carried on by other firms. A number of cotton textile mills located in a particular area can be benefited of a separate calendaring factory (i.e. finishing the surface of cloth).
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EXTERNAL DISECONOMIES
1----When the industry is localized in a particular area, there is a huge demand of skilled labor therefore, wages and price of land increases hence the cost of production increases.
2----Firms compete themselves for hiring transport, hence freight charges increase.
3----Prices of raw material (especially of those which are in short supply) increase, due to excessive demand by all firms of same industry of that area .
4----Due to concentration and localization of large factories of the same nature congestion and pollution creates a lot of social/health problems.
EXTERNALITIES
Externality is an activity that imposes involuntary costs or benefits on others. It is an activity whose effects are not completely reflected in prices and market transactions. It is a situation in which a benefit or a cost associated with an economic activity affects third parties. Market failure is a situation in which the operation of supply and demand fails to produce a solution that truly reflects all of costs and benefits that go into producing and consuming a good or service. One such market failure involves pollution. In course of production of steel by a steel mill, the price it charges for the steel products reflects only the costs that the steel mill has incurred. In the course of production smoke dispersal is a by-product and it is the people in community who pay that cost in the form of dirtier clothes, dirtier houses and more respiratory illnesses. This is a spillover effect or an externality, which is an external cost. In this case some costs associated with the production of steel have spilled over third parties, parties other than buyers and seller of steel products. Externalities are un-intended by-products.
Private costs are explicit costs that are borne directly by consumers and producers when they are engaged in any resource using activity, whereas social costs are private costs plus any other costs that are external to decision maker. For example, social costs of driving include all private costs plus any pollution and congestion caused. When private costs differ from social costs, externalities exist, because individual decision makers are not internalizing all costs that society is bearing. When social costs exceed private costs, environmental problems ensue, such as excessive pollution of air & water and these are problems of externalities.
TYPES OF EXTERNALITIES
(1) -----POSITIVE EXTERNALITY
Positive Externality or external economies means production or consumption yields positive benefits to others without those others paying any thing. A firm that hires a security guard scares thieves from the neighborhood, thus providing external security services.
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(2)--- NEGATIVE EXTERNALITY
Negative Externality or external dis-economies means production or consumption imposes uncompensated costs on other parties. Steel mills that emit smoke and sulfurous fumes harm local property and public health yet the injured parties are not paid for the damages.
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