Assignment on Laws of Returns Prepared for

Mr. Ahmed Reza Choudhury

Lecturer Managerial Economics Department of Business Administration University of Information Technology & Sciences

Date of Submission

Prepared By
Name
Md. Akhtar-Uz-Zaman

Id
12515033

UNIVERTY OF INFORMATION TECHNOLOGY & SCIENCE

Laws of Returns - The Traditional Approach Introduction The traditional theory resources used for the production of a product are known as factors of production. Factors of production are now termed as inputs which may means the use of the services of land, labor, capital and organization. The Production Function The Production function expresses a functional relationship amidst quantities of raw materials and goods. It shows how and to what extent output changes with variations in raw materials during a specified period. In the words of Stigler The production function is the name given to the relationship between rates of input of productive services and the rate of output of product. It is economists summary of technical knowledge. It is expressed as follows. __ Q =F (L,M,N,C,T), where Q stands for the output of a good per Unit of time, L for labor, M__ for management of organization, N for land or natural resources, C for Capital and T for given technology and F refers to the functional relationship. Law of Variable of Proportions If one input is variable and all other raw materials are fixed the concerns production function exhibits the law of variable proportions. If the number of units of a variable factor is increased, keeping other factors constant, how output changes is the concern of this law. As per Leftwich The law of variable proportions states that if a variable quantity of one resource is applied to a fixed amount of other input, output per unit of variable input will increase but beyond some point the resulting increases will be less and less with total output reaching a maximum before it finally begins to decline. Postulations This law is based on the below postulations. 1. It is feasible to alter the proportions in which the a range of factors are collective 2. Only one factor is erratic while others are held invariable
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3. All units of the changeable factor are standardized 4. There is no variation in expertise 5. It presumes a short run condition 6. The produce is calculated in physical units, in quintals, tonnes etc. 7. The price of the produce is specified invariable Explanation of the Law To explain this law more clearly, let us construct a sketch.

The TP curve first rises at an enhancing rate up to point A where its slope is highest. From point A upwards, the total product increases at a diminishing rate till it reaches its highest point C and then is starts falling. Point A where the tangent touches the TP curve is called the inflection point upto which the total product increases at an increasing rate and from where it starts increasing at a diminishing rate. The average product curve AP and the marginal product curve MP also raise with TP. The MP curve reaches its maximum point D when the slope of the TP curve is the maximum at point A.
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The maximum point on the AP curve is E where it coincides with the MP curve. This point also coincides with point B on the TP curve from where the total product starts a gradual rise. When the TP curve reaches its maximum point C, the MP curve becomes zero at point F. When the TP starts declining the MP curve becomes negative, i.e. is below X axis. The rising, the falling and the negative phases of the total, marginal and average products are in fact the different stages of the law of variable proportions which are discussed below. Phase I Increasing Returns In this stage, the average product reaches the maximum and equals the marginal product when 4 workers are employed which is represented in the above diagram. This stage is portrayed here from the origin to point E where the MP and AP curves meet. In this stage the TP curve also increases rapidly. The main reason for increasing returns in the first stage is that in the beginning the fixed factor is large in quantity than the variable factor. When more units of the variable factor are applied to a fixed factor, the fixed factor is used more intensively and production increases rapidly. It is also explained in another way. In the beginning the fixed factor cannot be put to the maximum use due to the non-adequacy of sufficient units of the variable factor. But when units of the variable factor are applied in sufficient quantities, division of labour and specialisation lead to per unit increase in production and the law of increasing returns operate. Another reason for increasing returns is that the fixed factor is indivisible which means that it must be used in a fixed factor, production increases more than proportionately. This cause points towards the law of increasing returns. Phase II Law of diminishing returns In this stage, between phases I and III is the most significant stages of production. Phase II starts when the average product is at its maximum to the zero point of the marginal product. At the latter point, the total product is the highest. This is represented in the

diagram as the phases EB and FC. Here land is scarce and is used intensively. More and more workers are employed in order to have larger output. Thus the total product increases at a diminishing rate and the average and marginal products decline. Throughout this stage, the marginal product is below the average product. This is the only phase in which production is feasible and profitable. Hence it is incorrect to say that the law of variable proportions is another name for the law of diminishing returns. In fact, the law of diminishing returns is only one phase of the law of variable proportions. Phase III Negative Marginal Returns Production cannot take place in the phase III either. For in this phase total product starts declining and the marginal product becomes negative. The employment of the last worker actually causes a decrease in total output. The dotted line represented in the diagram, FC where the MP curve is below the x axis. Here the workers are too many in relation to the available land making it absolutely impossible to cultivate it. To the right of Point F, the variable input is used excessively. Therefore production will not take place in this stage. The Law of Diminishing Returns Benham defines the law of diminishing returns as As the proportion of one factor in a combination of factors in increased, after a point the average and marginal product of that factor will diminish. Its Application Marshall applied the operation of this law to agriculture fisheries, mining, forests and the building industry. He has defined as An increase in the capital and labour applied in the cultivation of land causes in general a less than proportionate increase in the amount of produce raised, unless it happens to coincide with an improvement in the arts of agriculture. Importance 1. In the words of Wick steed, the law of Diminishing returns is an universal as the law lie itself. The universal applicability of this law has taken economics to the realm of science.
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2. It forms the basis of a number of a number of doctrines in economics. The Malthusian theory of population shoot from the fact that food supply does not amplify rapidly than the growth in population since the operation of the law of diminishing returns in agriculture. In fact this law was responsible for Malthus pessimism. 3. Ricardo also based his theory of rent on this principle. Rent arises in the Ricardian sense because the operation of diminishing returns on land forces the application of additional doses of labour and capital on a piece of land does not increase output in the same proportion due to the operation of this law. 4. Like wise, the law of diminishing marginal utility in the theory of demand and that of diminishing marginal physical productivity in the theory of distribution are also based on the doctrine. 5. In under developed countries it is of an elementary importance for understanding their problems. In such economies agriculture is the main occupation of the people. The heaviness of populace on land enlarges with the augment in population. Consequently more and more persons are employed on land which is a fixed factor. This leads to declining marginal productivity of workers. The Law of Returns to Scale The law of returns to scale explains the relationship amidst outputs and the scale of inputs in the long run when all the inputs are increased in the same proportion. As per Roger Miller the law of returns to scale refers to the relationship between changes in output and proportionate changes in all factors of production. To meet a long run change in demand, the firm enhances its scale of production by using more space, more machines and laborers in the factory. Literature Review The Law of Diminishing Marginal Returns Although this topic is called 'Costs and revenues', it is important that we look at the law of diminishing marginal returns first because it is from this law that the cost curves are derived. To start with, we need to define a few terms.

Total, average and marginal product Before commencing the bulk of the topic, it is important to make a few assumptions. The following analysis applies to the short run only. The short run is defined as the period of time where at least one factor of production is fixed. Only in the long run can we assume that the amount of capital (e.g. machines) can vary. For simplicity, we will only be dealing with capital and labour, and ignoring the other two factors of production; land and the entrepreneur. So, in the short run, we will assume that capital is fixed, but the firm can vary the amount of labor used. Now we need to define the terms that we will be using.

Total product This is the quantity of output produced by a given number of workers over a given period of time. Remember the amount of capital (or machines) is fixed. Average product This is the quantity of output per unit of input. In this model, the input is labour. In other words, we are dealing with the output per worker, on average. Marginal product The addition to total output produced by one extra unit of input (again, labour). It is the extra output produced at the margin (i.e. by adding a marginal unit of labour).

At this point it is worth looking at the relationship between the total, average and the marginal in more detail. It will come up again when we look at costs and then revenues, so it is important that you understand it fully. Look at the table below. Let us assume that the firm in question is making computer laser printers and they have four machines in the factory (capital = 4). Capit Labor al (L) 4 4 4 0 1 2 Marginal product Total product Average product (MP) (TP) (AP) 5 8 0 5 13 5.0 6.5
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4 4 4 4 4 4 4

3 4 5 6 7 8 9

10 11 10 7 4 1 -2

23 34 44 51 55 56 54

7.7 8.5 8.8 8.5 7.9 7.0 6.0

Remember that capital is fixed in the short run. I have assumed that capital is fixed at 4 units (or machines, in this case). The second column shows the progressive addition of units of labour. The third column shows marginal product (MP). Each figure represents the output produced as a result of adding an extra worker. So, for instance, the addition of the seventh worker results in an increase in output of 4 units. Once the fourth worker is added, another 11 units are produced, etc. Notice that marginal product rises quite quickly, peaks at 11, and then begins to fall, reaching a negative figure for the ninth worker. Diminishing Marginal Returns (DMR) set in after the fourth worker. Go to the last section in this Learn It for the full explanation of DMR. The fourth column gives total product (TP). This is calculated quite easily by adding, cumulatively, the marginal products. The first worker makes 5 units, so the total is 5. The second worker adds a further 8 units, so the total is now 13 (5 + 8), and so on. In fact, you can work out the marginals from the totals. Take the sixth worker, for example. His marginal product is 7. This can be calculated by taking the TP from six workers and subtracting the TPfrom five workers (51 - 44). Algebraically: MP6 = TP6 TP5. (i.e. 7 = 51 44). The fifth column gives average product (AP). The figures in this column represent output (or product) per worker. The average product once the eighth worker has been added is 7. This was calculated by taking the TPwith eight workers and dividing by the number of workers (also eight). Algebraically:

Now try and work out the table below to see if you understand what is going on. Click the relevant area in the table to display the answer. Here are the relevant curves. They have been plotted using the figures from the first table; not the one you have just filled in.

Notice that the point at which diminishing marginal returns sets in is to the left of the point where diminishing average returns begins. Also, the total product keeps rising even though the marginal, and the average, product is falling. This is not hard to understand. Just because the marginal product is falling, it is still positive. Hence, these extra workers may well be adding less than previous workers, but they are still contributing to the grand total. Total product keeps rising, albeit at a diminishing rate. It is only when the marginal product is negative, with the addition of the ninth worker that total product starts to fall. Finally, notice that the marginal product curve cuts the average product curve at its highest point, where it is momentarily flat. It is important that

you understand why this happens because this concept is applied to the cost and revenue curves. I think it deserves its own little section: Why the marginal curve cuts the average curve where it is momentarily flat Imagine you are with a group of friends, waiting at the bus stop in anticipation of a great Friday night out. You all decide to check that you have enough money for the frivolities that lie ahead. There are nine of you and, coincidentally, you all have exactly Tk20 each. This means that the average amount of money that each of you holds is also Tk20. Your tenth friend is late, but finally arrives. He only has Tk10 on him. This means that between you the total amount of money is Tk190, and the new average is Tk190 divided by 10, which is Tk19. The arrival of your tenth friend has reduced the average because the amount he added to the total, the marginal, was less than the prevailing average. If your tenth friend had had Tk30 on him, the new total would have been Tk210, and the new average would have been Tk210 divided by 10, which is Tk21. The arrival of your tenth friend would have increased the average because the amount he added to the total, the marginal, was more than the prevailing average. If your tenth friend had also exactly Tk20 on him, then the average would have remained unchanged; Tk200 divided by 10 is still Tk20. This is exactly what is going on with the average and marginal product curves. When the marginal curve is above the average curve, then the average is rising. When the marginal curve is below the average curve, then the average is falling. When the marginal is the same as the average (which is where they cross) then the average remains the same. The issue is not whether the marginal is rising or falling, but whether it is above or below the average curve. In the diagram, you can see that the marginal product curve rises to start with and then begins to fall, but the average product curve only starts to fall when the marginal product curve drops below the average product curve. The law of diminishing marginal returns

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Note: the textbook definition: If a firm increases output by adding variable labor to fixed capital then eventually diminishing marginal returns (physical product of labor) will set in. In other words, at some point an extra worker will add less output to the grand total than the previous worker. In our initial example, the factory has four machines. As the first, second, third and fourth workers are added; they each have at least one machine each to work on. In fact the marginal product continually increases because each worker can do a different job and so get the products finished quicker. But when you add the fifth, sixth, seventh, etc. workers, somebody will be standing around doing nothing and adding little to total output. The marginal product is still positive, perhaps they can take over when one of the initial workers gets tired, but the total product rises at a slower rate. The ninth worker has a negative marginal product. His addition has resulted in a fall in total output. We have now reached the point where 'too many cooks spoil the broth', as the saying goes. It is for these reasons that the marginal product curve looks as it does (rises, peaks and then falls). Also, the shape of the average product curve is directly dependent on the marginal product curve for the reasons explained in the section called 'Why the marginal curve cuts the average curve where it is momentarily flat'. So we have explained where these product curves come from. At the end of the next Learn-It (called 'Costs and their curves') you will see that the cost curves are derived from these product curves. In other words, the cost curves are derived from the law of diminishing marginal returns. The title of this Learn-It is 'the law of diminishing marginal returns'. Why is it a law? It is something that is accepted by just about all economists as being true in all situations, just like nearly everybody accepts the laws of the land.

Conclusion Therefore the best stage of production is phase II, law of diminishing returns where the production and profitability both are feasible. Not only that, the production is optimum in this phase. Unlike other two phases, where the production is impossible and hence there is no profit generated.

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Thus phases I and III are of economic absurdity or mere economic non-sense. Hence no manufacturer will produce in this phase by employing more units of the variable factor beyond the point zero marginal products MP because there is reduction in total product TP.

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