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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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which they are in a position to produce most modern machinery, best chemical fertilizers,
pesticides and superior quality seeds. As a result agricultural productivity instead of
decreasing has increased. But this does not contradict with law of diminishing returns
because operation of the law of diminishing returns is subject to condition that technical
knowledge, capital equipment and other aids of production should remain the same.

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 T.P. M.P. A.P. M.C Marginal cost

and capital (Mds) (Mds) (Mds) per unit (Rs .)
1 50 50 50 Rs 1000/50 mds 20
2 90 40 45 Rs 1000/40 mds 25
3 120 30 40 Rs 1000/30 mds 33
4 140 20 35 Rs 1000/20 mds 50

MC
A
Marginal Product

Marginal cost
D
50 50
B
40 C
C 33
30 30 B
D 25
20 20
A
10 MP 10

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 ni crease. 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 T.P M..P A..P. M.C. M.C.

and capital Rs. per socks
1 50 50 50 Rs.1000/50 socks 20
2 110 60 55 Rs.1000/60 socks 16
3 180 70 60 Rs.1000/70 socks 14
4 260 80 65 Rs.1000/80 socks 12.50

MP
D A
20
80 C B
Marginal Product

16

Marginal Cost
70 C
B D
60 12
A
MC
50 8

0
0 1 2 3 4 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 T.P M.P A.P M.C. M.C. per

and capital Unit unit
1 50 50 50 Rs.1000/50 20
2 100 50 50 Rs.1000/50 20
3 150 50 50 Rs.1000/50 20
4 200 50 50 Rs.1000/50 20
Marginal product

A MP
B C D A B C D

Marginal cost
50 20 MC

10
25
0 0
1 2 3 4 1 2 3 4
Units of Labor & Capital 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 4th and 5th 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

1 80 80 80
2 170 90 85 ONE
3 270 100 90
4 368 98 92
5 430 62 86 TWO
6 480 50 80
7 504 24 72
8 504 0 63
9 495 -9 55 THREE
10 470 -25 47

Stage one Stage Stage

L
Output A.P, M.P, T.P

two Three
N

W TP

AP
0 3 8 12
Number of workers MP

STAGE ONE
1-----Total product is increasing with employment of additional labor and up to 3rd
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 8th 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 Output

Land + Labor+ Capital Increasing returns
1 10 units
2 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 Output

Land + Labor+ Capital Decreasing returns
1 10 units
2 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 Output

Land + Labor+ Capital Constant returns
1 10 units
2 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

A large-scale business having large finances can install heavy machinery, which
1 gives greater production. It can have its own workshop facilities hence cost of
production reduces.
In it Division of labor is possible. Division of labor increases output because each
2 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
3 firm.
4 It can provide securities and therefore can easily obtain loan facilities from banks.
5 It purchases raw material in bulk quantities they therefore it get at a lower rate.
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

DISADVANTAGES LARGE SCALE PRODUCTION or BUSINESS

In this business uniform types of goods are produced and individual customer’s
1 choice is not given any importance.
There is lack of supervision on the staff as well as on the product and due to
2 carelessness and dishonesty of workers cost of production increases.
There is always rift between owners and employees in a large business due to lack
3 of confidence trust and friendly relationship between the two sides. This situation
results in strikes and lockouts.
Proper control and supervision is not possible hence quality of goods deteriorates
4 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
Since business is very small and owner is always present there is no waste of raw
2 material or machinery
There are friendly ties between owner and workers therefore there are no strikes
3 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
chance of
5 failure of business.

DISADVANTAGES SMALL SCALE PRODUCTION/BUSINESS

Due to shortage of capital, installation of large machinery and division of labor is

1 not possible.
It purchases raw material in less quantity therefore price concessions are not
2 available to it.
It cannot offer proper securities to banks therefore loan is not easily available to
3 small business.
4 Due to lack of finance it is not in a position to properly advertise its product.
It cannot use waste material and cannot make by-products due to shortage of
5 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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