Fundamental Laws of Production

Function
Law of Variable Proportion:
The law of variable proportion or law of Diminishing
marginal return. The law of variable proportion is the
study of short run production function with some
factors fixed and some factors variable.
Law of Returns of Scale:
The law of returns to scale describes the relationship
between output and the scale of inputs in the long-run
when all the factor inputs are increased or decreased
in the same proportion.

Law of Variable Proportion

It states that when total output or

production of a commodity is
increased by adding units of a
variable input, while the quantities of
other inputs are held constant, the
increase in total production becomes,
after some point, smaller and
smaller.

Assumptions of the law

The state of technology remains
constant
Only one factor input is variable and
other factors are kept constant
The product is measured in physical
units
It assumes a short-run situation; in
the long-run all productive factors
are variable.

Units of Labour Total Product Marginal Product Average Product

1

12

16

18

3.6

18

14

-4

-6

I stage: Increasing Returns

In this stage, TP rises from zero, at an increasing
rate upto point A. Beyond A, TP continuous to rise
at a decreasing rate, as the marginal product falls
but it is positive.
The point A where the TP stops increasing at an
increasing rate and starts increasing at a
diminishing rate is called the point of inflexion. At
this point, the MP is at the maximum.
The maximum on the AP curve is B, where it
coincides with the MP curve. Thus stage I refers to
the increasing stage where the TP and AP are
increasing and MP is positive.

I stage: Increasing
Returns
Specialisation and Division of labour
Indivisibility of factors: The factors employed in the
production process are indivisible, i.e. they cannot be
divided into smaller parts, when more units of the
variable factor are combined with the fixed factors
like land and machinery, returns are increasing
To maximise the profit, the producer can continue to
increase the variable factor as long as the AP is
increasing.

II stage: Decreasing
Returns
In the second stage, the total product continuous
to increase but at diminishing rate until it
reaches a point M, where it complete stops to
increase any further.
The second stage shows decreasing AP and MP
of labour but they are positive. When TP achieve
its highest level at M, MP falls to zero.
The second stage is the stage of diminishing
returns.

II stage: Decreasing
Returns
Optimum use of fixed factor: Returns
start diminishing when the fixed factor,
land, is fully utilized in relation to labour
employed on it.
Lack of perfect substitution between
factors: The factors of production cannot
be substituted to any extent, that makes
the returns diminishes after a point.

III stage: Negative Returns

In this stage, the TP declines and
therefore the AP decreases still
further. MP falls faster than AP and
becomes negative.

Which is a Best Phase/Stage?

Law of Variable Proportion
A rational producer will not choose to produce in stage I
where the MP of the fixed factor is zero. So stage I is not
rational.
In the stage I, though the producer is faced with increasing
returns, yet the producer can increase his profit by
switching to Stage II in which the total product is still
rising.
Similarly Stage III is irrational. In this stage, the producer
will be incurring the greater cost as he is utilising more
variable factor but is simultaneously receiving less returns
because each additional unit of variable input results in
decline in total output. Labourer works to reduce revenue.
This is irrational.

Law of Returns to Scale

The law of returns to scale describes the
relationship between variable inputs and
output when all the factor inputs are
increased in the same proportion.
Returns to scale answer the question: If
labor, capital, and other inputs increase by
the same proportion (say 10 percent) does
output increase by more than, less than, or
equal to this proportion (more than 10
percent, less than 10 percent, or exactly 10
percent)?

Law of Returns to Scale

Returns to scale can take one of three forms:
Increasing returns to scale
Decreasing returns to scale
Constant returns to scale
Increasing Returns to Scale: This occurs if a
proportional increase in all inputs results in a
greater than proportional increase in total
output/production. In other words, a 10 percent
increase in labour, capital, and other inputs,
results in greater than 10 percent increase in
production.

Law of Returns to Scale

Decreasing Returns to Scale: This

occurs if a proportional increase in all
inputs results in a less than
proportional
increase
in
total
output/production. In other words, a
10 percent increase in labour,
capital, and other inputs, results in
less than 10 percent increase in
production.

Law of Returns to Scale

Constant Returns to Scale: This

occurs if a proportional increase in all
inputs result in an equal proportional
increase in production. In other
words, a 10 percent increase in
labour, capital, and other inputs,
result in an equal 10 percent
increase in production.

Law of Returns to Scale

Suppose, for example, The Royal Enfield Industry
employs 1,000 workers in a 5,000 square foot
factory to produce 1 million Motor Cycles each
month. What happens to production if the scale of
operation expands to 2,000 workers in a 10,000
square foot factory--a doubling of the inputs.
If production increases to exactly 2 million Motor
Cycles, twice the original quantity, then The Royal
Enfield Industry has ______________. If production
increases by more than 2 million Motor Cycles,
then The Royal Enfield Industry has ____________.
And if production increases by less than 2 million
Motor Cycles, then The Royal Enfield Industry has
____________.

Law of Returns to Scale

Increasing returns to scale is due to economies of
scale which mean that long-run average cost
decreases, corresponding to increasing returns to
scale in terms of production.
Decreasing returns to scale is due to diseconomies of
scale which mean that long-run average cost
increases, corresponding to decreasing returns to
scale in terms of production.
Constant returns to scale for production terms results
when long-run average cost neither increases nor
decreases.

Increasing Returns to Scale

When the firm needs to increase its
production, it needs to vary the all factor
inputs. The firm would need to buy more
land, capital, enterprise and labour; that
is increase all of the factors of production,
which is only possible in the long run.
As the firm increases in size, it will
achieve increasing returns to scale due to
the economies of scale.

Economies of Scale
Economies of scale are a key advantage for a
business that is able to grow.
Most firms find that, as their production output
increases, they can achieve lower costs per unit
produced.
Economies of scale are the cost advantages
that a business can exploit by expanding their
scale of production in the long-run. The effect
of economies of scale is to reduce the average
(unit) costs of production in the long-run.

External Economies of Scale

External economies of scale include the
benefits enjoyed by firms externally as a
result of the development of an industry.
For example, as an industry develops in a
particular region, an infrastructure of
transport & communications will develop,
which all industry members can benefit
from. Specialist suppliers may also enter
the industry and existing firms may
benefit from their proximity.

External Economies of Scale

Secondly, banks and other financial institutions
may set up their branches, so that all the firms
in the area can obtain liberal credit facilities
easily.
Thirdly, the transport and communication
facilities may get improved considerably.
Further, the power requirements can be easily
met by the electricity boards. Lastly,
supplementary industries may emerge to assist
the main industry.

Internal Economies

Internal economies of scale include the

benefits enjoyed by firms internally as a
result of the large scale production in
the long-run.

1. Technical Economies
Technical economies are those, which
accrue to a firm from the use of better
machines and techniques of production.
As a result, production increases and
cost per unit of production decreases.

Internal Economies
2. Economies of the Use of By-products
A large firm is in a better position to utilize the byproducts efficiently and attempt to produce another new
product. For example, in a large sugar factory, the
molasses left over after the manufacture of sugar from
out of the sugarcane can be used for producing power
alcohol by installing a small plant.
3. Labor Economies
A large firm employs a large number of laborers.
Therefore, each person can be employed in the job to
which he is most suited. Moreover, a large firm is in a
better position to attract specialized experts into the
industry. Likewise, specialization saves time and
encourages new inventions. All these advantages result
in lower costs of production.

Internal Economies

4. Financial Economies
The credit requirements of the big firms can be met from
banks and other financial institutions easily. A large firm
is able to mobilize much credit at cheaper rates. Firstly,
investors have more confidence in investing money in
the well-established large firms. Secondly, the shares of
a large firm can be disbursed or sold easily and quickly in
the share market.
5. Risk Bearing Economies
A big firm produces a large number of items and of
different varieties so that the loss in one can be counter
balanced by the gain in another. For example, an
Industrial unit in a particular locality is facing a loss, it
can recall its resources from other units/branches, and
can easily overcome the critical situation. Thus,
diversification avoids putting all its eggs in one basket.

Internal Economies

6. Economies of Research
A large sized firm can spend more money on its
research activities. It can spend huge sums of
money in order to innovate varieties of products or
improve the quality of the existing products.
Innovations or new methods of producing a product
may help to reduce its average cost.
7. Economies of Welfare
A large firm can provide welfare facilities to its
employees such as subsidized housing, subsidized
canteens, crches for the infants of women worker,
recreation facilities etc.; all these measures have
an indirect effect on increasing production and at
reducing the costs.

Internal Economies
8. Marketing Economies
Since the large firm purchases its
requirements in bulk, it can bargain on its
purchases on favorable terms. It can
ensure
continuous
supply
of
raw
materials. It is eligible to get concessions
from transport companies, adequate
credit
from
banks.
In
terms
of
advertisements cost, it is better placed
than the smaller firms.

Diseconomies of Scale

1. Marketing Diseconomies

The expansion of a firm beyond a certain limit may

also lead to marketing problems. Raw materials may
not become available at sufficient quantities.
Moreover, since the firms are operating competitive
world, they have to face stiff cutthroat competition
from their rivals. Therefore, extensive advertising
and sales promotion measures may have to be
undertaken and it may ultimately lead to higher
costs.
2. Increased risks
As the size of a firm expands, risks also may
increase rapidly. If the production manager or sales
manager miscalculates market trends, sales will
suffer which may lead to heavy losses.

Diseconomies of Scale

3. External diseconomies
The growth and localization of industries
ultimately lead to increased demand for labor,
finance, raw materials, power, transport etc.
Thus, competition among the various firms
tends to increase the cost per unit.
4. Danger of overproduction
Large-scale production involves output in large
quantities. If supply outstrips demand, there is
a possibility of market-glut. Market situation
where the supply of a good or service far
exceeds its demand, usually resulting in a
substantial fall in its price.

Diseconomies of Scale

5. No cordial relationship
Paid managers generally manage a large
business firm. Therefore, the personal touch
and sympathy, which is supposed to exist
between the management and his labourers,
are missed. The hostile attitudes of the
managers and labourers may very well end in
strikes and lockouts.
6. Dependence on foreign markets
A large producer has to depend upon foreign
markets for his products. But dependence on
a foreign market is extremely dangerous
during exchange rate volatility.

Diseconomies of Scale

7. The concentration of similar firms in an area, may

lead to an increase in demand for raw materials
used by the firms. This will cause the prices of raw
materials to increase. This consequently would
increases the cost of production in the industry.
8. As the industry grows, demand for skilled labor
mainly needed in the industry increases. Wage rates
will tend to increase as firms begin to compete for
the services of the skilled workers.
9. Problems of waste disposal may arise. Firms may
be compelled to employed costly waste disposal
methods in order to keep the area clean.

Diseconomies of scale

Economies of Scale
In conclusion, reduction in cost
(average cost) in the long-run is due
to both internal and external
economies of scale. Increase in the
long-run average costs is due to
internal and external diseconomies of
scale.