Production Analysis

Chapter Outline
10.1 Meaning and Concept of Production
10.2 Law of Variable Proportions
(Short Run Production Analysis)
10.2.1 Classical Approach
10.2.2Modern Approach
10.2.3 Three Stages of Law of Variable Proportions
10.2.4 Stage of Operation
10.2.5 Causes of Increasing Returns
10.2.6 Causes of Diminishing Returns
10.2.7 Causes of Negative Returns
10.2.8 Importance of Law
10.3 Lawof Returns to Scale
(LongRun Production Analysis)
10.4 Economies and Diseconomies Of Scale
(Causes of Operation of Law of Returns to Scale)
10.4.1 Internal Economies
10.4.2 Internal Diseconomies
10.4.3 External Economies and Diseconomies
10.5 Returns to'a Factor versus Returns to Scale
 10.1 directly or indirectly satisfies the wants
economic activity, whichside ofthe market. The standards ofli
Production is an important
concerned with the supply produced. Without
ofgoods
needsof the people.It is and the variety nation and performance of the econom
the volume ofthe
the people depend on Richness or poverty produce commodities and services in
which
cannot be consumption. Those nations less are considered
poor. I
ofproduction. produce
judged by its level and others which or several
quantities are considered rich output ofa commodity
ofinputs into the
transformation time at the given state of technology.
Productionis the period of
in a specific intangible. Thus, the word In
(in case of joint production) input and output may be
productionprocess even both transformation in the matter, it also
physical
to effecting financing, retailing, packagin
Economicsis not simply confined consultancy,
transporting,
rendering ofservices such as teaching, ofform, place and time
the creation or addition
etc.In a broad sense,production implies ofdifferent usable commodities and services.
by the production and storage, distribution form in which the cons
product by changing it to the
Productionenhancesthe utilityofthe the usefulness
of the product by bringing it
increases
need it. Distribution through transportation of transportation, the product maybe
needs it. In the absence
to the location where the consumer still a collection of raw materials. LikeWisg
it would be ifit were
just as useless to the consumer as it.
needs
storage gets the product to the consumer when he
PRODUCTION ANALYsls)
10.2 LAWOFVARIABLEPROPORTIONS(SHORTRUN
The short run production function gives the maximum output obtainable from different amounts
of variableinput, given a specified amount of the fixed input and the required amounts ofthe
ingradient inputs. The law ofvariable proportions is one of the most important, fundamental and
unchallenged law ofproduction. This law is also termed as return to afactor, as under it one factor
is varied, while keeping all other factors fixed. these variations in the quantity Ofone factor,
keeping the quantity ofother factors constant, the ratio ofemployment of the
variable factor to
thatofthe fixed factor keeps on changing. As westudy the effectsof variations
infactorproportions
under this law, this is called the law of variableproportions.
There are two important approaches
availableto study this law:

10.2.1 Classical Approach

The law ofvariable proportions is
the new name for the famous
classical economists like Adam 'Law of Diminishing Returns'
Smith, Ricardo, Malthus, of
a logical and scientific etc. But, the real credit
basis ofthe law, which goes to Marshall
was confined to agriculture
only. He
increase in the capital and
labour
applied in the cultivation
proportionateincrease in the ofland causes in general
amount of product a less than
raised unless it
happens to coincide with an
The following Table
explains the operation
ofthe law
1. ofdiminishing returns;
8thEdiUon, 2150
 Analysis
production 10.3

Table 10.1 : Total

and Marginal Product
Unitsof Total Product
Marginal Product
Labour (in quintals) Average
(in quintals) Product
(in quintals)
1 20
20 20
2 30
10 15
3 38
8 12.6
4 44
6 11
5 48 4 9.6
6 5 8.3
2
Theabovetable shows that cultivator employs more and more units oflabour to get more produce.
Oneunit of labour gives a total product of 20 quintals. When two units of labour are employed,
thetotal product rises to 30 quintals. The marginal product (i.e., addition to total product with
employmentof one additional factor) in this case is 10 quintals.When one additionalunit of
further employed, the marginal product becomes 8 quintals,which is less than the marginal
labouris total
productin the previous situation. With each successiveincrease in the units of labour, the
at a decreasing rate. in other words, the marginal product diminishes with
productincreases, but,
of diminishing
employmentof additional units of labour. Fig. 10.1 depicts the operation of the law
oflabour (variablefactor)
returns.Curve AB in the figure has a negative slope.Thus, more units
marginal product.
providediminishing

10

3 4 5 6
2

product
Fig. 10.1 : Marginal

often applicableto
it is more
static technology. That is why, However,improvements
returns assumes in the technology. of
L'aw•
of dunishmg scope for improvement is subject to a number
little law
where there is very assumed away.This
cannot be perfectly
in the art of agriculture
limitations.
 J0.4 law assumes away any improvem
The
of Cultivation: inserting the phrase unless it h
(1) Improvements in Methods has clarified it by
in his
the arts ofagriculture. Marshall
definition
in the arts ofagriculture"
methods ofcultivation (use
to coincide with an improvement scientific or improved
i.e., the returns are bound to
this assumption is relaxed, etc.) are adopted,
seeds. better agriculture
implements,
However, there is some limit to the improvemen
hold true. the law ofdiminishing returns is
and the law will no longer or latter,
Hence, sooner under cultivation, the additional return
the methods ofproduction. brought
virgin soil is cause increasing returns initially f
to operate. Similarly, ifa capital may
and
each successive dose oflabour
with
(2) Vanable Fad on Working
land).
to keep some factor fixed (say, of variable factors are assumed
All the units
(3) Hetrogenous Variable Factors : diminishing
marginal returns are not dueto to
words,
homogenous or identical. In other However, in real world various factor units
factor.
use of inferior units of the variable

The operation
(4) Inadequate Units ofvariable factors, i.e., labour and capital
units
also held up for sometimes, ifthe cultivate to the full capacity of that
to pieceof
a certain fixed piece of land is insufficient
land.
Appraisal
ofdiminishing returns. He di
AlfredMarshallgave a fairly satisfactory explanation ofthe law
agriculture can be advocated on several
the law in relation to agriculture. Applicability of the law to
grounds:
(i) Overdependenceofagricultureon unpredicatablenatural factors like rainfall, climateand
weather conditions, particularly in less developed countries.
(ii) Littlescopeforthe useofimplements, machinesand other improved methods ofproduction.
(iii) Seasonal employment in agriculture reduces the productivityofagriculture labour.
(iv) Effectivesupervisionisnotpossibleduetoscattered agricultural operations
overavastare
and over a number of mon ths.
(v) Quantity ofland remains fixed.
(vi) Last, but the most importantreason is that fertility of the soil
gradually falls. So, theuseof
additional units oflabour and capital result in less than proportionate increase
in output
The law is equally applicable to the mines, forests
and fisheries, which get exhausted as
more are taken out ofthem. Hence, same quantities more and
oflabour and capital produce or extract
andlesserquantityoffinalproduct. For instance, in lesser
the beginning, coal is found near
earth. Gradually,one has to go deeper and the surfaceof
deeper into the bowels of the earth to get
amount ofcoal and fish in the two the same
cases respectively.
Marshall'slaw ofdiminishing returns
appliesnot only to agriculture
developed), but also to extractive (for which it was originally
industries and to other
resources are important. industries, where land or other natural
However, there is little scope ofapplicability
of this law for most Ofthe
 10.5
Analysis
uction
production through
industries, which enjoy the advantages of large scale
possible only temporarily. Ultimately,
by machinary, men and management. But, this is to be
law has been found
to diminishing returns is bound to appear. In brief, theproduction,
industrial because in the
in agriculturalproduction more quickly than in man made factors
factor (i.e., land) plays a predominant role, while in the latter,
formera natural
major role.
playthe
ModernApproach
Marshall
f diminishing returns enunciated by the classical and neo-classical economists like
Lawo uliarto agriculture. Modern economists have given universal law which applies to all lines
ofp@duction and in all sectors of the economy-agriculture, manufacturing and service sector.
variable
Thislawagainassumes presence of some fixed factor (not necessarilyland) and one or more
and
factors(saylabour, capital). Moreover, modern economists believe that diminishing, constant
law of
.ßreasingreturns are not three different laws, but they are three phases of one general
proportions.
variable
ofproduction
lawofvariableproportions states that as we use more and more units ofsomefactors
then at a
toworkwithone or morefixedfactors, the total product will increase at an increasing rate,
rate and finally at a diminishing rate. In other words, the marginal, average and total
constant
roductwillrise up to a certain stage and then will decline in that order. The law has been stated by
in the following words:
variouseconomists
equalincrements of one input are added; the inputs of other productive service being held
constant,beyond a certain point the resulting increments ofproduct will decrease, i.e., the marginal
G. Stigler2
products will diminish".
first the
"Asthe proportion of one factor in a combination of factors is increased, after a point
and then the average product of that factor will diminish". E Benham3
marginal
"Anincreasein some inputs relative to other fixed inputs will, in a given state of technology, cause
outputto increase;but after a point the extra output resulting from the same additions of extra
inputs willbecome less and less".
P.A. Samuelson 4
avoids the use of loose expression,'diminishing returns', which can be variously
K.E.Boulding
interpreted.He rather names the law as 'The Law of Eventually Diminishing Marginal Physical
Productivity'and defines it; "Aswe increase the quantity of any one input which is combined with
afixedquantityof the other inputs the marginal physicalproductivity of the variable input must
eventually decline 5".
TheviewsofAlfred Marshall (stated under classical approach), G.Stigler,F. Benham, P.A. Samuelson
on this law are fundamentallythe same. The only difference is that whereas
andK.E.Boulding
accordingto Benham, the law operates when both MP and AP begin to diminish. But, this is not
withother economists. According to them, the law must be stated in terms of marginal product
ratherthan averageproduct as the former is more important.

2. Stiger, G.J.: Theory of Price, The Macmillan Co., 1953, P. 111

3. Benham, P.: Economics, 2ndEdition, 1960, RI 10
4. Samuelson, P.A,: Economics, 8thEdition, P.25
5. Boulding,K.E. : Economic Analysis, P. 589
 10.6
Economi
It is obvious from the above definitions ofthe law ofvariable proportions (or the law ofdimin.
ofone factor is
returns) that it refers to the behaviour ofoutput as the quantity increased
product and averagepr
the quantityofotherfactors fixed.It furtherstatesthat the
factor are combined With
will decline eventually, as more and more quantities ofvariable
one constant factor. east)
assumptions:
Law of variable proportions is based upon the following
Ifthere is improvementin
(i) Thestateoftechnologyisgiven and remains constant. ofdiminishing. techn
then marginal and averageproducts may rise instead
(ii) Quantityofatleastonefactorinputisconstantand one know its
and effects on output.
this way that the firm can alter the factor proportions
be estimated correctly.
(iii) Effectofchanging units ofa variablefactor on output can
(iv) Thelawis based upon the possibilityofvarying theproportionsin which the variousfactors
in
can be combined to produce a product. The law does not apply those situations,
In such situations,
the factors must be used in fixed proportions to yield a product. increere
the marginal product
in one factor would not lead to any increasein outpu t, i.e.,
drivers can not drive theofth
factor will be zero and not diminishing. For example, two same
vehicle at the same time. However, such situations are very
(v) All the units of variable factor are homogenous, i.e., equal in efficiency.
(vi) Inputpricesremain unchanged.
(vii) Output is measured in physical units

10.2.3 Three Stages of Law of Variable Proportions

In the short run, output may be varied by varying the quantity (quantities) of the variable
factor
(s), while keeping the quantity (quantitieé)ofotherfactors constant. The behaviour ofoutput
in
such situation actuallyfalls into threedistinct stages.In Fig. 10.2, we have graphically
the production function with one factor variable (for the sake of convenience), illustrated
while all other
factors are held constant. Quantity of the variable factor is shown on the X-axis and total
product,average

Point
Inflexion

Stage 1 Stage 2 Stage 3

AP
o x
Units of VariableFactor
Fig. 10.2 : Three Stages of
Law of Variable Proportions
 10,7
Analysis
duction
total, average
d marginal product are measured along the Y-axis.The variations in the
figure. Here,
d product by varying the quantity of variable factore are shown in this
and marginal
duct (TP) goes on rising to a point and after that it starts falling. Average
earlier than the
also rise and then decline. However. marginal product curve falls
Three stages of the law are explained in Table 10.2.
product curve.
Product
: Relationshipamong Total Product, Marginal Product and Average
Total Product Marginal Product AverageProduct
stage
(TP=MP) (MP = ATP (AP = TP/Q)
First increases at Increases Increases,but at a lower
1 increasing rate. rate than that of the mar-
ginal product.
Then increases at Reaches a maximum Continues to increase
diminishingrate. point and begins to and becomes maximum.
diminish.
Continues to incre- Continues to diminish Becomes equal to MP
and then begins to
11
ase at diminishing and becomes equal to
rate and becomes zero. diminish.
maximum.

Ill Diminishes. Becomes negative Continues to diminish,

but will always be greater
than zero.

1. Stage I (Stage oflncreasing Returns)

Fig. 10.2,
Inthis stage,total product increases at an increasingrate till point 'C'. It is clear from the
concave
wherethe slope of the total product curve (TP) increasesupto pöint 'C' (TP curve is
to
upwardsupto this point). Thus, marginal product rises upto point 'D', vertically downwards
marginal
point'C'.This shows that the firm is moving towards optimum combination. Rising
I, the total
productalso pulls up the average product. From point 'C' onwards during the stage
downwards), i.e.,
productcontinues to rise, but, at a diminishing rate (total product is concave
stops rising at a
marginalproduct falls, but, is positive.The point 'C' where the total product
however, will continue to
diminishingrate is called the point of inflexion. The average product,
exceeds its average product.
riseevenafter the point ofinflexion, as marginal product (though falling)
The marginal product of the
Risingaverageproduct indicates increase in the efficiency of labour.
variablefactor is equal to the average product of the factor at point 'E'.
here, efficiency of labour
ThestageI ends, where the average product reaches its highest point. So,
product of the
is maximum.This stage is known as the stage of increasingreturns, as average
in
variablefactorrises throughout the stage and marginal product of the variable factor rises a
significantpart of this stage.
much relative to
In stageI, total product is not fully utilised. The quantity of the fixed factor is too
product
quantityof variable factor so that if some of the fixed factors are withdrawn, the total
 conohti

ofthefixedfactor is negative. No ,
marginalproduct factor costs nothing (in
Thus, in the.first ifthe fixed
would increase. this stage even can expand production by
to produce in R). producer
will choose at point fixed factor.
offirst stage, use ofthe
he will stop the end make efficient
factor and
quantity ofthe variable
(StageofDimlnishlngReturns) diminishing rate, until it reaches the m
2. Stage Il at a product and marginal
continues to average
In stage Il, the total
product
stage, both the falling at faster rate. That is
stage ends. In this the latter
point where the second (but not negative),
ofthe variable are
to rise. The average product
that factor continues this stage.
factor decreasesand factor throughout
the product ofthe of the variable factor is
variable mc•tor marginal product very crucial. It is the
at point This stage is
At the end of second stage, i.e., ofthe TP curve). where both the Of
(corresponding to the highest point produce in this stage,
alwaysseek to
operation. A rational producer will
usually formulated,
ofDiminishing Returns as it is
dThe Law increases in the amounts ofother
In the words ofJoan Robinson, successive
factor of-production, ofoutput't
that with a fixed amount ofany increments
factors will,after a point, yield diminishing
3. Stagelll(StageofNegativeReturns)
Ofthe variable factor becomes negative
In stage Ill, total product declines. So, marginal product as total product, average
ofnegative returns,
and falls below the X-axis. This stage is called the stage average product of the variable factor
the
product and marginalproduct fall during this stageand
well as fixed factor declines and factor ratio is
is non-negative. In this stage, efficiency ofvariable as factor.
variable
highly sub-optimal. Produces should reduce the amount of
10.2.4 Stage of Operation
The stage I and Ill are similar. In stage I, the fixed factor is too much relative to the variable factor
and so marginalproduct offixed factor is negative.In stage Ill, variable factor is too much relative
to fixed factor. Therefore, in this stage marginal product of the variable factor is negative. This
stage is ruled out on the ground of technicalinefficiency.Thus, a rational producer will never
produce in stage Ill. Even if the variablefactor is availablefree of cost, the producer will stop
production at the end ofsecond stage, where the marginal product of variable factor is zero. Here,
the producer will be maximising the totalproduct and will be making maximum use of the variable
factor.
It is thus clear from the above discussion that the rational
producer will never choose to produce in
stage I or Ill. Both ofthese stages are called stages
ofeconomic absurdity or economic nonsense.
These stages represent non-economicregions
inproductionfunction. Stage Il represents the range
ofrationalproduction decision.Theparticularpoint ofproduction
factors. The producer wil employ additional depends upon the prices ofthe
units ofvariable factor till
becomes equal to marginal cost. The its marginal revenue product
lesser is the price of fixed
factor (due to relative scarcity of factor relative to that ofvariable
variable factor), the chosen
point of production will be closer to
 Analysis and
dyction the fixed factor is costless
of stage Il and vice-versa.In extreme case,
where Il
at the point where the stage
for, the firm will choose to produce
is to be paid
at the point, where the stage 11ends.
chooseto produce
will
Increasing Returns
causes of proportionate
10.2.5 additionofthe variable factor (i.e.,labour and capital) causes more than important
every
is said to be the operation oflaw ofincreasing returns. There are two
inoutput,it
increasingreturns•, (i) indivisibility, and (ii) specialisation.
for
Generally, the fixed factors which are combined with variable factors are
(l) Indivisibility :
factorscannot be divided into smaller units, since division will result either
indivisible. Such
produce smaller or
intotaluselessnessor partial loss in efficiency. These indivisible factors
of Stonier and
largerquantities,almost with the same amount ofexpenditure. In the words output they
"Most factors of production can be most efficiently employed at the
be divided
weredesignedfor and work less efficientlyat smaller outputs because they cannot
and asked to
intosmallerunits. They are indivisible. A manager cannot be chopped in half
used less
producehalf the current output. Plant cannot be used less fully without being
6
economically".
nst ent, arginimum amount
In •visi techn al re
fthat must be employgd..yhatevecis the leve ofqutput. n initial stages, the supply of the
fixe&factor1st Olarge •t is factor nits are
T , the d indivisiblefactorjs not efficientlyemployä: en the units of the
iablefactor are Increased and combined with this fixed factor, the latter is utilised better
d morefully.This causes increasing returns, which continue till the best proportion
eenthé actor and variable factors is reached.
(2) specialisation Another cause for increasing returns is the advantages offered by
ialisation.Greater is the quantity of the variable factor, greater is the scope of
specialisation.The most important advantages of specialisation of labour include better
skill,productivity,efficiency,avoidanceof waste oftime in shifting from one task to another,
employmentof persons best suited to particular type of work, etc. In assembly line
production,cost of production is drastically reduced due to division of labour and
Each worker acquires manual dexterity and proficiency in the job assigned.
specialisation.
It improvesthe quality of product produced and saves time.

10.2.6Causesof Diminishing Returns

Thestageofdiminishingreturns, like that of increasing returns, can be explained on the basis of
indivisibility
offactor. Once the optimum r and yariable units has
been achieved,
ative
to factor.Conse uen!ltyerage product and marginal product w!kinish,
wmthe
blefactor.Diminishing returns are due to increasing inefficiency of production
after the
6. Stonier,A.W.and
Hague, D.C.: A Text Book of Economic Theory, 4th Edition,
P. 129
 10.10 Econom

has been reached and the limit to specialisatio

maximum capacity of the indivisible factor the firm (or industry) will h uh
as after sometime aveto
crossed. Diminishing returns also arise
used up.
inferior factor units, when superior ones are perfect SUbstitute fixed factor were .
that ifsome
Joan Robinson goes a step ahead. She holds have been compensated by the increased
would
then the deficiency ofthe scarce fixed factor possibility Ofsuch substitution. In fact, factors
to the the elasticity
of its substitute. However, there is limit In other words, ofsubstituh.on
are imperfect substitutes for one another,
production
between the factors is not infinite. long as at least one factor is fixed and cannot
to appear as the application of the b
Thus, diminishing returns are bound "The main cause of
Benham,
substituted for the other. To quote other factor
ofproduction. When variable factors Of
scarcity ofone or the
diminishing returns is the
.
are increased on a fixed factor, this law applies

10.21 Causes of Negative Returns of other factor, a stage

to increase with fixed amount
As the amount ofvariable factor continues
and the marginal product becomes_.negative. This
reached, when the total product declines the units of variable
due to the fact that the number of factor
phenomenon ofnegativereturns is et in each other' way, with theresult
factor, so that the
become too excessive relative to the fixed Of the variable factors impairthe
that the total product starts too large a mber broth'
spoil the aptly applies to such
efficiency of the fixed factor. The proverb 'too many 00ks will raise the total product.
e factor
situation. Here, a reduction in the units of the vari
units were homogenous ( we are assuming
If the factors were perfectly divisible and allo eir nor
(or negative) increasing returns
away the possibility of specialisation), neither diminishing
returns in such cases, i.e., small plant
would have occured. We would have experienced constant world's food problem byjust
solve
would be as efficient as big plant. In such case, we would
increasing the number of workers on a small field.

10.2.8 Importance of Law

The law of variable proportions occupiesan important place in modern economic theory.It
influences every aspect ofeconomic life. This law (especially its phase ofdiminishing returns) has
universalapplication in the field of production, in any form. A number of economic principles
find their expression in the law ofdiminishing returns. Principle ofSubstitution, Marginal Utility
Theory of Value,Marginal ProductivityTheory of Distribution, Ricardian Theory of Rentand
Malthusian Theory of Population are some illustrations.
Law of variable proportions has vast general applicability. This law applies as much to industries as
to agriculture. However,in agriculture, where nature plays the major role, diminishing returnsset
in at an early stage than the industries, where man's role is more important. Experiences ofthe
under developed countries ofthe worldjustify the operation ofthis law in agriculture. Phenomenon
ofdisguised unemployment revealing zero or near zero or negative marginal productivity ofla bour
is one such example. Withdrawal ofdisguised unemployed people and employing it in industrial
sector can increase the output ofagriculture.
 Analysis 10.11
duction
pro
production and productivity can be
dcultural through progress in substantially increased by making advancement
technology
agricultural
Bg science. Scientific rotation ofcrops, improved seeds,

Most ofdeveloped tountries

ftheworldhave been successful on this front. However,
done,
technology advancement shifts the total
ductcurve upwards. It will just postpone the
operation of this law and eventually diminishing
p mswillset in. Thus, the application of the law
of variable proportions is inevitable, inexorable
pervading.
all

10.3LAWOF RETURNSTO SCALE (LONG RUN PRODUCTION

ANALYSIS)
Thelawofreturns to scale is concerned with the
study of production function (i.e., input- output
relationship)in the long run (when all inputs
are variable).Thus, long run production theory or
thelawof returns to scale studies the behaviour
ofoutput in response to changes in scale. A change
inscalemeans that all inputs or factors are varied in
the same proportion, keeping the factor
proportions constant. When the quantities ofall
factors are changed along a particular scale,size of
thefirmand scale of output will change. The
responsiveness of output to such changes in inputs is
scale. Technology is assumed
calledreturns to to remain constant.
Whena producer increases all the inputs in a
given proportion, there are three possibilities, viz.,
totaloutput may increase more than proportionately,just proportionately
which
or less than
proportionately, occur in that order.
Thelawof returns to scale can be explained more precisely through the production function.
productionfunction involving two variable inputs, say, capital
(K) and labour (L) can be expressed
as

Here,'Q' denotesthe quantity of commodity produced. Suppose,both 'K' and 'L' are increased in
proportioncm'and the total output increases in proportion 'n'. The new production function is
nQ = f(mK, mL)
Theproportion 'n' may be equal to, greater than or less than em'. Accordingly, three stages of the
lawof returns to scale follow :
(i) If n > m, i.e., increase in the total output is greater than the proportional increase in the
inputs, it means that a situation of increasingreturns to scale exists. Thus, if inputs are
doubled,then the total output is more than doubled. The technology used is such that the
requirement of real resources per unit of output tends to decrease.Here, eQ1> I
(ii) Ifn = m, i.e., increase in the total output is proportional to the increase in inputs, it means
that a situation ofconstant returns to scale exists. To take an example, if all inputs are doubled,
then total output is also doubled. In this case, eQ17=1

7. eq.l(Input elasticity ofoutput or elasticity ofproduction)

%Changein total output (Q) dQ/Q dQ I dQ/dI MP

% Change in variable inputs (I) dill dl Q Q/l AP

In estimated production function, the aggregate of input elasticities is termed as the 'function coefficient'.