THEORY OF PRODUCTION: PART 2

LAW OF VARIABLE PROPORTIONS/LAW OF DIMINISHING RETURNS:

Law of variable proportions occupies an important place in the economic theory. It
examines the production function with one factor variable, keeping the quantities of other
factors constant. This law tells us how the total output or marginal output is affected by a
change in the proportion of the factors used. The law states that when one factor is
increased keeping others fixed, the marginal and average product eventually declines.
According to Stigler, “As equal increments of one input are added; the inputs of other
productive services being held constant, beyond a certain point the resulting increments
of product will decrease, i.e., the marginal products will diminish.” Thus, an increase in the
quantities of a variable factor to a fixed factor results in increase in output to a point
beyond which it eventually declines.

Assumptions of the law:

1. The state of technology is assumed to be constant.

2. There must be some inputs whose quantity is kept fixed.

3. The law is based upon the possibility of varying the proportions in which the various
factors can be combined to produce a product. It cannot be applied to the cases where
the factors must be used in fixed proportions to yield a product.

The law of variable proportions is explained with the help of following table.
With a given fixed quantity of land, numbers of workers are increased from 1 to 10. When
there are 7 workers engaged, the output is maximum, i.e., 118 kgs. Beyond this point, the
total product starts diminishing. Up to 3rd unit of worker, the total product increases at an
increasing rate and after that at diminishing rate. This is clear from the third (MP) column
that marginal product is falling continuously after 3rd unit of worker and even becomes
negative beyond 8th unit of worker. Average product increases up to 4th unit of labour
and falls through out thereafter.

The law can be also explained using Fig. 1 shown as under:

In this figure, the X-axis measures units of variable factor and the Y-axis measures output:
total, marginal and average products. We observe three different stages of law of variable
proportions as explained below:
1. The first stage goes from the origin to the point where average product is at its
maximum (point I is called the point of diminishing average returns). In this stage,
marginal product increases, reaches its maximum at point H (point of diminishing
marginal returns), and starts to fall. The total product increases throughout the stage. It
initially increases at an increasing rate, then from point E (point of inflexion) onwards,
continues to increase but at a diminishing rate. This stage is known as the stage of
increasing returns. The reason for increasing returns is that when more and more units
of the variable factor are added to the constant quantity of fixed factor, the fixed factor is
more effectively and intensively used. This causes output to increase at a fast rate.
2. The second stage goes from the point where the average output is maximum to the
point where marginal output is zero (point C). In this stage, marginal product keeps falling
till it becomes zero. AP keeps falling too but remains positive. When the fixed factor is
most efficiently used, then further increase in the variable factor causes marginal and
average products to decline because the fixed factor now is scarce relative to the quantity
of variable factor. Therefore, this stage is known as the stage of diminishing returns. TP
reaches it maximum (G).
3. The third stage starts when the total product is maximum and marginal product is zero.
In this stage, marginal product becomes negative. The number of variable factors
becomes too large relative to the fixed factor so that the total output falls and marginal
output becomes negative. This is the reason why this stage is known as the stage of
negative returns.

For instance, with a view of raising agricultural production, labour (that is, farmers) can be
increased to any extent but not the land, being fixed factor. Thus when more and more
units of the variable factor like labour is applied to a fixed factor then their marginal
product starts to diminish and this law becomes operative.

The Stage of Operation:

Now, an important question is in which stage a rational producer will seek to produce. A
rational producer will never choose to produce in stage 3 where marginal product of the
variable factor is negative. Marginal product of the variable factor being negative in stage
3, a producer can always increase his output by reducing the amount of the variable
factor.
At the end point C of the second stage where the marginal product of the variable factor
is zero, the producer will be maximising the total product and will thus be making
maximum use of the variable factor.
A producer producing in stage 1 means that he will not be making the best use of the
fixed factor and further that he will not be utilising fully the opportunities of increasing
production by increasing quantity of the variable factor whose average product continues
to rise throughout the stage 1. Thus, a rational entrepreneur will not stop in stage 1 but
will expand further.
It is thus clear from above that the rational producer will never be found producing in
stage 1 and stage 3. Stage 1 and 3 may, therefore, be called stages of economic
absurdity or economic non-sense. The stages 1 and 3 represent non-economic regions in
production function.
A rational producer will always seek to produce in stage 2 where both the marginal
product and average product of the variable factor are diminishing. At which particular
point in this stage, the producer will decide to produce depends upon the prices of
factors. The stage 2 represents the range of rational production decisions.

Condition or Causes of Applicability:

There are many causes which are responsible for the application of the law of variable
proportions. They are as follows:
1. Under Utilisation of Fixed Factor:
In the initial stage of production, fixed factors of production (for instance, physical capital
like machines), is under-utilised. More units of variable factor, like labour, are needed for
its proper utilisation. As a result of employment of additional units of variable factors there
is proper utilisation of fixed factor. In short, increasing returns to a factor begins to
manifest itself in the first stage.
2. Fixed Factors of Production.
The foremost cause of the operation of this law is that some of the factors of production
are fixed during the short period. When the fixed factor is used with variable factor, then
its ratio compared to variable factor falls. Production is the result of the joint utilisation of
all factors. When an additional unit of a variable factor has to produce with the help of
relatively fixed factor, then the marginal return of variable factor begins to decline.
3. Optimum Production:
After making the optimum use of a fixed factor, then the marginal return of such variable
factor begins to diminish. The simple reason is that after the optimum use, the ratio of
fixed and variable factors become defective. Let us suppose a machine is a fixed factor of
production. It is put to optimum use when 4 labourers are employed on it. If more than 4
labourers are put on it, then total production increases very little and the marginal product
diminishes.
4. Imperfect Substitutes:
Economist Joan Robinson has put forward the argument that imperfect substitution of
factors is mainly responsible for the law of diminishing returns. One factor cannot be used
in place of the other factor. After optimum use of fixed factors, variable factors are
increased and the amount of fixed factor could be increased by its substitutes. Such a
substitution would increase the production in the same proportion as earlier. But in real
practice factors are imperfect substitutes. However, after the optimum use of a fixed
factor, it cannot be substituted by another factor.

LAW OF RETURNS TO SCALE:

Scale of production relates to size of plant. Every entrepreneur has to decide about the
size of their plant or business. The question is how large a business should be. Because
up to a certain size of plant what is called ‘economies of scale’ take place. Economies
refers to benefits arise due to the expansion of a business. Economies of scale can be
broadly divided into two categories- internal and external. Internal economies are caused
by some internal factors, which arise within the firm and are not shared by other firms.
Use of better technology, purchase of raw materials at cheaper rates and selling the final
goods at high price, easy availability of finance from financial institutions etc, are some
examples of internal economies/benefits that a firm enjoys. External economies are those
advantages which are available to all firms located in an area. Development of
transportation, good and fast communication, good banking and insurance facilities, etc
are the examples of external economies. Too big or too small size of plant or business is
not viable in the economic sense. Optimum scale, which at least covers up cost per unit
of output, is more desirable than too small or too large plant.
The study of changes in output as a result of changes (increase or decrease) in the scale
is the subject matter of returns to scale. An increase/decrease in the scale refers to
increase/ decrease in all inputs in the same proportion. Thus in returns to scale we study
the effect of doubling or trebling and so on of all inputs on the total output. The law can
be explained with the help of a table shown below:

Scale TP MP Stage

1 lab + 2 units of land 3 3 I

2 lab + 4 units of land 7 4 I

3 lab + 6 units of land 12 5 I

4 lab + 8 units of land 18 6 II

5 lab + 10 units of land 24 6 II

6 lab + 12 units of land 30 6 II

7 lab + 14 units of land 35 5 III

8 lab + 16 units of land 39 4 III

9 lab + 18 units of land 42 3 III

Thus we find three phases of returns to scale explained as under. Up to 4th labour,
marginal product or returns increases. Returns are constant over the 5th and 6th units of
labour and thereafter, returns begin to decline.
Stage I: Output increases in a greater proportion than the increase in inputs. Thus if all
inputs are increased by 10%, and as result output increases by 20%, then increasing
returns to scale operates. This is also shown in the Fig. 2 below. In the beginning when
the scale is increased, increased division of labour is possible and is undertaken, as result
of which, output increases rapidly.
Stage II: If all inputs are increased in a given proportion and the output increases in the
same proportion then returns to scale is constant. More clearly, if all inputs are increased
by 10%, and as result output also increases by 10%, then constant returns to scale
prevails. Up to a certain point division of labour is possible. After such a point, further
increase in scale will make returns to remain constant.
Stage III: If all inputs are increased in a given proportion and the output increases in less
than that proportion, then returns to scale is diminishing. That is, if all inputs are increased
by 10%, and as result output also increases by 6%, then diminishing returns to scale
prevails. When scale is increased to a point when division of labour is not possible,
returns begins to decline.
 Fig. 2

ISOQUANT CURVE:
An Iso-quant curve may be defined as a curve showing the possible combinations of two
variable factors that can be used to produce the same total product.The term Isoquant is
composed of two words, iso = equal, quant = quantity or product or output.
Thus it means equal quantity or equal product. Different factors are needed to produce a
good. These factors may be substituted for one another. A given quantity of output may
be produced with different combinations of factors. Isoquant curves are also known as
Equal-product or Iso-product curves. Thus, an Iso-product or Isoquant curve is that curve
which shows the different combinations of two factors yielding the same total product.
Isoquant curves slope downward from left to right, and are convex to the origin. The slope
of an Isoquant curve expresses the marginal rate of technical substitution (MRTS).

Fig. 3 below shows what an Isoquant curve looks like. Iq denotes the Isoquant, X-axis
and Y-axis measure units of labour and capital respectively.
 Fig. 3

The main assumptions of Isoquant curves are as follows:

1. Two Factors of Production: Only two factors are used to produce a commodity.
2. Divisible Factor: Factors of production can be divided into smaller parts.
3. Constant Technique: Technique of production is constant or is known before hand.
4. Possibility of Technical Substitution: The substitution between the two factors is
technically possible.
5. Efficient Combinations: Under the given technique, factors of production can be used
with maximum efficiency.

Isoquant Map:
An Isoquant Map shows a set of iso-product curves. They are just like contour lines which
show the different levels of output. A higher iso-product curve represents a higher level of
output. In Fig. 4 below we have family iso-product curves, each representing a particular
level of output.
 Fig. 4

The properties of Iso-product curves:

1. Iso-Product Curves Slope Downward from Left to Right: They slope downward
because the Marginal Rate of Technical Substitution (MRTS) of one input (say, labour) for
another (say, capital) diminishes. When we increase labour, we have to decrease capital to
produce a given level of output.
2. Isoquants are Convex to the Origin: In order to understand this fact, we have to
understand the concept of diminishing marginal rate of technical substitution (MRTS),
because convexity of an isoquant implies that the MRTS diminishes along the isoquant.
The marginal rate of technical substitution between L and K is defined as the quantity of K
which can be given up in exchange for an additional unit of L. It can also be defined as
the slope of an isoquant.
It can be expressed as:
MRTSLK = – ∆K/∆L
Where ∆K is the change in capital and AL is the change in labour.
The equation states that for an increase in the use of labour, fewer units of capital will be
used. In other words, a declining MRTS refers to the falling marginal product of labour in
relation to capital. To put it differently, as more units of labour are used, and as certain
units of capital are given up, the marginal productivity of labour in relation to capital will
decline. It means that the marginal rate of technical substitution is diminishing. This is the
concept of diminishing marginal rate of technical substitution (DMRTS).
Thus it may be observed that due to falling MRTS, the isoquant is always convex to the
origin.
3. Two Iso-Product Curves Never Intersect Each Other: Just as two indifference curves
cannot cut each other, two iso-product curves cannot cut each other. In Fig. 5 below, two
Iso-product curves intersect each other. Both curves IQ1 and IQ2 represent two levels of
output. But they intersect each other at point A. Then combination A = B and combination
A = C. Therefore B must be equal to C. This is absurd. B and C lie on two different iso-
product curves. Therefore two curves which represent two levels of output cannot
intersect each other.

Fig. 5

4. Higher Iso-Product Curves Represent Higher Level of Output.

5. Isoquants Need Not be Parallel to Each Other: It so happens because the rate of
substitution in different isoquant schedules need not be necessarily equal. Usually they
are found different and, therefore, isoquants may not be parallel.
6. No Isoquant can Touch Either Axis: If an isoquant touches X-axis, it would mean that
the product is being produced with the help of labour alone without using capital at all.
This is a logical absurdity, as labour alone will be unable to produce anything. Similarly,
capital alone cannot produce anything without the use of labour either.

Other Types of Isoquants:

Apart from the usual convex shaped isoquant, there exist a few other exceptional form of
isoquants as well. They are as follows:
1. Linear Iso-quant Curve: This curve (denoted by X in Fig. 6) shows the perfect
substitutability between the factors of production. This means that any quantity can be
produced either employing only capital or only labor or through “n” number of
combinations between these two.
 Fig. 6

2. Leontief Isoquant: This is one of the types of isoquant curves where there is a strict
complementarity with no substitution between the factors of production. According to
this, there is only one method of production to produce any one commodity. This curve is
also known as an input-output isoquant or a right-angled isoquant or an L-shaped
isoquant, as shown below (in Fig. 7).

Fig. 7
3. Kinked isoquant Curve: This curve (denoted by X in Fig. 8 below) assumes, that there is
a limited substitutability between the factors of production. This shows that substitution
of factors can be seen at the kinks since there are a few processes to produce any one
commodity. Kinked isoquant curve is also known as activity analysis programming iso-
quant or linear programming isoquant.

Fig. 8

ISOCOST LINE:
Isocost line may be defined as the line which shows different possible combinations of
two factors that the producer can afford to buy given his total expenditure to be incurred
on these factors and price of the factors. It refers to those different combinations of two
factors that a firm can obtain at the same cost. Just as there are various isoquant curves,
so there are various iso-cost lines, corresponding to different levels of total output.

The concept of iso-cost line can be explained with the help of the following table and Fig.
9. Suppose the producer’s budget for the purchase of labour and capital is fixed at Rs.
100. Further suppose that a unit of labour cost the producer Rs. 10 while a unit of capital
Rs. 20.
From the table cited above, the producer can adopt the following options:
(i) Spending all the money on the purchase of labour, he can hire 10 units of labour
(100/10 = 10)
(ii) Spending all the money on the capital he may buy 5 units of capital.
(iii) Spending the money on both labour and capital, he can choose between various
possible combinations of labour and capital such as (4, 3) (2, 4) etc.

Fig. 9

In Fig. 9, labour is given on OX-axis and capital on OY-axis. The points A, B, C and D
convey the different combinations of two factors, capital and labour which can be
purchased by spending Rs. 100. Point A indicates 5 units of capital and no unit of labour,
while point D represents 10 units of labour and no unit of capital. Point B indicates 4 units
of capital and 2 units of labour. Likewise, point C represents 4 units of labour and 3 units
of capital.

Equation of an Isocost Line:

If C is total cost, r is rate of interest of capital, w is the wage rate and K and L are the
units of capital and labor respectively, we can write a general equation for isocost line as
follows:
C=wL+rK
This shows that the slope of the isocost line is -w/r.

Shifts in Isocost Line:

A firm’s isocost line can shift if there is:
(a) a change in total expenditure/outlay of the firm on inputs (Fig 10A),
(b) a change in price of the inputs (Fig. 10B)
If a firm decides to spend more money on production, its isocost line shifts outwards/
rightwards parallel to the original isocost line. It is because more budget allows the firm to
simultaneously employ more capital and labor at the same time. A reduction in budget
would have an exactly opposite effect i.e. it would move the isocost line inwards/
leftwards. A parallel shift can also happen if prices of both inputs change by equal
proportion. However, where the change in prices of inputs is not proportionate, it changes
the slope of the isocost line (recall the fact that the slope of the isocost line equals the
ratio of price of one factor to the other). Such a change in slope rotates the isocost line.
Fig. 10A

Fig. 10B
Producer’s equilibrium or Optimisation:
Producer’s equilibrium or optimisation occurs when they earn maximum profit with
optimal combination of factors. A profit maximising firm faces two choices of optimal
combination of factors/inputs:
1. To minimise its cost for a given output; and
2. To maximise its output for a given cost.
This point of least-cost combination of factors for a given level of output is where the
isoquant curve is tangent to an iso-cost line. In Figure 11, the isocost line GH is tangent
to the isoquant 200 at point M.
The firm employs the combination of ОС of capital and OL of labour to produce 200 units
of output at point M with the given cost-outlay GH. At this point, the firm is minimising its
cost for producing 200 units.
Any other combination on the isoquant 200, such as R or T, is on the higher iso-cost line
KP which shows higher cost of production. The iso-cost line EF shows lower cost but
output 200 cannot be attained with it. Therefore, the firm will choose the minimum cost
point M which is the least-cost factor combination for producing 200 units of output.
M is thus the optimal combination for the firm. The point of tangency between the iso-
cost line and the isoquant is an important first order condition but not a necessary
condition for the producer’s equilibrium.

Fig. 11

At the point of optimisation, the slope of the isocost line must equal the slope of the
isoquant curve. The slope of the isocost line is equal to the ratio of the price of labour (w)
to the price of capital (r) i.e. w/r. The slope of the isoquant curve is equal to the marginal
rate of technical substitution of labour and capital (MRTSLK) which is, in turn, equal to the
ratio of the marginal product of labour to the marginal product of capital (MPL/MPK).
Thus the equilibrium condition for optimality can be written as:
w/r = MPL/MPK = MRTSLK
Also, at the point of tangency, the isoquant curve must he convex to the origin. In other
words, the marginal rate of technical substitution of labour for capital (MRTSLK) must be
diminishing at the point of tangency for equilibrium to be stable.

Now let us consider the diagram below (Fig. 12):

Fig. 12

The firm is in equilibrium at point P where the isoquant curve 200 is tangent to the iso-
cost line CL.
At this point, the firm is maximising its output level of 200 units by employing the optimal
combination of OM of capital and ON of labour, given its cost outlay CL. But it cannot be
at points E or F on the iso-cost line CL, since both points give a smaller quantity of
output, being on the isoquant 100, than on the isoquant 200.
The firm can reach the optimal factor combination level of maximum output by moving
along the iso-cost line CL from either point E or F to point P. This movement involves no
extra cost because the firm remains on the same iso-cost line.
The firm cannot attain a higher level of output such as isoquant 300 because of the cost
constraint. Thus the equilibrium point has to be P with optimal factor combination OM +
ON. At point P, the slope of the isoquant curve 200 is equal to the slope of the iso-cost
line CL. Again, it implies that
w/r = MPL/MPK = MRTSLK remains the stable equilibrium point for the producer.

EXPANSION PATH:
We know that the production function of the firm gives us the isoquant map of the firm,
one isoquant (IQ) for each particular level of output, and the cost equation of the firm
gives us the family of parallel isocost lines, given the prices of the inputs, each isocost
line for one particular level of cost. This is demonstrated in Fig. 13 below. If we now join
the point of origin 0 and the points of tangency, E1, E2, E3, etc., between the Isoquants
and the Isocost lines by a curve, then this curve (OK in Fig. 13) would give us what is
known as the expansion path of the firm.
 Fig. 13

The expansion path is so called because if the firm decides to expand its operations, it
would have to move along this path. Let us note that the firm may expand in two ways:
First, it may want to expand by successively increasing its level of cost or its expenditure
on the inputs X and Y, i.e., by using more and more of inputs, and, consequently, by
producing more of its output.
Second, the firm may decide to expand by increasing its level of output per period. This
the firm may do by increasing the expenditure on the inputs, i.e., by using more and more
of them.

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