LAWS OF RETURNS – RETURNS TO A

FACTOR AND RETURNS TO SCALE

 PRODUCTION FUNCTION
• Production – Transformation of input to output
• Act of making goods and services thereby adding utility
to the object
• Production function – expresses relationship between
physical inputs and physical output of a firm
• Shows the maximum quantity of a commodity that can
be produced per unit of time with the given amount of
inputs, when the best production technique available is
used.
Q = f( F1, F2....Fn)
 Fixed and Variable Factors
• Fixed Factor
– Those factors that cannot be changed easily in the short run
– Not directly related to the level of output
– Must be paid for even when output is zero
– Eg: Building
• Variable Factor
– Those fop that can be changed in the short run
– Directly related to the level of output

– Eg: Raw Material

• Short Run – Period of time when a firm can
change only some factors ie variable factors
but not its fixed factors
• Long Run – Period of time when a firm can
change all of its factors ie a period of time
when all factors are variable
 PRODUCTION FUNCTION
Production
function

Short Run Long Run

Production Production
Function Function

Returns one input is

all inputs are Returns
to a variable, all
variable to Scale
Factor others constant
 LAW OF VARIABLE PROPORTIONS
Unit of TP AP MP
variable Assumptions of the law
factor
- State of technology remains
0 0 0 0 constant
1 2 2 2 - Units of the variable factor are
2 6 3 4 homogenous
3 12 4 6 - One factor remains fixed while
4 20 5 8 the other is varied
5 25 5 5
6 29 4.8 4
7 31 4.4 2
8 31 3.9 0
9 29 3.3 -2
 TP, AP and MP
• Total output of a commodity produced by a firm with given inputs during
a specified period of time
TP/TPP • TP = ∑MP
• TP = AP * N

• Addition to the total output when an additional unit of variable factor is

MP/MP employed
P • MP = Change in output/change in input
• MP = TPn – TPn-1

• Output per unit of the variable input

AP/APP
• AP = TP/ No of units of input
 LAW OF VARIABLE PROPORTIONS
Law of variable proportion Law of diminishing returns
• As more and more units of • As more and more units of
the variable factor are the variable factor is
employed with fixed employed with fixed
factors, the TP increases at factors, a stage must
an increasing rate, then ultimately come when MP
increases at a diminishing ie additional output starts
rate
declining
• If quantities of a variable
factor are increased while
keeping other factors fixed,
MP first increases, then
falls but remains positive
and finally declines
 LAW OF VARIABLE PROPORTIONS
• Stage of increasing returns to a factor
– Upto 4th unit, it is the first stage of prodn ie increasing
returns
– Fixed factors are not fully utilised. For each variable
factor introduced, there is a proportional increase in
returns
– 1st stage characterised by TP increasing at an increasing
rate or constant rate
– MP rises first and reaches maximum
– AP remains increasing
LAW OF VARIABLE PROPORTIONS
 Causes
 Fuller utilisation of fixed factor
 Increased efficiency of variable factor – process
based division of work
 LAW OF VARIABLE PROPORTIONS
• Stage of diminishing returns to a factor
– Upto 8th unit, it is the second stage of production ie
diminishing returns
– Resources are now fully utilised. Hence, for each
additional variable factor introduced, productivity begin to
reduce
– Characterised by falling MP though MP is still positive
– AP rises for a short while and then cuts MP and is higher
than MP
– At the end of this stage, MP is 0 and TP has reached its
maximum
– During this stage, TP increases but at a diminishing rate
LAW OF VARIABLE PROPORTIONS
 Causes
 Disturbing the optimum proportion - Excessive
application of variable factor – ideal factor ratio is
stretched
 Imperfect factor substitutability – Cannot keep
replacing labour with capital beyond a point
 LAW OF VARIABLE PROPORTIONS
• Stage of negative returns to a factor
– Beyond the 8 th unit, it is the third stage of
production ie negative returns
– Characterised by falling TP, falling AP and negative
MP
– This stage starts when MP becomes 0
LAW OF VARIABLE PROPORTIONS
 Causes
 Overcrowding – too many variable factors – lower
availability of tools, getting in each other’s way
 Management problems – shifting responsibility –
drop in efficiency
 RELATIONSHIP BETWEEN TP, AP AND MP
TP and MP
When TP rises at an increasing rate, MP rises
When TP rises at a diminishing rate, MP falls but remains positive
When TP is maximum, MP is zero
When TP falls, MP becomes negative
MP and AP
When MP >AP, AP increases
When MP=AP, AP reaches its maximum
When MP<AP, AP falls
While MP can be zero or negative, AP is never zero
AP curve and MP curve
As long as MP curve is above AP curve, the AP curve is rising
MP curve begins to fall and intersects AP curve at its highest point
When MP curve lies below AP curve, AP curve falls
RELATIONSHIP BETWEEN TP, AP AND MP
Stage TP AP MP
I TP increases at an Increases and Increases, reaches
increasing rate reaches maximum maximum and
and then at a falls
decreasing rate

II Increases at a Decreases Falls to reach zero

decreasing rate
and reaches
maximum

III Falls Decreases, Negative

remains positive
 DECISION TO PRODUCE
• Stage III – stage of economic nonsense or
absurdity
– TP is falling, MP negative
• Stage I – not employing fixed factors fully –
not taking full advantage – has opportunity to
add variable factors
• Stage II – Ideal stage for producer
 LAW OF RETURNS TO SCALE
• Returns to scale explains the behaviour of output when
all factor inputs are changed in a specific proportion
• Three tendencies of the law
– Increasing returns to scale – Proportionate Increase in
output > Proportionate increase in input – Inputs 50%,
output 75%
– Constant returns to scale – Proportionate increase in output
= Proportionate increase in input – inputs 50%, output 50%
– Diminishing returns to scale – Proportionate increase in
output < Proportionate increase in input – inputs
50%,output 25%
 Comparison
Reason Law of variable Law of returns to
proportions scale
Factor One factor is changed, All factors change
all others remain
constant
Scale of No change in scale of Scale of production
production production changes
Time period Short run Long run
Factor changes Remains the same
proportion
 REASONS FOR THE OPERATION OF
THE LAW
Reasons for increasing returns
• Division of labour
• Specialisation
• Economies of Scale – Advantages enjoyed by
firm/industry due to size or scale of operation
– Internal economies
• Advantages/benefits enjoyed by the individual firm alone
– Technological – Better m/c and technology employed by the firm
– Managerial – Better organisation structure and delegation of
authority, division of labour
– Financial – Better credit worthiness, ability to get loans at lower rates
of interest
– Marketing – Better networking, contacts with suppliers to obtain raw
materials at a lower price – Volume discounts
– Risk-bearing – Large firm – Able to diversify risk - subcontract
REASONS FOR THE OPERATION OF
THE LAW
– External economies
• Advantages/benefits enjoyed by the entire
industry/region including small firms
– Transportation and communication facilities
– Roads and railways
– Banks, warehouses
 REASONS FOR THE OPERATION OF
THE LAW
Reasons for diminishing returns
• Diseconomies – Disadvantages suffered by
firm/industry due to excessive increase in scale
of operation
– Internal diseconomies – Generally for larger firms
only

– External diseconomies – Beyond a certain point,

too much concentration/localisation of industries
creates diseconomies to all firms in general
• Infrastructure, shortage of raw materials