MCom I Semester Managerial Economics production Function Laws Returns & Scale Study Material Notes
Table of Contents
MCom I Semester Managerial Economics production Function Laws Returns & Scale Study Material Notes: Law of Increase Returns Meaning and Definition Law of Constant Returns Applicability or Practicability of The Law or Constant returns Law of Increasing Returns and Cost Scope of the law of Increasing Returns Causes of the Operating of Law of Increasing Returns Scope of Law Condition or causes to the Operation of Law of Diminishing returns :
CTET Paper Level 2 Set VIII Model Paper in English
PRODUCTION FUNCTIONS: LAWS OF RETURNS AND RETURNS TO SCALE
LAW OF INCREASING RETURNS: MEANING AND DEFINITION
When an increase in output is in greater proportion than increase in inputs, it is known as the law of increasing returns. This law explains that when the quantity of a variable factor of production is increased, marginal product shows an increasing tendency and total product increases at an increasing rate. This law has been defined as under:
1 “An increase of labour and capital leads generally to improved organisation, which increases the efficiency of the work of labour and capital”. —Marshall
2. “When an increased amount of any factor of production is devoted to a certain use, it is often the case that improvements in organisation can be introduced which will make natural units of the factors (men, land and money capital) more efficient, so that an increase in output does not require a proportionate increase in the physical amount of factors.” -Mrs. John Robinson
Thus, law of increasing returns is the state of production when quantity of one or more factors of production is kept constant and the quantities of other Variable factors are gradually increased, and corresponding return to an utional unit of variable factor goes on increasing. It can be made clear with the help of above production schedule and curve.
In the given figure, units of labour are shown on x-axis and Marginal and average products are shown on y-axis. MP is marginal product curve and AP is average product curve. Both the MP and AP are increasing as the units of labour are increased. It implies that total product is increasing at an increasing rate.
CAUSES OF THE OPERATION OF LAW OF INCREASING RETURNS
Prof. Chamberlin has stated the following causes for the operation of the law of increasing returns :
(1) Economics of Division of Labour and Specialization. Due to increase in scale of production, it becomes possible for the firm to adopt division of labour and specialization. It increases the efficiency of labourers and raises their productivity. Higher productivity implies more production.
(2) Improvement in the Technique of Production. Division of labour promotes innovations on the part of workers. Thus, the productivity of workers increases substantially. It leads to increasing returns to scale.
(3) Economics of the Use of Specialised Machinery. Increase in the scale of production makes it possible for firm to use latest and improved machines and equipments. As a result, total product increases at a higher rate.
(4) Managerial Economics. When scale of production is increased, task of management can be divided on function basis such as production, purchases, sales, finance, personnel and public relations etc. It increases managerial efficiency and production.
(5) Economics of Buying and Selling. Firm gets many advantages in buying and selling as : (i) Higher bargaining power, (ii) Preferential treatment by the firms they deal with, (iii) Concessions in freight, (iv) Quick availability of means of transport, (v) Cheap credit facilities from banks and other financial institutions, (vi) Facilities for standardisation and gradation.
LAW OF INCREASING RETURNS AND COST
Law of increasing returns states the situation when increase in production is more than increase in inputs. It states that, marginal and average product show an increasing trend. It implies that marginal and average cost of production will show decreasing trend. So long as the law of increasing returns applies, marginal and average cost decrease. For this reason, this is also known as the law of diminishing costs.
TSCOPE OF THE LAW OF INCREASING RETURNS
Prof. Marshall was of the opinion that law of increasing returns applies only on manufacturing industries because in these industries, contribution of man is more important than that of nature. But this is not correct. The fact is that this law applies in all the spheres of production till an optimum ratio is established between factors of production. However, the law applies in manufacturing industries more frequently.
LAW OF CONSTANT RETURNS
Law of constant returns explains intermediate stage between the laws of increasing returns and diminishing returns. This law explains that if the quantity of variable factors of production is changed, average and marginal product will not change. Thus, this law states a situation in which increase in one or more variable factors of production and the increase in production are equal. In the words of Prof. Stigler, “When all the productive services are increased in a given proportion and the product is also increased in the same proportion, law of constant returns applies.” This law can be illustrated as follows:
In above figure, units of labour are shown on x-axis and marginal and average products are shown on y-axis. Both marginal and average products are on the same curve. It is clear from above figure that both MP and AP are constant at all the levels of production. It implies that total product is increasing at constant rate.
APPLICABILITY OR PRACTICABILITY OF THE LAW OF CONSTANT RETURNS
Some of the economists are of the view that this law is only theoretical and it does not apply in real life while other economists are of the opinion that this law applies in all the spheres of production. They are of the opinion that when the tendency of increasing returns ceases and the tendency of diminishing returns does not begin, this law applies, however, for a short while.
LAW OF DIMINISHING RETURNS
Law of diminishing returns explains the stage of production in which the quantity of one input is increased with a fixed quantity of other inputs and the resulting increase in production decreases after a certain points. This law has been defined as under
1 “As the proportion of one factor in a combination of factors is increased, after a point, the marginal and average product of that factor will diminish.”
2. “If the quantity of one productive service is increased by equal increments, the quantities of other productive services remaining fixed, the resulting increments of the product will decrease after a certain point.” –Stigler
3. “An increase in some inputs relative to other comparatively fixed inputs, will cause output to increase, but after a point, the extra output resulting from the same additions of input will become less and less.”
Samuelson Thus, law of diminishing returns states that when the quantity of one factor of production is increased, keeping the number of other factors constant, average and marginal product will eventually decline. This law illustrated as follows:
In above figure, units of labour are shown on x-axis. Marginal and average products are shown on y-axis. MP curve and AP curve are also shown. Both the MP and AP curves are declining as and when the units of labour are increased. It implies that total product is increasing at a diminishing rate.
ASSUMPTIONS OR LIMITATIONS OF THE LAW OF DIMINISHING RETURNS
1 It is assumed that the state of technology remains unchanged.
2. It is assumed that the organisational structure and managerial efficiency of the firm remain unchanged.
3. It is assumed that there are some inputs whose quantity may be kept fixed and the number of other inputs may be changed, as required.
4. All the units of the variable factor are homogeneous.
5. This law is concerned with the physical quantity of the product only and not with its value.
6. It is assumed that the optimum combination of resources of production has already been achieved.
7. It is also assumed that the factors of production, particularly variable factors, are divisible as required.
CONDITIONS OR CAUSES OF THE OPERATION OF LAW OF DIMINISHING RETURNS
(1) Fixity of One or More Factors of Production. If the quantity of only one factor of production is increased and the quantity of other factors remains fixed, the increased quantity of variable factor will have to work with less quantity of fixed factors. It will reduce the productivity of variable factors. It will result in less proportionate production.
(2) Scarcity of Productive Resources. If there is a factor of production, the quantity of which cannot be increased beyond a certain limit, firm will have to do with the fixed and scarce quantity of that factor. It will reduce the productivity of other factors of production and as a result, law of diminishing returns will apply.
(3) Going beyond the Optimum Combination of Factors of Production. When the quantity of only one factor of production is changed keeping the quantity of all other factors constant, an optimum combination of factors is achieved. If the quantity of variable factor is further increased, law of diminishing returns will apply.
(4) Factors of Production are not Perfect Substitutes for One Another. This cause was established by Mrs. John Robinson. In her words. there is a limit to the extent to which one factor of production can be substituted for another. Beyond this limit, law of diminishing returns will start to apply.
SCOPE OF LAW
Prof. Marshall was of the opinion that this law applies only on the activities in which the contribution of nature is more than that of man like Agriculture, fisheries, and minning etc. and not on manufacturing industries. But this opinion is not correct. The fact is that this law is universal and applies on all the spheres of production. Whenever, the quantity of a single factor of production is increased, keeping other factors constant, this law will apply, beyond optimum combination of factors of production, on all the productive activities, whether it is agriculture or industry or any other activity.
SIGNIFICANCE OF THE LAW OF DIMINISHING RETURNS
(1) Universal Application. Law of diminishing returns is a fundamental law of economics and applies on all the activities of production : agriculture, fisheries, construction, minning, manufacturing etc.
(2) Base of Malthusian Population Theory. Malthusian population theory explains that population of country increases at a faster rate than increase in foodgrains because the production of foodgrains can increase subject to the law of diminishing returns.
(3) Base of Ricardian Theory of Rent. Ricardian theory of rent explains that rent is a differential surplus. This theory assumes the application of law of diminishing returns.
(4) Base of Marginal Productivity Theory. This law is the base of marginal productivity theory also. According to this theory, reward of all the factors of production is determined on the basis of their marginal productivity which itself depends upon the law of diminishing returns.
(5) Base of Determination of Standard of Living. If population of a country increases at a higher rate than other means, law of diminishing returns will apply and as a result, the standard of living of the people will be low.
(6) Responsible for Migration of Population. When pressure of population increases on a country, law of diminishing returns starts to apply and as a result, some persons migrate to another country.
LAW OF NEGATIVE RETURNS
Law of negative returns is the last stage of production process. It explains the situation in which total product starts to decline and marginal product becomes negative. No producer likes to get this situation. He would discontinue to increase the quantity of variable factors of production because as soon as the quantity of variable factors of production is increased under this stage, total product starts to decline and marginal product turns to be negative. This situation can be improved by reducing the quantity of variable factors of production
INTER-RELATIONSHIP BETWEEN THREE LAWS OF RETURNS
There laws of returns are not contrary to each other. They are closely inter-related. These laws explain three different stages of production. All the three laws apply in all the spheres of production and on all productive activities. Law of increasing return and at the ultimate stage, law of diminishing returns applies. However, the duration for which each of these laws will apply, cannot be ascertained. Such inter-relationship between laws of returns can be illustrated with the help of following diagram:
In above diagram, quantity of variable factors of production has been presented on OX-axis and quantity of production has been presented on OY-axis. TP is total product curve, AP is average product curve and MP is marginal product curve. Till first stage, law of increasing returns is applying because AP curve is continuously increasing. Law of diminishing returns is applying at second stage because at this stage, AP and MP curves are declining and TP curve is increasing but at declining rate. Third stage represents the law of negative returns because at this stage, TP curve is declining and MP curve is negative, M is the point of maximum production.
production Function Laws Returns
STAGES OF OPERATIONS OF LAW
An important question arising regarding laws of returns is that which stage of laws of returns is most favourable to producers. Answer to this question is very simple. Second stage of laws of returns (Law of diminishing returns) is most favourable to producers.
No producer would like to produce at the third stage (negative returns) because at this stage, total product starts to decline and marginal product becomes negative. As soon as this stage is reached, producers would like to cause the quantity of variable factors of production by doing so, he can improve the situation.
Similarly, no producer would like to continue to work at the first stage for a long time because it implies under-utilisation of fixed factors of production. Every producer would try to achieve more production by increasing the quantity of variable factors of production.
Above discussion makes it clear that a producer does not like to work at the first and third stages of production. He always likes to work at the second stage of production. Thus, in long run, only the law of diminishing returns applies. Several economists have called the first and second stages of production as Economic Absurdity or Economic non-sense. Q. 6. Explain increasing returns to scale.
INCREASING RETURNS TO SCALE
When quantity of all the factors of production is increased simultaneously in a certain ratio and as a result, quantity of production increases in greater proportion, it is said to be increasing returns to scale. Example: Quantity of all the factors of production is increased by 20% and as a result, quantity of production increases by 25%, it will be the stage of increasing returns to scale. It can be explained with the help of following diagram :
In this diagram, quantity of labour (L) is shown on x-axis and the quantity of capital (C) is shown on y-axis. IP, IP, IP, and IP, are identical production lines. These lines represent equal increase in the quantity of production but increase in the quantity of labour and capital to get this equal increase in the quantity of production is continuously going on decreasing. In other words, proportionate increase in the quantity of production is more than proportionate increase in the factors of production. This stage is known as the stage of increasing returns to scale. Q. 7. Explain constant returns to scale.
CONSTANT RETURNS TO SCALE
When quantity of all the factors of production is increased simultaneously in a certain proportion and as a result, the quantity of production also increases in the same proportion, it is said to be constant returns to scale. Example : Quantity of all the factors of production is increased by 20% and as a result, quantity of production also increases by 20%, it will be the stage of constant returns to scale. It can be explained with the help of a diagram as follows:
In this diagram, quality of labour (L) is shown on x-axis and the quantity of capital (C) is shown on y-axis. IP, IP, IPand IP are identical product lines. These lines represent equal increase in the quantity of production. Increase in the quantity of labour and capital is also in the same proportion. This stage is known as the stage of constant returns to scale. Q. 8. Explain diminishing returns to scale.
DIMINISHING RETURNS TO SCALE
When quantity of all the factors of production is increased simultaneously in a certain proportion and as a result, the quantity of production increases in less same proportion, it is said to be diminishing returns to scale. Example: Quantity of all the factors of production is increased by 20% and as a result, quantity of production increases only by 15%, it will be the stage of diminishing returns to scale. It can be explained with the help of following diagram:
In above diagram, quantity of labour (L) shown on x-axis and the quantity of capital (C) is shown on y-axis IP, IP, IP; and IPA are identical product lines. These lines represent equal increase in the quantity of production but increase in the quantity of labour and capital to get this increase in continuously increasing. In other words, increase in the quantity of factors of production. This stage is known as the stage of decreasing returns to scale.
Simultaneous Presentation of All the Three Returns to Scale. Three returns to scale are not contrary to ecah other, they are closely inter-related.
These returns to scale, explain three different stages of production. All the stages apply in all the spheres of production. At the initial stage of production, increasing returns to scale applies, then comes the constant returns to scale and at the ultimate stage of production, decreasing returns to scale annlies. However, the duration for which each of these will apply cannot be ascertained. Such inter-relationship between these returns to scale can be explained with the help of following diagram :
In above diagram, quantity of labour (L) is shown on x-axis and the quantity of capital (C) is shown on y-axis. IP, IP, and IP: represent increasing returns to scale which applies at the initial stage of production IP4, IPs, and IP represent constant returns to scale. IP, IP, and IP, represent decreasing returns to scale which applies at the last stage of production.
Internal Economies are internal to a firm when it expands its size or increases its output. They are open to a single factory or a single firm independently. Modern economists distinguish it as Real Internal Economies. These real internal economies are associated with a reduction in the physical quantity of inputs, raw materials, various types of labour and various types of capital (fixed or circulating) used by a large firm.
External Economies are external to a firm which are available to it when the output of the whole industry expands. They are shared by a number of firms or industries when the scale of production in any industry or group of industries increases. They are not monopolised by a single firm when it grows in size, but are conferred on it when some other firms grow larger. Modern economists distinguish it as Real External Economies. According to Prof. Jacob Viner. these occure to firm in an industry due to Technological and Information influences.
