Laws of Production Function

7/24/2019 Laws of Production Function

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Fundamental Laws of ProductionFunction

Law of Variable Proportion:

The law of variable proportion or law of Diminishingmarginal return. The law of variable proportion is the

study of short run production function with somefactors xed and some factors variable.

Law of Returns of Scale:

The law of returns to scale describes the relationshipbetween output and the scale of inputs in the long-runwhen all the factor inputs are increased or decreasedin the same proportion.



Law of Variable Proportion

• t states that when total output orproduction of a commodity isincreased by adding units of avariable input! while the "uantities ofother inputs are held constant! the

increase in total production becomes!after some point! smaller andsmaller.



Assumptions of the law

• The state of technology remainsconstant

• #nly one factor input is variable andother factors are $ept constant

• The product is measured in physicalunits

• t assumes a short-run situation% inthe long-run all productive factorsare variable.



Units of Labour Total Product Marginal Product Average Product

1 2 2 2

2 6 4 3

3 12 6 4

4 16 4 4

5 18 2 3.6

6 18 0 3

7 14 -4 2

8 8 -6 1





I stage: Increasing Returns

• n this stage! TP rises from &ero! at an increasingrate upto point '. (eyond '! TP continuous to riseat a decreasing rate! as the marginal product fallsbut it is positive.

• The point ' where the TP stops increasing at anincreasing rate and starts increasing at adiminishing rate is called the point of in)exion. 'tthis point! the *P is at the maximum.

• The maximum on the 'P curve is (+! where itcoincides with the *P curve. Thus stage refers tothe increasing stage where the TP and 'P areincreasing and *P is positive.



I stage: IncreasingReturns

• ,pecialisation and Division of labour

• ndivisibility of factors The factors employed in theproduction process are indivisible! i.e. they cannot bedivided into smaller parts! when more units of thevariable factor are combined with the xed factorsli$e land and machinery! returns are increasing

• To maximise the prot! the producer can continue toincrease the variable factor as long as the 'P isincreasing.



II stage: DecreasingReturns

• n the second stage! the total product continuousto increase but at diminishing rate until itreaches a point *! where it complete stops toincrease any further.

• The second stage shows decreasing 'P and *Pof labour but they are positive. hen TP achieveits highest level at *! *P falls to &ero.

• The second stage is the stage of diminishingreturns.



II stage: DecreasingReturns

• #ptimum use of xed factor /eturnsstart diminishing when the xed factor!land! is fully utili&ed in relation to labour

employed on it.

• Lac$ of perfect substitution between

factors The factors of production cannotbe substituted to any extent! that ma$esthe returns diminishes after a point.



III stage: Negative Returns

• n this stage! the TP declines andtherefore the 'P decreases stillfurther. *P falls faster than 'P andbecomes negative.



Which is a est Phase!Stage"Law of Variable Proportion

• ' rational producer will not choose to produce in stage where the *P of the xed factor is &ero. ,o stage is notrational.

•

n the stage ! though the producer is faced with increasingreturns! yet the producer can increase his prot byswitching to ,tage in which the total product is stillrising.

• ,imilarly ,tage is irrational. n this stage! the producerwill be incurring the greater cost as he is utilising morevariable factor but is simultaneously receiving less returnsbecause each additional unit of variable input results indecline in total output. Labourer wor$s to reduce revenue.

This is irrational.



Law of Returns to Scale

• The law of returns to scale describes therelationship between variable inputs andoutput when all the factor inputs areincreased in the same proportion.

• /eturns to scale answer the "uestion flabor! capital! and other inputs increase by

the same proportion 0say 12 percent3 doesoutput increase by more than! less than! ore"ual to this proportion 0more than 12percent! less than 12 percent! or exactly 12

percent34




/eturns to scale can ta$e one of three forms

• ncreasing returns to scale

• Decreasing returns to scale

• 5onstant returns to scale

• ncreasing /eturns to ,cale This occurs if aproportional increase in all inputs results in a

greater than proportional increase in totaloutput6production. n other words! a 12 percentincrease in labour! capital! and other inputs!results in greater than 12 percent increase in

production.




• Decreasing /eturns to ,cale Thisoccurs if a proportional increase in allinputs results in a less than

proportional increase in totaloutput6production. n other words! a12 percent increase in labour!

capital! and other inputs! results inless than 12 percent increase inproduction.




• 5onstant /eturns to ,cale Thisoccurs if a proportional increase in allinputs result in an e"ual proportional

increase in production. n otherwords! a 12 percent increase inlabour! capital! and other inputs!

result in an e"ual 12 percentincrease in production.




• ,uppose! for example! The /oyal 7neld ndustry

employs 1!222 wor$ers in a 8!222 s"uare footfactory to produce 1 million *otor 5ycles eachmonth. hat happens to production if the scale ofoperation expands to 9!222 wor$ers in a 12!222s"uare foot factory--a doubling of the inputs.

• f production increases to exactly 9 million *otor5ycles! twice the original "uantity! then The /oyal7neld ndustry has ::::::::::::::. f productionincreases by more than 9 million *otor 5ycles!

then The /oyal 7neld ndustry has ::::::::::::.'nd if production increases by less than 9 million*otor 5ycles! then The /oyal 7neld ndustry has ::::::::::::.




• ncreasing returns to scale is due to economies ofscale which mean that long-run average costdecreases! corresponding to increasing returns toscale in terms of production.

• Decreasing returns to scale is due to diseconomies ofscale which mean that long-run average costincreases! corresponding to decreasing returns to

scale in terms of production.

• 5onstant returns to scale for production terms resultswhen long-run average cost neither increases nordecreases.



Increasing Returns to Scale

•

hen the rm needs to increase itsproduction! it needs to vary the all factorinputs. The rm would need to buy moreland! capital! enterprise and labour% that

is increase all of the factors of production!which is only possible in the long run.

•

's the rm increases in si&e! it willachieve increasing returns to scale due tothe economies of scale.



7conomies of ,cale

• 7conomies of scale are a $ey advantage for abusiness that is able to grow.

•

*ost rms nd that! as their production outputincreases! they can achieve lower costs per unitproduced.

• 7conomies of scale are the cost a#vantages that a business can exploit by e$pan#ing theirscale of pro#uction in the long%run& The e;ectof economies of scale is to reduce the average0unit3 costs of production in the long-run.



7xternal 7conomies of ,cale

•

External economies of scale include thebenets en<oyed by rms externally as aresult of the development of an industry.

• For example! as an industry develops in aparticular region! an infrastructure oftransport = communications will develop!

which all industry members can benetfrom. ,pecialist suppliers may also enterthe industry and existing rms maybenet from their proximity.



7xternal 7conomies of ,cale

• ,econdly! ban$s and other nancial institutionsmay set up their branches! so that all the rmsin the area can obtain liberal credit facilitieseasily.

• Thirdly! the transport and communicationfacilities may get improved considerably.

Further! the power re"uirements can be easilymet by the electricity boards. Lastly!supplementary industries may emerge to assistthe main industry.



nternal 7conomies

• Internal economies of scale include the

benets en<oyed by rms internally as aresult of the large scale production inthe long-run.

'& (echnical )conomies

• Technical economies are those! which

accrue to a rm from the use of bettermachines and techni"ues of production.'s a result! production increases andcost per unit of production decreases.



Internal )conomies

*& )conomies of the +se of ,%pro#ucts

•

' large rm is in a better position to utili&e the by-products e>ciently and attempt to produce another newproduct. For example! in a large sugar factory! themolasses left over after the manufacture of sugar fromout of the sugarcane can be used for producing power

alcohol by installing a small plant.

-& Labor )conomies

• ' large rm employs a large number of laborers.

Therefore! each person can be employed in the <ob towhich he is most suited. *oreover! a large rm is in abetter position to attract speciali&ed experts into theindustry. Li$ewise! speciali&ation saves time andencourages new inventions. 'll these advantages result

in lower costs of production.



nternal 7conomies

.& /inancial )conomies

•

The credit re"uirements of the big rms can be met fromban$s and other nancial institutions easily. ' large rmis able to mobili&e much credit at cheaper rates. Firstly!investors have more condence in investing money inthe well-established large rms. ,econdly! the shares of

a large rm can be disbursed or sold easily and "uic$ly inthe share mar$et.

0& Ris1 earing )conomies

• ' big rm produces a large number of items and of

di;erent varieties so that the loss in one can be counterbalanced by the gain in another. For example! anndustrial unit in a particular locality is facing a loss! itcan recall its resources from other units6branches! andcan easily overcome the critical situation. Thus!

diversication avoids ?putting all its eggs in one bas$et.@



nternal 7conomies

2& )conomies of Research

•

' large si&ed rm can spend more money on itsresearch activities. t can spend huge sums ofmoney in order to innovate varieties of products orimprove the "uality of the existing products.nnovations or new methods of producing a product

may help to reduce its average cost.

3& )conomies of Welfare

• ' large rm can provide welfare facilities to its

employees such as subsidi&ed housing! subsidi&edcanteens! crAches for the infants of women wor$er!recreation facilities etc.% all these measures havean indirect e;ect on increasing production and at

reducing the costs.



nternal 7conomies

4& 5ar1eting )conomies

• ,ince the large rm purchases itsre"uirements in bul$! it can bargain on its

purchases on favorable terms. t canensure continuous supply of rawmaterials. t is eligible to get concessionsfrom transport companies! ade"uate

credit from ban$s. n terms ofadvertisements cost! it is better placedthan the smaller rms.



Diseconomies of ,cale

1. Marketing Diseconomies

• The expansion of a rm beyond a certain limit mayalso lead to mar$eting problems. /aw materials maynot become available at su>cient "uantities.*oreover! since the rms are operating competitive

world! they have to face sti; cutthroat competitionfrom their rivals. Therefore! extensive advertisingand sales promotion measures may have to beunderta$en and it may ultimately lead to highercosts.

2. Increased risks• 's the si&e of a rm expands! ris$s also may

increase rapidly. f the production manager or salesmanager miscalculates mar$et trends! sales will

su;er which may lead to heavy losses.




3. External diseconomies

• The growth and locali&ation of industriesultimately lead to increased demand for labor!nance! raw materials! power! transport etc. Thus! competition among the various rms

tends to increase the cost per unit. 4. Danger of overproduction

• Large-scale production involves output in large"uantities. f supply outstrips demand! there is

a possibility of mar$et-glut. *ar$et situationwhere the supply of a good or service farexceeds its demand! usually resulting in asubstantial fall in its price.




5. No cordial relationsip

• Paid managers generally manage a largebusiness rm. Therefore! the personal touchand sympathy! which is supposed to existbetween the management and his labourers!

are missed. The hostile attitudes of themanagers and labourers may very well end instri$es and loc$outs.

!. Dependence on foreign markets

• ' large producer has to depend upon foreignmar$ets for his products. (ut dependence ona foreign mar$et is extremely dangerous

during exchange rate volatility.




B. The concentration of similar rms in an area! may

lead to an increase in demand for raw materialsused by the rms. This will cause the prices of rawmaterials to increase. This conse"uently wouldincreases the cost of production in the industry.

C. 's the industry grows! demand for s$illed labormainly needed in the industry increases. age rateswill tend to increase as rms begin to compete forthe services of the s$illed wor$ers.

. Problems of waste disposal may arise. Firms maybe compelled to employed costly waste disposalmethods in order to $eep the area clean.



Diseconomies of scale



7conomies of ,cale

• n conclusion! reduction in cost0average cost3 in the long-run is dueto both internal and external

economies of scale. ncrease in thelong-run average costs is due tointernal and external diseconomies of

scale.

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Laws of Production Function