Law of Variable Proportions and Law of Returns to Scale

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This presentation puts emphasis on Law of Variable proportion and Law of Returns to Scale It also puts light on production function, cost function, etc.

Text of Law of Variable Proportions and Law of Returns to Scale

  • Done by Amara Bandukada Umme Baba Ayush Parekh Suchit Chauhan Arul Collins A1 Batch
  • Economics is the study of the production and consumption of goods transfer of wealth to produce and obtain those goods. Economics explains how people interact within markets to get what they want or accomplish certain goals.
  • Macroeconomics Macroeconomics contains broader view by analyzing the economic activity of an entire country or the international marketplace. Microeconomics focuses on the actions of individuals and industries, like the dynamics between buyers and sellers, borrowers and lenders. Microeconomics
  • A production function is an equation, table or graph, which specifies the maximum quantity of output, which can be obtained, with each set of inputs. Prof. Richard H. Leftwich states that production function refers to the relationship between inputs and outputs at a given period. (Inputs = resources such as land, labor, capital and organization used by a firm Outputs = goods or services produced by the firm)
  • It is written as Q = F(X1, X2 Xn). Where Q is the maximum quantity of output and X1, X2, Xn are the quantities of the various inputs. If there are only two inputs, labor L and capital K, we write the equation as Q = F(L,K). The concept of production function stems from the following two things: 1. It must be considered with reference to a particular period. 2. It is determined by the state of technology. Any change in technology may alter output, even when the quantities of inputs remain fixed.
  • Total Product : It is the total output or quantity that is produced by a firm using fixed and variable factors at a given point of time. Average Product : It is defined as the product produced per unit of variable input employed when fixed inputs are held constant. Average Product = (Total Product) / (Variable Inputs Employed) Marginal Product : It is defined as the change in total product that comes as a result of a one unit increase in the variable input. Marginal Product = (dTP) / (dVI) (where TP is total product and VI is variable inputs. )
  • Prof. Marshall stated, An increase in the quantity of a variable factor added to fixed factors, at the end results in a less than proportionate increase in the amount of product, given technical conditions.
  • Only one variable factor unit is to be varied while all other factors should be kept constant Different inits of variable factor are homogenous Techniques of production remain constant The law will hold good only short and a given period There are possibilities of varying the proportion of factor inputs.
  • The proportion of variable factors is greater than the quantity of fixed factors. Hence both AP and MP decline. Total output diminishes because there is a limit to the full utilization of indivisible factors and introduction of specialization. Hence Output declines. Imperfect suitability of factor inputs is another cause. Up to certain point substitution is beneficial, once optimum point is reached, the fixed factors cannot be compensated by the variable factor.
  • The law of returns to scale examines the relationship between output and the scale of inputs in the long-run when all the inputs are increased in the same proportion.
  • All the factors of production (such as land, labor and capital) but organization are variable The law assumes constant technological state. It means that there is no change in technology during the time considered The market is perfectly competitive Outputs or returns are measured in physical terms.
  • The law of increasing returns The law of constant returns The law of decreasing returns
  • Unit Scale of Production Total Returns Marginal Returns 1 1 Labor + 2 Acres of Land 4 4 (Stage I - Increasing Returns) 2 2 Labor + 4 Acres of Land 10 6 3 3 Labor + 6 Acres of Land 18 8 4 4 Labor + 8 Acres of Land 28 10 (Stage II - Constant Returns) 5 5 Labor + 10 Acres of Land 38 10 6 6 Labor + 12 Acres of Land 48 10 7 7 Labor + 14 Acres of Land 56 8 (Stage III - Decreasing Returns) 8 8 Labor + 16 Acres of Land 62 6
  • Production function A production function relates physical output of a production process to physical inputs or factors of production Cost function The cost-of-production theory of value is the theory that the price of an object or condition is determined by the sum of the cost of the resources that went into making it. The cost can comprise any of the factors of production (including labor, capital, or land) and taxation.
  • Total Cost Total cost in economics includes the total opportunity cost of each factor of production as part of its fixed or variable costs. The total product (or total physical product) of a variable factor of production identifies what outputs are possible using various levels of the variable input Total Product
  • Average cost Average cost or unit cost is equal to total cost divided by the number of goods produced (the output quantity, Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus average fixed costs (total fixed costs divided by Q) Average product is the per unit production of a firm. Conceptually, it is simply the arithmetic mean of total product calculated for each variable input over a whole range of variable input quantities Average Product
  • Marginal cost Marginal cost is the change in the total cost that arises when the quantity produced has an increment by unit. That is, it is the cost of producing one more unit of a good. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit The marginal product of an input (factor of production) is the extra output that can be produced by using one more unit of the input (for instance, the difference in output when a firm's labor usage is increased from five to six units), assuming that the quantities of no other inputs to production change Marginal product
  • Law of Variable Proportions Short period Only one factor is varied The factor ratio remains changed There are three stages: a) Increasing returns to factor. b) Diminishing returns to factor c) Negative returns to factor Productions is of variable type Long period All factors varied The factor ratio remains unchanged There are three stages: a) Increasing returns to scale b)Decreasing returns to scale c)Constant returns to scale Productions is of constant type Law of Returns to Scale
  • SHORT RUN Short run is defined as a period when production can be increased only with increase in variable factors . LONG RUN Long run is defined as a period which allows the firm to change their sizes and scales to increase output
  • SHORT RUN The short run as the time horizon over which the scale of operation is fixed and the only available business decision is the number of workers to employ. Quantity of labor is variable but quantity of capital and production processes are fixed LONG RUN The long run as time horizon is needed for a producer to have flexibility over all relevant production decisions Long run: Quantity of labor, quantity of capital, and production processes are all variable
  • SHORT RUN In the short run, firms have already chosen whether to be in business and at what scale and technology of production. The number of firms in an industry is fixed LONG RUN In the long run, firms have the flexibility to fully enter or exit an industry. The number of firms in an industry is variable since firms can enter and exit
  • SHORT RUN Firms will produce if the market price at least covers variable costs, since fixed costs have already been paid and, as such, don't enter the decision-making process. Firms' economic profits can be positive, negative or zero. LONG RUN Firms will enter a market if the market price is high enough to result in positive economic profit. Firms will exit a market if the market price is low enough to result in negative economic profit. If all firms have the same costs, firm profits will be zero in the long run in a competitive market
  • It is helpful in understanding clearly the process of production. The law tells us that the tendency of diminishing returns is found in all sectors of the economy . The law tells us that any increase in the units of variable factor will lead to increase in the total product at a diminishing rate.
  • This law may not apply universally to all kinds