Production

Law of variable proportion

• Law of variable proportions occupies an important
place in economic theory. This law examines the
production function with one factor variable, keeping
the quantities of other factors fixed.
• When the quantity of one factor is increased keeping
the quantity of the other factors constant, the
proportion between the variable factor and the fixed
factor is altered; the ratio of employment of the
variable factor to that of the fixed goes on increasing
as the quantity of the variable factor is increased also.
• According to this law when one factor increases, other factors held constant, after a
point, marginal returns to the variable factor diminishes, hence also known as law
of diminishing returns.
Assumptions of the Law
1) the state of technology is assumed to be given and unchanged.
2) there must be some other inputs such as capital must be 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.
Illustration
 Three Stages of Production

Stage 1
• In this stage, total product increases at an increasing rate to a point and ends where
the average product curve reaches its highest point. Stage 1 is called by some
economists as the stage of increasing returns because average product of the variable
factor increases throughout this stage.
Stage 2
• In stage 2, the total product continues to increase at a diminishing rate until it reaches
its maximum point H where the second stage ends. In this stage, both the marginal
product and average product of the variable factor are diminishing but are positive. At
the end of the second stage, that is, at point M marginal product of the variable factor
is zero (corresponding to the highest point H of the total product curve.
• This stage is known as the stage of diminishing returns as both the average and
marginal products of the variable factor continuously fall during this stage.
 Three Stages of Production

Stage 3
In stage 3, total product declines and therefore the total product curve TP
slopes downward. In this stage, variable factor is too much relative to the
fixed factor. This stage is called the stage of negative returns, since the
marginal product of the variable factor is negative during this stage.
The Stage of Operation
• 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 variable factor. It is thus
clear that a rational producer will never be producing in stage 3.
• 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 utilizing fully
the opportunities of increasing production by increasing quantity of the
variable factor whose average product continues to rise throughout the
stage 1.
• So, a rational producer will operate in second stage.
 Causes of varying returns to variable factor

Causes of Initial Increasing Marginal Returns to a Variable Factor

• In the beginning, the quantity of the fixed factor is abundant relative to
the quantity of the variable factor. Therefore, when more and more units
of the variable factor are added to the constant quantity of the fixed
factor, then the fixed factor is more intensively and effectively utilized,
that is, the efficiency of the fixed factor increases as additional units of the
variable factors are added to it. This causes the production to increase at a
rapid rate.
Causes of Diminishing Marginal Returns
Once the point is reached at which the amount of the variable factor is
sufficient to ensure the efficient utilization of the fixed factor, further
increases in the variable factor will cause marginal and average products
to decline because the fixed factor then becomes inadequate relative to
the quantity of the variable factor. In other words, the contributions to the
production made by the variable factor after a point becomes less and less
because the additional units of the variable factor have less and less of the
fixed factors to work with.
 Three Stages of Production

Causes of Negative Marginal Returns

The negative marginal returns to the variable factor is due to the fact that
the amount of the variable factor becomes excessive relative to the fixed
factor so that they get in each other’s way with the result that the total
output falls instead of rising.
 Law of Returns to Scale
• In the long run all factors of production are variable. No factor is fixed.
Accordingly, the scale of production can be changed by changing the
quantity of all factors of production.
• “The term returns to scale refers to the changes in output as all factors
change by the same proportion.”
• “Returns to scale relates to the behaviour of total output as all inputs are
varied and is a long run concept”.
• Types:
• 1. Increasing Returns to scale.
• 2. Constant Returns to Scale
• 3. Diminishing Returns to Scale
Change in Factor Proportion and Scale
• As we move towards right on the line ST, the
amount of labour varies while the amount of
capital remains fixed at OS, this is known as
change in factor proportion. Same is true along
GH, where Labour is fixed and capital is being
varied.
• along the line OP the inputs of both the
factors, labour and capital, vary
proportionately, with ratio between the two
factors remaining the same throughout, this is
known as change in scale.
• If any other straight line through the origin
such as OQ or OR is drawn, it will show, like the
line OP, the changes in the scale but it will
represent a different given proportion of
factors which remains the same along the line.
•
 CONSTANT RETURNS TO SCALE
• If we increase all factors (i.e., scale) in a
given proportion and the output increases
in the same proportion, returns to scale are
said to be constant. Thus, if a doubling or
trebling of all factors causes a doubling or
trebling of output respectively, returns to
scale are constant.
• It will be seen from the figure that
successive isoquants showing equal
increments in output are equidistant from
each other along each straight line drawn
from the origin. Thus, along the line OP, AB
= BC = CD, and along the line OQ, A′ B′ = B′
C′ = C′ D′ and along the ray OR, A′′ B′′ = B′′ C
′′ = C′′ D′′. The distance between the
successive isoquants being the same along
any straight line through the origin, means
that if both labour and capital are
increased in a given proportion, output
expands by the same proportion.
•
INCREASING RETURNS TO SCALE
Increasing returns to scale means that output
increases in a greater proportion than the
increase in inputs. If, for instance, all inputs are
increased by 25%, and output increases by 40%,
then the increasing returns to scale will be
prevailing. When a firm expands, the increasing
returns to scale occur at least in the initial
stages.
• When increasing returns to scale occur, the
successive isoquants representing equal
increments in output will lie at successively
smaller distances along a straight line ray OR
through the origin. In Fig. 19.17 the various
isoquants Q1, Q2, Q3, are drawn which
represent 100, 200 and 300 units of output
respectively. It will be seen that distances
between the successive isoquants decrease as
we expand output by increasing the scale. Thus,
increasing returns to scale occur since AB < OA
and BC < AB which means that equal increases
in output are obtained by successively smaller
increments in inputs.
•
 DECREASING RETURNS TO SCALE
• when output increases in a smaller proportion
than the increase in all inputs, decreasing
returns to scale are said to prevail. When a firm
goes on expanding by increasing all its inputs,
eventually diminishing returns to scale will
occur.
• When the firm has expanded to a too gigantic
size, it is difficult to manage it with the same
efficiency as previously. For example, managing
a large number of workers and coordinating the
activities of several divisions of the firm is quite
difficult and results in decline in productivity of
inputs used.
• The case of decreasing returns to scale can be
shown on an isoquant map. When successive
isoquants representing equal increments in
output lie at progressively larger and larger
distance on a ray through the origin, returns to
scale will be decreasing. In Fig. 19.18
successively decreasing returns to scale occur
since AB > OA, and BC > AB. It means that more
and more of inputs (labour and capital) are
required to obtain equal increments in output.
 Economies of Scale

• Economies of scale refer to the cost advantage experienced by a firm when it

increases its level of output. The advantage arises due to the inverse relationship
between the per-unit fixed cost and the quantity produced. The greater the
quantity of output produced, the lower the per unit fixed cost.
• Economies of scale also result in a fall in average variable costs (average non-
fixed costs) with an increase in output. This is brought about by operational
.
efficiencies as a result of an increase in the scale of production

Effects of Economies of Scale on Production Costs

• It reduces the per-unit fixed cost. As a result of increased
production, the fixed cost gets spread over more output than
before.
• It reduces per-unit variable costs. This occurs as the expanded scale
of production increases the efficiency of the production process.
•
 Economies of Scale

Types of Economies of Scale

1. Internal Economies of Scale
• This refers to economies that are unique to a firm. For instance, a firm
may hold a patent over a mass production machine, which allows it to
lower its average cost of production more than other firms in the industry.

2. External Economies of Scale

• These refer to economies of scale enjoyed by an entire industry. For
instance, suppose the government wants to increase steel production. In
order to do so, the government announces that all steel producers who
employ more than 10,000 workers will be given a 20% tax break.
• Thus, firms employing less than 10,000 workers can potentially lower
their average cost of production by employing more workers. This is an
example of an external economy of scale – one that affects an entire
industry or sector of the economy.
 Economies of Scale

Sources of Economies of Scale

1. Purchasing
• Firms might be able to lower average costs by buying the inputs required
for the production process in bulk or from special wholesalers. By
negotiating with suppliers for volume discounts, the purchasing firm takes
advantage of economies of scale.
2. Managerial
• Firms might be able to lower average costs by improving the management
structure within the firm. The firm might hire better skilled or more
experienced managers.
3. Technological
• A technological advancement might drastically change the production
process. For instance, fracking completely changed the oil industry a few
years ago. However, only large oil firms that could afford to invest in
expensive fracking equipment could take advantage of the new
technology.
4.Financial
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 Diseconomies of Scale

• Diseconomies of scale occur when an additional production unit of output

increases marginal costs, which results in reduced profitability. Instead of
production costs declining as more units are produced (which is the case with
economies of scale), the opposite happens, and costs increase with the production
of each additional unit.
Causes of Diseconomies of Scale
1. Communication Breakdown
Communication is important in any organization, especially in managing economies of
scale. A communication breakdown could be the beginning of diseconomies of
scale and have far-reaching adverse effects on the business. During the growth
process in any entity, an efficient communication channel is vital in the proper
running of the business.
2. Reduced Motivation
• As the business grows, the employee base increases, which can make them feel
isolated and thus less motivated. A small business employs a few individuals with a
personal connection to the business and a close working relationship with the
owner and management. A large workforce with less interaction with the top
management can easily lose focus, leading to reduced profitability and
diseconomies of scale.
 Diseconomies of Scale

• 3. Lack of Coordination and Loss of Direction

• As an entity grows in size, it becomes harder to coordinate the employees
who, in turn, lose direction and motivation. Many employees are used to a
routine, and face the risk of losing motivation and interest in improving
the profitability of the business. Managers and supervisors also
experience a hard time organizing operations and ensuring that everyone
is playing their part effectively.
• Businesses will be forced to hire or promote more supervisors to oversee
the increased operations and monitor the performance of employees. The
move will result in increased costs as the company gears towards
optimizing its operations.
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