SASTRA DEEMED UNIVERSITY
SCHOOL OF MANAGEMENT
MGT513 - MANAGERIAL ECONOMICS & PUBLIC POLICY
Unit 3 - Production Function & Market Structure
Production Function: Law of Variable Proportions and Law of Returns to Scale!
Introduction:
In traditional production theory resources used for the production of a product are known as
factors of production. Factors of production are now termed as inputs which may mean the use
of the services of land, labour, capital and organization in the process of production. The term
output refers to the commodity produced by the various inputs.
Production theory concerns itself with the problems of combining various inputs, given the
state of technology, in order to produce a stipulated output. The technological relationships
between inputs and outputs are known as production functions.
Production:
Production in economic, terms is generally understood as the transformation of inputs into out-
puts. The inputs are what the firm buys, namely productive resources, and outputs are what it
sells. Production is not the creation of matter but it is the creation of value. Production is also
defined as producing goods which satisfy some human want. Production is a sequence of
technical processes requiring either directly or indirectly the mental and physical skill of
craftsman and consists of changing the shape, size and properties of materials and ultimately
The Production Function:
The production function expresses a functional relationship between quantities of inputs and
outputs. It shows how and to what extent output changes with variations in inputs during a
specified period of time. In the words of Stigler, “The production function is the name given
to the relationship between rates of input of productive services and the rate of output of
product.
It is the economist’s summary of technical knowledge.” Basically, the production function is a
technological or engineering concept which can be expressed in the form of a table, graph and
equation showing the amount of output obtained from various combinations of inputs used in
production, given the state of technology. Algebraically, it may be expressed in the form of an
equation as
Q =f (L, M, N, К, T)…………. (1)
where Q stands for the output of a good per unit of time, L for labour, M for management (or
organisation), N for land (or natural resources), К for capital and T for given technology, and
refers to the functional relationship.
The production function with many inputs cannot be depicted on a diagram. Moreover, given
the specific values of the various inputs, it becomes difficult to solve such a production function
mathematically. Economists, therefore, use a two-input production function. If we take two
inputs, labour and capital, the production function assumes the form
Q = f (L, K) ….(2)
The production function as determined by technical conditions of production is of two
types:
It may be rigid ox flexible. The former relates to the short run and the latter to the long run.
The Short-Run Production Function:
In the short run, the technical conditions of production are rigid so that the various inputs used
to produce a given output are in fixed proportions. However, in the short run, it is possible to
increase the quantities of one input while keeping the quantities of other inputs constant in
order to have more output. This aspect of the production function is known as the Law of
Variable Proportions. The short-run production function in the case of two inputs, labour and
capital, with capital as fixed and labour as the variable input can be expressed as
Q=f (L,K)
where K refers to the fixed input. … (3)
This production function is depicted in Figure 1 where the slope of the curve shows the
marginal product of labour. A movement along the production function shows the increase in
output as labour increases, given the amount of capital employed K;. If the amount of capital
increases to K, at a point of time, the production function Q = f (L, K 1) shifts upwards to Q =
f (L,K2 ), as shown in the figure.
On the other hand, if labour is taken as a fixed input and capital as the variable input, the
production function takes the form Q =f (KL) …(4)
This production function is depicted in Figure 2 where the slope of the curve represents the
marginal product of capital. A movement along the production function shows the increase in
output as capital increases, given the quantity of labour employed, L2 If the quantity of labour
increases to L2 at a point of time, the production function Q = f (K,L 1) shifts upwards to
Q=f(KL2).
The Long-Run Production Function:
In the long run, all inputs are variable. Production can be increased by changing one or more
of the inputs. The firm can change its plants or scale of production. Equations (1) and (2)
represent the long-run production function. Given the level of technology, a combination of the
quantities of labour and capital produces a specified level of output.
The long-run production function is depicted in Figure 3 where the combination of OK of
capital and OL of labour produces 100 Q. With the increase in inputs of capital and labour to
OK1 and OL1, the output increases to 200 Q. The long-run production function is shown in
terms of an isoquant such as 100 Q.
In the long run, it is possible for a firm to change all inputs up or down in accordance with its
scale. This is known as returns to scale. The returns to scale are constant when output increases
in the same proportion as the increase in the quantities of inputs. The returns to scale are
increasing when the increase in output is more than proportional to the increase in inputs. They
are decreasing if the increase in output is less than proportional to the increase in inputs.
Let us illustrate the case of constant returns to scale with the help of our production function.
Q = (L, M, N, К, T)
Given T, if the quantities of all inputs L, M, N, K are increased n-fold, the output Q also
increases и-fold. Then the production function becomes nQ –f (nL, nM, nN, nK).
This is known as linear and homogeneous production function, or a homogeneous function of
the first degree. If the homogeneous function is of the Kth degree, the production function is
nk.Q = f (nL, nM, nN, nK) If k is equal to 1, it is a case of constant returns to scale; if it is
greater than 1, it is a case of increasing returns of scale; and if it is less than 1, it is a case of
decreasing returns to scale.
Thus a production function is of two types:
(i) Linear homogeneous of the first degree in which the output would change in exactly the
same proportion as the change in inputs. Doubling the inputs would exactly double the output,
and vice versa. Such a production function expresses constant returns to scale,
(ii) Non-homogeneous production function of a degree greater or less than one. The former
relates to increasing returns to scale and the latter to decreasing returns to scale.
The Law of Variable Proportions:
If one input is variable and all other inputs are fixed the firm’s production function exhibits the
law of variable proportions. If the number of units of a variable factor is increased, keeping
other factors constant, how output changes is the concern of this law. Suppose land, plant and
equipment are the fixed factors, and labour the variable factor.
When the number of labourers is increased successively to have larger output, the proportion
between fixed and variable factors is altered and the law of variable proportions sets in. The
law states that as the quantity of a variable input is increased by equal doses keeping the
quantities of other inputs constant, total product will increase, but after a point at a diminishing
rate.
Its Assumption:
The law of diminishing returns is based on the following assumptions:
(1) Only one factor is variable while others are held constant.
(2) All units of the variable factor are homogeneous.
(3) There is no change in technology.
(4) It is possible to vary the proportions in which different inputs are combined.
(5) It assumes a short-run situation, for in the long-run all factors are variable.
(6) The product is measured in physical units, i.e., in quintals, tonnes, etc. The use of money
in measuring the product may show increasing rather than decreasing returns if the price of the
product rises, even though the output might have declined.
The law of variable proportions is presented diagrammatically in Figure. The TP curve first
rises at an increasing rate up to point A where its slope is the highest. From point A upwards,
the total product increases at a diminishing rate till it reaches its highest point С and then it
starts falling.
Point A where the tangent touches the TP curve is called the inflection point up to which the
total product increases at an increasing rate and from where it starts increasing at a diminishing
rate. The marginal product curve (MP) and the average product curve (AP) also rise with TP.
The MP curve reaches its maximum point D when the slope of the TP curve is the maximum
at point A.
The maximum point on the AP curves is E where it coincides with the MP curve. This point
also coincides with point В on TP curve from where the total product starts a gradual rise.
When the TP curve reaches its maximum point С the MP curve becomes zero at point F. When
TP starts declining, the MP curve becomes negative. It is only when the total product is zero
that the average product also becomes zero. The rising, the falling and the negative phases of
the total, marginal and average products are in fact the different stages of the law of variable
proportions which are discussed below.
Three Stages of Production:
Stage-I: Increasing Returns:
In stage I the average product reaches the maximum and equals the marginal product when 4
workers are employed, as shown in the Table 1. This stage is portrayed in the figure from the
origin to point E where the MP curve reaches its maximum and the AP curve is still rising. In
this stage, the TP curve also increases rapidly.
Thus this stage relates to increasing returns. Here land is too much in relation to the workers
employed. It is, therefore, profitable for a producer to increase more workers to produce more
and more output. It becomes cheaper to produce the additional output. Consequently, it would
be foolish to stop producing more in this stage. Thus the producer will always expand through
this stage I.
Causes of Increasing Returns:
1. The main reason for increasing returns in the first stage is that in the beginning the fixed
factors are larger in quantity than the variable factor. When more units of the variable factor
are applied to a fixed factor, the fixed factor is used more intensively and production increases
rapidly.
2. In the beginning, the fixed factor cannot be put to the maximum use due to the non-
applicability of sufficient units of the variable factor. But when units of the variable factor are
applied in sufficient quantities, division of labour and specialization lead to per unit increase
in production and the law of increasing returns operates.
3. Another reason for increasing returns is that the fixed factors are indivisible which means
that they must be used in a fixed minimum size. When more units of the variable factor are
applied on such a fixed factor, production increases more than proportionately. This points
towards the law of increasing returns.
Stage-II: Diminishing Returns:
It is the most important stage of production. Stage II starts when at point E where the MP curve
intersects the AP curve which is at the maximum. Then both continue to decline with AP above
MP and the TP curve begins to increase at a decreasing rate till it reaches point C. At this point
the MP curve becomes negative when the TP curve begins to decline, table 1 shows this stage
when the workers are increased from 4 to 7 to cultivate the given land.
In figure 1, it lies between BE and CF. Here land is scarce and is used intensively. More and
more workers are employed in order to have larger output. Thus the total product increases at
a diminishing rate and the average and marginal product decline. This is the only stage in which
production is feasible and profitable because in this stage the marginal productivity of labour,
though positive, is diminishing but is non-negative.
Hence it is not correct to say that the law of variable proportions is another name for the law
of diminishing returns. In fact, the law of diminishing returns is only one phase of the law of
variable proportions.
Its Causes: The Law in General Form:
But the law of diminishing returns is not applicable to agriculture alone; rather it is of universal
applicability. It is called the law in its general form, which states that if the proportion in which
the factors of production are combined, is disturbed, the average and marginal product of that
factor will diminish.
The distortion in the combination of factors may be either due to the increase in the proportion
of one factor in relation to others or due to the scarcity of one in relation to other factors. In
either case, diseconomies of production set in, which raise costs and reduce output.
For instance, if plant is expanded by installing more machines, it may become unwieldy.
Entrepreneurial control and supervision become lax, and diminishing returns set in. Or, there
may arise scarcity of trained labour or raw material that leads to diminution in output.
In fact, it is the scarcity of one factor in relation to other factors which is the root cause of the
law of diminishing returns. The element of scarcity is found in factors because they cannot be
substituted for one another.
Stage-III: Negative Marginal Returns:
Production cannot take place in stage III either. For in this stage, total product starts declining
and the marginal product becomes negative. The employment of the 8th worker actually causes
a decrease in total output from 60 to 56 units and makes the marginal product minus 4. In the
figure, this stage starts from the dotted line CF where the MP curve is below the A’-axis. Here
the workers are too many in relation to the available land, making it absolutely impossible to
cultivate it.
The Best Stage:
In stage I, when production takes place to the left of point E, the fixed factor is excess in relation
to the variable factors which cannot be used optimally. To the right of point F, the variable
input is used excessively in Stage III. Therefore, no producer will produce in this stage because
the marginal production is negative.
Thus the first and third stages are of economic absurdity or economic nonsense. So production
will always take place in the second stage in which total output of the firm increases at a
diminishing rate and MP and AP are the maximum, then they start decreasing and production
is optimum. This is the optimum and best stage of production.
The Law of Returns to Scale:
The law of returns to scale describes the relationship between outputs and scale of inputs in the
long-run when all the inputs are increased in the same proportion. In the words of Prof. Roger
Miller, “Returns to scale refer to the relationship between changes in output and proportionate
changes in all factors of production. To meet a long-run change in demand, the firm increases
its scale of production by using more space, more machines and labourers in the factory’.
Assumptions:
This law assumes that:
(1) All factors (inputs) are variable but enterprise is fixed.
(2) A worker works with given tools and implements.
(3) Technological changes are absent.
(4) There is perfect competition.
(5) The product is measured in quantities.
Explanation:
Given these assumptions, when all inputs are increased in unchanged proportions and the scale
of production is expanded, the effect on output shows three stages: increasing returns to scale,
constant returns to scale and diminishing returns to scale. They are explained with the help of
Table 2 and Fig. 5.
1. Increasing Returns to Scale:
Returns to scale increase because the increase in total output is more than proportional to the
increase in all inputs.
The table reveals that in the beginning with the scale of production of (1 worker + 2 acres of
land), total output is 8. To increase output when the scale of production is doubled (2 workers
+ 4 acres of land), total returns are more than doubled. They become 17. Now if the scale is
trebled (3 workers + о acres of land), returns become more than three-fold, i.e., 27. It shows
increasing returns to scale. In the figure RS is the returns to scale curve where R to С portion
indicates increasing returns.
Causes of Increasing Returns to Scale:
Returns to scale increase due to the following reasons:
(i) Indivisibility of Factors:
Returns to scale increase because of the indivisibility of the factors of production. Indivisibility
means that machines, management, labour, finance, etc. cannot be available in very small sizes.
They are available only in certain minimum sizes. When a business unit expands, the returns
to scale increase because the indivisible factors are employed to their maximum capacity.
(ii) Specialisation and Division of Labour:
Increasing returns to scale also result from specialisation and division of labour. When the scale
of the firm is expanded there is wide scope of specialization and division of labour. Work can
be divided into small tasks and workers can be concentrated to narrower range of processes.
For this, specialised equipment can be installed. Thus with specialisation, efficiency increases
and increasing returns to scale follow.
(iii) Internal Economies:
As the firm expands, it enjoys internal economies of production. It may be able to install better
machines, sell its products more easily, borrow money cheaply, procure the services of more
efficient manager and workers, etc. All these economies help in increasing the returns to scale
more than proportionately.
(iv) External Economies:
A firm also enjoys increasing returns to scale due to external economies. When the industry
itself expands to meet the increased long-run demand for its product, external economies
appear which are shared by all the firms in the industry.
When a large number of firms are concentrated at one place, skilled labour, credit and transport
facilities are easily available. Subsidiary industries crop up to help the main industry. Trade
journals, research and training centres appear which help in increasing the productive
efficiency of the firms. Thus these external economies are also the cause of increasing returns
to scale.
2. Constant Returns to Scale:
Returns to scale become constant as the increase in total output is in exact proportion to the
increase in inputs. If the scale of production in increased further, total returns will increase in
such a way that the marginal returns become constant. In the table, for the 4th and 5th units of
the scale of production, marginal returns are 11, i.e., returns to scale are constant. In the figure,
the portion from С to D of the RS curve is horizontal which depicts constant returns to scale.
It means that increments of each input are constant at all levels of output.
Causes of Constant Returns to Scale:
Returns to scale are constant due to:
(i) Internal Economies and Diseconomies:
But increasing returns to scale do not continue indefinitely. As the firm expands further,
internal economies are counterbalanced by internal diseconomies. Returns increase in the same
proportion so that there are constant returns to scale over a large range of output.
(ii) External Economies and Diseconomies:
The returns to scale are constant when external diseconomies and economies are neutralised
and output increases in the same proportion.
(iii) Divisible Factors. When factors of production are perfectly divisible, substitutable, and
homogeneous with perfectly elastic supplies at given prices, returns to scale are constant.
3. Diminishing Returns to Scale:
Returns to scale diminish because the increase in output is less than proportional to the increase
in inputs. The table shows that when output is increased from the 6th, 7th and 8th units, the
total returns increase at a lower rate than before so that the marginal returns start diminishing
successively to 10, 9 and 8. In the figure, the portion from D to S of the RS curve shows
diminishing returns.
Causes of Diminishing Returns to Scale:
Constant returns to scale is only a passing phase, for ultimately returns to scale start
diminishing. Indivisible factors may become inefficient and less productive. Business may
become unwieldy and produce problems of supervision and coordination. Large management
creates difficulties of control and rigidities. To these internal diseconomies are added external
diseconomies of scale.
These arise from higher factor prices or from diminishing productivities of the factors. As the
industry continues to expand, the demand for skilled labour, land, capital, etc. rises. There
being perfect competition, intensive bidding raises wages, rent and interest. Prices of raw
materials also go up. Transport and marketing difficulties emerge. All these factors tend to
raise costs and the expansion of the firms leads to diminishing returns to scale so that doubling
the scale would not lead to doubling the output.