Q.1Discuss the law of variable proportions. Use a diagram.

Ans.:

(a) Statement of law. The law of variable proportions examines input-output relationship when output is increased by varying the quantity of one factor (variable input) while other factors are kept constant. According to this law, if more and more units of a variable factor are employed with fixed factors, total product (TP) increases at an increasing rate in the beginning, then increase at a diminishing rate and finally starts falling.

(b) Tabular and diagrammatic presentation of law. The law of variable proportion can be illustrated with the help of the following imaginary schedule. In this example we have assumed use of two factors in which land is the fixed factor and labour is a variable factor. The table shows successive application of variable factor (labour) to the fixed factor (land) and the corresponding changes in output.

Land

(Acre)No. of

labourersTP

(quintal)AP

(quintal)MP

(quintal)

1

1

1

1

1

1

1

1

10

1

2

3

4

5

6

7

80

2

6

12

16

18

18

14

80

2

3

4

4

3.6

3

2

1(2

4 Phase I

6

4

2 Phase II

0

(4

(6 Phase III

(c) Three stages (phases) of law. The following three phases are noticed in the relation between variable factor and the physical output as more and more units of variable factor (labour) are employed to a given quantity of fixed factor (land).

Phase I. TP increases at an increasing rate. In other words, MP rises. In phase I covers from origin to point R where AP is maximum and also AP = MP. In this phase both MP and AP increase. TP curve rises from point A to point B in the same way as TP increases at an increasing rate. When more and more units of variable factor are applied to fixed factors, the underutilized fixed factors get fully utilized raising MP of variable factor. Thus the firm is moving towards optimum combination of factor of production and thereby getting increasing returns.

Phase II. TP increase at a diminishing rate., i.e., MP falls but remains positive (+). This phase covers from point R (where AP is maximum) to point S (where MP = 0). In this phase TP rises but at a diminishing rate like TP curve from point B to point C. Remember, TP is maximum when MP = 0. During this phase which is called the phase of diminishing returns, both MP and AP fall. A rational firm tries to operate in this phase.

Phase III. TP starts declining., MP becomes negative ((). Its reason is that quantity of variable inputs become too heavy to be handled by quantity of fixed factors. This stage starts from point S (where MP = 0 and TP is maximum) and covers whole range of negative marginal product. TP starts falling and as a result slope of TP curve become negative.

In short, three stages of production (i) increasing returns, (ii) diminishing returns, and (iii) negative returns are noticed when in production more and more units of a variable factor are applied to a given quantity of fixed factors.

(d) Assumptions of law. The law operates on the basis of following assumptions or pre-conditions.

(i) Technique of production does not change. The law will not apply if there is improvement in technology. (ii) Different quantities of one factor can be varied / combined with fixed factors. It is possible to change the factor-proportions. (iii) All units of a variable factor are equally efficient. (iv) Factors of production are not perfect substitutes. (v) There is short period of operation.

(e) Reasons for operation of the law.

(1) Main reasons for increasing returns are:

1. Realisatin of optimum combination of factors. Among different combination of factors of production, there is one optimum combination which gives maximum production with given resources. Moreover better coordination among factors result in increasing returns.

2. Specialization resulting from division of labour increases efficiency which helps in getting increasing returns, i.e., MP goes on rising till it achieves maximum production with given inputs.

3. Full utilization of fixed factor. When we go towards this optimum, we get increasing returns because the underutilized fixed factors (like machinery, building) are better and more fully used. In other words, factor proportion becomes more suitable for production.

4. Volume discounts. It is the discount on price when raw material in large quantity is purchased.

(2) Reasons for diminishing returns are (i) Use beyond optimum capacity (This makes fixed factor proportion unsuitable and inadequate for increased quantity of variable factor.) (ii) Lack of perfect substitution between factors. (iii) Fall in quantity of fixed factors inputs per unit of variable factor inputs, and (iv) Scarcity of factors.

Q.2Discuss law of returns to scale.

Ans.:(a) Law of Returns to Scale1. Meaning. Return to scale explains the behaviour of output when quantities of all the inputs are changed in the same proportion.

2. Three stages of Returns to Scale. When all the inputs are increased in the same proportions, the following three types of situations in output are observed.

(i) Increasing Returns to Scale. It occurs when output increases by a greater proportion (say, by 120%) than the proportion of increase (say, by 100%) in all the inputs.

(ii) Constant Returns to Scale. It happens when output increases by the same proportion (say by 100%) as that of increase (say, by 100%) in inputs.

(iii) Diminishing Returns to Scale. It occurs when output increases by a lesser proportion (say, by 80%) than the proportion of increase (say, by 100%) in inputs.

3. Tabular and diagrammatic presentation. The above mentioned three stages of returns to scale are further clarified with the help of an imaginary following table, presuming that the firm is employing only two factors, namely, labour and capital (machines). Labour is measured in man-hours, capital in machine-hours and the commodity in metres. It is presumed that units of different factors are homogeneous and equally efficient. According to the following table, units of labour and 1 unit of machine produce 200 metres of cloth in the beginning.

Sr. No.Scale of inputsTotal product

(mts)Marginal product

(mts)

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.Increasing Returns

2 labourers + 1 machines

4 labourers + 2 machines

6 labourers + 3 machines

Constant Returns

8 labourers + 4 machines

10 labourers + 5 machines

12 labourers + 6 machines

Diminishing Returns

14 labourers + 7 machines

16 labourers + 8 machines

18 labourers + 9 machines

20 labourers + 10 machines200

500

900

1400

1900

2400

2800

3100

3300

3400200

300

400

500

500

500

400

300

200

100

We shall now translate the above schedule in the following diagram:

Q.3Write note on the Internal and external economies.

Ans.:Meaning of Economies. Modern economists have explained increasing returns to scale in terms of internal and external economies, which a firm enjoys on expansion of its scale of production. Economies are the advantages or the benefits which a firm gets by expanding its scale of production. When a firm expands its scale of production from small scale to large scale and yet larger scale, the firm experiences the following internal and external economies (benefits) of production leading to increasing returns.

1. Internal Economies. These refer to the advantages which accrue to a firm when it expands size (scale) of production by employing more units of all the factors. These benefits are confined and specific to the individual firm arising from individual efforts. These economies increase efficiency and productivity and thus they become cause of increasing returns to scale. Internals economies are as under:

(i) Technical economies involving use of specialized machinery and division of labour. Economies from process-based division of labour and specialization increase productivity of labour.

(ii) Managerial economies involving delegation of duties and functional specialization in management.

(iii) Marketing economies in purchase of raw materials at a lower price and sale of manufactured goods at higher prices.

(iv) Financial economies involving availability of more loan facilities at lower rate of interest.

(v) Risk bearing economies involving diversification of output, markets and sources of supply.

Mind, internal economies and increasing returns cannot continue indefinitely. They are available till optimum combination of factors of production, after which internal economies give place to diseconomies resulting in diminishing returns.

2. External Economies. These refer to those economies or general advantages which are enjoyed by all the firms in a locality or as a result of growth of industry as a whole. These accrue to a firm as a result of expansion in the output of the whole industry. They are external in the sense that they accrue to a firm not because of internal situation but from outside. Since these advantages arise due to localisation of industry or development of a particular locality, these are available to all the firms in a locality and industry. Again whereas internal economies arise to large scale firms only, external economies are available to both large and small scale firms. But effect of both is the same, i.e., output increases and cost of production falls. When an industry is localized or an area is developed the following external economies appear:

(i) Transport facilities become available. Roads and railways are built. (ii) Communication facilities in the form of post and telegraph office, internet etc. are also available. (iii) specialized labour become available. (iv) Services of banks, warehouses, insurance companies are available. (v) Subsidiary industries spring up in the neighbourhood. (vi) Low price for bulk buying of raw material. All these economies of localisation add to the productivity and bring increasing returns to a firm. It should be kept in mind that economies are not operative forever. They operate only to the extent of optimum level of production.

Diseconomies. These are disadvantages arising from expansion of scale of production beyond optimum capacity. When a firm extends production beyond the optimum combination of factors or beyond the level of optimum output, it becomes too big to manage with same efficiency as before. As a result, following diseconomies replace economies giving rise to diminishing returns to scale.

(i) Beyond a certain stage, management and coordination becomes difficult. The firm faces increased problems and complexities of large scale management.

(ii) Use of machinery and equipment beyond its optimum capacity reduces efficiency of capital goods. This is called technical diseconomy.

(iii) Beyond a point, a firm may be compelled to buy raw materials at a higher cost; pay higher wages to attract more labour; confront non-availability of sufficient fuel and power; face financial problems and traffic problems.

(iv) Again beyond a certain limit, factor of production cannot be substituted for each other, i.e., beyond the optimum limit, the factors become imperfect substitutes.

All these diseconomies of large scale production lead to diminishing returns.

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