Theory Of Production and Law of variable proportions
• In General, Production means, "Any Activity of Making Something Material."
• In Economics, Production means, "Any Economic Activity which is directed to the Satisfaction of the Wants of the People.
• Production means "Creation or Addition of Utility".
- Form Utility
- Place Utility
- Time Utility
• Form Utility
Changing the Form of Natural Resources i.e. Converting the Raw Material into items Possessing Utility.
For Example, Changing the form of a Log of Wood into a Table or Changing the form of Iron into a Machine.
• Place Utility
Changing the Place of Resources from the Place where they are of little or no use to another place where they are of Greater use. Extraction from Earth
• Removal of Coal , Gold etc from Mines & Supplying them to Markets.
Transferring Goods from Where they give little or no Satisfaction to places where utility is more
• Time Utility
Making Available Materials at times when they are not Normally Available.
For Example, Harvested Food Grains are Stored for use till next Harvest. Canning of Seasonal Fruits is undertaken to make them available during off Season.
Factors of Production
- Natural Resources
- • Land
- Human Resources
- • Labour
- • Capital
- • Entrepreneur
Land in Economics does not mean Soil or Earth’s Surface alone but refers to all Free Gifts of Nature which would include Natural Resources, Fertility of Soil, Water, Air, etc.
Characteristics of Land
• Land is a Free Gift of Nature.
• Land is Strictly Limited in Quantity.
• Land cannot be Shifted from one place to another place.
• Properties of Land cannot be Destroyed.
• Land does not Yield any Result unless Human Efforts are employed
• Labour is referred to as "Mental or Physical Exertion directed to Produce Goods or Services ".
• Work done for the Sake of Pleasure or Love does not represent Labour in Economics. Eg. If a Person Sings before his Friends, it will not be Labour as it is done for the Sake of Pleasure.
Characteristics of Labour
• Directly connected with Human Efforts.
• Highly ‘Perishable’
– A Labourer cannot Store his Labour.
• Inseparable from Labourer
• Labour Power differs from Labourer to Labourer
• All Labour is not productive
• Capital is that part of Wealth of an Individual or Community which is used for further Production of Wealth.
• It is a Stock Concept which yields a Periodical Income which is a Flow Concept.
• It is Termed as "Produced Means of Production" or "Man Made Instruments of Production" e.g. Factories, Dams, etc.
• It means a Sustained Increase in the Stock of Real Capital in a Country.
• Also Known as Investment.
• Stages of Capital Formation:
– Mobilization of Savings
• Entrepreneur mobilizes all the Factors of Production i.e. Land, Labour & Capital, Combines in the Right Proportion, Initiates the Process of Production & bears Risk involved in it.
• Also known as "The Organiser"; "The Manager"; "The Risk Taker".
Functions of Entrepreneur
• Initiating a Business Enterprise & Resource Co-Ordination
• Risk Bearing or Uncertainty Bearing
– Financial Risk
– Technological Risk
• It states the relationship between Inputs & Output.
• It defines the Minimum Quantities of various Inputs that are required to Yield a given Quantity of Output under a given State of Technology.
• Capital is a Fixed Factor
• Law of Variable Proportions is applied
• All Variable Factors
• Law of Returns to Scale is applied
Basic Concepts to Law of Variable Proportions
- Total Product
- Average Product
- Marginal Product
Total Product (TP)
• Total Product is the Total Output resulting from the efforts of all the Factors of Production combined together at any Time.
• One Factor kept Constant, Total Product will vary with the Quantity used of the Variable Factor.
• Total Product rises as more & more Units of
Average Product (AP)
• Average Product is the Total Product per unit of the Variable Factor. i.e.
AP = Total Product
Units of Variable Factor
Marginal Product (MP)
• Marginal Product is the Change in Total Product per unit Change in the Quantity of Variable Factor. i.e., Marginal Product if the Addition made to the Total Production by an Additional Unit of Output.
MP = TUn – TUn-1
Relationship Between AP & MP
• Derived from Total Product
• MP > AP, when AP rises as a result of an Increase in Quantity of Variable Input
• MP = AP, when AP is Maximum i.e. MP curve cuts the AP curve at its Maximum
• MP < AP, when AP falls as a result of a Decrease in Quantity of Variable Input
Law of Variable Proportions
• It refers to Input-Output relationship, when the Output is Increased by varying the Quantity of one Input.
• Law Operates in Short-Run when all the Factors of Production cannot be Increased or Decreased.
• Law states that "As we Increase the Quantity of One Input which is combined with other Fixed Inputs, the Marginal Physical Productivity of the Variable Input must eventually Decline.
• The Law of Variable Proportions states that if the Input of one Resource is Increased by equal Increments per unit of Time while the Inputs of other resources are held Constant, Total Output will Increase, but beyond some point the resulting Output Increased will become Smaller & Smaller. By: Leftwitch
• The Law states that an Increase in some Input relative to other Fixed Input will, in a given State of Technology, cause Total Output to Increase; but after a point the extra Output resulting from the same addition of extra Inputs is likely to become Less & Less. By: Samuleson
Assumptions to the Law
• One of the Factor is Variable while all other Factors are Fixed.
• All Units of the Variable Factor are Homogenous.
• State of Technology is Constant.
• Factors of Production can be used in Different Proportions.
Stage of Operation
• A Rational Producer will not Produce in
– Stage 3 as MP of Variable Factor is Negative.
– Stage 1 as Factors of Production are Under- Utilised.
• A Rational Producer will always Produce in Stage 2 where both the Marginal Product & Average Product of the Variable Factors are Diminishing. At which particular Point in this Stage, a Producer will decide to Produce depends upon Prices of Factors
Causes of Applicability of the Law
• Underutilization of Fixed Factor
• Fixed Factors of Production
• Optimum Production
• Imperfect Substitute
Law of Returns to Scale
• It refers to Input-Output relationship, when the Output is Increased by varying the Quantity of All Inputs.
• Law Operates in Long-Run when all the Factors of Production can be Increased or Decreased.
• It is the study of Behaviour of Output in response to Change in Scale i.e. All Factors are Increased or Decreased in Same Proportion.
Constant Returns to Scale
• With the Increase in the Scale in some Proportion, Output Increases in Same Proportion
Increasing Returns to Scale
• With the Increase in the Scale in some Proportion, Output Increases in Greater Proportion
Decreasing Returns to Scale
• With the Increase in the Scale in some Proportion, Output Increases in Smaller Proportion
Economies of Scale of Production
• According to Stigler, "Economies of Scale is Synonym of Returns to Scale".
• When Scale of Production is Increased, up to a Point, One gets Economies of Scale. Thereafter Diseconomies of Scale will follow.
• Increasing Returns to Scale is the result of these Economies.
Internal Economies of Scale
• When a Firm Increases its Scale of Production, it enjoys several Economies which are termed as "Internal Economies".
• According to Cairncross, "Internal Economies are those which are open to a Single Factory, or a Single Firm independently of the action of Other Firms. They result from an Increase in the Scale of Output of a Firm & cannot be achieved unless Output Increases".
Real Economies of Scale
• Real Economies are those associated with a Reduction in the Physical Quantity of Inputs, Raw Materials, Various types of Labour & Various Types of Capital.
• These are of following types:
a) Labour Economies
b) Technical Economies c) Inventory Economies d) Marketing Economies
e) Managerial Economies
f) Transport & Storage Economies
• Labour Economies
Increase in Scale of Production results into the following Economies of Labour:
b) Time Saving
c) New Inventions
d) Automation of Production Process
• Technical Economies
These Economies influence the Size of the Firm. These result from Greater Efficiency of the Capital Goods employed by the Firm. These are of following types:
a) Economies of Increased Dimension
b) Economies of Linked Processes
c) Economies of Use of By-Product
• Inventory Economies
A Large-sized Firm enjoys several types of Inventory Economies such as:
a) Large Stock of Raw Materials
b) Large Stock of Spare Parts & Small Tools As such there is no Fear of Stoppage of Production.
• Marketing Economies
A Large-sized Firm enjoys several types of Marketing Economies such as:
a) Economies on Account of Advertisement
b) Appointment of Sole Distributors & Authorized Dealers
c) Economies on account of Research & Development
All this enables the Firm to Produce Quality Products.
• Managerial Economies
a) Appointment of Efficient & Talented Managers.
b) Decentralization of Task With the Increase in Production, the Management Cost goes on Falling.
• Transport & Storage Economies
a) Own Transportation System
b) Own Storage & Godown Facilities.
With this the Firm is able to Sell its Products at the Opportune Time & at Favourable Price.
Pecuniary Economies of Scale
• Pecuniary Economies are Economies realized from paying Lower Prices for the Factors used in Production & Distribution due to bulk buying by the Firm as its size Increases.
• For Example, Procurement of Raw Material at Low Prices, Concessional Loans from Bank, Large Discounts & Commissions on Advertisement & Publicity of their Products, etc.
External Economies of Scale
• External Economies of Scale refers to all those Benefits & Facilities which are available to all the Firms in a given Industry.
• In the words of Cairncross, "External Economies are those which are shared in by a number of Firms or Industries when the Scale of Production in Industry or Group of Industries Increases. They are not Monopolized by a Single Firm when it grows in Size, but are conferred on it when other Firms grow Larger".
• The following 3 are External Economies:
a) Economies of Concentration b) Economies of Information
c) Economies of Disintegration
Economies of Concentration
• When several Firms of an Industry establish themselves at one place, then they enjoy many benefits together.
• For Example, Availability of Developed means of Communication & Transport, Trained Labour by Products, Development of New Inventions pertaining to that Industry, etc.
Economies of Information
• When the number of Firm in an Industry Increases, then it becomes possible for them to have concerted efforts & collective activities such as Publication of Scientific & Trade Journals providing sundry Information to the Firms of a given Industry.
Economies of Disintegration
• When an Industry develops, the Firms engaged in it Mutually Agree to divide the Production Process among them. Every firm Specializes in the Production of a particular item concerning that Industry.
• It is of Two Types:
– Horizontal Disintegration
– Vertical Disintegration
Diseconomies of Scale
• When a given percentage Increase in all the Factors causes less than proportionate Increase in Output after a point, is referred to as Diseconomies of Scale. i.e. Increase in Scale beyond the Optimum level, results in Diseconomies of Scale.
• It is of Two kinds:
– Internal Diseconomies
– External Diseconomies
Internal Diseconomies of Scale
• These Diseconomies arise when a given Firm Increases its Scale of Production beyond a certain Point.
• These do not affect the entire
• These arise because of 2 reasons:
a) Unwieldy Management
b) Technical Difficulties
External Diseconomies of Scale
• These Diseconomies are suffered by all the Firms in an Industry irrespective of their Scale of output.
• For Example, when many Firms are localized at a particular place, then it becomes difficult for Means of Transport to cope up with the additional burden of Traffic, and hence Transport Costs go up.
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