Law of Supply
Under the ceteris paribus assumption, the law of supply may be stated as follows:
“Other things remaining unchanged, the supply of a commodity expands (rises)
with a rise in its price, and contracts (falls) with a fall in its price.”
Limitations of Law of Supply:
•. Cost of Production.
•2. Technique of production.
•3. Natural Factors.
•4. Government Policies.
•5. Transport Facilities.
•6. Business combines.
•7. Goals of firms
•8. Price of that commodity
•9. Prices of related commodities
•10. Expectations of future level of prices.
Explicit Costs & Implicit Costs.
•Explicit costs are direct contractual monetary payments incurred through market
•Explicit costs are usually costs shown in the accounting statements and include costs of
raw materials, wages and salaries, power and fuel, rent, interest payments of capital
invested, Insurance, Taxes and duties, Misc. expenses such as selling, transport,
advertising & sales promotional expenses.
•Implicit costs are the opportunity costs of the use of factors which a firm does not
buy or hire but already owns.
•Implicit costs include
•Wages of labour rendered by the entrepreneur himself.
•Interest on capital supplied by him.
•Rent of land and premises owned by the entrepreneur and used for production.
•Normal returns or profits of entrepreneur as compensation for his management and
Law of Variable Proportions.
•Prof. Benham states the law as follows:
•“As the proportion of one factor in a combination of factors is increased after a
point, the average and marginal production of that factor will diminish”.
•G. J. Stigler:
•“As equal increments of one input are added, the inputs of other productive
services being held constant, beyond a certain point the resulting increments of
product will decrease, i.e. the marginal product will diminish.”
•The law is summarised thus:
•In the short run, as the amount of variable factors increases, other things
remaining equal, output (or the returns to the factors varied) will increase more
than proportionately to the amount of variable inputs in the beginning, then it may
increase in the same proportion and ultimately it will increase less proportionately”.
The conditions underlying the law are :
Only one factor is varied; all other factors remain constant.
The scale of output is unchanged and production capacity remains constant.
Technique of production is unchanged.
All units of factor input varied, are homogeneous – all units have identical efficiencies
All factors of production cannot be substituted for one another.
Law of Diminishing Marginal Returns
Marshall stated this law as follows:
“An increase in capital and labour applied in the cultivation of land causes in general a
less than proportionate increase in the amount of produce raised, unless it happens to
coincide with an improvement in the arts of agriculture.”
In the initial stages of cultivation of a given piece of land, perhaps due to under-
cultivation of land, when additional units of capital and labour are invested, additional
output may be more than proportionate. But after a certain extent when the land is
cultivated with some more investment, the additional output will be less than
proportionate under all normal circumstances, unless some improvements take place in
the methods of techniques of cultivation.
The law is applicable to all fields of production such as industry, mining, house
construction, besides agriculture.
Assumptions of the Law of Diminishing Marginal Returns
•The law of diminishing marginal returns holds good subject the following two
•1. Same technology is used throughout the process of production. Whatever change
takes place in the proportion of factor inputs is within the scope of available methods and
•2. Units of different factor inputs are perfectly homogeneous; every unit is of equal
efficiency and therefore, are interchangeable with any other factor input in the production
•Stage I – The law of diminishing returns becomes evident in the marginal product line.
Initially the marginal product of the variable input (labour) rises. The total product rises
at an increasing rate (=marginal product). Average product also rises. This is the stage of
•Stage II – Reaching a certain point, the marginal product begins to diminish. Thus, the
rate of increase in the total output slows down. This is the stage of diminishing returns.
When the average product is maximum, the average product is equal to the marginal
•Stage III – As the marginal product tends to diminish, it ultimately becomes zero and
•When the marginal product becomes zero, the total product is the maximum. Thus when
marginal product becomes negative, the total product begins to decline in the same
proportion. Even though AP is decreasing, it does not become negative immediately.
THE PRODUCT CURVES
Stage I Stage II Stage III
O Units of Variable Factor (LABOUR) MP X
Explanation of the three stages:
The operation of the law of diminishing returns in the three stages is attributed to two
fundamental characteristics of factors of production.
1. Indivisibility of certain fixed factors – a factor like machinery will be underutilized
when only a few units of a variable input like labour are applied.
2. Imperfect substitutability between factors.
Increasing Returns: The combination of fixed and variable factors tends to be near
optimum. Thus the resultant output tends to be in greater proportion to the increase in
variable factor units. This is also attributed to managerial efficiency. Increasing returns
will be noticeable only if fixed factors are Indivisible, while variable factors are
obtainable in small units.
Diminishing Returns: The marginal product decreases because a given quantity of fixed
factors, is combined with larger and larger amounts of variable factors. So there is a
disproportional of factor Inputs causing diminishing returns.
Negative Returns: Having reached the maximum production capacity, when the input of
variable factor employed in much in excess in relation to the fixed components, resulting
in negative returns. E.g. Excessive use of chemical fertilizers in a farm. Employment of
more and more labour after full capacity of machine is reached
Total Product, Average Product, Marginal Product
•Total Product: Total number of units produced per unit of time by all factor inputs in
referred to as total product. In the short run, since Total Product (output)(TP) increases
with an increase in the Quantity of Variable Factor (QVF), TP = f(QVF).
•Average Product: Average Product refers to the total product per unit of the given
variable factor. AP = TP/QVF
•Marginal Product: Owing to the addition of a unit to a variable factor, all other factors
being held constant, the addition realised in the total product is technically called
»MPn = TPn – TPn-1
Relationship between Marginal Cost and Average Cost
•1. When Average Cost is minimum, Marginal cost is equal to Average Cost.
MC curve intersects at the minimum point of ATC curve.
•2. When MC curve is below AC curve, marginal cost is less than average cost, and the
•3.When the MC curve is above AC curve, marginal cost is more than average cost, the
A firm is faced with a number of uncertainties
Demand (consumer behavior)
Nature of competition (related to product or price or both) product competition is
Cost (no control over wages, raw materials, Indirect taxation)
Technology (continuous improvements make products obsolete)
Unless a firm is prepared to face the uncertainties created by these risks, its profits would
be left to chance.
Under such circumstances, a thorough understanding of the relationship of cost, price
and volume is helpful.
Method of determining this relationship is Break-even Analysis.
Limitations of BEA:
1. It is static – In BEA, everything is assumed to be constant. This being a static
condition, is not suited to a dynamic situation.
2. It is unrealistic: It is based on assumptions, which do not hold good in practice.
Linearity of cost and revenue functions are true only for a limited range of output.
3. It has many shortcomings: It regards profit as a function of output only. Ity fails to
consider the impact of technological change, better management, division of
labour, improved productivity and such other factors also influence profits.
4. Its scope is limited to short-run only. It is not suitable for a long-run analysis.
5. It assumes horizontal demand curve with the given price of the product. This is
not so in the case of a monopoly.
6. It is difficult to handle selling costs in the BEA. Selling costs do not vary with
output. They manipulate sales and affect the volume of output.
7. The traditional BEA is very simple. It makes no provision for Corporate Taxes.