2. Laws of Returns
• There are three laws of returns known to
economists:
– Law of Diminishing Returns
– Law of Increasing Returns
– Law of Constant Returns
3. Law of Diminishing Returns
• The law of diminishing returns (also called the Law of
Increasing Costs) is an important law of micro
economics.
• The law of diminishing returns states that:
– "If an increasing amounts of a variable factor are applied
to a fixed quantity of other factors per unit of time, the
increments in total output will first increase but beyond
some point, it begins to decline".
• Richard A. Bilas describes the law of diminishing
returns in the following words:
– "If the input of one resource to other resources are held
constant, total product (output) will increase but beyond
some point, the resulting output increases will become
smaller and smaller”.
4. Operation of Law of Diminishing Returns in Agriculture
• The classical economists were of the opinion that
– the law of diminishing returns applies only to agriculture
and to some extractive industries, such as mining, fisheries
urban land, etc.
• The law was first stated by a Scottish farmer as such.
– It is the practical experience of every farmer that if he
wishes to raise a large quantity of food or other raw
material requirements of the world from a particular piece
of land, he cannot do so.
– He knows it fully that the producing capacity of the soil is
limited and is subject to exhaustation.
– As he applies more and more units of labor to a given
piece of land, the total produce no doubt increases but it
increases at a diminishing rate.
5. Example
Fixed Input Inputs of Variable Total Produce TP Marginal product
Resources (in tons) MP (in tons)
12 Acres 1Labor 50 50
12 Acres 2Labor 120 70
12 Acres 3Labor 180 60
12 Acres 4Labor 200 20
12 Acres 5Labor 200 0
12 Acres 6Labor 195 -5
7. Laws of Variable Proportions
• Law of Diminishing Returns is a misnomer (wrongly applied
name)
• It is only the third stage of one of the basic law i.e. Law of
variable proportions
• This law is also called Law of Proportionality
• This law tells us how the total output or marginal output is
affected by a change in the proportion of the factors used
• Since, the return to the variable factor does not change at
the same rate in all stages, it is also called the Law of Non-
proportional Returns
8. Explanation of Law of VP
• In production process, after a stage, the marginal
return begins to diminish
– It is due to the technological facts underlying the
production of the product in question
– Every industry has its own peculiar set of technical facts.
For example
• Agriculture is dominated by the nature of land
– In agriculture, the MR starts diminishing early
• Manufacturing industry by capital
– In industry, it starts diminishing very late
– Which a wise entrepreneur can altogether avoid
• The Law of Variable Proportion occupies a very
important place in economic theory
– It describes the production function with one variable
factor while the quantities of other factors of production
are fixed
9. Law of VP in words of Economists
• In the word of Stigler
– As equal increments of one input are added, the inputs of other
productive services being held constant, beyond a certain point
the result in increment of product will decrease i.e. the MP will
diminish
• Prof. Samuelson states
– An increase in some inputs relative to other fixed inputs will, in
a given state of technology, cause output to increase; but after a
point the extra output resulting from the same additions of
extra inputs will become less and less
• Prof. Benham also states
– As the proportion of one factor in a combination of factors is
increased, after a point, first the marginal and then the average
product of that factor will diminish
10. Assumptions of the Law of VP
• State of Technology remains unaltered
– It is obvious that improvements in technology are
bound to raise the MP and AP and they will not
diminish
• Some inputs are kept constant
– This law does not apply in case all inputs are variable
• Does not apply in the case of factors used in fixed
proportions
11. Limitations of Law of DR
• Improved methods of Cultivation
– Scientific rotation of crops, improved seeds, better
irrigation facilities are bound to give increasing return
• New Soil
– Virgin soil gives more yield. Later the return will
diminish
• Insufficient Capital
– If less capital in the beginning then first yeild will
increase
– Beginning part is exception to the law
12. Why Law Applies to Agriculture?
• The agricultural operations are spread out
over a wide area
– Supervision cannot be effective
• Scope of use of specialized machinery is
limited
– Economies of large scale cannot be reaped
• Seasonal nature of the industry
– Interrupted by rain and climatic changes
13. Why this law operates?
• Wrong combination
– In the initial stages, the fixed factor is not fully used
since the units of variable factor are too few
• Hence, increase in variable factor is productive
– Then optimum combination
– Further, increase counter productive
• Scarcity of Factors
– The expansion of an industry, provided that additional
supplies of some agent in production, which is
essential cannot be obtained
• Imperfect Substitutes
– Factor of production are imperfect substitutes
14. Law of Increasing Returns
• An industry is subject to the law of increasing
returns if
– extra investment in the industry is followed by
more than proportionate returns e.g if the
marginal product increases
• These two laws of increasing and diminishing
returns can also be explained in terms of
optimum business unit
– Increasing returns when moving towards optimum
– Diminishing returns when moving beyond
optimum
15. Why Law of Increasing Returns
Operates?
• No scarcity of factors
– Law of diminishing returns operate when there is scarcity
of some factor. If there is no such scarcity then law of
increasing returns will operate
• Right Combination
– Law of diminishing returns operate when there is wrong
combination of factors of production when there is right
combination of the factors law of increasing returns will
apply
• Full use of Indivisible Factors
– Plant may be setup to meet the higher demand so
increasing returns when more utilization
16. Law of Constant Returns
• There can be a situation where neither law of
diminishing operates and nor law of increasing
rates operate
– Over there law of constant returns will operate
• An industry is subject to the law of constant
returns when,
– Whatever the output or scale of production, the
cost per unit remains unaltered, or
– increased investment of labour and capital results
in a proportionate increase in the output.
17. Returns to Scale
• Returns of scale is meant
– the behaviour of production or returns
– when all the productive factors are increased or
decreased simultanously
– in the same ratio
• The returns to scale of production may clearly be
distinguished from the law of variable
proportions
– In the law of variable proportions
• Some factors are variable atleast one is constant
– In returns to scale
• All the necessary factors of production are increased or
decreased to the same extent
• So that whatever the scale of production, the proportion
among the factors remains the same
18. Three Phases of Returns to Scale
• First Phase
– With increase in scale of production returns increase
more than increase in scale of production
• Second Phase
– Increase in returns proportionally increase with the
increase in scale of production
• Third Phase
– Increase in return is, proportionally, less than increase
in scale of production
