Unit – III

Producers Behaviour: Factors of Production – Law of

Variable Proportions – Law of Returns to Scale –
Economies and Diseconomies.

Factors of Production:
A factor of production may be defined as that good or
service which is required for production. A factor of
production is indispensable for production because
without it no production is possible. It is customary to
attribute the process of production to three factors, land,
labour and capital, to which we add organisation.
1. Land:
In economics, land as a factor of production does not
refer only to the surface of land but to all gifts of nature,
such as rivers, oceans, climate, mountains, fisheries,
mines, forests, etc.
In the words of Dr. Marshall “By land is meant
materials and forces which nature gives freely for
man’s aid, in land, water, in air, light and heat.” Land
is, thus, an important factor of production which helps in
the production of goods and services in one way or the
other.
2. Labour:
Labour refers to all mental and physical work
undertaken for some monetary reward. It includes the
services of a factory worker, a doctor, a teacher, a lawyer,
an engineer, an officer, etc. But labour does not include
any work done for leisure or which does not carry any
monetary reward.
A person painting for leisure, singing a song to
entertain his friends, or attending to his garden would not
be considered to have done any labour in the sense of
economics. On the other hand, if a person sells his
paintings, a singer sings a song for a film and a gardener
looks after a garden in payment for money, their services
are regarded as labour. Thus labour is essential for
production.
3. Capital:
Capital means all man-made resources. It comprises
all wealth other than land which is used for further
production of wealth. It includes tools, implements,
machinery, seeds, raw materials and means of transport
such as roads, railways, canals, etc.
In modern usage, capital not only refers to physical
capital but also to human capital which is the “process of
increasing knowledge, the skills and capacities of all
people of the country.” It is this human capital which is
regarded more important than physical capital in
production these days.
As pointed out by Prof. Galbraith, “We now get the
larger part of our industrial growth not from more capital
investment but from investment in men and
improvements brought about by improved men.”
4. Organisation:
Land, labour and capital are respectively natural,
human and material means of production No production is
possible without bringing together these three factors of
production and employing them in right proportions.
So there must be somebody to hire them from their
owners by paying rent wages and interest, and to decide
the quantities of each needed for production, This is
known as organisation. Organisation refers to the services
of an entrepreneur who controls, organises and manages
the policy of a firm innovates and undertakes all risks.

Law of Variable Proportions:

Law of Variable Proportions occupies an important
place in economic theory. This law is also known as Law
of Proportionality.
 Keeping other factors fixed, the law explains the
production function with one factor variable. In the short
run when output of a commodity is sought to be
increased, the law of variable proportions comes into
operation.
Therefore, when the number of one factor is
increased or decreased, while other factors are constant,
the proportion between the factors is altered. For instance,
there are two factors of production viz., land and labour.
Land is a fixed factor whereas labour is a variable
factor. Now, suppose we have a land measuring 5
hectares. We grow wheat on it with the help of variable
factor i.e., labour. Accordingly, the proportion between
land and labour will be 1: 5. If the number of laborers is
increased to 2, the new proportion between labour and
land will be 2: 5. Due to change in the proportion of
factors there will also emerge a change in total output at
different rates. This tendency in the theory of production
called the Law of Variable Proportion.
Definitions:
“As the proportion of the factor in a combination of
factors is increased after a point, first the marginal and
then the average product of that factor will diminish.”
Benham
 “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.” Samuelson
“The law of variable proportion states that if the
inputs of one resource is increased by equal increment per
unit of time while the inputs of other resources are held
constant, total output will increase, but beyond some point
the resulting output increases will become smaller and
smaller.” Leftwitch
Assumptions:
Law of variable proportions is based on following
assumptions:
(i) Constant Technology:
The state of technology is assumed to be given and
constant. If there is an improvement in technology the
production function will move upward.
(ii) Factor Proportions are Variable:
The law assumes that factor proportions are variable.
If factors of production are to be combined in a fixed
proportion, the law has no validity.
(iii) Homogeneous Factor Units:
 The units of variable factor are homogeneous. Each
unit is identical in quality and amount with every other
unit.
(iv) Short-Run:
The law operates in the short-run when it is not
possible to vary all factor inputs.
Explanation of the Law:
In order to understand the law of variable proportions
we take the example of agriculture. Suppose land and
labour are the only two factors of production.
By keeping land as a fixed factor, the production
of variable factor i.e., labour can be shown with the
help of the following table:
 From the table 1 it is clear that there are three stages
of the law of variable proportion. In the first stage average
production increases as there are more and more doses of
labour and capital employed with fixed factors (land). We
see that total product, average product, and marginal
product increases but average product and marginal
product increases up to 40 units. Later on, both start
decreasing because proportion of workers to land was
sufficient and land is not properly used. This is the end of
the first stage.
The second stage starts from where the first stage
ends or where AP=MP. In this stage, average product and
marginal product start falling. We should note that
marginal product falls at a faster rate than the average
product. Here, total product increases at a diminishing
rate. It is also maximum at 70 units of labour where
marginal product becomes zero while average product is
never zero or negative.
The third stage begins where second stage ends. This
starts from 8th unit. Here, marginal product is negative
and total product falls but average product is still positive.
At this stage, any additional dose leads to positive
nuisance because additional dose leads to negative
marginal product.
Graphic Presentation:
In fig. 1, on OX axis, we have measured number of
labourers while quantity of product is shown on OY axis.
TP is total product curve. Up to point ‘E’, total product is
increasing at increasing rate. Between points E and G it is
increasing at the decreasing rate. Here marginal product
has started falling. At point ‘G’ i.e., when 7 units of
labourers are employed, total product is maximum while,
marginal product is zero. Thereafter, it begins to diminish
corresponding to negative marginal product. In the lower
part of the figure MP is marginal product curve.
 Up to point ‘H’ marginal product increases. At point
‘H’, i.e., when 3 units of labourers are employed, it is
maximum. After that, marginal product begins to
decrease. Before point ‘I’ marginal product becomes zero
at point C and it turns negative. AP curve represents
average product. Before point ‘I’, average product is less
than marginal product. At point ‘I’ average product is
maximum. Up to point T, average product increases but
after that it starts to diminish.

Law of Returns to Scale

The law of returns to scale explains the proportional
change in output with respect to proportional change in
inputs.
In other words, the law of returns to scale states when
there are a proportionate change in the amounts of inputs,
the behavior of output also changes.
The degree of change in output varies with change in
the amount of inputs. For example, an output may change
by a large proportion, same proportion, or small
proportion with respect to change in input.
On the basis of these possibilities, law of returns can
be classified into three categories:
 i. Increasing returns to scale
ii. Constant returns to scale
iii. Diminishing returns to scale
1. Increasing Returns to Scale:
If the proportional change in the output of an
organization is greater than the proportional change in
inputs, the production is said to reflect increasing returns
to scale. For example, to produce a particular product, if
the quantity of inputs is doubled and the increase in
output is more than double, it is said to be an increasing
returns to scale. When there is an increase in the scale of
production, the average cost per unit produced is lower.
This is because at this stage an organization enjoys high
economies of scale.
 In Figure-13, a movement from a to b indicates that
the amount of input is doubled. Now, the combination of
inputs has reached to 2K+2L from 1K+1L. However, the
output has Increased from 10 to 25 (150% increase),
which is more than double. Similarly, when input changes
from 2K-H2L to 3K + 3L, then output changes from 25 to
50(100% increase), which is greater than change in input.
This shows increasing returns to scale.
2. Constant Returns to Scale:
The production is said to generate constant returns to
scale when the proportionate change in input is equal to
the proportionate change in output. For example, when
inputs are doubled, so output should also be doubled, then
it is a case of constant returns to scale.
 In Figure-14, when there is a movement from a to b,
it indicates that input is doubled. Now, when the
combination of inputs has reached to 2K+2L from IK+IL,
then the output has increased from 10 to 20.
Similarly, when input changes from 2Kt2L to 3K +
3L, then output changes from 20 to 30, which is equal to
the change in input. This shows constant returns to scale.
In constant returns to scale, inputs are divisible and
production function is homogeneous.
3. Diminishing Returns to Scale:
Diminishing returns to scale refers to a situation
when the proportionate change in output is less than the
proportionate change in input. For example, when capital
and labor is doubled but the output generated is less than
doubled, the returns to scale would be termed as
diminishing returns to scale.
 In Figure-15, when the combination of labor and
capital moves from point a to point b, it indicates that
input is doubled. At point a, the combination of input is
1k+1L and at point b, the combination becomes 2K+2L.
However, the output has increased from 10 to 18,
which is less than change in the amount of input.
Similarly, when input changes from 2K+2L to 3K + 3L,
then output changes from 18 to 24, which is less than
change in input. This shows the diminishing returns to
scale.
Diminishing returns to scale is due to diseconomies
of scale, which arises because of the managerial
inefficiency. Generally, managerial inefficiency takes
place in large-scale organizations. Another cause of
diminishing returns to scale is limited natural resources.
For example, a coal mining organization can increase the
number of mining plants, but cannot increase output due
to limited coal reserves.

Economies and Diseconomies of Scale

Economies of scale are defined as the cost
advantages that an organization can achieve by expanding
its production in the long run.
 In other words, these are the advantages of large
scale production of the organization. The cost advantages
are achieved in the form of lower average costs per unit.
It is a long term concept. Economies of scale are
achieved when there is an increase in the sales of an
organization. As a result, the savings of the organization
increases, which further enables the organization to obtain
raw materials in bulk. This helps the organization to enjoy
discounts. These benefits are called as economies of scale.
The economies of scale are divided in to internal
economies and external economies discussed as
follows:

I. Internal Economies:

Refer to real economies which arise from the

expansion of the plant size of the organization. These
economies arise from the growth of the organization
itself. The examples of internal economies of scale are as
follows:
a. Technical economies of scale:
Occur when organizations invest in the expensive and
advanced technology. This helps in lowering and
controlling the costs of production of organizations. These
economies are enjoyed because of the technical efficiency
gained by the organizations. The advanced technology
enables an organization to produce a large number of
goods in short time. Thus, production costs per unit falls
leading to economies of scale.
b. Marketing economies of scale:
Occur when large organizations spread their
marketing budget over the large output. The marketing
economies of scale are achieved in case of bulk buying,
branding, and advertising. For instance, large
organizations enjoy benefits on advertising costs as they
cover larger audience. On the other hand, small
organizations pay equal advertising expenses as large
organizations, but do not enjoy such benefits on
advertising costs.
c. Financial economies of scale:
Take place when large organizations borrow money
at lower rate of interest. These organizations have good
credibility in the market. Generally, banks prefer to grant
loans to those organizations that have strong foothold in
the market and have good repaying capacity.
d. Managerial economies of scale:
Occur when large organizations employ specialized
workers for performing different tasks. These workers are
experts in their fields and use their knowledge and
experience to maximize the profits of the organization.
For instance, in an organization, accounts and research
department are created and managed by experienced
individuals, SO that all costs and profits of the
organization can be estimated properly.
e. Commercial economies:
Refer to economies in which organizations enjoy
benefits of buying raw materials and selling of finished
goods at lower cost. Large organizations buy raw
materials in bulk; therefore, enjoy benefits in
transportation charges, easy credit from banks, and
prompt delivery of products to customers.
II. External Economies:
Occur outside the organization. These economies
occur within the industries which benefit organizations.
When an industry expands, organizations may benefit
from better transportation network, infrastructure, and
other facilities. This helps in decreasing the cost of an
organization.
Some of the examples of external economies of scale
are discussed as follows:
a. Economies of Concentration:
Refer to economies that arise from the availability of
skilled labor, better credit, and transportation facilities.
b. Economies of Information:
Imply advantages that are derived from publication
related to trade and business. The central research
institutions are the source of information for
organizations.
c. Economies of Disintegration:
Refer to the economies that arise when organizations
split their processes into different processes.
Diseconomies of scale occur when the long run
average costs of the organization increases. It may happen
when an organization grows excessively large. In other
words, the diseconomies of scale cause larger
organizations to produce goods and services at increased
costs.
There are two types of diseconomies of scale, namely,
internal diseconomies and external diseconomies,
discussed as follows:
I. Internal diseconomies of scale:
Refer to diseconomies that raise the cost of
production of an organization. The main factors that
influence the cost of production of an organization
include the lack of decision, supervision, and technical
difficulties.
II. External diseconomies of scale:
Refer to diseconomies that limit the expansion of an
organization or industry. The factors that act as restraint
to expansion include increased cost of production,
scarcity of raw materials, and low supply of skilled
laborer.
There are a number of causes for diseconomies of
scale.
Some of the causes which lead to diseconomies of
scale are as follows:
I. Poor Communication:
Act as a major reason for diseconomies of scale. If
production goals and objectives of an organization are not
properly communicated to employees within the
organization, it may lead to overproduction or production.
This may lead to diseconomies of scale.
Apart from this, if the communication process of the
organization is not strong then the employees would not
get adequate feedback. As a result, there would be less
face-to-face interaction among employees- thus the
production process would be affected.
II. Lack of Motivation:
 Leads to fall in productivity levels. In case of a large
organization, workers may feel isolated and are less
appreciated for their work, thus their motivation
diminishes. Due to poor communication network, it is
harder for employers to interact with the employees and
build a sense of belongingness. This leads to fall in the
productivity levels of output owing to lack of motivation.
This further leads to increase in costs of the organization.
III. Loss of Control:
Acts as the main problem of large organizations.
Monitoring and controlling the work of every employee in
a large organization becomes impossible and costly. It is
harder to make out that all the employees of an
organization are working towards the same goal. It
becomes difficult for managers to supervise the sub-
ordinates in large organizations.
IV. Cannibalization:
Implies a situation when an organization faces
competition from its own product. A small organization
faces competition from products of other organizations,
whereas sometimes large organizations find that their own
products are competing with each other.