Principles of Economics PDF

# Principles of Economics ## The Tamilnadu Dr. Ambedkar Law University **Chennai - 600 028** - B.Com.LL.B - B.B.A.LL.B - B.C.A.LL.B ## Principles of Economics ### Lt.D.Jaisankar **Assistant Professor** **Department of Interdisciplinary Studies** **Tamil Nadu Dr. Ambedkar Law University** **Chennai...

# Principles of Economics ## The Tamilnadu Dr. Ambedkar Law University **Chennai - 600 028** - B.Com.LL.B - B.B.A.LL.B - B.C.A.LL.B ## Principles of Economics ### Lt.D.Jaisankar **Assistant Professor** **Department of Interdisciplinary Studies** **Tamil Nadu Dr. Ambedkar Law University** **Chennai** ## Message Knowledge is power. Legal Knowledge is a potential power. It can be exercised effectively everywhere. Of all the domains of reality, it is Legal Knowledge, which deals with rights and liabilities, commissions and omissions, etc., empower the holder of such knowledge to have prominence over the rest. Law Schools and Law Colleges that offer Legal Education vary in their stature on the basis of their ability in imparting the quality Legal Education to the students. Of all the Law Schools and Colleges, only those that educate their students to understand the nuances of law effectively and to facilitate them to think originally, excel. School of Excellence in Law aims to be in top of such institutions. The revolution in Information and Communication Technology dump lot of information in the virtual world. Some of the information are mischievous and dangerous. Some others are spoiling the young minds and eating away their time. Students are in puzzle and in dilemma to find out the right information and data. They do not know how to select the right from the wrong, so as to understand, internalise and assimilate into knowledge. Hence in the present scenario, the role of teachers gains much more importance in guiding the students to select the reliable, valid, relevant and suitable information from the most complicated, perplexed and unreliable data. The teachers of the School of Excellence in Law have made a maiden attempt select, compile and present a comprehensive book to guide the students in various subjects of law. The students can use such materials as guidance and travel further in their pursuit of legal knowledge. Guidance cannot be a complete source of information. It is a source that facilitates the students to search further source of information and enrich their knowledge. Read the materials, refer relevant text books and case laws and widen the knowledge. ### Dr.P.Vanangamudi **Vice-Chancellor** ## Preface Economics is a study of men as they live and move and think in the ordinary business of life. But it concerns itself chiefly with those motives which affect, most powerfully and most steadily, man's conduct in the business part of his life. Everyone who is worth anything carries his higher nature with him into business; and, there as elsewhere, he is influenced by his personal affections, by his conceptions of duty and his reverence for high ideals. And it is true that the best energies of the ablest inventors and organizers of improved methods and appliances are stimulated by a noble emula-tion more than by any love of wealth for its own sake. But, for all that, the steadiest motive to ordinary business work is the desire for the pay which is the material reward of work. The pay may be on its way to be spent selfishly or unselfishly, for noble or base ends; and here the variety of human nature comes into play. But the motive is supplied by a definite amount of money: and it is this definite and exact money measurement of the steadiest motives in business life, which has enabled economics far to outrun every other branch of the study of man. Just as the chemist's fine balance has made chemis-try more exact than most other physical sciences; so this economist's balance, rough and imperfect as it is, has made economics more exact than any other branch of social science. The basic objective of this course is to make the students to understand the various advance economic principles as well as their applications. In addition to that this course also enables the students to understand sectors specific and they are impact in shaping trends in economic indicators in India. ## Principles of Economics ### 5 YEAR B.B.A / B.C.A.LL.B (HONS.) COURSE ## Economics ## Unit-I: ## Micro Economic Concepts ## Meaning of Economics The word 'Economics' was derived from two Greek words, *oikos* (a house) and *nemein* (to manage) which would mean 'managing an household' using the limited funds available, in the most satisfactory man-ner possible. Economics is the science that deals with human wants and their satisfaction. It studies about man's efforts to make a living first, and then a better living. The central focus of economics is on scarcity of resources and choices among their alternative uses. The resources or inputs available to produce goods are limited or scarce. This scarcity induces people to make choices among alternatives, and the knowledge of economics is used to compare the alternatives for choosing the best among them. ## Subject Matter of Economics Two major factors are responsible for the emergence of economic problems. They are: i) the existence of unlimited human wants and ii) the scarcity of available resources. The numerous human wants are to be satisfied through the scarce resources available in nature. Economics deals with how the numerous human wants are to be satisfied with limited resources. Thus, the science of economics centre's on want - effort - satisfaction. ## Wants - Satisfaction ## Efforts - Economics not only covers the decision making behaviour of individuals but also the macro variables of economies like national income, public finance, international trade and so on. ## Definitions of Economics Several economists have defined economics taking different aspects into account. ## Wealth Definition Adam smith (1723 - 1790), in his book "An Inquiry into Nature and Causes of Wealth of Nations" (1776) defined economics as the science of wealth. He explained how a nation's wealth is created. He consid-ered that the individual in the society wants to promote only his own gain and in this, he is led by an "invisible hand" to promote the interests of the society though he has no real intention to promote the society's interests. ### Criticism: Smith defined economics only in terms of wealth and not in terms of human welfare. Ruskin and Carlyle condemned economics as a 'dismal science', as it taught selfishness which was against ethics. However, now, wealth is considered only to be a mean to end, the end being the human welfare. Hence, wealth definition was rejected and the emphasis was shifted from 'wealth' to 'welfare'. ## Welfare Definition Alfred Marshall (1842 - 1924) wrote a book "Principles of Economics” (1890) in which he defined "Political Economy" or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well being". The important features of Marshall's definition are as follows: ### According to Marshall, - economics is a study of mankind in the ordinary business of life, i.e., economic aspect of human life. - economics studies both individual and social actions aimed at promoting economic welfare of people. - Marshall makes a distinction between two types of things, viz. material things and immaterial things. - Material things are those that can be seen, felt and touched, (E.g.) book, rice etc. - Immaterial things are those that cannot be seen, felt and touched. (E.g.) skill in the operation of a thrasher, a tractor etc., cultivation of hybrid cotton variety and so on. In his definition, Marshall considered only the material things that are capable of promoting welfare of people. ### Criticism: a) Marshall considered only material things. But immaterial things, such as the services of a doctor, a teacher and so on, also promote welfare of the people. Marshall makes a distinction between (i) those things that are capable of promoting welfare of people and (ii) those things that are not capable of promoting welfare of people. But anything, (E.g.) liquor, that is not capable of promoting welfare but com-mands a price, comes under the purview of economics. Marshall's definition is based on the concept of welfare. But there is no clear-cut definition of welfare. The meaning of welfare varies from person to person, country to country and one period to another. However, generally, welfare means happiness or comfortable living conditions of an individual or group of people. The welfare of an individual or nation is dependent not only on the stock of wealth possessed but also on political, social and cultural activities of the nation. ## Scarcity Definition Lionel Robbins published a book "An Essay on the Nature and Significance of Economic Science" in 1932. According to him, "economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses". The major features of Robbins' definition are as follows: - Ends refer to human wants. Human beings have unlimited number of wants. - Resources or means, on the other hand, are limited or scarce in supply. There is scarcity of a commodity, if its demand is greater than its supply. - The scarce means are capable of having alternative uses. Hence, anyone will choose the resource that will satisfy his particular want. Thus, economics, according to Robbins, is a science of choice. ### Criticism: a) Robbins does not make any distinction between goods conducive to human welfare and goods that are not conducive to human welfare. In the production of rice and alcoholic drink, scarce resources are used. But the production of rice promotes human welfare while production of alcoholic drinks is not conducive to human welfare. However, Robbins concludes that economics is neutral between ends. In economics, we not only study the micro economic aspects like how resources are allocated and how price is determined, but we also study the macroeconomic aspect like how national income is generated. But, Robbins has reduced economics merely to theory of resource allocation. Robbins definition does not cover the theory of economic growth and development. ## Growth Definition Prof. Paul Samuelson defined economics as "the study of how men and society choose, with or without the use of money, to employ scarce productive resources which could have alternative uses, to produce vari-ous commodities over time, and distribute them for consumption, now and in the future among various people and groups of society". ### The major implications of this definition are as follows: - Samuelson has made his definition dynamic by including the element of time in it. Therefore, it covers the theory of economic growth. Samuelson stressed - The problem of scarcity of means in relation to unlimited ends. Not only the means are scarce, but they could also be put to alternative uses. - The definition covers various aspects like production, distribution and consumption. Of all the definitions discussed above, the 'growth' definition stated by Samuelson appears to be the most satisfactory. However, in modern economics, the subject matter of economics is divided into main parts, viz., i) Micro Economics and ii) Macro Economics. Economics is, therefore, rightly considered as the study of allocation of scarce resources (in relation to unlimited ends) and of determinants of income, output, employment and economic growth. ## Scope of Economics Scope means province or field of study. In discussing the scope of economics, we have to indicate whether it is a science or an art and a positive science or a normative science. It also covers the subject matter of economics. ### Economics is a science Science is a systematized body of knowledge that traces the relationship between cause and effect. Another attribute of science is that its phenomena should be amenable to measurement. Applying these characteris-tics, we find that economics is a branch of knowledge where the various facts relevant to it have been system-atically collected, classified and analyzed. Economics investigates the Possibility of deducing generalizations as regards the economic motives of human beings. The motives of individuals and business firms can be very easily measured in terms of money. Thus, economics is a science. ### Nature of Economics ### Positive and Normative Economics Economics is both positive and normative science. - **Positive science:** It only describes what it is and normative science prescribes what it ought to be. Positive science does not indicate what is good or what is bad to the society. It will simply provide results of economic analysis of a problem. - **Normative science:** It makes distinction between good and bad. It prescribes what should be done to promote human welfare. A positive statement is based on facts. A normative statement involves ethical values. ### Scope of Economics The study of economics divided into two.i.e., micro economics and macro economics. - **Microeconomics analyses** the economic behaviour of any particular decision making unit such as a household or a firm. Microeconomics studies the flow of economic resources or factors of produc-tion from the households or resource owners to business firms and flow of goods and services from business firms to households. It studies the behaviour of individual decision making unit with regard to fixation of price and output and its reactions to the changes in demand and supply conditions. Hence, microeconomics is also called price theory. - **Macroeconomics studies** the behaviour of the economic system as a whole or all the decision-making units put together. Macroeconomics deals with the behaviour of aggregates like total employment, gross national product (GNP), national income, general price level, etc. So, macroeconomics is also known as income theory. Microeconomics cannot give an idea of the functioning of the economy as a whole. Similarly, macro-economics ignores the individual's preference and welfare. What is true of a part or individual may not be true of the whole and what is true of the whole may not apply to the parts or individual decision- making units. By studying about a single small-farmer, generalization cannot be made about all small farmers, say in Tamil Nadu state. Similarly, the general nature of all small farmers in the state need not be true in case of a particular small farmer. Hence, the study of both micro and macroeconomics is essential to understand the whole system of economic activities ## Methods of Economic Analysis Economics as a science adopts two methods for the discovery of its laws and principles, viz., (1) deductive method and (2) inductive method. - **Deductive method:** Here, we descend from the general to particular, i.e., we start from certain principles that are self-evident or based on strict observations. Then, we carry them down as a process of pure reasoning to the consequences that they implicitly contain. For instance, traders earn profit in their busi-nesses is a general statement which is accepted even without verifying it with the traders. The deductive method is useful in analyzing complex economic phenomenon where cause and effect are inextricably mixed up. However, the deductive method is useful only if certain assumptions are valid. (Traders earn profit, if the demand for the commodity is more). - **Inductive method:** This method mounts up from particular to general, i.e., we begin with the observation of particular facts and then proceed with the help of reasoning founded on experience so as to formulate laws and theorems on the basis of observed facts. E.g. Data on consumption of poor, middle and rich income groups of people are collected, classified, analyzed and important conclusions are drawn out from the results. In deductive method, we start from certain principles that are either indisputable or based on strict observations and draw inferences about individual cases. In inductive method, a particular case is examined to establish a general or universal fact. Both deductive and inductive methods are useful in economic analysis ## Sub-Division of Economics - **Consumption:** The satisfaction of human wants through the use of goods and services is called consumption. - **Production:** Goods that satisfy human wants are viewed as "bundles of utility". Hence production would mean creation of utility or producing (or creating) things for satisfying human wants. For production the resources like land, labour, capital and organization are needed. - **Exchange:** Goods are produced not only for self-consumption, but also for sales. They are sold to buyers in markets. The process of buying and selling constitutes exchange. - **Distribution:** The production of any agricultural commodity requires four factors, viz., land labour, capital and organization. These four factors of production are to be rewarded for their services ren-dered in the process of production. The land owner gets rent, the labourer earns wage, the capitalist is given with interest and the entrepreneur is rewarded with profit. The process of determining rent, wage, interest and profit is called distribution. - **Public finance:** It studies how the government gets money and how it spends it. Thus, in public finance, we study about public revenue and public expenditure ## Basic Economic Problems America's first Nobel Prize winner for economics, the late Paul Samuelson is often credited with pro-viding the first clear and simple explanation of the economic problem - namely, that in order to solve the problem of scarcity all societies, no matter how big or small, developed or not, must endeavour to answer three basic question - What to Produce? - How to Produce? - For Whom to Produce? ## Law of Demand In economics, demand for a commodity refers to the desire backed by the necessary purchasing power. (Desire, decision, purchasing power of party). Marshall defined the law of demand thus, "the greater amount to be sold, the smaller must be the price at which it is offered in order that it may find purchasers". The inverse relationship between price and quantity demanded, when the price level increases at the same time the quantity of demanded also decreases. If the price level fall at the same time the quantity of demand also raise. If other thing remaining same. ## Functions of Demand: *Dx = f(Px,Ps, Y,T,W,Pp, Ve, We,) Where, - Dx = Demand for commodity - F = Function - Px = Price of commodity x - Ps = Price of substitute goods - Y = Income - T = Taste and preference - W = Wealth - Pp = Population - Ve = Veblen effect - We = Weather conditions ## Elasticity of Demand Elasticity of demand refers to the degree of responsiveness of change in quantity demanded and change in price. ### Types of Elasticity of Demand - (i) Price elasticity - (ii) Income elasticity - (iii) Cross elasticity ## Cardinal Utility Theory Utility means want satisfying power of a commodity. ### Cardinal Utility The exponents of marginal utility analysis regard utility to be a cardinal concept. In other words, they hold the view that utility is a measurable and quantifiable entity. According to them, a person can express the utility or satisfaction he derives from the goods in quantitative terms. ### Assumptions - Consumer is rational - Cardinal Measurability of Utility - Independent Utilities - Constancy of the Marginal Utility of Money - Introspective Method. ## Law of Cardinal Marginal Utility Analysis With the above basic premises, the founders of cardinal utility analysis have developed two laws which occupy an important place in economic theory and have several applications and uses. These two laws: - Law of Diminishing Marginal Utility and - Law of Equi-Marginal Utility. ## Critical Evaluation of Cardinal Marginal Utility Analysis - Hedonistic premises of utility analysis challenged - Cardinal measurability of utility is unrealistic - Hypothesis of independent utilities is wrong - Assumption of constant marginal utility of money is not valid - Marshallian demand theorem cannot genuinely be derived except in a one commodity case - Cardinal utility analysis does not split up the price effect into substitution and income effect - Marshall could not explain Giffen Paradox - Marshallian utility analysis assumes too much and explain little. ## Indifference curve Approach (Edgeworth) - Ordinal Measurement of Utility - Preference Hypothesis of Indifference Curve Approach - Week-ordering Preference Hypothesis ## Indifference Curve and Indifference Map The basic tool of Hicks-Allen ordinal analysis of demand is the indifference curve which represents all those combination of goods which give same satisfaction to the consumer. ## Assumptions of Nature of Consumer Preferences - Complete Ranking - Transitivity - Non-Satiation ## Indifference Curve Schedule and Map | Good X | Good Y | Good X | Good Y | |---|---|---|---| | 1 | 12 | 2 | 14 | | 2 | 8 | 3 | 10 | | 3 | 5 | 4 | 7 | | 4 | 3 | 5 | 5 | | 5 | 2 | 6 | 4 | A complete description of consumer's taste and preferences can be shown by an indifference map which consists of a set of indifference curves. ## Properties of Indifference Curve - Indifference curves slope downward to the right - Indifference curves are convex to the origin - Indifference curves cannot intersect each other - A higher Indifference curves represents a higher level of satisfaction than the lower Indifference curves. ## Application and Uses of Indifference Curve - Edgewoth Box Diagram ## Consumer's Equilibrium A consumer is said to be in equilibrium when he is buying such combination of goods as leaves him with no tendency to rearrange his purchases of goods. Consumer is assumed to be rational in the sense that he aims at maximizing his satisfaction. ### Assumption - The consumer has a given indifference map exhibiting his scal of preferences for various combinations of two goods, X and Y. - He has a fixed amount of money to spend on the two goods. H has ti spend whole of his given money on the two goods. - Prices of the goods are given and constant for him. He cannc influence the prices of the goods by buying more or less of them. - Goods are homogeneous and divisible. ## The Relationship Between Normal Goods and Giffen Good: Goods or items used by us are classified by economists based upon our behavior. If the consumption of a good increases when our income levels increase, it is said to be a normal good, on the other hand, if its consumption goes down, it is classified as an inferior good. This dichotomy is still not clear, so let us take a closer look through examples. In the normal course, one would expect consumption of goods to increase with increasing income lev-els. This is a positive correlation between quantity and income, and suggests an increase in demand when the income of an individual increases. A good is normal if the coefficient of elasticity of demand is positive and less than one. One example that reflects this phenomenon is the demand for luxury cars. Luxury cars are liked by everyone. But, as they are very expensive, they are bought, only when the income levels of an individual rises. However, there are circumstances when opposite of this tendency takes place. Demand of certain goods and service is negatively affected when income levels rise. For example, a person might be traveling through bus or other forms of public transport, but as soon as he buys his own motorcycle or car, he stops using public transport. In such a case, public transport is classified as an inferior good, though in reality it might not be so. The demand for such goods goes down with the increase in income. There is nothing to suggest that the quality of good is inferior, but the classification by economists is such that it makes people confused. A classic example of inferior goods is noodles that are prepared instantly. Though, there is nothing to suggest that noodles are of inferior quality, they are consumed less as income levels rise and are consumed mostly by students. However, there are goods that cannot be classified as either normal or inferior as their demand or use shows no appreciable change with the increase in income levels. Soap used in the bathroom or the dishwashing detergent in the kitchen do not get increased in quantity when income levels rise nor their use is lessened in any way. Thus, these types of goos are neither normal nor inferior. ## Consumer Surplus Consumer Surplus = Potential price-Actual price ## Unit-II: ## Theory of Supply and Market ### (A).Law of Supply and Theories of Production ## Law of Supply Supply is defined as how much of goods will be offered for sale at a given time andgive price level. There is positive relationship between price and quantity of supply. *Sx = f (Px, Ps, I, e, W, Gx, We, Te,) Where, - Sx = Supply of commodity - F = Function - Px = Price of commodity - Ps = Price of substitute goods - I = Investment - e = Rate of interest - Gx = Government taxation - We = Weather conditions - Te = Technology ## Actors of Production In traditional production theory resources used for the production of a product are known as factors of production. Factors of production are now termed as inputs which may mean the use of the services of land, labour, capital and organization in the process of production. The term output refers to the commodity produced by the various inputs. Production theory concerns itself with the problems of combining various inputs, given the state of technology, in order to produce a stipulated output. The technological relationships between inputs and out-puts are known as production functions. ## Production: Production in economic, terms is generally understood as the transformation of inputs into outputs. The inputs are what the firm buys, namely productive resources, and outputs are what it sells. Production is not the creation of matter but it is the creation of value. Production is also defined as producing goods which satisfy some human want. Production is a sequence of technical processes requiring either directly or indi-rectly the mental and physical skill of craftsman and consists of changing the shape, size and properties of materials and ultimately converting them into more useful articles. ## Methods of Production: There are three methods of production: - Unit production - Mass production - Batch production The unit production is otherwise known as job-order production. This type of production is used for things which cannot be produced on large scale, things of high artistic nature, i.e. production of exclusive goods. This is a method to meet the individual requirements of customers. This type of production requires lot of flexibility in operation. Mass production uses mechanical aids for material handling. This type of production requires specially planned layout, special purpose machines, jigs and fixtures, automatic machines, etc. Mass production is continuous production, i.e. it does not have any non-producing time. Batch production is generally adopted in medium size enterprises. It is a stage in-between unit produc-tion and mass production. It is bigger in scale than unit production while it is smaller than mass production. In this type of production, variety of products is manufactured in lots at regular interval. Therefore, this is known as batch production. The theory of production centres round the concept of production function which we explain now. ## Production Function The production function expresses a functional relationship between quantities of inputs and outputs. It shows how and to what extent output changes with variations in inputs during a specified period of time. In the words of Stigler, "The production function is the name given to the relationship between rates of input of productive services and the rate of output of product. It is the economist's summary of technical knowledge." Basically, the production function is a techno-logical or engineering concept which can be expressed in the form of a table, graph and equation showing the amount of output obtained from various combinations of inputs used in production, given the state of technol-ogy. Algebraically, it may be expressed in the form of an equation as *Q=f (L, M, N, Ê, T)............. (1)* where Q stands for the output of a good per unit of time, L for labour, M for management (or organisation), N for land (or natural resources), Ê for capital and T for given technology, and refers to the functional relationship. The production function with many inputs cannot be depicted on a diagram. Moreover, given the specific values of the various inputs, it becomes difficult to solve such a production function mathematically. Economists, therefore, use a two-input production function. If we take two inputs, labour and capital, the production function assumes the form *Q= f (L, K) ....(2)* The production function as determined by technical conditions of production is of two types: It may be rigid ox flexible. The former relates to the short run and the latter to the long - run. ## The Nature of Production Function: The production function depends upon the following factors: - The quantities of inputs to be used. - The state of technical knowledge. - The possible processes of production. - The size of the firm. - The prices of inputs. Now if these factors change the production function automatically changes. ## Attributes of Production Function: The following are the important attributes of production function: - The production function is a flow concept. - A production function is a technical relationship between inputs and outputs expressed in physical terms. - The production function of a firm depends on the state of technology and inputs. - From the economic point of view, a rational firm is interested not in all the numerous possible levels of output but only in that combination which yields maximum outputs. - The short run production function pertains to the given scale of production. The long run production function pertains to the changing scale of production. ## The Short-Run Production Function: In the short run, the technical conditions of production are rigid so that the various inputs used to produce a given output are in fixed proportions. However, in the short run, it is possible to increase the quantities of one input while keeping the quantities of other inputs constant in order to have more output. This aspect of the production function is known as the Law of Variable Proportions. The short-run production function in the case of two inputs, labour and capital, with capital as fixed and labour as the variable input can be expressed as *Q=f (L,K) where K refers to the fixed input. ... (3)* ## The Long-Run Production Function: In the long run, all inputs are variable. Production can be increased by changing one or more of the inputs. The firm can change its plants or scale of production. Equations (1) and (2) represent the long-run production function. Given the level of technology, a combination of the quantities of labour and capital produces a specified level of output. In the long run, it is possible for a firm to change all inputs up or down in accordance with its scale. This is known as returns to scale. The returns to scale are constant when output increases in the same proportion as the increase in the quantities of inputs. The returns to scale are increasing when the increase in output is more than proportional to the increase in inputs. They are decreasing if the increase in output is less than proportional to the increase in inputs. ## Thus a Production Function Is of Two Types: - **Linear homogeneous** of the first degree in which the output would change in exactly the same pro-portion as the change in inputs. Doubling the inputs would exactly double the output, and vice versa. Such a production function expresses constant returns to scale, - **Non-homogeneous production function** of a degree greater or less than one. The former relates to increasing returns to scale and the latter to decreasing returns to scale. ## Conclusion: The production function exhibits technological relationships between physical inputs and outputs and is thus said to belong to the domain of engineering. Prof. Stigler does not agree with this commonly held view. The function of management is to sort out the right type of combination of inputs for the quantity of output he desires. ## The Law of Variable Proportions: If one input is variable and all other inputs are fixed the firm's production function exhibits the law of variable proportions. If the number of units of a variable factor is increased, keeping other factors constant, how output changes is the concern of this law. Suppose land, plant and equipment are the fixed factors, and labour the variable factor. When the number of labourers is increased successively to have larger output, the proportion between fixed and variable factors is altered and the law of variable proportions sets in. The law states that as the quantity of a variable input is increased by equal doses keeping the quantities of other inputs constant, total product will increase, but after a point at a diminishing rate. ## This Principle Can Also Be Defined Thus: When more and more units of the variable factor are used, holding the quantities of fixed factors con-stant, a point is reached beyond which the marginal product, then the average and finally the total product will diminish. The law of variable proportions (or the law of non-proportional returns) is also known as the law of diminishing returns. But, as we shall see below, the law of diminishing returns is only one phase of the more comprehensive law of variable proportions. ### Assumption: The law of diminishing returns is based on the following assumptions: - Only one factor is variable while others are held constant. - All units of the variable factor are homogeneous. - There is no change in technology. - It is possible to vary the proportions in which different inputs are combined. - It assumes a short-run situation, for in the long-run all factors are variable. - The product is measured in physical units, i.e., in quintals, tonnes, etc. The use of money in measuring the product may show increasing rather than decreasing returns if the price of the product rises, even though the output might have declined. ### Explanation: Given these assumptions, let us illustrate the law with the help of Table, where on the fixed input land of 4 acres, units of the variable input labour are employed and the resultant output is obtained. The production function is revealed in the first two columns. The average product and marginal product columns are derived from the total product column. ## Table. 1: Output of Wheat in Physical Units (Quintals) | No of Workers | Total Product | Average Product | Marginal Product | |---|---|---|---| | 1 | 8 | 8 | 8 | | 2 | 20 | 10 | 12 | | 3 | 36 | 12 | 16 | | 4 | 48 | 12 | 12 | | 5 | 55 | 11 | 7 | | 6 | 60 | 10 | 5 | | 7 | 60 | 8.6 | 0 | | 8 | 56 | 7 | -4 | | | | | | | | Stage I | | | Stage II | | | Stage III | | | | | | The average product per worker is obtained by dividing column (2) by a corresponding unit in column (1). The marginal product is the addition to total product by employing an extra worker. 3 workers produce 36 units and 4 produce 48 units. Thus the marginal product is 12 i.e., (48-36) units. An analysis of the Table shows that the total, average and marginal products increase at first, reach a maximum and then start declining. The total product reaches its maximum when 7 units of labour are used and then it declines. The average product continues to rise till the 4th unit while the marginal product reaches its maximum at the 3rd unit of labour, then they also fall. It should be noted that the point of falling output is not the same for total, average and marginal product. The marginal product starts declining first, the average product following it and the total product is the last to fall. This observation points out that the tendency to diminishing returns is ultimately found in the three productivity concepts. The law of variable proportions is presented diagrammatically. The TP curve first rises at an increasing rate up to point A where its slope is the highest. From point A upwards, the total product increases at a dimin-ishing rate till it reaches its highest point Ñ and then it starts falling. ## Three Stages of Production: ### Stage-I: Increasing Returns: In stage I the average product reaches the maximum and equals the marginal product when 4 workers are employed. This stage is portrayed in the figure from the origin to point E where the MP curve reaches its maximum and the AP curve is still rising. In this stage, the TP curve also increases rapidly. Thus this stage relates to increasing returns. Here land is too much in relation to the workers employed. It is, therefore, profitable for a producer to increase more workers to produce more and more output. It becomes cheaper to produce the additional output. Consequently, it would be foolish to stop producing more in this stage. Thus the producer will always expand through this stage I. ### Causes of Increasing Returns: 1. The main reason for increasing returns in the first stage is that in the beginning the fixed factors are larger in quantity than the variable factor. When more units of the variable factor are applied to a fixed factor, the fixed factor is used more intensively and production increases rapidly. 2. In the beginning, the fixed factor cannot be put to the maximum use due to the non-applicability of sufficient units of the variable factor. But when units of the variable factor are applied in sufficient quantities division of labour and specialization lead to per unit increase in production and the law of increasing returns operates. 3. Another reason for increasing returns is that the fixed factors are indivisible which means that they must be used in a fixed minimum size. When more units of the variable factor are applied on such a fixed factor, production increases more than proportionately. This points towards the law of increasing returns. ### Stage-II: Diminishing Returns: It is the most important stage of production. Stage II starts when at point E where the MP curve intersect the AP curve which is at the maximum. Then both continue to decline with AP above MP and the TP curve begins to increase at a decreasing rate till it reaches point C. At this point the MP curve becomes negative when the TP curve begins to decline. Thus the total product increases at a diminishing rate and the average and marginal product decline. This is the only stage in which production is feasible and profitable because in this stage the marginal produc-tivity of labour, though positive, is diminishing but is non-negative. ### Stage-III: Negative Marginal Returns: Production cannot take place in stage III either. For in this stage, total product starts declining and the marginal product becomes negative. Here the workers are too many in relation to the available land, making it absolutely impossible to cultivate it. ## The Law of Returns to Scale: The law of returns to scale describes the relationship between outputs and scale of inputs in the long-run when all the inputs are increased in the same proportion. In the words of Prof. Roger Miller, "Returns to scale refer to the relationship between changes in output and proportionate changes in all factors of production. To meet a long-run change in demand, the firm increases its