The relationship between the inputs and the output in the process of production is clearly explained by the Laws of Returns or the Law of Variable Proportions. This law examines the production function with only one factor variable, keeping the quantities of other factors constant. The laws of returns comprise of three phases:
- The Law of Increasing Returns.
- The Law of Constant Returns.
- The Law of Diminishing Returns.
The Laws of Returns in Economics may be stated as follows:
“If in any process of production, the factors of production are so combined that if the varying quantity of one factor is combined with the fixed quantity of other factor (or factors), then there will be three tendencies about the additional output or marginal returns:
- Firstly, in the beginning, as more and more units of a variable factor are added to the units of a fixed factor, the additional output or Marginal Returns will go on increasing. Here we have the Law of Increasing Returns operating.
- Secondly, if still more units of variable factor inputs are added to the units of a fixed factor, the additional output or marginal returns will remain constant. The Law of Constant Returns begins to operate; and
- Finally, if still more units of variable factors are fed into the process of production, then the additional output or marginal returns begins to decline. Thus, eventually, we have the operation of the Law of Diminishing Returns.
We can best illustrate these three stages of Law of Returns with the help of a model. Let us assume that a farmer has a fixed size of land, say one acre, and that he now applies gradually doses of variable factor, say labor, in order to produce rice. We can now tabulate the results as follows:
Fixed input Land, (acres) | Variable Input (Units of Labor) | Total production of rice (Kg) | Average Product | Marginal Product | Returns |
1 | 1 | 40 | 40 | 40 | Increasing Returns |
1 | 2 | 95 | 47.5 | 55 | |
1 | 3 | 160 | 53.3 | 65 | |
1 | 4 | 230 | 57.5 | 70 | Constant Returns |
1 | 5 | 300 | 60 | 70 | |
1 | 6 | 360 | 60 | 60 | Diminishing Returns |
1 | 7 | 400 | 57.1 | 40 | |
1 | 8 | 410 | 51.25 | 10 | |
1 | 9 | 410 | 45.55 | 0 | Zero Returns |
1 | 10 | 400 | 40 | -10 | Negative Returns |
We can illustrate the relation between the variable inputs and the Marginal Returns graphically by plotting the units of inputs on X-axis and the Marginal Returns on Y-axis. Here too we may consider Samuelsonian Approach for plotting Marginal Returns on the graph, in which marginal returns can be viewed as occurring in the interval between the two successive units of inputs, e.g. Marginal Returns of 65 Kgs. cover the interval of labour units between 2 and 3 and would be graphically represented half-way between them; or we may confine ourselves to the schedule and plot points accordingly. (We need not enter into this controversy here, because ultimately both approaches are able to serve our purpose equally well.)
It is now clear that as more and more units of variable factors are added, the total returns will go on increasing, first at a faster rate, then at a diminishing rate; whereas the marginal returns will first increase, then remain constant and then will begin to decline. The Marginal Returns may even become zero and may even become negative; thus the total returns may even start declining.
In the initial stages, we experience the phase of Increasing Returns, because in the beginning, the quantity of fixed factor is abundant in relation to the quantity of variable factors. Hence, when more and more units of variable factors are added to the constant quantity of fixed factors, then the fixed factor is more efficiently utilized. This causes the output to increase at a rapid rate. Besides, generally those factors are taken as fixed which are “indivisible”. Indivisibility of a factor means that due to technological requirements, a minimum amount of it must be employed, irrespective of the size of output. Thus, as more units of variable factors are employed the indivisible fixed factor is then fully and effectively utilized so as to yield increasing returns. Besides, when more variable factors are introduced, then the greater is the scope for specialization and division of labor and hence greater the tendency towards Increasing Returns. However, ultimately we reach the stage when the Returns start diminishing. Once the point is reached at which the amount of the variable factor is sufficient to ensure the efficient utilization of the fixed factor, further increases in the variable factor will cause the marginal returns to decline, because now the fixed factor becomes inadequate relative to the variable factor. If the fixed factor was divisible neither increasing nor diminishing returns would have occurred. Thus, it is the “indivisibility” of the fixed factor which is responsible for the laws of variable proportions.
Mrs. Joan Robinson tries to point out that Diminishing Returns occur because the factors of production are imperfect substitutes for one another, viz. fixed factors are scarce and perfect substitutes for them are rare to come across. If perfect substitutes were available, then the paucity of the scarce factors in combining with variable factor would have been avoided.
When there are 9 laborers on our assumed plot of land, they start to get in one anothers way, Marginal Returns then become nil and thereafter they may even become negative and the total output may even begin to decline absolutely.
Although we have elaborated the Law of Diminishing Returns in case of agriculture, it needs to be stressed that this Hypothesis of Eventually Diminishing Returns is applicable not in the case of land alone, but is also equally applicable in case of any and every other process of production. It is equally applicable in case of industry, business, trading, etc.
It may, however, be noted that the Law of Diminishing Returns is based on the following assumptions and limitations:
- This law is based on the assumption that all the successive units of variable factors are homogeneous, i.e. every additional unit of labour is equally efficient. This is not necessarily so.
- The law also assumes that in case of extensive cultivation, we first cultivate the superior land and then the inferior.
- The law is based on the assumption that the technology and the techniques of production remain unaltered; but if better methods of production are used, the stage of diminishing returns can be postponed.